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**Chapter 5: The Open Economy**

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International Trade A country’s participation is measured by the value of its export as a percentage of GDP Import as a percentage of GDP Data indicate that while international trade is important in the U.S., it is even more vital for other countries such as Canada and France.

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International Trade

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**National Income Accounting**

The GDP for an open economy: Y = C + I + G + NX Consumption = C Investment = I Government purchases = G Net Exports = NX (Exports less Imports)

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**National Income Identity**

Y = C + I + G + NX Y – C – G = I + NX S = I + NX Where S = Y - C - G is National Savings

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**Saving Investment Identity**

Equilibrium in the product market: S – I(r) = NX Net Foreign Investment = Trade Balance If S>I: foreign capital outflow; hence NX>0: trade surplus If S<I: foreign capital inflow; hence NX<0: trade deficit

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Twin Deficits The federal budget deficit (G>T), reduces national savings (S = Y – C – G) Reduced national savings foreign capital inflow, hence causing a trade deficit (NX<0) So, budget deficit causes trade deficit

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**Saving Investment: Small Open Economy**

For a small open economy, r = r*, where r = domestic real interest rate r* = world real interest rate So, S – I(r*) = NX

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**Determination of Real Interest Rate**

If r<r*, then S>I for capital outflow and a trade surplus. If r>r*, then S<I for capital inflow and a trade deficit. NX>0 r* r Domestic real interest rate r* I(r*) NX<0 I

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**Fiscal Policy at Home S2 S1 r* I(r*) Real interest rate**

An increase in G or a decrease in T results in a lower S. Now S<I induces capital outflow and a trade deficit. S2 S1 r* NX<0 I(r*) Investment, Saving

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**Fiscal Policy Abroad S I(r*) Real interest rate NX<0**

An increase in G or a decrease in T in the U.S. results in a higher r* causing S>I and a trade surplus. r2* r1* I(r*) Investment, Saving

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**Increase in Investment Demand**

Real interest rate An increase in I(r*) results in S<I and a trade deficit. S r* NX<0 I2(r*) I1(r*) Investment, Saving

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Exchange Rate Nominal exchange rate = e: the relative price of the currency of two countries; e.g., $1 = 120 yen or 1 yen = $ Real exchange rate = ε: nominal exchange rate adjusted for the foreign price difference ε = e (P/P*) where P = domestic price level P* = foreign price level

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**Real Exchange Rate and Trade Balance**

ε NX<0 The lower the real exchange rate, the less expensive are domestic goods relative to foreign goods, thus the greater is the net export. NX>0 NX(ε) - + NX

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**Determinants of Real Exchange Rate**

Equilibrium value of ε is determined by: Net Foreign Investment = Trade Balance S – I = NX Here, the quantity of dollars supplied for net foreign investment equals the quantity of dollars demanded for the net export of goods and services.

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**Determinants of Real Exchange Rate**

ε S - I ε Equilibrium real exchange rate NX(ε) I

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**Fiscal Policy at Home ε2 ε1 Real exchange rate S2 - I S1 - I**

An increase in G or a decrease in T reduces S, shifting S-I line to the left. This shift causes ε to increase, but NX to decrease. ε2 ε1 NX(ε) NX2 NX1 Net export

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**Fiscal Policy Abroad ε1 ε2 Real exchange rate S1 - I S2 - I**

An increase in G or a decrease in T in the U.S. results in a higher r* causing I to decrease. This shift causes ε to decrease, but NX to increase ε2 NX(ε) NX1 NX2 Net export

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**Increase in Investment Demand**

Real exchange rate S – I2 S – I1 ε2 An increase in I shifts S-I line to the left. This shift causes ε to increase, but NX to decrease. ε1 NX(ε) NX2 NX1 Net export

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**Effect of Trade Protectionism**

Real exchange rate Protectionism reduces the demand for imports, increasing net export. A higher NX line causes ε to increase, with no net change in net export. S - I ε2 ε1 Here the value of foreign trade is unchanged because the rise in the real exchange rate discourages exports, which offsets the decline in imports. NX(ε)2 NX(ε)1 NX1 = NX2 Net export

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**Determinants of Real Exchange Rate**

From ε = e * (P/P*), write e = ε (P*/P) Take percentage rate: %Δe = %Δε + %ΔP* - %ΔP %Δe = %Δε + (* - ) Where ( * - ) is the difference in inflation rates of the two countries

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**Inflation and Nominal Exchange Rate**

Countries with relatively high inflation tend to have depreciating currencies. Countries with relatively low inflation tend to have appreciating currencies.

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**Inflation and Nominal Exchange Rate**

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