1、S E V E N T H E D I T I O N2 0 1 0 U P D A T Eaccounting identities for the open economythe small open economy modelwhat makes it “small”how the trade balance and exchange rate are determinedhow policies affect trade balance & exchange rateImports and exports (% of GDP), 20193CHAPTER 5 The Open

2、EconomyIn an open economy,spending need not equal outputsaving need not equal investment4CHAPTER 5 The Open EconomyPreliminariesEX = exports = foreign spending on domestic goodsIM = imports = C f + I f + G f = spending on foreign goodsNX = net exports (a.k.a. the “trade balance”) = EX IMdfCCCdfIIIdf

3、GGGsuperscripts:d = spending on domestic goodsf = spending on foreign goods5CHAPTER 5 The Open EconomyGDP = expenditure on domestically produced g & sdddYCIGEX()()()fffCCIIGGEX()fffCIGEXCIGCIGEXIMCIGNX6CHAPTER 5 The Open EconomyThe national income identity in an open economyY = C + I + G + NXor,

4、 NX = Y (C + I + G )net exportsdomestic spendingoutput7CHAPTER 5 The Open EconomyTrade surpluses and deficitstrade surplus: output spending and exports imports Size of the trade surplus = NXtrade deficit: spending output and imports exports Size of the trade deficit = NXNX = EX IM = Y (C + I + G )8C

5、HAPTER 5 The Open EconomyInternational capital flowsNet capital outflow=S I=net outflow of “loanable funds”=net purchases of foreign assets the countrys purchases of foreign assets minus foreign purchases of domestic assetsWhen S I, country is a net lenderWhen S I, country is a net borrower9CHAPTER

6、5 The Open EconomyThe link between trade & cap. flowsNX = Y (C + I + G )implies NX = (Y C G ) I = S Itrade balance = net capital outflowThus, a country with a trade deficit (NX 0) is a net borrower (S 0 (demand increase)NX = 0(supply fixed) IM 0 (policy)EX 0(rise in ) 245CHAPTER 5 The Open Econo

7、myThe determinants of the nominal exchange rateStart with the expression for the real exchange rate:*ePPSolve for the nominal exchange rate:*PeP46CHAPTER 5 The Open EconomyThe determinants of the nominal exchange rate( *,)ML rYPp( )()*NX SI rSo e depends on the real exchange rate and the price level

8、s at home and abroadand we know how each of them is determined:*PeP*( *,)ML rYPp47CHAPTER 5 The Open EconomyThe determinants of the nominal exchange rateRewrite this equation in growth rates (see “arithmetic tricks for working with percentage changes,” Chap 2 ):*PeP*ePPePP *p pp p For a given value

9、of , the growth rate of e equals the difference between foreign and domestic inflation rates. Inflation differentials and nominal exchange rates for a cross section of countries% change in nominal exchange rateinflation differentialIcelandMexicoU.K.S. KoreaJapanSingaporeCanadaAustraliaS. AfricaPakis

10、tan49CHAPTER 5 The Open EconomyPurchasing Power Parity (PPP)Two definitions:A doctrine that states that goods must sell at the same (currency-adjusted) price in all countries.The nominal exchange rate adjusts to equalize the cost of a basket of goods across countries. Reasoning: arbitrage, the law o

11、f one price50CHAPTER 5 The Open EconomyPurchasing Power Parity (PPP)PPP: e P = P* Cost of a basket of domestic goods, in foreign currency.Cost of a basket of domestic goods, in domestic currency.Cost of a basket of foreign goods, in foreign currency.Solve for e : e = P*/ P PPP implies that the nomin

12、al exchange rate between two countries equals the ratio of the countries price levels. 51CHAPTER 5 The Open EconomyPurchasing Power Parity (PPP)If e = P*/P, then *1PPPePPPand the NX curve is horizontal:NXNX = 1S - IUnder PPP, changes in (S I ) have no impact on or e. 52CHAPTER 5 The Open EconomyDoes

13、 PPP hold in the real world?No, for two reasons:1.International arbitrage not possible.nontraded goodstransportation costs2.Different countries goods not perfect substitutes.Yet, PPP is a useful theory:Its simple & intuitive.In the real world, nominal exchange rates tend toward their PPP values

14、over the long run. no changeno change no changeno change 129.4-2.019.46.317.43.9115.1-0.32.2closed economysmall open economyactual changeNXIrSG T1980s1970sData: decade averages; all except r and are expressed as a percent of GDP; is a trade-weighted index. CASE STUDY: The Reagan deficits

15、revisited54CHAPTER 5 The Open EconomyThe U.S. as a large open economySo far, weve learned long-run models for two extreme cases:closed economy (chap. 3)small open economy (chap. 5)A large open economy like the U.S. fallsbetween these two extremes. The results from large open economy analysis are a m

16、ixture of the results for the closed & small open economy cases. For example 55CHAPTER 5 The Open EconomyNXIrlarge open economysmall open economyclosed economyA fiscal expansion in three modelsfalls, but not as much as in small open economyfallsno changefalls, but not as much as in closed econom

17、ynochangefallsrises, but not as much as in closed economynochangerisesA fiscal expansion causes national saving to fall.The effects of this depend on openness & size:Net exports-the difference between exports and importsa countrys output (Y ) and its spending (C + I + G)Net capital outflow equal

18、spurchases of foreign assets minus foreign purchases of the countrys assetsthe difference between saving and investmentNational income accounts identities:Y = C + I + G + NXtrade balance NX = S - I net capital outflowImpact of policies on NX :NX increases if policy causes S to rise or I to fallNX does not change if policy affects neither S nor I. Example: trade policyExchange ratesnominal: the price of a countrys currency in terms of another countrys currencyreal: the price of a countrys