The classical model of the SMALL

OPEN economy

Open Economy Macroeconomics

Dr hab. Joanna Siwińska-Gorzelak

slide 1

Overview

This lecture is based on the chapter „The Open

Economy” from G. Mankiw „Macroeconomics”

This lecture reviews

accounting identities for the open economy

the small open economy model

what makes it “small”

how the trade balance and exchange rate are

determined

how policies affect trade balance & exchange

rate

slide 2

Why learn this?

To understand:

what trade surpluses and trade deficits are.

the link between the trade balance and net capital

outflow or net lending to/borrowing from abroad

why countries have huge trade deficits?

what can the government do about this?

slide 3

In an open economy,

spending need not equal output

saving need not equal investment

slide 4

Preliminaries

EX = exports =

foreign spending on domestic goods

IM = imports = C f + I f + G f

= spending on foreign goods

NX = net exports (a.k.a. the “trade balance”)

= EX – IM

d fC C C

d fI I I

d fG G G

superscripts:

d = spending on

domestic goods

f = spending on

foreign goods

slide 5

GDP = expenditure on

domestically produced g & s

d d dY C I G EX

( ) ( ) ( )f f fC C I I G G EX

( )f f fC I G EX C I G

C I G EX IM

C I G NX

slide 6

The national income identity

in an open economy

Y = C + I + G + NX

or, NX = Y – (C + I + G )

net exports

domestic

spending

output

slide 7

Trade surpluses and deficits

trade surplus:

output > spending and exports > imports

Size of the trade surplus = NX

trade deficit:

spending > output and imports > exports

Size of the trade deficit = –NX

NX = EX – IM = Y – (C + I + G )

slide 8

International capital flows

Net capital outflow

= S – I

= net (out)flow of “loanable funds”

= net purchases of foreign assets the country’s purchases of foreign assets

minus foreign purchases of domestic assets

When S > I, country is a net lender (funds flow

out)

When S < I, country is a net borrower (funds flow

in)

slide 9

The link between trade & cap. flows

NX = Y – (C + I + G )

implies

NX = (Y – C – G ) – I

= S – I

trade balance = net capital outflow

Thus,

a country with a trade deficit (NX < 0)

is a net borrower (S < I ).

slide 10

Classical model of small open

economy

An open-economy version of the classical

model of the closed economy:

Includes many of the same elements:

production function

consumption function

investment function

exogenous policy variables

assume fully flexible prices (!)

Y Y F K L ( , )

C C Y T ( )

I I r ( )

G G T T ,

slide 11

Classical model of SOP

Assumptions: fully flexible prices; production

always equal to potential output, economy is

small, capital is perfectly mobile across countries

This is a long run model (!), not suitable to

analyse short-term shocks and fluctuations

slide 12

National saving: The supply of loanable funds

r

S, I

Assumption:

national saving does

not depend on the

interest rate

( )S Y C Y T G

S

slide 13 slide 13

Recall: types of saving

private saving = (Y –T ) – C

public saving = T – G

national saving, S

= private saving + public saving

= (Y –T ) – C + T – G

= Y – C – G

slide 14

Investment

Recall from your macro course:

Profit max. implies MPK = user cost

User cost in its simplest form is:

uc=(r+d)

Hence, ceteris paribus, as r falls, the DESIRED

level of capital stock increases, hence

investment increases

slide 15

Investment:

The demand for loanable funds

Investment is still a

downward-sloping function

of the interest rate,

r *

but the exogenous

world interest rate…

…is one of the

several factors that

determines the

country’s level of

investment.

I (r* )

r

S, I

I (r )

slide 16

If the economy were closed…

r

S, I

I (r )

S

rc

cI

S

r

( )

…the interest

rate would

adjust to

equate

investment

and saving:

slide 17

Assumptions: Capital flows

a. domestic & foreign bonds are perfect substitutes

(same risk, maturity, etc.);

b. perfect capital mobility:

no restrictions on international trade in assets

c. economy is small:

cannot affect the world interest rate, denoted r*

a & b imply r = r*

c implies r* is exogenous

slide 18

But in a small open economy…

r

S, I

I (r )

S

rc

r*

I 1

the exogenous

world interest

rate determines

investment…

…and the

difference

between saving

and investment

determines net

capital (out)flow

and net exports

NX

slide 19 CHAPTER 5 The Open Economy

slide 20

A small open economy that lends abroad, with

saving dependent on the interest rate

slide 21

A small open economy that borrows from

abroad, with saving that depends on the

interest rate

slide 22

Saving and Investment in a Small

Open Economy

Result: rw may be such that Sd > Id, Sd = Id, or Sd < Id

If Sd > Id, the excess of desired saving over desired

investment is lent internationally

(net foreign lending is positive) and NX > 0

If Sd = Id, there is no net foreign lending and

NX = 0

If Sd < Id, the excess of desired investment

over desired saving is financed by borrowing

internationally (net foreign lending is negative) and

NX < 0

slide 23

Next, three experiments:

1. Fiscal policy at home

2. Fiscal policy abroad

3. An increase in investment demand

slide 24

1. Fiscal policy at home

r

S, I

I (r )

1S

I 1

An increase in G

or decrease in T

reduces saving. 1

*r

NX1

2S

NX2

Results:

0I

0NX S

slide 25

Recall that national saving is a sum of

government saving and private saving

The previous slide assumed that the change in

fiscal policy will not affect private savings

However, recall Ricardian Equivalence that

holds that a change in public saving will be offset

by the change in private saving

1. Fiscal policy at home

slide 26

The Ricardian view

due to David Ricardo (1820),

more recently advanced by Robert Barro

According to Ricardian equivalence,

a debt-financed tax cut has no effect on

consumption, national saving, net exports, or

real GDP, even in the short run.

slide 27

The logic of Ricardian Equivalence

Consumers are forward-looking,

know that a debt-financed tax cut today

implies an increase in future taxes

that is equal – in present value – to the tax cut.

The tax cut does not make consumers better off,

so they do not increase consumption spending.

Instead, they save the full tax cut in order to repay

the future tax liability.

Result: Private saving rises by the amount

public saving falls, leaving national saving

unchanged.

slide 28

2. Fiscal policy abroad

r

S, I

I (r )

1SExpansionary

fiscal policy

abroad raises

the world

interest rate. 1

*rNX1

NX2

Results:

0I

0NX I

2

*r

1( )*I r2( )*I r

slide 29

3. An increase in investment demand

r

S, I

I (r )1

EXERCISE:

Use the model to

determine the impact

of an increase in

investment demand

on NX, S, I, and

net capital outflow.

NX1

*r

I 1

S

slide 30

3. An increase in investment demand

r

S, I

I (r )1

ANSWERS:

I > 0,

S = 0,

net capital

outflow and

NX fall by the

amount I

NX2

NX1

*r

I 1 I 2

S

I (r )2

slide 31

The nominal exchange rate

e = nominal exchange rate,

the relative price of

foreign currency in terms of

domestic currency OR domestic

currency

in terms of foreign currency

slide 32

The real exchange rate is the price level adjusted exchange

rate. Its meant to capture the relative value of goods and

services across countries

P

PeRER

*

Nominal Exchange Rate

(DOMESTIC currency to

FOREIGN currency) Domestic price

Foreign price

one good: Big Mac

price in PL:

P = 10 PLN

price in USA:

P* = $4.00

nominal exchange rate

e = 4 PLN/$ To buy a U.S. Big Mac,

someone from PL

would have to pay an

amount that could buy

1.6 Polish Big Macs.

~ McZample ~

slide 33

6,110

16

10

4*4*

PLN

PLN

PLN

USDUSD

PLN

P

eP

slide 34

ε in the real world & our model

In the real world:

We can think of ε as the relative price of

a basket of domestic goods in terms of a

basket of foreign goods

In our macro model:

There’s just one good, “output.”

So ε is the relative price of one country’s

output in terms of the other country’s output

slide 35

How NX depends on ε

ε Home goods become LESS expensive

relative to foreign goods

IM, EX

NX INCREASES

slide 36

The net exports function

The net exports function reflects this positive

relationship between NX and ε :

NX = NX(ε )

slide 37

The NX curve for Home.

0 NX

ε

NX (ε)

ε1

When ε is

relatively high,

Home goods are

relatively

inexpensive

NX(ε1)

so Home

net exports

will

be high

slide 38

How ε is determined

The accounting identity says NX = S – I

We saw earlier how S – I is determined:

S depends on domestic factors (output, fiscal

policy variables, etc)

I is determined by the world interest

rate r *

So, ε must adjust to ensure

( ) ( )*NX ε S I r

slide 39

How ε is determined

Neither S nor I

depend on ε,

so the net capital

outflow curve is

vertical.

ε

NX

NX(ε )

1 ( *)S I r

ε adjusts to

equate NX

with net capital

outflow, S I.

ε 1

NX 1

slide 40

Interpretation: Supply and demand in the foreign exchange market

Demand (NX):

Demand for home

currency to buy

home’s net exports.

ε

NX

NX(ε )

1 ( *)S I r

Supply:

Net capital flow (S

I )

is the supply of

home currency

offered to buy

Foreign’s assets.

ε 1

NX 1

slide 41

Next, four experiments:

1. Fiscal policy at home

2. Fiscal policy abroad

3. An increase in investment demand

4. Trade policy to restrict imports

slide 42

1. Fiscal policy at home

A fiscal expansion

reduces national

saving, increases

net capital inflow,

and the supply of

home currency

in the foreign

exchange market…

…causing the real exchange

rate to appreciate and NX to

decline (i.e. trade DEFICT to

increase)

ε

NX

NX(ε )

1 ( *)S I r

ε 1

NX 1 NX 2

2 ( *)S I r

ε 2

slide 43

2. Fiscal policy abroad

An increase in r*

reduces

investment,

increasing net

capital outflow and

the supply of home

currency in the

foreign exchange

market…

…causing the real

exchange rate to

depreciate and NX to

rise.

ε

NX

NX(ε )

1 1( *)S I r

NX 1

ε 1

21 ( )*S I r

ε 2

NX 2

slide 44

3. Increase in investment demand

An increase in

investment demand

decreases net

capital outflow and

the supply

of home currency in

the foreign

exchange market…

ε

NX

NX(ε ) …causing the real

exchange rate to

appreciate and NX

to fall.

ε 1

1 1S I

NX 1

21S I

NX 2

ε 2

slide 45

4. Trade policy to restrict imports

ε

NX

NX (ε )1

S I

NX1

ε 2

NX (ε )2

At any given value of

ε, an import quota

IM NX

increases the

demand for

home currency

Trade policy doesn’t

affect S or I , so

capital flows and the

demand for currency

remains fixed.

ε 1

slide 46

4. Trade policy to restrict imports

ε

NX

NX (ε )1 S I

NX1

ε 2

NX (ε )2

Results:

ε < 0

(demand

increase)

NX = 0

(supply fixed)

IM < 0

(policy)

EX < 0

(decrease in ε

)

ε 1

slide 47

The determinants of the nominal exchange rate - intro

Start with the expression for the real exchange

rate:

*

e Pε

P

Solve for the nominal exchange rate: *P

e εP

slide 48

The determinants of the nominal exchange rate - intro

( * , )M

L r YP

( ) ( )*NX ε S I r

So e depends on the real exchange rate and

the price levels at home and abroad…

…and we know how each

of them is determined:

*Pe ε

P

** *

*( * *, )

ML r Y

P

slide 49

Implications for growth

Recall the Solow growth model, where the

setady state level of capital per labour depends

on the amount of savings

This no longer holds, as the level of investment

– at least in theory – is detached from savings

The steady-state value of capital stock should

depend on world interest rate and on country’s

marginal product of capital

The Open Economy

slide 50

Chapter Summary

Net exports--the difference between

exports and imports

a country’s output (Y )

and its spending (C + I + G)

Net capital outflow equals

purchases of foreign assets

minus foreign purchases of the country’s assets

the difference between saving and investment

slide 50

slide 51

Chapter Summary

National income accounts identities:

Y = C + I + G + NX

trade balance NX = S I net capital outflow

Impact of policies on NX :

NX increases if policy causes S to rise

or I to fall

NX does not change if policy affects

neither S nor I. Example: trade policy

slide 51

slide 52

Chapter Summary

Exchange rates

nominal: the price of a country’s currency in

terms of another country’s currency

real: the price of a country’s goods in terms of

another country’s goods

The real exchange rate equals the nominal rate

times the ratio of prices of the two countries.

slide 52

slide 53

Chapter Summary

How the real exchange rate is determined

NX depends negatively on the real exchange

rate, other things equal

The real exchange rate adjusts to equate

NX with net capital outflow

slide 53