open economy - csufmihaylofaculty.fullerton.edu/sites/skhalifa/macro2lecture8.pdf · open economy...

Open Economy

Sherif Khalifa

Sherif Khalifa () Open Economy 1 / 66

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 a nation’s exports minus the value of itsimports; also called the trade balance.

Net exports

= Value of country ′s exports − Value of country ′s importsSherif Khalifa () Open Economy 3 / 66


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 currencies.

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 foreign ownership of domesticassets.


Open Economy

Y = C d + I d + G d + X

C = C d + C f

I = I d + I f

G = G d + G f

Y =(C − C f

)+(I − I f

)+(G − G f

)+ X

Y = C + I + G + X −(C f + I f + G f

)Y = C + I + G + X −MY = C + I + G +NX


Open Economy

Y = C + I + G +NX

Y − C − G = I +NX

S = I +NX

S − I = NX

NCO = NX

Net Capital Outflow = Trade Balance


Open Economy

An economy’s net exports must always equal the difference betweenits saving and its investment.

An economy’s net capital outflow must always equal the differencebetween its saving and its investment.

If net capital outflow is positive, the economy’s saving exceeds itsinvestment, and it is lending the excess to foreigners.

If the net capital outflow is negative, investment exceeds saving, andthe economy is financing this extra investment by borrowing fromabroad.


Open Economy

With trade surplus, we are net lenders in world financial markets andwe are exporting more goods than we are importing.

With trade deficit, we are net borrowers in world financial marketsand we are importing more goods than we are exporting.

If domestic saving exceeds domestic investment, the surplus saving isused to make loans to foreigners.

Foreigners require these loans because we are providing them withmore goods and services than they are providing us.

If investment exceeds saving, the extra investment must be financedby borrowing from abroad.

These foreign loans enable us to import more goods and services thanwe export.


Open Economy

0%

5%

10%

15%

1950

1955

1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

Exports

Imports

Percentof GDP


Open Economy

4%

8%

12%

16%

20%

1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

6%

4%

2%

0%

2%

4%

6%

8%

10%Sa

ving

,Inv

estm

ent(

% o

f GD

P)

Net C

apital Outflow

(% of G

DP

)Investment

NCO(right scale)

Saving


Open Economy

DefinitionA small open economy is an economy that is a small part of the worldmarket and thus can have only a negligible effect on the world interest rate.

DefinitionPerfect capital mobility means the residents of the country have full accessto world financial world markets.

r = r ∗

Residents of the small open economy need never borrow at anyinterest rate above r ∗, because they can always get a loan at r ∗ fromabroad.

Residents of the small open economy need never lend at any interestrate below r ∗, because they can always earn r ∗ by lending abroad.


Open Economy

Y = Y = F(K , L

)C = C (Y − T )

I = I (r)

NX = (Y − C − G )− INX = S − I

NX =[Y − C

(Y − T

)− G

]− I (r ∗)

NX = S − I (r ∗)


Open Economy

S

I,S

r

r1

I(r)


Open EconomyFiscal Expansion at Home

The increase in government spending decreases national saving.

With an unchanged world real interest rate, investment remains thesame.

Saving falls below investment, and some investment must be financedby borrowing from abroad.

The fall in saving implies a fall in NX, and the economy runs a tradedeficit.


Open EconomyFiscal Expansion at Home

S

I,S

r

r1

I(r)

NX


Open EconomyFiscal Expansion Abroad

The increase in government spending abroad decreases world saving.

The decrease in world saving causes the world interest rate toincrease.

The increase in the interest rate increases the cost of borrowing, anddecreases investment.

Because there is no change in domestic saving, saving now exceedsinvestment, and saving begins to flow abroad.

Thedecrease in investment also must increase NX and a trade surplus.


Open EconomyFiscal Expansion Abroad

S

I,S

r

r1

I(r)

r2

NX


Open EconomyExchange Rates



DefinitionThe exchange rate between two countries is the price at which residents ofthose countries trade with each other.

DefinitionThe nominal exchange rate is the relative price of the currencies of twocountries. When the domestic currency appreciates, it buys more of theforeign currency; when it depreciates, it buys less.

DefinitionThe real exchange rate is the relative price of the goods of two countries.It is the rate at which we can trade the goods of one country for the goodsof another



Real Exchange Rate = Nominal Exchange Rate

X(Price of Domestic GoodPrice of Foreign Good

)ε = e

(PP∗

)



e = ε

(P∗

P

)

%∆e = %∆ε+%∆P∗ −%∆P= %∆ε+ π∗ − π

If a country has a high inflation rate relative to the United States, adollar will buy an increasing amount of the foreign currency over time.

If a country has a low inflation rate relative to the United States, adollar will buy an decreasing amount of the foreign currency over time.



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.A 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



DefinitionThe law of one price states that the same good cannot sell for differentprices in different locations at the same time.

DefinitionPurchasing power parity states that, if international arbitrage is possible, adollar must have the same purchasing power in every country.



If a dollar could buy more of a good domestically than abroad, therewould be opportunities to profit by buying this good domestically andselling it abroad.

Profit seeking arbitrageurs would drive up the domestic price of thegood relative to the foreign price.

If a dollar could buy more of a good abroad than domestically, therewould be opportunities to profit by buying this good abroad andselling it domestically.

Profit seeking arbitrageurs would drive down the domestic price of thegood relative to the foreign price.



ExampleAssume purchasing power parity holds.Coffee in Japan = 500 YenCoffee in U.S. = $5

Nominal Exchange rate =500Yen

$5=100Yen

$1

Real Exchange rate = 1



If the exchange rate is high, foreign goods are relatively cheap, anddomestic goods are relatively expensive.

Domestic residents will want to buy many imported goods, andforeigners will want to buy few of our goods.

Therefore, the quantity of our net exports demanded will be low.

If the exchange rate is low, foreign goods are relatively expensive, anddomestic goods are relatively cheap.

Domestic residents will want to purchase fewer imported goods, andforeigners will want to buy more of our goods.

Therefore, the quantity of our net exports demanded will be high.


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 32 / 66


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 Economy

r

Y

r

NCOe

$

LM

IS NCO

S(NCO)

D(NX)

e1

r1

Y1


Open EconomyFiscal Policy

An increase in government purchases or a cut in taxes shifts the IScurve to the right.

This shift leads to an increase in income and an increase in theinterest rate.

The higher interest rate decreases the net capital outflow.

This decreases the supply of dollars and the exchange rate appreciates.

Because doemstic goods become more expensive relative to foreigngoods, net exports fall.


Open EconomyFiscal Policy

r

Y

r

NCOe

$

LM

IS NCO

S(NCO)

D(NX)

e1

r1

Y1

r2

e2


Open EconomyMonetary Policy

An increase in the money supply shifts the LM curve to the right.

The level of income increases and the interest rate decreases.

The lower interest rate leads to a higher net capital outflow.

This increases the supply of dollars and the exchange rate decreases.

As domestic goods become cheaper relative to foreign goods, netexports increase.


Open EconomyMonetary Policy

r

Y

r

NCOe

$

LM

IS NCO

S(NCO)

D(NX)

e1

r1

Y1

r2

e2


Open EconomyMundell-Fleming

r = r ∗

If the domestic interest rate increases, foreigners would see the highinterest rate and start lending to this country

The capital inflow would drive the domestic interest rate back downto r ∗.

If the domestic interest rate decreases, capital would flow out of thecountry to earn a higher return abroad.

The capital outflow would drive the domestic interest rate back up tor ∗.

Y = C (Y − T ) + I (r ∗) + G +NX (e)



e

NX

E

Ye

Y

NX(e)

PE1

Y1

IS*

e1

NX1

e1

Y1

e2

NX2

Y2

Y2

e2

PE2

AE



e

NX

E

Ye

Y

NX(e)

PE1

Y1

IS*1

e1

NX1

e1

Y1 Y2

PE2

AE

Y2

IS*2



An increase in the exchange rate lowers net exports.

The reduction in net exports shifts the planned expenditure scheduledownward and thus lowers income.

The IS∗ curve summarizes this relationship between the exchange rateand income.



MP

= L (r ,Y )

MP

= L (r ∗,Y )

The supply of real money balances equals the demand for real moneybalances.

The demand for real money balances depends negatively on theinterest rate and positively on income.

The supply of real money balances is controlled by the central bank.



LM*

Y1

Y

e



LM*

Y1Y

e

e1

IS*



DefinitionUnder a system of floating exchange rates, the exchange rate is set bymarket forces and is allowed to fluctuate in response to changing economicconditions.

DefinitionUnder a fixed exchange rate, the central bank announces a value for theexchange rate and stands to buy and sell the domestic currency to keepthe exchange rate at its announced level.



Suppose the government stimulates domestic spending by increasinggovernment purchases or by cutting taxesSuch expansionary fiscal policy increases planned expenditure, andshifts the IS∗ curve to the right.The exchange rate appreciates, while the level of income remains thesame.As the interest rate increases above the world interest rate, foreigninvestors need to buy the domestic currency to invest in the domesticeconomy.The capital inflow increases the demand for the domestic currency,bidding up the value of the domestic currency.The appreciation of the domestic currency makes domestic goodsexpensive relative to foreign goods, reducing net exports.The fall in net exports exactly offsets the effects of the expansionaryfiscal policy on income.Sherif Khalifa () Open Economy 58 / 66


LM*1

Y1Y

e

e1

IS*1

e2

IS*2



Suppose the central bank increases the money supply.

Because the price level is assumed fixed, the increase in the moneysupply means an increase in real money balances.

The increase in real money balances shifts the LM∗ curve to the right.

An increase in the money supply increases income and lowers theexchange rate.

As the increase in money supply starts to put downward pressure onthe domestic interest rate.

Capital flows out of the economy as investors seek a higher returnelsewhere.



This capital outflow prevents the domestic interest rate from fallingbelow the world interest rate.

Investing abroad requires converting domestic currency into foreigncurrency.

The capital outflow increases the supply of domestic currency.

This causes the domestic currency to depreciate in value.

This makes domestic goods inexpensive relative to foreign goods.

This stimulates net exports and thus total income.



LM*1

Y1Y

e

e1

IS*1

e2

LM*2

Y2



Suppose the government stimulates domestic spending by increasinggovernment purchases or by cutting taxes

Such expansionary fiscal policy increases planned expenditure, andshifts the IS∗ curve to the right.

This puts upward pressure on the market exchange rate.

Arbitrageurs respond to the rising exchange rate by selling foreigncurrency to the central bank, leading to a monetary expansion.

The rise in money supply shifts the LM∗ curve to the right.

Fiscal expansion increases aggregate demand.



LM*1

Y1Y

e

e1

IS*1

e2

IS*2

LM*2

Y2



Suppose the central bank increases the money supply.

Because the price level is assumed fixed, the increase in the moneysupply means an increase in real money balances.

The increase in real money balances shifts the LM∗ curve to the right.

An increase in the money supply increases income and lowers theexchange rate.

Arbitrageurs respond to the falling exchange rate by selling thedomestic currency to the central bank.

This causes the money supply and the LM∗ curve to return to theirinitial positions.



LM*1

Y1Y

e

e1

IS*1

e2

LM*2

Y2


open economy - csufmihaylofaculty.fullerton.edu/sites/skhalifa/macro2lecture8.pdf · open economy...

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