1. Chapter 5: The Open Economy

2. 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.

3. International Trade

4. 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)

5. National Income Identity
Y = C + I + G + NX
Y – C – G = I + NX
S = I + NX
Where S = Y - C - G is National Savings

6. 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

7. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. Real Exchange Rate and Trade Balanceε
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

16. 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.

17. Determinants of Real Exchange Rateε
S - I ε
Equilibrium real exchange rate
NX(ε) I

18. 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

19. 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

20. 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

21. 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

22. 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

23. 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.

24. Inflation and Nominal Exchange Rate