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Chapter 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

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international trade
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.
national income accounting
National Income Accounting
  • The GDP for an open economy:

Y = C + I + G + NX

Consumption = C

Investment = I

Government purchases = G

Net Exports = NX (Exports less Imports)

national income identity
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
Saving Investment Identity
  • Equilibrium in the product market:

S – I(r) = NX

Net Foreign Investment = Trade Balance

If S>I: foreign capital outflow; hence NX>0: trade surplus

If S<I: foreign capital inflow; hence NX<0: trade deficit

twin deficits
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
Saving Investment: Small Open Economy
  • For a small open economy, r = r*, where

r = domestic real interest rate

r* = world real interest rate

  • So, S – I(r*) = NX
determination of real interest rate
Determination of Real Interest Rate

r

S

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.

NX>0

r*

r

Domestic real interest rate

r*

I(r*)

NX<0

I

fiscal policy at home
Fiscal Policy at Home

Real interest rate

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

S1

r*

NX<0

I(r*)

Investment, Saving

fiscal policy abroad
Fiscal Policy Abroad

Real interest rate

S

NX<0

An increase in G or a decrease in T in

the U.S. results in a higher r* causing

S>I and a trade surplus.

r2*

r1*

I(r*)

Investment, Saving

increase in investment demand
Increase in Investment Demand

Real interest rate

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

trade deficit.

S

r*

NX<0

I2(r*)

I1(r*)

Investment, Saving

exchange rate
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 level

P* = foreign price level

real exchange rate and trade balance
Real Exchange Rate and Trade Balance

ε

NX<0

The lower the real exchange rate, the less

expensive are domestic goods relative to

foreign goods, thus the greater is the net export.

NX>0

NX(ε)

-

+

0

NX

determinants of real exchange rate
Determinants of Real Exchange Rate
  • Equilibrium value of ε is determined by:

Net Foreign Investment = Trade Balance

S – I = NX

  • Here, 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 rate1
Determinants of Real Exchange Rate

ε

S - I

ε

Equilibrium real exchange rate

NX(ε)

I

fiscal policy at home1
Fiscal Policy at Home

Real exchange rate

S2 - I

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.

ε2

ε1

NX(ε)

NX2

NX1

Net export

fiscal policy abroad1
Fiscal Policy Abroad

Real exchange rate

S1 - I

S2 - I

ε1

An increase in G or a decrease in T in

the U.S. results in a higher r* causing I

to decrease. This shift causes ε to decrease,

but NX to increase

ε2

NX(ε)

NX1

NX2

Net export

increase in investment demand1
Increase in Investment Demand

Real exchange rate

S – I2

S – I1

An increase in I shifts S-I line to the left.

This shift causes ε to increase, but NX

to decrease.

ε2

ε1

NX(ε)

NX2

NX1

Net export

effect of trade protectionism
Effect of Trade Protectionism

Real exchange rate

Protectionism reduces the demand

for imports, increasing net export.

A higher NX line causes ε to increase,

with no net change in net export.

S - I

ε2

ε1

Here the value of foreign

trade is unchanged because

the rise in the real exchange

rate discourages exports, which

offsets the decline in imports.

NX(ε)2

NX(ε)1

NX1 = NX2

Net export

determinants of real exchange rate2
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
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.