Chapter 5 the open economy
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Chapter 5: The Open Economy. accounting identities for the open economy the small open economy model what makes it “small” how the trade balance and exchange rate are determined how policies affect trade balance & exchange rate. Imports and exports (% of GDP), 2008. In an open economy,.

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Chapter 5: The Open Economy

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Chapter 5 the open economy

Chapter 5: The Open Economy

  • accounting identities for the open economy

  • the small open economy model

    • what makes it “small”

    • how the trade balance and exchange rate are determined

    • how policies affect trade balance & exchange rate


Imports and exports of gdp 2008

Imports and exports (% of GDP), 2008


In an open economy

In an open economy,

  • spending need not equal output

  • saving need not equal investment


Preliminaries

Preliminaries

superscripts:

d =spending on domestic goods

f =spending on foreign goods

EX = exports = foreign spending on domestic goods

IM = imports = Cf+ If+ Gf= spending on foreign goods

NX = net exports (a.k.a. the “trade balance”) = EX – IM


Gdp expenditure on domestically produced g s

GDP = expenditure on domestically produced g & s


The national income identity in an open economy

Y = C + I + G + NX

net exports

domestic spending

output

The national income identity in an open economy

or, NX= Y– (C+ I + G)


Trade surpluses and deficits

Trade surpluses and deficits

  • trade surplus:output > spending and exports > imports Size of the trade surplus = NX

  • trade deficit:spending > output and imports > exports Size of the trade deficit = –NX

NX = EX – IM = Y– (C+ I + G )


International capital flows

International capital flows

  • Net capital outflow

    =S – I

    =net outflow of “loanable funds”

    =net purchases of foreign assets the country’s purchases of foreign assets minus foreign purchases of domestic assets

  • When S > I, country is a net lender

  • When S < I, country is a net borrower


The link between trade cap flows

The link between trade & cap. flows

NX= Y– (C+ I+ G )

implies

NX = (Y– C– G ) – I

= S – I

trade balance = net capital outflow

Thus, a country with a trade deficit (NX < 0) is a net borrower (S <I ).


Saving investment and the trade balance percent of gdp 1960 2010

Saving, investment, and the trade balance (percent of GDP) 1960-2010

investment

saving

trade balance (right scale)


U s the world s largest debtor nation

U.S.: “The world’s largest debtor nation”

  • Every year since 1980s: huge trade deficits and net capital inflows, i.e. net borrowing from abroad

  • As of 12/31/2009:

    • U.S. residents owned $18.4 trillion worth of foreign assets

    • Foreigners owned $21.1 trillion worth of U.S. assets

    • U.S. net indebtedness to rest of the world:$2.7 trillion--higher than any other country, hence U.S. is the “world’s largest debtor nation”


Saving and investment in a small open economy

An open-economy version of the loanable funds model from Chapter 3.

Includes many of the same elements:

production function

consumption function

investment function

exogenous policy variables

Saving and investment in a small open economy


National saving the supply of loanable funds

r

S, I

National saving: The supply of loanable funds

As in Chapter 3,national saving does not depend on the interest rate


Assumptions about capital flows

Assumptions about capital flows

a.domestic & foreign bonds are perfect substitutes (same risk, maturity, etc.)

b.perfect capital mobility:no restrictions on international trade in assets

c.economy is small:cannot affect the world interest rate, denoted r*

a & b imply r = r*

c implies r*is exogenous


Investment the demand for loanable funds

r

I(r)

S, I

Investment: The demand for loanable funds

Investment is still a downward-sloping function of the interest rate,

but the exogenous world interest rate…

r*

…determines the country’s level of investment.

I(r*)


If the economy were closed

r

rc

I(r)

S, I

If the economy were closed…

…the interest rate would adjust to equate investment and saving:


But in a small open economy

r

r*

rc

I(r)

S, I

I1

But in a small open economy…

the exogenous world interest rate determines investment…

NX

…and the difference between saving and investment determines net capital outflow and net exports


Next three experiments

Next, three experiments:

1.Fiscal policy at home

2.Fiscal policy abroad

3.An increase in investment demand(exercise)


1 fiscal policy at home

r

NX2

NX1

Results:

I(r)

S, I

I1

1. Fiscal policy at home

An increase in G or decrease in T reduces saving.


Nx and the federal budget deficit of gdp 1965 2009

Budget deficit (left scale)

Net exports (right scale)

NX and the federal budget deficit (% of GDP), 1965-2009

8%

2%

6%

4%

0%

2%

-

2%

0%

-

4%

-

2%

-

4%

-

6%

1965

1970

1975

1980

1985

1990

1995

2000

2005

2010


2 fiscal policy abroad

r

NX2

NX1

I(r)

S, I

2. Fiscal policy abroad

Expansionary fiscal policy abroad raises the world interest rate.

Results:


Now you try 3 increase in investment demand

r

S

NX1

I(r)1

S, I

I1

NOW YOU TRY:3. Increase in Investment Demand

Use the model to determine the impact of an increase in investment demand on NX, S, I, and net capital outflow.


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