open economy - csufmihaylofaculty.fullerton.edu/sites/skhalifa/macro1lecture9.pdf · an open...

Open Economy

Sherif Khalifa

Sherif Khalifa () Open Economy 1 / 47

Open EconomyInternational Flows

DefinitionA closed economy is an economy that does not interact with othereconomies.

DefinitionAn open economy is an economy that interacts freely with othereconomies.



DefinitionExports are goods and services that are produced domestically and soldabroad.

DefinitionImports are goods and services that are produced abroad and solddomestically.

DefinitionNet exports is the value of exports minus the value of imports. Netexports is also called the trade balance.

Trade Balance = Net exports

= Value of Exports − Value of ImportsSherif Khalifa () Open Economy 3 / 47


If net exports are positive, exports > imports, and the country is saidto run a trade surplus.

If net exports are negative, imports > exports, and the country is saidto run a trade deficit.

If net exports are zero, imports = exports, and the country is said tohave a balanced trade.



Factors that influence net exports:

The tastes of consumers for domestic and foreign goods.

The prices of domestic and foreign goods.

The exchange rates at which people can use domestic currency to buyforeign currency.

The incomes of consumers at home and abroad.

The cost of transporting goods from country to country.

Government policies toward international trade.



DefinitionNet capital outflow is the purchase of foreign assets by domestic residentsminus the purchase of domestic assets by foreigners.

Net capital outflow

= Capital outflow − Capital inflow= Purchase of foreign assets by domestic residents

−Purchase of domestic assets by foreigners

When NCO > 0, domestic purchases of foreign assets > foreignpurchases of domestic assets.When NCO < 0, foreign purchases of domestic assets > domesticpurchases of foreign assets.



Factors that influence net capital outflow:

The real interest rate paid on foreign assets.

The real interest rate paid on domestic assets.

The perceived economic and political risks of holding assets abroad.

The government policies that affect capital flows.



NCO = NX

Every transaction that affects NX also affects NCO by the sameamount, and vice versa.

When a foreigner purchases a good from the U.S., U.S. exports andNX increase, the foreigner pays with currency or assets.

The U.S. acquires some foreign assets, causing NCO to increase.

When a U.S. citizen buys foreign goods, U.S. imports increase andNX decreases, the U.S. buyer pays with U.S. dollars or assets.

So the other country acquires U.S. assets, causing U.S. NCO todecrease.



Y = C + I + G +NX

Y − C − G = I +NX

S = I +NX

S − I = NX

S − I = NCO

When U.S. citizens save a dollar of their income for the future, thatdollar can be used to finance accumulation of domestic capital.When U.S. citizens save a dollar of their income for the future, thatdollar can be used to finance the purchase of capital abroad.When S > I, the excess loanable funds flow abroad, and NCO>0.When S < I, foreigners are financing some of the country’sinvestment, and NCO < 0.Sherif Khalifa () Open Economy 9 / 47


The U.S. Economy’s Increasing Openness

0%

5%

10%

15%19

50

1955

1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

Exports

Imports

Percentof GDP

Trade deficit = 6%of GDP in 7/2005

Trade deficit = 6%of GDP in 7/2005



U.S. Saving, Investment, and NCO

4%

8%

12%

16%

20%19

60

1965

1970

1975

1980

1985

1990

1995

2000

2005

6%

4%

2%

0%

2%

4%

6%

8%

10%

Savi

ng,I

nves

tmen

t(%

of G

DP

)N

et Capital O

utflow(%

of GD

P)

Investment

NCO(right scale)

Saving


Open EconomyExchange Rates

DefinitionThe Nominal exchange rate is the rate at which we exchange the currencyof one country for the currency of another.

DefinitionAppreciation is an increase in the value of a currency as measured by theamount of foreign currency it can buy.

DefinitionDepreciation is a decrease in the value of a currency as measured by theamount of foreign currency it can buy.



80Yen = 1 Dollar → 1Yen =180Dollar

Appreciation of the Dollar & Depreciation of the Yen


Depreciation of the Dollar & Appreciation of the Yen




DefinitionThe Real exchange rate is the rate at which we exchange the goods andservices of one country for the goods and services of another.

Real exchange rate = Nominal exchange rate xDomestic priceForeign price

Real exchange rate = Nominal exchange rate(PP∗

)P: Domestic price.P∗: foreign price.This real exchange rate measures the price of a basket of goods andservices available domestically relative to a basket of goods and servicesavailable abroad.



American car=$10,000Japanese car=2,400,000 Yen

$1 = 120Yen

Real Exchange Rate =120x10, 0002, 400, 000

=12

1 American car =12Japanese car



American television=$100.Japanese television=16,000 Yen.

$1 = 80Yen

Real Exchange Rate =80x 10016000

=12

1 American television =12Japanese television



4/5 pounds of Canadian beef = 1 pound of U.S. beef.1 pound of U.S. beef = $2$1= 600 Canadian dollars

Real exchange rate =Nominal exchange rate x Domestic price

Foreign price(45

)=

600x2Canadian price

Canadian price =1200x54

= 1500



DefinitionLaw of one price asserts that a good should sell for the same price in allmarkets.

DefinitionPurchasing power parity is a theory of exchange rates whereby a unit ofany given currency should be able to buy the same quantity of goods in allcountries.

The process of taking advantage of differences in prices for the sameitem in different markets is called arbitrage.If the price of a good is higher in a country compared to another,traders will buy the good at the lower price and sell it at the higherprice.This process of arbitrage will equalize prices eventually.



Assume purchasing power parity holds.Japanese Coffee = 500 YenAmerican Coffee = $5

Nominal Exchange rate =500Yen

$5=100Yen

$1Real Exchange rate = 1



Exchange rates do not always adjust to equalize prices across countries:

Many goods cannot easily be traded.

Tradable goods are not perfect substitutes.


Open EconomyOpen Economy Model

S = I +NCO

Supply of loanable funds comes from national savings.Demand for loanable funds comes from domestic investment and netcapital outflow.A higher interest rate encourages people to save and increases thequantity of loanable funds supplied.A higher interest rate makes borrowing to finance capital projectsmore costly, discourages investment and decreases the quantity ofloanable funds demanded.A higher interest rate discourages Americans from buying foreignassets and encourages foreigners to buy U.S. assets, and thusdecreases net capital outflow.At the equilibrium interest rate, the amount that people want to saveexactly balances domestic investment and net capital outflow.Sherif Khalifa () Open Economy 21 / 47


r

D(I+NCO)

S(S)

r1

L1L



NCO = NX

NX is the demand for dollars, because foreigners need dollars to buyU.S. net exports.

NCO is the supply of dollars, because U.S. residents sell dollars toobtain the foreign currency they need to buy foreign assets.

A higher real exchange rate makes U.S. goods more expensive andreduces the quantity of dollars demanded to buy those goods.

The supply curve is vertical because the quantity of dollars suppliedfor net capital outflow does not depend on the exchange rate.

At the equilibrium exchange rate, the demand for dollars by foreignersarising from U.S. net exports exactly balances the supply of dollarsfrom Americans arising from U.S. net capital outflow.



$

e

e1

D(NX)

S(NCO)

Q1



NCO

r

NCO



r

L

r

NCOe

$

S(S)

D(I+NCO) NCO

S(NCO)

D(NX)

e1

r1

L1



A budget deficit decreases the supply of loanable funds and increasesthe interest rate.

With a higher interest rate, net capital outflow decreases becauseinvesting abroad is less attractive.

Higher rates of return also attract foreign investors who want to earnthe higher returns on U.S. assets.

Because net capital outflow decreased, people need less foreigncurrency to buy foreign assets, and therefore supply fewer dollars inthe market.

The decreased supply of dollars causes the exchange rate toappreciate.

This appreciation makes U.S. goods more expensive compared toforeign goods decreasing U.S. exports and causing a trade deficit.



r

L

r

NCOe

$

S(S)

D(I+NCO) NCO

S(NCO)

D(NX)

e1

r1

L1

e2

r2



1961

65

1966

70

1971

75

1976

80

1981

85

1986

90

1991

95

TheThe ““Twin DeficitsTwin Deficits””

Per

cent

of G

DP

Net exports and the budget deficitoften move in opposite directions.Net exports and the budget deficitoften move in opposite directions.

U.S. federalbudget deficit

U.S. net exports

5%4%3%2%1%0%1%2%3%4%5%

1995

200

0

2001

05



A trade import tariff decreases imports at any given exchange rate,and thus increases net exports.

Because foreigners need dollars to buy U.S. net exports, there is anincreased demand for dollars in the market for foreign currencyexchange.

The increase in the demand for dollars causes the dollar to appreciatecausing domestic goods to become more expensive relative to foreigngoods.

The appreciation encourages imports and discourages exports andboth of these changes work to offset the direct increase in net exportsdue to the import tariff.



r

L

r

NCOe

$

S(S)

D(I+NCO) NCO

S(NCO)

D(NX)

e1

r1

L1

e2



Capital flight is a large and sudden decrease in the demand for assetslocated in a country.

Investors sell their Mexican assets and buy U.S. assets, whichincreases Mexican capital outflow.

When net capital outflow increases, there is greater demand forloanable funds to finance these purchases of capital assets abroad.

This causes the interest rate in Mexico to increase.

The increase in net capital outflow increases the supply of Pesos inthe market, which causes the Peso to depreciate.

The depreciation of the currency makes exports cheaper and importsmore expensive, pushing the trade balance into surplus.



r

L

r

NCOe

$

S(S)

D(I+NCO) NCO

S(NCO)

D(NX)

e1

r1

L1

e2

r2


Open EconomyComparative Advantage

It is impossible for individuals to provide themselves with all theconsumption requirements.

They engage in the activities for which they have a comparativeadvantage in terms of their natural abilities or endowments.

They can then exchange any surplus of these products for productsthat others may be relatively suited to produce.

The principle of comparative advantage asserts that a country shouldspecialize in the export of the products that it can produce at thelowest relative cost.



Country 1 Meat 1 PotatoPotatoeville 60 labor 15 laborBeefyland 20 labor 10 labor



Country 1 Meat 1 PotatoPotatoeville 4 potatoes 1

4 meatBeefyland 2 potatoes 1

2 meat

A country has a comparative advantage in producing a certain good if it isable to produce the good at a lower opportunity cost than anotherproducer.A country should specialize in producing and exporting the good it has acomparative advantage in.



Assume every country has 480 workers.

Country Meat PotatoPotatoeville 8 32Beefyland 24 48



Potatoes

Meat

8

4

16 20 32



Potatoes

Meat

24

12

24 48

14



Potatoeville Beefyland

1M 4P 1M 2P

3P

1M



Potatoeville BeefylandMeat Potatoes Meat Potatoes

Without TradeProduction & Consumption 4 16 12 24

With TradeProduction 0 32 18 12Trade +4 -12 -4 +12Consumption 4 20 14 24

Gains from Trade 0 +4 +2 0



Potatoeville BeefylandMeat Potatoes Meat Potatoes

Without TradeProduction & Consumption 4 16 12 24

With TradeProduction 0 32 18 12Trade +5 -15 -5 +15Consumption 5 17 13 27

Gains from Trade +1 +1 +1 +3


Open Economy

DefinitionThe world price is the price of a good that prevails in the world market forthat good.

If the world price is higher than the domestic price, then the country wouldbecome an exporter.If the world price is lower than the domestic price, then the country wouldbecome an importer.


Open Economy

S

D

QeQuantity

Price

Pe

Exports


Open Economy

S

D

QeQuantity

Price

Pe

Imports


Open Economy

Definitiona tariff is a tax on imported goods. It is a tax on goods produced abroadand sold domestically.


Open Economy

S

D10

Quantity

Price

40

30

155

10

2 22

Tariff Price

No Tariff Price


open economy - csufmihaylofaculty.fullerton.edu/sites/skhalifa/macro1lecture9.pdf · an open...

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