Economics Chapter 6 Homework I emphasize the advantages of using different models to

123

CHAPTER 6

The Open Economy

Notes to the Instructor

Chapter Summary

This chapter introduces a simple model of a small open economy in the long run. The main aims

of the chapter are as follows:

2. To provide a simple model of international flows of capital and goods, emphasizing that

these ultimately depend upon the determinants of saving and investment.

4. To explain the determination of the nominal exchange rate.

Comments

Students are interested in the open economy; this chapter provides them with the tools to think

about open economy issues. I emphasize the fact that we can figure out the trade balance before

we introduce the exchange rate into the analysis. This is often surprising to students. The chapter

questions and explain that the large open economy represents some kind of average of a small

open economy and a large closed economy. I note that we can combine the two models to obtain

a more complicated model that does apply more directly to the United States. Time permitting, it

is worth going through the large open economy case to drive home the point that we are not

misled by combining the conclusions from the closed economy and small open economy cases.

Use of the Web Site

As a hard but worthwhile exercise, students could be asked to combine the models of Chapters 3

and 6 to understand the large open economy. A good starting point is to suppose that the United

States is half the world economy and to think about Chapter 3 as a model of the world economy.

Now suppose, for example, that government spending is increased by $200 billion. This is like

an increase of $100 billion in the world economy. The Chapter 3 model can be used to figure out

124 | CHAPTER 6 The Open Economy

Use of the Dismal Scientist Web Site

Go to the Dismal Scientist Web site and download annual data since 1973 for the U.S. dollar

exchange rate against the Japanese yen, the British pound, and the Canadian dollar. Now,

download data on the Consumer Price Index (CPI) for the United States, Japan, United

Kingdom, and Canada. Compute real exchange rates by multiplying the foreign currency price

of a dollar by the CPI for the United States and then dividing by the CPI of the respective

country. Discuss how the real exchange rates have changed over time. Some economists argue

Chapter Supplements

This chapter includes the following supplements:

6-1 The Terminology of Trade

6-3 The Open Economy in the Very Long Run

6-5 The Exchange Rate and the Inflation Rate (Case Study)

6-7 Purchasing–Power Parity and Real Exchange Rates

6-8 More on the Big Mac and PPP (Case Study)

Lecture Notes | 125

!Table 6-1

!Figure 6-1

Lecture Notes

Introduction

We now have a nearly complete picture of the macroeconomy in the long run. Output is

determined by capital, labor, and technology. The price level depends on the money supply, and

the inflation rate is determined by the growth rate of the money supply. We have explained the

long–run determination of several of the variables that interest macroeconomists, and we have

The first and most important point is that virtually all economies are integrated into a

larger world economy. Economies do not exist in isolation but have extensive trading relations

with the rest of the world. Economies that trade with other economies are called open

economies. In the United States in 2010, for example, exports were $1,840 billion and imports

were $2,357 billion (13 percent and 16 percent of GDP, respectively). In other countries,

international trade is even more important.

6-1 The International Flows of Capital and Goods

The Role of Net Exports

In an open economy, we have to revise our basic national income identity to read

Y = C + I + G + NX,

where NX = net exports = exports minus imports. Net exports is the difference between

output (Y) and domestic spending (C + I + G). Remember that this equation is the equilibrium

citizens of other countries and so are a source of demand not included in domestic spending.

International Capital Flows and the Trade Balance

Our analysis of the closed economy emphasized that saving equals investment. The same is true

in the open economy if we expand our definition of saving to include saving by other countries.

Starting from

Y = C + I + G + NX

126 | CHAPTER 6 The Open Economy

finance the difference and we refer to this as negative net capital outflow.

Thus, the national income accounts identity illustrates how the international flow of funds

to finance capital accumulation and international trade in goods and services are two ways of

looking at the same question. When saving is greater than needed to finance investment, we lend

the excess to foreigners. Foreigners use this loan to purchase more goods and services from us

International Flows of Goods and Capital: An Example

Net exports must always equal net capital outflow because this relationship is an identity. The

intuition behind this relationship involves tracing out the movement of money in a series of

transactions. The example in the textbook involves Bill Gates selling a copy of the Windows

operating system to Japan and considers the set of transactions that Mr. Gates could make with

the proceeds of the sale that must always satisfy the identity.

FYI: The Irrelevance of Bilateral Trade Balances

6-2 Saving and Investment in a Small Open Economy

Capital Mobility and the World Interest Rate

When analyzing an open economy, we obviously can no longer restrict our attention to domestic

variables. In particular, world interest rates become central to the analysis, raising the issue of

whether or not such variables are independent of what goes on in the domestic economy. If we

are analyzing the economy of, say, Iceland, it is probably reasonable to suppose that changes in

the Icelandic economy have a negligible effect on world interest rates. Such an economy is

referred to as a small open economy. It is less evident that this is an appropriate assumption for a

large open economy like the United States. Nonetheless, we first consider the behavior of a

small open economy and later show that the appropriate analysis for a large open economy lies

somewhere between the small open economy model and the closed economy model that we have

already considered.

Lecture Notes | 127

!Figure 6-3

!Figure 6-4

Why Assume a Small Open Economy?

We use the assumption of a small open economy to simplify the analysis. Our intent is to build a

basic model that captures the most important features of the economy while ignoring additional

complications. For some countries, this assumption is more likely to be realistic than others. In

The Model

Apart from the assumption that r = r*, the model closely resembles our earlier analysis. As

before, we will let Y =

Y

, C = C(Y – T), and I = I(r) and take government policy (G and T) as

exogenous. The classical model presented in Chapter 3 showed that saving is then also

exogenous (

S

). The level of investment is determined simply by the investment function given

the world interest rate [I(r*)]. Combining these with the accounting identity that sets net exports

equal to net capital outflow, we obtain

How Policies Influence the Trade Balance

This model permits easy analysis of the effects of fiscal policy in an open economy. If the

government increases spending or cuts taxes, then, just as in the closed economy model, national

saving falls. If the economy starts in a position of trade balance (NX = 0), then the consequence

is a trade deficit and negative net capital outflow since there is now insufficient domestic saving

to finance domestic investment.

We might also be interested in the consequences of changes in the fiscal policies of other

countries. To understand these, we must go back to our closed economy analysis. Since we are

considering an economy that is negligible in world markets, we can view the rest of the world as

a closed economy, which means that if there is an increase in spending by the rest of the world,

Evaluating Economic Policy

Trade deficits arise when there is insufficient domestic saving to finance domestic investment.

Low levels of saving in an economy are analogous to low levels of saving by an individual; they

imply that consumption in the present is high at the expense of consumption in the future. In a

closed economy, low levels of saving result ultimately in a low capital stock, as shown by the

S

128 | CHAPTER 6 The Open Economy

!Figure 6-6

!Figure 6-7

!Supplement 6–4,

“Tourism and the

Case Study: The U.S. Trade Deficit

The small open economy model can help us understand the evolution of the U.S. trade deficit

during the 1980s, 1990s, and early 2000s. By using the identity that net exports equal the

difference between saving and investment, we can analyze the combination of movements in

saving and investment that gave rise to the trade deficit during this period. In the 1980s, the

deficit increased sharply at the same time that national saving declined due to the rise in the

federal budget deficit. This emergence of simultaneous deficits in both trade flows and the

government budget has been referred to as the twin deficits. After falling sharply at the start of

Case Study: Why Doesn’t Capital Flow to Poor Countries?

The U.S. trade deficit is financed by the flow of capital into the United States from foreign

countries. But many of the countries with trade surpluses are much poorer than the United

States, and so one would expect that they would be borrowers rather than lenders. Furthermore,

if capital is scarce in poor countries, then the marginal product of capital should be high,

compared to rich countries where capital is abundant. One would expect that a high marginal

product of capital in poor countries would attract capital inflows.

6-3 Exchange Rates

Our next task is to explain the exchange rate. Here, it is important to be clear on definitions.

Nominal and Real Exchange Rates

The nominal exchange rate (e) denotes the amount of foreign currency that can be bought with

$1. Equivalently, it is the price of a dollar in terms of foreign currency. The value of e is

determined in a market—the market for foreign exchange. Note that since the nominal exchange

!Figure 6-8

!Figure 6–10

!Figure 6-9

!Figure 6–11

the monetary authorities fix the value of e by standing ready to buy and sell dollars at that rate.

Managed floating is somewhere between the two. The U.S. dollar is currently floating, though

the U.S. monetary authorities do sometimes intervene in foreign exchange markets, buying and

selling the dollar in attempts to influence its value. We return to fixed exchange rates in Chapter

13; for the present, we restrict our attention to floating exchange rates.

cheap and domestic goods are relatively expensive. The opposite is true when the real exchange

rate is low.

The Real Exchange Rate and the Trade Balance

Net exports depend upon the real exchange rate. If the dollar is more valuable, imports are

The Determinants of the Real Exchange Rate

The real exchange rate adjusts to ensure that net exports equal the difference between domestic

saving and domestic investment (net capital outflow). We know that

NX(ε) =

S

S – I(r*).

Since S is fixed at

S

and r is fixed at r*, then ε must adjust to ensure balance.

We noted earlier that the exchange rate is ultimately determined in the market for foreign

exchange. When we export to foreigners, they need to acquire U.S. dollars to purchase our

goods. When we wish to import goods, we sell dollars to get other currencies. If we export more

How Policies Influence the Real Exchange Rate

Earlier, we looked at the effects of various policies on net exports and net capital outflow. We

can now consider how those policies affect the exchange rate. First, consider an expansionary

fiscal policy, which reduces national saving. This reduces net capital outflow, thus reducing the

supply of dollars and causing an appreciation of the exchange rate.

Fiscal expansions abroad, as discussed earlier, increase the world interest rate and so

reduce investment at home. This increases the supply of dollars, leading to a depreciation of the

exchange rate. Conversely, an exogenous increase in domestic investment demand (perhaps due

to domestic policies to stimulate investment) reduces net capital outflow, reduces the supply of

dollars, and appreciates the exchange rate.

130 | CHAPTER 6 The Open Economy

!Figure 6–13

!Supplement 6–5

“The Exchange

Rate and the

Inflation Rate”

The Effects of Trade Policies

There is often discussion in the news of trade policies—that is, policies directly targeted at the

trade balance. These principally take the form of tariffs (taxes on imports) or quotas (restrictions

on the quantity of imports). Perhaps surprisingly, protectionist policies of this sort are not

successful because they simply cause appreciation of the exchange rate without affecting the

The Determinants of the Nominal Exchange Rate

After considering the determinants of the real exchange rate, our next step is to think about the

nominal exchange rate. We know that

ε = eP/P*.

By now we are familiar enough with growth rates to move straight from this equation to

∆ε/ε = ∆e/e + π – π*,

Case Study: Inflation and Nominal Exchange Rates

The relationship between inflation and nominal exchange rates is evident in the data. Countries

with very high rates of inflation experience massive depreciation of their exchange rate. The

relationship is also visible for countries experiencing more moderate inflation rates.

The Special Case of Purchasing–Power Parity

From the equation

∆e/e = ∆ε/ε + (π* – π),

we can see that if the real exchange rate never changed, then movements in the nominal

exchange rate would be explained solely by differences in inflation rates. One particular and

simple theory of the exchange rate, called purchasing–power parity (PPP), suggests that the real

exchange rate should be constant through time. The argument is that the nominal exchange rate

should always adjust so that goods cost the same in different countries because, otherwise,

arbitrage could take place. For example, suppose that pizzas are cheaper in the United States

than in Canada. Then, an arbitrageur could buy pizza in the United States, ship it across the

Lecture Notes | 131

!Table 6-2

!Supplement 6–8

“More on the Big

!Figure 6–15

!Figure 6–16

!Figure 6–18

!Figure 6–19

appreciated sharply. This appreciation was not a response to changes in purchasing power. PPP

is still useful, however, because it offers some guide to the long–run value of the exchange rate.

Over the long run, the real exchange rate differs from its PPP value to only a limited extent.

Case Study: The Big Mac Around the World

The Economist news magazine collected data on the price of a McDonald’s hamburger around

6-4 Conclusion: The United States as a Large Open Economy

Finally, what about the fact that the U.S. economy is not actually a small open economy but

instead a large economy whose actions affect world financial markets? As might be expected,

the appropriate analysis for the U.S. economy turns out to be a mixture of the two special cases

of the small open economy and the large closed economy. This is an example of how an

understanding of reality is sometimes easier in terms of two “unrealistic” models rather than one

more realistic model. The appendix details the working of the more complicated large open

economy model.

Appendix: The Large Open Economy

Net Capital Outflow

To think about the large open economy, we work with two basic equations:

CF(r) = S – I(r)

and

NX(ε) = CF(r),

where CF(r) is net capital outflow. The closed economy analysis sets NX = 0, implying that CF

= 0, and leaves us with an equation to determine r, S = I(r). This is the model of Chapter 3. The

small open economy sets r = r* and says that net capital outflow can take on any value at r*;

funds flow freely into and out of the country, with no effect on the world interest rate. This

means that we can substitute to get an equation determining ε : NX(ε ) = I(r*) – S. The large

open economy is between the two.

Policies in the Large Open Economy

We analyze the large open economy by considering the loanable–funds market, the CF schedule,

and the foreign exchange market.

132 | CHAPTER 6 The Open Economy

!Figure 6–20

!Figure 6–21

A fiscal expansion reduces saving in the world loanable–funds market, increasing the

world interest rate. At a higher interest rate, we wish to carry out less investment, both at home

and abroad. The decrease in net capital outflow reduces the supply of dollars and so causes the

exchange rate to appreciate. The trade balance falls.

An increase in domestic investment demand also pushes up the world interest rate, so net

capital outflow falls. Again, there is an appreciation of the exchange rate and a decline in net

!Figure 6–23

LECTURE SUPPLEMENT

6-1 The Terminology of Trade

In discussing the international flows of goods, services, and capital, we have made some important

simplifications. We have used the terms “net exports” and “trade balance” interchangeably, although in

practice these terms sometimes differ slightly in meaning. More importantly, we have also shown how the

simple income identity requires that net exports equal net capital outflow, although in practice this is not

precisely correct. These simplifications helped us highlight the important features of the analysis without

bringing in too much detail. This supplement provides some additional background on concepts relating to

the international flow of goods, services, and capital.

Another simplification we have made is to equate net exports with net capital outflow. Because

residents of a country may earn interest on assets held abroad and/or earn wages from working abroad,

national income may differ from GDP. In addition, because residents of a country may give gifts to and/or

receive gifts from foreigners, their income again may differ from GDP. These net factor payments and net

foreign transfer payments are important in measuring domestic saving and thus in measuring the

difference between domestic saving and domestic investment. Since the difference between domestic

saving and domestic investment equals net capital outflow, these payment flows have implications for the

S – I = NX + Net Factor Payments + Net Foreign Transfers

or

Net Capital Outflow = Current Account.

The modified identity thus relates a broader measure of trade flows—known as the current account—

to net capital outflow.

One final term sometimes used in place of net capital outflow is the capital account. When we