Chapter 5:The Open EconomyChapter 5:The Open Economy

International Trade

A country’s participation is measured by the value of its – export as a percentage of GDP– Import as a percentage of GDP

Data indicate that while international trade is important in the U.S., it is even more vital for other countries such as Canada and France.

International Trade

National Income Accounting

The GDP for an open economy:Y = C + I + G + NX

Consumption = CInvestment = IGovernment purchases = GNet Exports = NX (Exports less Imports)

National Income Identity

Y = C + I + G + NX

Y – C – G = I + NX

S = I + NX

Where S = Y - C - G is National Savings

Saving Investment Identity

Equilibrium in the product market: S – I(r) = NX

Net Foreign Investment = Trade BalanceIf S>I: foreign capital outflow; hence NX>0: trade surplusIf S<I: foreign capital inflow; hence NX<0: trade deficit

Twin Deficits

The federal budget deficit (G>T), reduces national savings (S = Y – C – G)

Reduced national savings foreign capital inflow, hence causing a trade deficit (NX<0)

So, budget deficit causes trade deficit

Saving Investment: Small Open Economy

For a small open economy, r = r*, where

r = domestic real interest rater* = world real interest rate

So, S – I(r*) = NX

Determination of Real Interest Rate

I

I(r*)

r

S

Domestic real interest rate

r

r*

r*

NX>0

NX<0

If r<r*, then S>I for capital outflow and a trade surplus. If r>r*, then S<I for capital inflow and a trade deficit.

Fiscal Policy at Home

Investment, Saving

I(r*)

S1

r*

An increase in G or a decrease in T results in a lower S. Now S<I induces capital outflow and a trade deficit.

S2

NX<0

Real interest rate

Fiscal Policy Abroad

Investment, Saving

I(r*)

S

r1*

An increase in G or a decrease in T inthe U.S. results in a higher r* causing S>I and a trade surplus.

Real interest rate

r2*NX<0

Increase in Investment Demand

Investment, Saving

I1(r*)

S

r*

An increase in I(r*) results in S<I and a trade deficit.

Real interest rate

I2(r*)NX<0

Exchange Rate

Nominal exchange rate = e: the relative price of the currency of two countries; e.g., $1 = 120 yen or 1 yen = $0.00834

Real exchange rate = ε: nominal exchange rate adjusted for the foreign price difference

ε = e (P/P*)where P = domestic price levelP* = foreign price level

Real Exchange Rate and Trade Balance

NX

ε

0

NX<0

NX>0

- +

The lower the real exchange rate, the less expensive are domestic goods relative toforeign goods, thus the greater is the net export.

NX(ε)

Determinants of Real Exchange Rate

Equilibrium value of ε is determined by:Net Foreign Investment = Trade Balance

S – I = NXHere, the quantity of dollars supplied for net foreign investment equals the quantity of dollars demanded for the net export of goods and services.

Determinants of Real Exchange Rate

I

NX(ε)

ε S - I

Equilibrium real exchange rate

ε

Fiscal Policy at Home

Net export

NX(ε)

S1 - I An increase in G or a decrease in T reduces S, shifting S-I line to the left. This shift causes ε to increase, but NX to decrease.

S2 - I

Real exchange rate

ε1

ε2

NX1NX2

Fiscal Policy Abroad

Net export

NX(ε)

S2 - IS1 - I

Real exchange rate

ε2

ε1

NX2NX1

An increase in G or a decrease in T inthe U.S. results in a higher r* causing Ito decrease. This shift causes ε to decrease, but NX to increase

Increase in Investment Demand

Net export

NX(ε)

S – I1

An increase in I shifts S-I line to the left. This shift causes ε to increase, but NX to decrease.

S – I2

Real exchange rate

ε1

ε2

NX1NX2

Effect of Trade Protectionism

Net export

NX(ε)1

Real exchange rate

S - I

ε1

NX(ε)2

ε2

NX1 = NX2

Protectionism reduces the demand for imports, increasing net export.A higher NX line causes ε to increase,with no net change in net export.

Here the value of foreign trade is unchanged becausethe rise in the real exchangerate discourages exports, which offsets the decline in imports.

Determinants of Real Exchange Rate

From ε = e * (P/P*), write e = ε (P*/P)Take percentage rate:%Δe = %Δε + %ΔP* - %ΔP%Δe = %Δε + (* - )

Where ( * - ) is the difference in inflation rates of the two countries

Inflation and Nominal Exchange Rate

Countries with relatively high inflation tend to have depreciating currencies.

Countries with relatively low inflation tend to have appreciating currencies.

Inflation and Nominal Exchange Rate