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