1
Intermediate
Macroeconomics
Lecture 13
2
The Open Economy
? Why do countries trade with each other?
“No nation was ever ruined by trade.”
--- Benjamin Franklin
More varieties; higher quality; cheaper price
3
The Open Economy
? Imports and exports as a % of GDP (2002)
France
HK
Japan
Macao
U.S.
0
20
40
60
80
100
120
140
160
China Germany India Korea,
Rep.
U.K.
EX/GDP IM/GDP
4
The Open Economy
? The international flows of capital & goods
? Savings and investment in a small open economy
? Exchange rates
? Large open economy
5
International Flows of K & Goods
? National Identity
EXGICY ddd ????
fd CCC ?? fd III ?? fd GGG ??
EXGGIICCY fff ??????? )()()(
)( fff GICEXGICY ???????
IMEXGICY ?????
NXGICY ????
6
International Flows of K & Goods
?The capital & current account
NXGICY ????
0????? NXIGCY
0??? NXIS
0)( ??? NXSI
7
International Flows of K & Goods
(I-S),capital account
NX,current account
(S-I),net foreign investment (NFI)
0)( ??? NXSI
8
International Flows of K & Goods
? Net Foreign Investment (NFI)
what we lend to foreigners – what we borrow from
foreigners (net capital outflows)
net capital outflows=NFI = NX= trade balance
NFI = -capital account
? S>I,net lender
? S<I,net borrower
9
International Flows of K & Goods
? Capital and current account balance
NX > 0 current account (trade) surplus
?NFI = (S-I) > 0 (lender)
?Capital account deficit
10
Small Open Economy
? Closed economy,
1) Output must equal consumption
2) Savings must equal investment,
? Open economy,
? Access to world financial markets
? Interest rates do not need to clear the
domestic financial market
11
Small Open Economy
? What makes a country,small”?
--- the scale of the economy is so small that
it cannot affect the world interest rate
?Price taker --- take world real interest rate
12
Small Open Economy
? r = r*
? Interest rate no longer equilibrates savings and
investment
? Domestic & foreign bonds are perfect substitutes
? Capital is perfectly mobile
13
Small Open Economy
? Model
),( ??? ?? LKFYY
)( TYCC ?? ?
*)( rII ?
ISN F INX ???
*)()( rIGTYCYNX ????? ??
14
Small Open Economy
? Therefore,if there is no change in fiscal policy,
*)( rISNX ?? ?
15
Small Open Economy
? Influence of home fiscal policies
NX=0,then,G↑
? S↓
? I unchanged
? (S-I )↓
?NFI ↓& NX ↓
? Current account deficit & capital account surplus
16
Small Open Economy
I,S
r
I (r*)
r*
S I
Negative
NX
17
Small Open Economy
? Influence of home fiscal policy
NX=0,then,T↓
? C↑& S ↓
? I unchanged
? (S-I )↓
?NFI↓& NX↓
? Current account deficit & capital account surplus
18
Small Open Economy
? Higher budget deficit at home leads to
higher trade deficit (current account deficit)
--- The Twin Deficits
19
Small Open Economy
?Twin deficit (U.S.)
20
Small Open Economy
NX & Budget deficit as a % of GDP (China)
-4
-2
0
2
4
6
1
9
9
0
1
9
9
2
1
9
9
4
1
9
9
6
1
9
9
8
2
0
0
0
year
%
budget
trade
21
Small Open Economy
? NX=0,then,home demand for investment ↓
I,S
r S
I
r*
I S
net
lender
positive
NX
22
Small Open Economy
? Influence of foreign fiscal policies (large)
G (f)↑
? S (f) ↓ ? r (f) ↑
? r* ↑
23
Small Open Economy
I,S
r S
I
r*
I S
net
lender
positive
NX
24
Exchange Rates
? What does the exchange rate measure?
? How are exchange rates determined?
25
Nominal v.s,Real ex-rate
? Nominal exchange rate
--- the relative p of the currency of two countries
? Real exchange rate
--- the relative p of the goods of two countries
26
Nominal v.s,Real ex-rate
? Nominal ex-rate
Appreciation & depreciation
e.g,RMB￥ 8/U.S.$ ? RMB ￥ 10/U.S.$
U.S.$__/ RMB￥ ? U.S.$__/ RMB￥
27
Nominal v.s,Real ex-rate
? Real exchange rate
RMB￥
U.S.$ R ex-rate
(1 domestic good =
foreign good)
Tomato 2.00 3.00
Banana 2.00 0.70
Beatle 300,000 20,000
IPOD 3,000 270
28
Nominal v.s,Real ex-rate
N ex-rate,RMB￥ 8/U.S.$ ? U.S.$0.125/RMB￥
Tomato,RMB￥ 2.00/Chinese tomato
U.S.$3.00/American tomato
to m a toCSU
R M BSUto m a toCR M B
./25.0.$.
/125.0.$../2
?
? ￥￥
to m a toC
to m a toSU
to m a toSUSU
to m a toCSU
.12
..1
../3.$.
./25.0.$,?
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Nominal v.s,Real ex-rate
? Real exchange rate depends on the nominal exchange
rate and the prices of the goods measured in the
domestic currencies
Both real ex-rate and nominal ex-rate are measured as,
n foreign currency or good /domestic currency or good
*P
Pe ???
30
Nominal v.s,Real ex-rate
? Real ex-rate > 1 ? foreign goods are cheaper
? Real ex-rate = 1 ? goods have the same p
? Real ex-rate < 1 ? domestic goods are cheaper
? The higher is the real ex-rate the more
expensive is the domestic good compared to the
foreign good
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The Real ex-rate and NX
? Real ex-rate < 1,the country exports
? Real ex-rate > 1,the country imports
NX
ε
NX(ε)
0
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Determinants of the Real Ex-rate
? The real ex-rate is related to the current
account,The higher is the real ex-rate,the
more expensive are domestic goods
relative to foreign goods,the lower is the
net demand for exports,and the smaller is
the current account,
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Determinants of the Real Ex-rate
? current account balance capital account
? current account equals the difference between
savings and investment
S is fixed by the consumption function and fiscal
policy
I is fixed by the investment function and the
world interest rate
34
Determinants of the Real Ex-rate
NX
ε
NX(ε)
S-I
Eq’m
real ex-rate
Eq’m quantity of NX
35
Determinants of the Real Ex-rate
? At the eq’m real ex-rate,the supply of domestic
currency available for foreign lending balances
the demand for domestic currency by foreigners
buying our net exports,
? The supply of domestic currency for capital-
account transactions balances the demand for
domestic currency for current-account
transactions