Topic E

The Open Economy

 IN THIS TOPIC, YOU WILL LEARN:

▪ 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

1
Imports and exports of selected countries, 2018
In an open economy,
▪ spending need not equal output
▪ Residents of an open economy can spend more
than the country’s output simply by importing
foreign goods.
▪ Residents can spend less than output, and the
extra output will be exported.
 In an open economy,
▪ saving need not equal investment
▪ If individuals in an open economy want to save
more than domestic firms want to borrow, they
simply send their extra funds abroad to buy
foreign assets.
▪ If domestic firms want to borrow more than
individuals are willing to save, then the firms
simply borrow from abroad (i.e., sell bonds to
foreigners).

CHAPTER 6 The Open Economy 4

Preliminaries superscripts:
C =C d +C f d = spending on
domestic goods
d f
I =I +I f = spending on
foreign goods
G =G d +G f
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
GDP = Expenditure on
domestically produced g&s

Y = C d + I d + G d + EX
= (C − C f ) + (I − I f ) + (G − G f ) + EX

= C + I + G + EX − (C f + I f + G f )

= C + I + G + EX − IM

= C + I + G + NX
The national income identity
in an open economy

Y = C + I + G + NX

or, NX = Y – (C + I + G )

domestic
net exports spending

output
Trade surpluses and deficits

NX = EX – IM = Y – (C + I + G )

▪ 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
International capital flows
▪ Net capital outflow
=S–I
= net outflow 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

▪ When S < I, country is a net borrower
The link between trade & cap. flows

Y = C + I + G + NX
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 ).
CHAPTER 6 The Open Economy 11
Saving, investment, and the trade
balance 1960–2019
U.S.: the world’s largest debtor nation
▪ Every year since the 1980s: huge trade deficits
and net capital inflows, i.e., net borrowing from
abroad
▪ As of 12/31/2014:
▪ U.S. residents owned $24.7 trillion worth of
foreign assets
▪ Foreigners owned $31.6 trillion worth of
U.S. assets
▪ U.S. net indebtedness to rest of the world:
$6.9 trillion—higher than any other country,
hence U.S. is the “world’s largest debtor nation”
Saving and investment in a
small open economy
▪ An open-economy version of the loanable
funds model
▪ Assumptions about 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*
 Saving and investment in a
small open economy
▪ Assumptions about 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
CHAPTER 6 The Open Economy 15
 Saving and investment in a
small open economy
▪ An open-economy version of the loanable
funds model
▪ Includes many of the same elements:
▪ production function Y = Y = F (K , L )
▪ consumption function C = C (Y − T )
▪ investment function I = I (r )
▪ exogenous policy variables G = G , T = T

CHAPTER 6 The Open Economy 16

National saving:
The supply of loanable funds
r S = Y − C (Y −T ) − G

National saving does

not depend on the
interest rate

S S, I
Investment:
The demand for loanable funds
r Investment is still a
downward-sloping function
of the interest rate,
but the exogenous
world interest rate…
r*
…determines the
country’s level of
investment.
I (r )

I (r* ) S, I
 If the economy were closed . . .
r S
. . . the
interest rate
would
adjust to
equate
investment rc
and saving.
I (r )

I (rc ) S, I
=S
 But in a small open economy…
r
the exogenous S
world interest
rate determines
investment… NX
r*
…and the
difference rc
between saving
and investment I (r )
determines net
capital outflow I1 S, I
and net exports
Three experiments:
1. Fiscal policy at home

2. Fiscal policy abroad

3. An increase in investment demand

(exercise)
 1. Fiscal policy at home
r S 2 S1
An increase in G
or decrease in T NX2
reduces saving. r
1
*

NX1
Results:
I = 0
NX = S  0 I (r )

I1 S, I
NX and the federal budget deficit
(% of GDP), 1960–2020
2. Fiscal policy abroad
r S1
Expansionary
NX2
fiscal policy
abroad raises r2*
NX1
the world
r1
*
interest rate.

Results:
I  0 I (r )
NX = −I  0 S, I
I (r )
2
*
I (r1* )
NOW YOU TRY
3. An increase in investment demand
r
Use the S
model to
determine r*
the impact of
an increase
NX1
in investment
demand on
NX, S, I, and I (r )1
net capital
outflow. I1 S, I

25
ANSWERS
3. An increase in investment demand
r
S
ΔI > 0, NX2
ΔS = 0, r*
net capital
outflow and
NX fall NX1
by the I (r )2
amount ΔI I (r )1

I1 I2 S, I

26
The nominal exchange rate

e= nominal exchange rate,

the relative price of
domestic currency
in terms of foreign currency
(e.g., yen per dollar)
A few exchange rates, as of 16/09/2023

Country Exchange rate

Euro area 1.07 euro / usd
Indonesia 15,367.00 rupiahs / usd
Japan 147.78 yen / usd
Mexico 17.08 pesos / usd
Russia 96.80 rubles / usd
South Africa 18.97 rand / usd
U.K. 0.81 pounds / usd
 The real exchange rate

ε = real exchange rate,

the relative price of
the lowercase domestic goods
Greek letter in terms of foreign goods
epsilon
(e.g. Japanese Big Macs per
U.S. Big Mac)
Understanding the units of ε
e P
ε =
P *
(Yen per $)  ($ per unit U.S. goods)
=
Yen per unit Japanese goods

Yen per unit U.S. goods

=
Yen per unit Japanese goods

Units of Japanese goods

=
per unit of U.S. goods
~ McZample ~
▪ One good: Big Mac
▪ Price in Japan:
P* = 200 Yen
▪ Price in USA:
P = $2.50
▪ Nominal exchange rate
e = 147.78 Yen / USD To buy a U.S. Big Mac,
someone from Japan
would have to pay an
𝟏𝟒𝟕. 𝟕𝟖 𝟐. 𝟓
𝜺= = 𝟏. 𝟖𝟓 amount that could buy
𝟏 𝟐𝟎𝟎
1.85 Japanese Big Macs.
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.
How NX depends on ε

If ε rises:
▪ domestic goods become more expensive
relative to foreign goods
▪ exports fall, imports rise
▪ net exports fall
 U.S. net exports and the real exchange rate,
1973-2014
4% 140
Trade-weighted real
exchange rate index 120
2%

Index (March 1973 = 100)

100
NX (% of GDP)

0%
80
-2%
60
-4%
40

-6% Net exports

(left scale) 20

-8% 0
1970 1975 1980 1985 1990 1995 2000 2005 2010 2015
The net exports function

▪ The net exports function reflects this inverse

relationship between NX and ε :

NX = NX(ε )
The NX curve for the U.S.

so U.S. net
When ε is exports will
relatively low, be high.
U.S. goods are
ε1
relatively
inexpensive NX(ε)

0 NX(ε1) NX
The NX curve for the U.S.

ε At high enough
values of ε,
ε2 U.S. goods become
so expensive that
we export
less than
we import.

NX(ε)

NX(ε2) 0 NX
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 *)
How ε is determined

Neither S nor I
ε S 1 − I (r *)
depends on ε,
so the net capital
outflow curve is
vertical.

ε1
ε adjusts to
equate NX NX(ε)
with net capital
outflow, S − I. NX
NX 1
Interpretation: supply and demand
in the foreign exchange market
Demand: S 1 − I (r *)
ε
Foreigners need
dollars to buy
U.S. net exports.

Supply: ε1
Net capital
outflow (S − I ) NX(ε)
is the supply of
NX
dollars to be NX 1
invested abroad.
Four experiments:
1. Fiscal policy at home

2. Fiscal policy abroad

3. An increase in investment demand

(exercise)

4. Trade policy to restrict imports

1. Fiscal policy at home

A fiscal expansion S 2 − I (r *)
reduces national ε S 1 − I (r *)
saving, net capital
outflow, and the ε2
supply of dollars
in the foreign
exchange ε1
market…
NX(ε )
…causing the real
NX
exchange rate to NX 2 NX 1
rise and NX to fall.
2. Fiscal policy abroad

An increase in r* S 1 − I (r1 *)
reduces
ε S 1 − I (r2 *)
investment,
increasing net
capital outflow ε1
and the supply of
dollars in the ε2
foreign exchange
market… NX(ε )

…causing the real NX

NX 1 NX 2
exchange rate to fall
and NX to rise.
NOW YOU TRY
3. Increase in investment demand

Determine the ε S1 − I 1
impact of an
increase in
investment
demand on
net exports, ε1
net capital
outflow, NX(ε )
and the real NX
exchange rate. NX 1

44
ANSWERS
3. Increase in investment demand
S1 − I 2
An increase in
ε S1 − I 1
investment
reduces net
capital outflow ε2
and the supply
of dollars in the
foreign ε1
exchange
NX(ε )
market…
NX
…causing the real NX 2 NX 1
exchange rate to
rise and NX to fall.
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4. Trade policy to restrict imports
At any given ε,
an import quota
ε S −I
reduces IM,
increases NX,
increases demand ε2
for dollars.
ε1
NX(ε)2
Trade policy doesn’t
affect S or I , so NX(ε)1
capital flows and the
NX
supply of dollars NX1
remain fixed.
4. Trade policy to restrict imports

Results:
ε S −I
Δε > 0
(demand
increase) ε2
ΔNX = 0
(supply fixed) ε1
ΔIM < 0 NX(ε)2
(policy) NX(ε)1
ΔEX < 0
NX
(rise in ε ) NX1
The U.S. as a large open economy
▪ So far, we’ve learned long-run models for
two extreme cases:
▪ closed economy
▪ small open economy
▪ A large open economy—like the U.S.—falls
between these two extremes.
▪ The results from large open economy analysis
are a mixture of the results for the closed & small
open economy cases.
▪ For example . . .
A fiscal expansion in three models
A fiscal expansion causes national saving to fall.
The effects of this depend on openness & size.
closed large open small open
economy economy economy
rises, but not as much no
r rises
as in closed economy change
falls, but not as much no
I falls
as in closed economy change
no falls, but not as much as
NX falls
change in small open economy
 TOPIC 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

50
 TOPIC 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

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 TOPIC 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.

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 TOPIC 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

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