GRIPS Macroeconomics II

Fall II Semester, 2014

Lecture 7: Open Economy 1 - Long Run Analysis of a Small Open Economy

Junichi Fujimoto
December 22, 2014

Open Economy versus Closed Economy

1.1 Importance of Trade

We have so far analyzed the closed economy. In the real economy, international trades are important elements of
economic activity. The importance of trade is especially large, for example, for small European countries.

Country Name Export/GDP (%) Import/GDP (%) (Ex+Im)/GDP (%)

Luxembourg
203
168
371
Ireland
105
84
189
Korea, Rep.
54
49
103
Germany
46
40
86
Canada
30
32
62
United Kingdom
30
32
62
France
28
30
58
China
26
24
50
Japan
16
19
35
United States
13
17
30
Figure 1: Volumes of Trade (2013)

1.2 The International Flows of Capital and Goods

The national accounting identity in an open economy is given by

Y = C + I + G + EX IM.

(1)

Let us examine how this expression is derived.

I d be investment in domestic goods and services, Gd be

government purchases of domestic goods and services, and EX be exports of goods and services. Then, the division
Let

Cd

be consumption of domestic goods and services,

of expenditure is expressed as,

Y = C d + I d + Gd + EX.
Then, letting

C f , I f , Gf

(2)

respectively denote consumption, investment, and government purchases in foreign goods

and services, we obtain

(C C f ) + (I I f ) + (G Gf ) + EX

= C + I + G + EX (C f + I f + Gf )
= C + I + G + EX IM.
1

(3)

By dening net exports by

N X = EX IM ,

this expression becomes

N X = S I.
This equation shows that net exports

NX

dierence from a closed economy, in which

(4)

equal net foreign investment (or net capital outow)

S=I

S I.

Note the

holds.

Saving and Investment in a Small Open Economy

In this lecture, we focus on the long run analysis of a small open economy - the short run analysis will be explored
in the next lecture.

2.1 Overview
A small open economy model with perfect capital mobility is a model often used to analyze an open economy.
Small here means the economy is so small relative to the world market that it has a negligible impact on the world
economy. Perfect capital mobility implies that the domestic real interest rate

equals the world interest rate

r .

To be more precise on this point, the world interest rate is determined such that in the world economy, which is
a closed economy, saving equals investment. In contrast, a small open economy, which is negligible in the world
market, takes the world interest rate as given.

2.2 Saving and Investment

In the long run, the economy's output is xed at its long run level

Y T , and

noting r = r ,

the disposable income

From (3) and

investment

NX

equals

between

Consumption

is an increasing function of

is a decreasing function of the real interest rate

[Y C(Y T ) G] I(r )

S I(r ).

Figure 2 draws saving and investment in this model.

Y .

r.

(5)

In a closed economy, the real interest rate is

I . In a small open economy, the real interest rate equals the world
S and I equals net exports N X . In Figure 2, there is trade surplus.

interest rate

r ,

rc ,

at which

and the dierence

X
r

rc
I (r )
S, I

Figure 2: Saving and Investment in a Small Open Economy

Let us analyze the eect of policies on the trade balance. Below, suppose the economy is originally in a position
of balanced trade (i.e.,

N X = 0).
2

(a) Fiscal Policy at Home

When the domestic government increases government purchases

G, domestic saving falls, so N X

falls. So, as shown

in Figure 3, there will be a trade decit. The same result follows when the domestic government decreases taxes

S2

T.

S1

I (r )

X

S, I

Figure 3: Fiscal Policy at Home

(b) Fiscal Policy Abroad

Suppose foreign governments increase government purchases. If these foreign governments are a small part of the
world economy, there will be no eect on the domestic economy. In contrast, if these governments are a large part
of the world economy, the increase in government purchases reduces world saving, and increases the world interest
rate. This lowers domestic investment, so the net foreign investment and net exports rise. Thus, there will be a
trade surplus.

X
r2

r1

I (r )

S, I

Figure 4: Fiscal Policy Abroad

(c) Shifts in Investment Demand

Suppose the government increases investment demand by providing investment tax credit. Such a policy reduces
net foreign investment

S I,

so as shown in Figure 5, there will be a trade decit.

r*

I 2 (r )
I1 ( r )

S, I

NX

Figure 5: Shifts in Investment Demand

(d) Case Study: Twin Decits in the U.S.

In the U.S., during the 1980s, there was a substantial reduction of personal income taxes without equal cut in
government spending. Such expansionary scal policy caused huge decits in the federal budget. At roughly the
same time, trade balance also went into decit. Such twin decits are consistent with the prediction of the model
above. In the late 1990s, however, while changes in scal policy and rapid productivity growth turned the federal
budget to surplus, the trade decit did not shrink, since domestic investment rose.

Exchange Rates

3.1 Nominal and Real Exchange Rates

The nominal exchange rate is the relative price of two currencies, which people usually talk about. The real exchange
rate, in contrast, is the relative price of goods in two countries.
Let us consider an example from the textbook (p148). Note that in this example, the U.S. is the home country,
and Japan is the foreign country.
Suppose an American car costs $25,000, and a similar Japanese car costs 4,000,000 yen. Suppose further that
a dollar is worth 80 yen.
of the Japanese car.

Then, the American car costs

80 25, 000 = 2, 000, 000

yen, which is half the price

In other words, at current prices, we can exchange 2 American cars for 1 Japanese car.

Mathematically,

Real Exchange Rate

More generally, letting

(80 Yen/Dollar)(25, 000 Dollars/American Car

(4, 000, 000 Yen/Japanese Car)

0.5

Japanese Car
American Car

denote the nominal exchange rate, and

P, P

denote, respectively, the domestic and

foreign price levels, the real exchange rate

is given by

=e

P
.
P

(6)

Note that the nominal exchange rate here is expressed in units of foreign currency per domestic currency. The
real exchange rate tells us how much a unit of domestic good costs in terms of units of foreign goods. Thus, the
greater the

e(),

the more expensive is the domestic currency (good), and the less expensive is the foreign currency

(good).

3.2 The Real Exchange Rate and the Trade Balance

The trade balance is determined by the relative price of domestic and foreign goods. When the real exchange rate
is high (=large

),

domestic goods are expensive relative to foreign goods, so exports fall and imports rise, hence

net exports fall. Conversely, if the real exchange rate is low, domestic goods are relatively inexpensive, so exports
rise and imports fall, hence net exports rise.
Therefore,

N X = N X()

becomes a decreasing function of

3.3 The Determinants of the Real Exchange Rate

The real exchange rate is determined by equation (4). In other words, the real exchange rate adjusts to equate
and

NX

S I.

NX ( )

SI

NX
Figure 6: The Determinants of the Real Exchange Rate

In Figure 6,
function of

SI

is vertical since it does not depend on

The equilibrium real exchange rate

; N X

is downward sloping since it is a decreasing

obtains at the intersection of these two curves.

Figure 6 can also be interpreted as depicting the foreign demand for domestic currency,
outow, or the supply of domestic currency,

N X , and the net capital

S I.

3.4 Eects of Policies on Trade Balances and the Real Exchange Rate
(a) Fiscal Policy at Home
When the domestic government increases government purchases

G,

domestic saving falls, so

SI

falls. As shown

in Figure 7, this raises the real exchange rate (= appreciation of the domestic currency), and reduces net exports.
The same result follows when the domestic government decreases taxes

T.

S2 I

S1 I

NX ( )

NX 2

NX , S I

NX 1

Figure 7: Fiscal Policy at Home

(b) Fiscal Policy Abroad

When foreign government increase government purchases, the world interest rate rises.

This reduces domestic

investment and increases net foreign investment. So, as shown in Figure 8, the real exchange rate falls, and net
exports increase.

S I (r1* ) S I (r2* )

NX ( )

NX1

NX , S I

NX 2

Figure 8: Fiscal Policy Abroad

(c) Shifts in Investment Demand

Suppose the government increases investment demand by providing investment tax credit. Such a policy reduces
net foreign investment

S I,

so as shown in Figure 9, the real exchange rate rises, and net exports decrease.

(d) The Eects of Trade Policies

Trade policies, such as taris and quotas, are policies that directly inuence the amount of goods and services
exported or imported. As an example of protectionist trade policies, consider the impact of ban on the import of

S I2

S I1

NX ( )

NX 2

NX , S I

NX 1

Figure 9: Shifts in Investment Demand

foreign cars. Such a policy reduces imports, so it increases net exports; thus it shifts the

NX

curve to the right, as

in Figure 10. In equilibrium, however, net exports do not change. This is because the rise in the real exchange rate
makes domestic goods relatively expensive, and reduces imports by the same amount as the decrease in exports.
Thus, both exports and imports are lower in the new equilibrium, which implies lower social welfare.

S I

NX 2 ( )
NX 1 ( )

NX , S I
Figure 10: Protectionist Trade Policies

3.5 The Determinants of the Nominal Exchange Rate

From (6), we obtain

e=

P
.
P

(7)

Thus, the nominal exchange rate is determined by the real exchange rate as well as the domestic and the foreign
price levels. For example, if the domestic price level
exchange rate

rises, the value of the domestic currency falls, so the nominal

falls.

Taking log of both sides of (7), and dierentiating with respect to time, we obtain

= + .
e

(8)

This equation implies that the nominal exchange rate of a country with relatively high ination rates falls (=
depreciation of the currency), and that of a country with relatively low ination rates rises (= appreciation of the
currency). This is consistent with the empirical ndings (see Figure 5-13 in textbook p145). Therefore, an increase
in the money supply causes ination, and lowers the nominal exchange rate.

3.6 Purchasing Power Parity

PPP (purchasing power parity) states that if international arbitrage is possible, a dollar (or any other currency)
must have the same purchasing power in every country. In other words, the same good must have the same price

1. On

=
0
in 8).

If PPP holds approximately, it implies that international arbitrageurs react very fast to international price

in any country; to be precise, this is called absolute PPP, and if it holds, the real exchange rate must equal
the other hand, relative PPP states that the real exchange rate is constant, such that

dierences, and so net exports are very sensitive to small changes in the real exchange rate.

Accordingly,

NX

becomes close to horizontal at the real exchange rate that achieves PPP. (See Figure 11). Then, changes in saving
or investment have little eect on the real or nominal exchange rate.

Moreover, since the real exchange rate is

almost constant, almost all changes in the nominal exchange rate result from changes in price levels.

SI

NX ( )

NX
Figure 11: Purchasing Power Parity
While PPP is an important concept, it does not apply perfectly in the real economy. This is due to, for example,
the presence of nontradable goods (e.g., haircut), imperfect substitution between domestic and foreign goods, and
transportation costs.