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Chapter Five
Introduction
Until now we simplified our analysis by assuming a closed
economy (no trade with other countries).
In reality most economies are open: they export goods/services
abroad, they import goods/services from abroad, and they
borrow/lend in world financial markets.
The first goal of this chapter is to learn the macroeconomic
variables that measure the interactions among countries;
accounting identities will reveal that the flow of goods across
borders equals the flow of funds to finance capital accumulation.
The second goal is to develop a small open economy model to
explain determinants of these international flows; the model
shows the factors that determine whether a country is a
borrower or a lender in world markets and how policies affect the
flows of capital and goods/services.
The last goal is to explain the determinants of nominal and real
exchange rates.
Y = Cd + Id + Gd + EX
(closed economy Y = C + I + G)
What part represents domestic spending on domestic
goods/services? What part represents foreign spending on
domestic goods/services?
Y = C + I + G + EX (Cf + If + Gf)
IM = imports = Cf + If + Gf
Y = C + I + G + EX - IM
domestic
spending
net
exports
output
I
NX capital.
=SI
flow of funds to finance
trade
tradebalance
balance==net
netcapital
capital
outflow
outflow
S I = NX > 0 trade surplus; are EX > IM? Are we
borrowers/lenders?
S I = NX < 0 trade deficit; are EX > IM? Are we
borrowers/lenders?
consumption function:
C C (Y T )
investment function:
I I (r )
The Model
Y = Y = F(K,L) C = C(Y T) I = I(r) r = r*
NX = (Y C G) I = S I
NX = [Y C(Y T) G] I(r*) = S I(r*)
As in
Chapter 3,
national
saving
r
does not
depend on *
the interest
rate
S
,I
Investment is still a
downward-sloping
function
of the but
interest
rate,
the exogenous
world interest
rate
determines
the
countrys
I(r)
level of
investment
I (r* )
. S
The Model
NX = S I(r*)
In a closed economy,
the real interest rate
adjusts to equilibrate
saving and investment
and is found where the
saving and investment
curves cross.
In the small open
economy, 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.
Net exports
(left scale)
exchange rate
6/6/02
exchange rate
8/18/03
Euro
1.06 Euro/$
0.8976 Euro/$
Japan
124.3 Yen/$
119.4 Yen/$
Mexico
9.7 Pesos/$
10.73 Pesos/$
Russia
31.4 Rubles/$
30.4 Rubles/$
South
Africa
9.8 Rand/$
7.28 Rand/$
Turkey
1,444,063.1 Liras/
$
1,404,436.2 Liras/
$
U.K.
0.68 Pounds/$
0.63 Pounds/$
e P
P*
~ McZample
~
one good: Big Mac
price in Japan:
P* = 200 Yen
price in USA:
P = $2.50
nominal exchange
rate
e = 120 Yen/$
To
Tobuy
buyaaU.S.
U.S.Big
BigMac,
Mac,
someone
someonefrom
fromJapan
Japan
would
wouldhave
haveto
topay
payan
an
amount
amountthat
thatcould
couldbuy
buy
1.5
1.5Japanese
JapaneseBig
BigMacs
Macs..
e P
P*
120 $2.50
How NX depends on
U.S. goods become more
expensive relative to foreign goods
EX, IM
NX
In this
this small
small open
open economy
economy model
model there
there is
is aa
In
negative relationship
relationship between
between the
the trade
trade
negative
balance and
and the
the real
real exchange
exchange rate.
rate.
balance
140
120
100
-1
80
-2
60
-3
40
-4
20
-5
1975
1980
1985
1990
1995
2000
1998:2 = 100
Percent of GDP
so U.S. net
exports will
be high
When is
relatively low,
U.S. goods are
relatively
inexpensive
NX(1)
NX(
)
N
X
At high enough
values of ,
U.S. goods
become so
expensive that
we export less
than we
import
NX(
)
NX(2)
( to)ensure:
S I
must NX
adjust
r( * )
How is determined
Neither S nor I
depend on ,
so the net
capital outflow
curve is
vertical.
adjusts to
equate NX
with net capital
outflow, S I.
S1 I (r *)
NX 1
NX(
)
NX
S1 I (r *)
NX 1
NX(
) NX
Given the value of if the domestic price level rises what happens to
e? Why? Given the value of what happens to e if the foreign price
e P P*
*
e
P
P
Chapter Summary
Net exports--the difference between exports and
imports or a countrys output (Y ) and its spending (C +
I + G)
2.
Net capital outflow equals purchases of foreign assets
minus foreign purchases of the countrys assets or the
difference between saving and investment.
3.
National income accounts identities state that Y = C +
I + G + NX and the trade balance NX = S I or net
capital outflow.
4.
Impact of policies on NX :
Chapter Summary
5) Exchange rates:
nominal: the price of a countrys currency in terms of another
countrys currency
real: the price of a countrys goods in terms of another countrys
goods
The real exchange rate equals the nominal rate times the ratio of
prices of the two countries.
6) 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