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 spending need not equal output

 saving need not equal investment
In an open economy, some outputs are sold
domestically and some are exported to be sold
abroad. We can divide expenditure on an open
economy’s output Y into four components:
 Cd, consumption of domestic goods and
services,
 I d, investment in domestic goods and services,
 Gd, government purchases of domestic goods
and services,
 EX, exports of domestic goods and services.
The division of expenditure into these
components is expressed in the identity:

Y=Cd +Id +Gd +EX

 Where:
d = spending on domestic goods
f = spending on foreign goods

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
The national income accounts identity shows
how domestic output, domestic spending,
and net exports are related. In particular,

NX =Y− (C + I + G)
If output exceeds domestic spending, we
export the difference: net exports are
positive. If output falls short of domestic
spending, we import the difference: net
exports are negative.
NX = Y – (C + I + G )
implies
NX = (Y – C – G ) – I
= S – I
trade balance = net capital outflows
Thus, a country with trade (NX<0), is a net
borrower (S<I)
The marginal propensity to import is the
increase in the dollar value of imports for
each $1 increase in GDP
Because a fraction of any income increase leaks
into imports in an open economy, the open-
economy multiplier is smaller than that of a
closed economy.

Open-economy multiplier
1
MPS + MPm
 We do not assume that the real interest rate
equilibrates saving and investment.
 National saving does
r S not depend on the
interest rate

I, S
 Investment curve is
r downward-sloping
and depends on
interest rate: when
the interest rate
rises, fewer
investment projects
are profitable.

r2

r1

I(r)

I(r2) I(r1) I, S
 r S

Interest rate in a
closed economy

I(r)

I, S
 Instead, we allow the economy to run a trade
deficit and borrow from other countries, or to
run a trade surplus and lend to other
countries.
 If the real interest rate does not adjust to
equilibrate saving and investment in this model,
what does determine the real interest rate?

We answer this question by considering the

simple case of a small open economy with
perfect capital mobility.
 By “small’’ we mean that this economy is a
small part of the world market and thus, by
itself, can have only a negligible effect on the
world interest rate.
 By “perfect capital mobility’’ we mean that
residents of the country have full access to
world financial markets. In particular, the
government does not impede international
borrowing or lending.

 Residents of the small open economy need
never borrow at any interest rate above r*,
because they can always get a loan at r* from
abroad.
 Similarly, residents of this economy need
never lend at any interest rate below r*
because they can always earn r* by lending
abroad.
 Thus, the world interest rate determines the
interest rate in our small open economy.
 In a closed economy, the equilibrium of
domestic saving and domestic investment
determines the interest rate.
 Barring interplanetary trade, the world
economy is a closed economy.
 Therefore, the equilibrium of world saving
and world investment determines the world
interest rate.
 r S

Interest rate in a
closed economy

I(r)

I, S
 Our small open economy has a negligible
effect on the world real interest rate because,
being a small part of the world, it has a
negligible effect on world saving and world
investment.
 Hence, our small open economy takes the
world interest rate as exogenously given.



Substituting our earlier assumptions,

 In the closed economy, the real interest rate
adjusts to equilibrate saving and investment—
that is, the real interest rate is found where the
saving and investment curves cross.
 In the small open economy, however, the real
interest rate equals the world real interest rate.
 The trade balance is determined by the difference
between saving and investment at the world
interest rate.
 r

The world interest

rate…

r*

I(r)
…determines the
country’s level of
investment
I(r*) I, S
 r S

S – I = NX
r*

Interest rate in a
closed economy

I(r)

I(r*) I, S
r S

Because S < I, there is trade

deficit. Investors borrow from
abroad.

NX
r*
I(r)

I(r*) I, S
r S

NX
r*
Because S > I, there is trade
surplus. The excess is lent to
other countries.

I(r)

I(r*) I, S
 Case 1: Increasing government purchases.
 reduces national saving, because S = Y − C − G.
 Taking into account; unchanged world real
interest rate, investment remains the same
 NX = S − I, the fall in S implies a fall in NX.

Result: TRADE DEFICIT.

 Case 2: Decrease in Tax
 Y −T
 stimulates consumption
 reduces national saving.
 NX = S − I

Result: TRADE DEFICIT.

 Case: Foreign governments increase their
government purchases.
 Countries which are large part of the world economy,
▪ increase in government purchases > reduces world saving >
world interest rate to rise.
▪ + cost of borrowing and > - investment in our small open
economy.
 No change in domestic saving S > I
 NX = S − I, more S, less I
Result: TRADE SURPLUS
 Case: Investment schedule shifts
outward
 Policies that + investment or - saving > trade
deficit, and policies that - investment or +
saving > trade surplus.
 Debate among economists and policymakers
 Trade Deficit: Policy makers – national problem?,
Economists – symptom of a problem
▪ signs of economic development: South Korea
▪ Case of US
Nominal exchange rate is the relative price
of the currency of two countries.
Real exchange rate is the relative price of the
goods of two countries.

It tells us the rate at which we can trade the

goods of one country for the goods of
another.

It is sometimes called the terms of trade.

Example:
Burger A in US : $5.2
Burger A in Philippines : P110
Real Exchange = ($1/ P42.33) x ( P110/Phil Burger)
Rate ($5.2/US Burger)
= 0.5 US burger/Phil burger
--we can exchange two Philippine burgers for
one US burger.
Real Exchange = Nominal Exchange Rate × Price of Domestic Good
Rate Price of Foreign Good
If the real exchange rate is high, foreign
goods are relatively cheap, and domestic
goods are relatively expensive.

The quantity of net exports demanded

will be low.
If the real exchange rate is low, foreign goods
are relatively expensive, and domestic goods
are relatively cheap.

The quantity of net exports demanded will be

high.
The real exchange rate is related to net exports.

The trade balance (net exports) must equal the

net capital outflow, which in turn equals
saving minus investment.
Net export – represents the net demand for local
currency coming from foreigners who want our
currency to buy our goods
S-I – represents net capital outflow and the
supply of local currency to be exchanged into
foreign currency and invested abroad
Equilibrium real exchange rate - the supply of
local currency available from the net capital
outflow balances the demand for local currency
by foreigners buying our net exports.
 If the gov’t reduces national saving by
increasing government purchases or
cutting taxes:
 reduction in saving lowers S − I and
thus NX
(NX=S-I)
 reduction in saving causes a trade
deficit
 If the foreign governments increase
government purchases or cut taxes:
 Reduces world saving
 Raises world interest rate
▪ Reduces domestic investment I → raises
S-I and thus NX
▪ Causes trade surplus
 If investment demand at home
increases:
 Leads to higher investment (at the given
world interest rate)
 Higher value of I means lower values of S-I
and NX
 Causes trade deficit
 are policies designed to influence
directly the amount of goods and
services imported or exported
 most often to protect domestic industries
from foreign competition
▪ Placing a tax on foreign imports (tariff)
▪ Restricting the amount of goods and services
that can be imported (a quota)
 ↓ imports → ↑ net exports
•net-exports schedule
shifts outward
•new equilibrium -
the real exchange rate
is higher
•net exports (NX) are
unchanged (because
the protectionist
policy does not alter
either saving or
investment)
 Real Nominal Ratio of
Exchange = Exchange X Price
Rate Rate Levels

є = e × (P/P*)
 e = є × (P*/P)
 Given the value of the real exchange rate, if
the domestic price level P rises, then the
nominal exchange rate e will fall
 However, if the Japanese price level P* rises,
then the nominal exchange rate will increase
 Exchange rate equation:
% Change in e = % Change in є + % Change in P*− % Change in
P
ᴖ % Change in є = change in the real exchange rate
ᴖ % Change in P = domestic inflation rate π
ᴖ % Change in P* = foreign country’s inflation rate π *
 Thus,
 % Change in e = % Change in є + (π* − π)
 If a [foreign] country has a high rate of
inflation relative to the domestic country, a
domestic currency will buy an increasing
amount of the foreign currency over time. If a
country has a low rate of inflation relative to
the domestic country, a domestic currency will
buy a decreasing amount of the foreign
currency over time.
 If a dollar could buy more wheat domestically
than abroad, there would be opportunities to profit by
buying wheat domestically and selling it abroad. Profit-
seekers would drive up the domestic price of wheat
relative to the foreign price. Similarly, if a dollar could
buy more wheat abroad than domestically, the profit-
seekers would buy wheat abroad and sell it
domestically, driving down the domestic price relative
to the foreign price. Thus, profit-seeking by
international arbitrageurs causes wheat prices to be
the same in all countries.
Any small movement in the real exchange rate leads to a large
change in net exports → guarantees that the equilibrium real
exchange rate is always close to the level ensuring purchasing-power
parity