MACROECONOMICS
cover art ROW 1 (90)
C H A P T E R
© 2008 Worth Publishers, all rights reserved
SIXTH EDITION
PowerPoint® Slides by Ron Cronovich
N. GREGORY MANKIW
The Open Economy
5

Chapter 5 extends the analysis to a small open economy.
This PowerPoint presentation contains a slide explaining why the U.S. is often called “the world’s
largest debtor nation.”  This material will help motivate the rest of the chapter:
First, students learn exactly what trade surpluses and trade deficits are.
Next, students learn the link between the trade balance and net capital outflow or net lending
to/borrowing from abroad.
Finally, students see a new time series graph on the U.S. trade deficit, and get the latest
available numbers on U.S. net indebtedness to the rest of the world.
This data begs the question:  how did it come to this?  why has the U.S. had such huge trade
deficits?  what can the government do about this?  These are among the many topical questions that
students will better understand as they study this chapter.
NOTE:  If you are planning on covering chapter 12 (Aggregate Demand in the Open Economy), then
covering this chapter is highly recommended.

cover R1,C4
slide ‹#›
CHAPTER 5   The Open Economy
CHAPTER 5   The Open Economy
In this chapter, you will learn…
§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

>

cover R1,C4
slide ‹#›
CHAPTER 5   The Open Economy
CHAPTER 5   The Open Economy
Trade-GDP ratio, selected countries, 2005
(Imports + Exports) as a percentage of GDP
Luxembourg
297.2%
Ireland
149.9
Czech Republic
141.5
Hungary
134.2
Austria
103.8
Sweden
89.8
Switzerland
89.0
Korea, Republic of
82.2
Germany
76.2%
Poland
74.7
Canada
72.0
Mexico
61.5
Turkey
61.4
United Kingdom
56.8
Spain
56.4
France
53.0
Italy
52.2
Australia
42.1
Japan
27.3
United States
26.8

This data shows the degree of “openness” (measured by the trade-to-GDP ratio) of selected OECD
countries.
Despite the huge absolute value of U.S. trade, most of the other countries shown have higher
trade-GDP ratios.
Source:  http://www.oecd.org/statistics

cover R1,C4
slide ‹#›
CHAPTER 5   The Open Economy
CHAPTER 5   The Open Economy
In an open economy,
§spending need not equal output
§saving need not equal investment

>

Regarding “spending need not equal output”:
Residents of an open economy can spend more than the country’s output simply by importing foreign
goods.   Residents can spend less than output, and the extra output will be exported.
Regarding “saving need not equal investment”:
If individuals in an open economy want to save more than domestic firms want to borrow, no
problem.  The savers simply send their extra funds abroad to buy foreign assets.  Similarly, if
domestic firms want to borrow more than individuals are willing to save, then the firms simply
borrow from abroad (i.e. sell bonds to foreigners).

cover R1,C4
slide ‹#›
CHAPTER 5   The Open Economy
CHAPTER 5   The Open Economy
Preliminaries
§EX = exports =
foreign spending on domestic goods
§IM = imports = C f + I f + G f
= spending on foreign goods
§NX = net exports (a.k.a. the “trade balance”)
   = EX – IM
superscripts:
d = spending on domestic goods
f = spending on foreign goods

Before displaying the second and subsequent lines, explain the first one:
Total consumption expenditure is the sum of consumer spending on domestically produced goods and
foreign produced goods.
EX:  The value of the goods we export to other countries equals their expenditure on our output.
IM:  The value of our imports equals the portion of our country’s expenditure (the portion of
C+I+G) that falls on foreign products.

cover R1,C4
slide ‹#›
CHAPTER 5   The Open Economy
CHAPTER 5   The Open Economy
GDP = expenditure on
domestically produced g & s

A country’s GDP is total expenditure on its output of final goods & services. The first line adds
up all sources of spending on domestically produced goods & services.
The second & subsequent lines present an algebraic derivation of the national income accounting
identity for an open economy.

cover R1,C4
slide ‹#›
CHAPTER 5   The Open Economy
CHAPTER 5   The Open Economy
The national income identity
in an open economy
§Y = C + I + G + NX
or,    NX = Y – (C + I + G )
net exports
domestic spending
output

Solving this identity for NX yields the second equation, which says:
   A country’s net exports---its net outflow of goods---equals the difference between its output
and its expenditure.
Example:  If we produce $500b worth of goods, and only buy $400b worth, then we export the
remainder.
Of course, NX can be a negative number, which would occur if our spending exceeds our
income/output.

cover R1,C4
slide ‹#›
CHAPTER 5   The Open Economy
CHAPTER 5   The Open Economy
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 )

U.S. net exports, 1950-2007
cover R1,C4

After learning the terms trade surplus and trade deficit on the preceding slides, we see here that
the U.S. has had trade deficits since the early 1980s.  In the early 1990s, the trade deficit
shrunk relative to GDP, but since then it’s become huge.
The next slides show the link between the trade balance and capital flows.  Students will see that
the huge trade deficits on this slide have caused the U.S. to become the world’s largest debtor
nation (and will learn exactly what that means).
source:  FRED Database, The Federal Reserve Bank of St. Louis,
http://research.stlouisfed.org/fred2/

cover R1,C4
slide ‹#›
CHAPTER 5   The Open Economy
CHAPTER 5   The Open Economy
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

In chapter 3, we examined a closed economy model of the loanable funds market.  Savers could only
lend money to domestic borrowers.  Firms borrowing to finance their investment could only borrow
from domestic savers.  Thus, S = I.
   But in an open economy, S need not equal I.  A country’s supply of loanable funds can be used to
finance domestic investment, or to finance foreign investment (e.g. buying bonds from a foreign
company that needs funding to build a new factory in its country).
   Similarly, domestic firms can finance their investment projects by borrowing loanable funds from
domestic savers or by borrowing them from foreign savers.
   International borrowing and lending is called “international capital flows” even though it’s not
the physical capital that is flowing abroad --- we don’t see factories uprooted and shipped to
Mexico (Ross Perot’s famous remark notwithstanding). Rather, what can flow internationally is
“loanable funds,” or financial capital, which of course is used to finance the purchase of physical
capital.
   Note:  foreign investment might involve the purchase of financial assets – stocks and bonds and
so forth – or physical assets, such as direct ownership in office buildings or factories.  In
either case, a person in one country ends up owning part of the capital stock of another country.
   The equation “net capital outflow = S – I”  shows that, if a country’s savers supply more funds
than its firms wish to borrow for investment, the excess of loanable funds will flow abroad in the
form of net capital outflow (the purchase of foreign assets).  Alternatively, if firms wish to
borrow more than domestic savers wish to lend, then the firms borrow the excess on international
financial markets; in this case, there’s a net inflow of loanable funds, and S < I.

cover R1,C4
slide ‹#›
CHAPTER 5   The Open Economy
CHAPTER 5   The Open Economy
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 ).

Starting from the equation derived on slides 6 and 7, we can derive another important identity:  NX
= S – I
This equation says that
Net exports (the net outflow of goods) = net capital outflow (the net outflow of loanable funds)
While the identity and its derivation are very simple, we learn a very important lesson from it:
   A country (such as the U.S.) with persistent, large trade deficits (NX < 0) also has low saving,
relative to its investment, and is a net borrower of assets.

cover R1,C4
slide ‹#›
CHAPTER 5   The Open Economy
CHAPTER 5   The Open Economy
“The world’s largest debtor nation”
§U.S. has had large trade deficits, been a
net borrower each year since the early 1980s.
§As of 12/31/2006:
§U.S. residents owned $13.8 trillion worth of foreign assets
§Foreigners owned $16.3 trillion worth of U.S. assets
§U.S. net indebtedness to rest of the world:
$2.5 trillion--higher than any other country, hence U.S. is the “world’s largest debtor nation”

>

Source:
Bureau of Economic Analysis,  http://www.bea.gov
Look for “International Investment Position” under “International” or “International Economic
Accounts”
The U.S.’ net indebtedness to the rest of the world (henceforth NIROW) is $2.7 trillion as of the
end of 2005.
The U.S. NIROW is bigger than any other country’s NIROW, which is why the U.S. has earned the
dubious distinction of being “the world’s largest debtor nation.”
Servicing this huge debt, of course, uses up some of our GDP each year (though fortunately
relatively little).
How did it get to this point?  Why do we have such huge trade deficits year after year?  How do
government policies affect the trade deficit?  These are the questions your students will learn
about in the rest of this chapter.

cover R1,C4
slide ‹#›
CHAPTER 5   The Open Economy
CHAPTER 5   The Open Economy
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

cover R1,C4
slide ‹#›
CHAPTER 5   The Open Economy
CHAPTER 5   The Open Economy
National saving:
The supply of loanable funds
r
S, I
As in Chapter 3,
national saving does not depend on the interest rate

cover R1,C4
slide ‹#›
CHAPTER 5   The Open Economy
CHAPTER 5   The Open Economy
Assumptions re: 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

This slide is the first on which students see a foreign variable, in this case, the foreign
interest rate r*.  In general, a star or asterisk “*” on a variable denotes the foreign or world
version of that variable.   Thus, Y* = foreign GDP, P* = foreign price level, etc.
The assumption that domestic & foreign bonds are perfect substitutes is implicit in the text, but
necessary for the equality of the domestic and foreign interest rate.
Students will realize that assumption a is unrealistic, and c is unrealistic for the U.S. (as well
as Japan and the Euro zone).  However, these assumptions keep our model simple, and we can still
learn a LOT about how the world works (just as the model of supply and demand in perfectly
competitive markets is often not realistic, yet teaches us a great deal about how the world
works).  At the end of the chapter, there’s a brief section discussing how the results we are about
to derive differ in a large open economy.  And you may wish to have your students read the appendix
to chapter 5, which presents a formal model of the large open economy.

cover R1,C4
slide ‹#›
CHAPTER 5   The Open Economy
CHAPTER 5   The Open Economy
Investment:
The demand for loanable funds
Investment is still a
  downward-sloping function
     of the interest rate,
r *
but the exogenous
   world interest rate…
…determines the
   country’s level of
       investment.
I (r* )
r
S, I
I (r )

cover R1,C4
slide ‹#›
CHAPTER 5   The Open Economy
CHAPTER 5   The Open Economy
If the economy were closed…
r
S, I
I (r )
rc
…the interest rate would adjust to
equate
investment
and saving:

cover R1,C4
slide ‹#›
CHAPTER 5   The Open Economy
CHAPTER 5   The Open Economy
But in a small open economy…
r
S, I
I (r )
rc
r*
I 1
the exogenous world interest rate determines investment…
…and the difference between saving and investment determines net capital outflow and net exports
NX

This graph really determines net capital outflow, not NX.  But, the national accounting identities
say that NX = net capital outflow, so we write “NX” on the graph as shown.
A little bit later in the chapter, we will see that it is the adjustment of the exchange rate that
ensures that NX = net capital outflow.  For now, though, students will just have to trust the
accounting identities.

cover R1,C4
slide ‹#›
CHAPTER 5   The Open Economy
CHAPTER 5   The Open Economy
Next, three experiments:
§1. Fiscal policy at home
§2. Fiscal policy abroad
§3. An increase in investment demand

>

In the textbook, NX = 0 in the economy’s initial equilibrium for each of these three experiments.
In these slides, NX > 0 in the initial equilibrium.
For completeness, you might have your students repeat the three experiments for the case of NX < 0
in the initial equilibrium.  This would be a good homework or in-class exercise.

cover R1,C4
slide ‹#›
CHAPTER 5   The Open Economy
CHAPTER 5   The Open Economy
1.  Fiscal policy at home
r
S, I
I (r )
I 1
An increase in G or decrease in T reduces saving.
NX1
NX2
Results:

In a small open economy, the fixed world interest rate pins down the value of investment,
regardless of fiscal policy changes.  Thus, a $1 decrease in saving causes a $1 decrease in NX and
net capital outflow.
Note that the analysis on this slide applies to ANYTHING that causes a decrease in saving.  Other
examples:  a shift in consumer preferences regarding the tradeoff between saving and consumption,
or a change in the tax laws that reduces the incentive to save.
Our model generates a prediction:  the government’s budget deficit and the country’s trade balance
should be negatively related.  Does this prediction come true in the real world?  Let’s look at the
data….

NX and the federal budget deficit
(% of GDP), 1960-2006
-6%
-4%
-2%
0%
2%
4%
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
-4%
-2%
0%
2%
4%
6%
8%
Net exports
(left scale)
Budget deficit
(right scale)
cover R1,C4
slide 20

Our model implies a negative relationship between NX and the budget deficit.  We observe this
negative relationship during most periods.  Exceptions:
1.  Late 1970s.
2.  1991-2001.
In the latter period, the U.S. enjoyed an unusually long expansion, which fueled a surge in both
imports and tax revenues.
Source:  Department of Commerce.
Obtained from:  http://research.stlouisfed.org/fred2/

cover R1,C4
slide ‹#›
CHAPTER 5   The Open Economy
CHAPTER 5   The Open Economy
2.  Fiscal policy abroad
r
S, I
I (r )
Expansionary fiscal policy abroad raises the world interest rate.
NX1
NX2
Results:

It might be worth taking a moment to explain that the world interest rate r* is determined by
saving and investment in the world loanable funds market.  S* is the sum of all countries’ saving;
I* the sum of all countries’ investment.  r* adjusts to equate I* with S*, just like in Chapter 3,
because the world as a whole is a closed economy.  A fiscal expansion in other countries would
reduce S* and raise r* (same results as in chapter 3).
The higher world interest rate reduces investment in our small open economy, and hence reduces the
demand for loanable funds.  The supply of loanable funds (national saving) is unchanged, so there’s
an increase in the amount of funds flowing abroad.

cover R1,C4
slide ‹#›
CHAPTER 5   The Open Economy
CHAPTER 5   The Open Economy
3. An increase in investment demand
r
S, I
I (r )1
EXERCISE:
Use the model to determine the impact of an increase in investment demand on NX, S, I, and
net capital outflow.
NX1
I 1
S

Have students get out a piece of paper, draw this graph on it, and then do the analysis.  A couple
minutes should suffice.
It might be useful to have them compare their answers with the results from the closed economy
case.

cover R1,C4
slide ‹#›
CHAPTER 5   The Open Economy
CHAPTER 5   The Open Economy
3. An increase in investment demand
r
S, I
I (r )1
ANSWERS:
 I  > 0,
 S  = 0,
net capital outflow and NX fall by the amount I
NX2
NX1
I 1
I 2
S
I (r )2

In contrast to a closed economy, investment is not constrained by the fixed (domestic) supply of
loanable funds.  Hence, the increase in firm’s demand for loanable funds can be satisfied by
borrowing abroad, which reduces net outflow of financial capital.  And since net capital outflow =
NX, we see a fall in NX equal to the increase in investment.

cover R1,C4
slide ‹#›
CHAPTER 5   The Open Economy
CHAPTER 5   The Open Economy
The nominal exchange rate
§e  = nominal exchange rate,
the relative price of
domestic currency
in terms of foreign currency
§ (e.g. Yen per Dollar)

Warning to students:
Some textbooks and newspapers define the exchange rate as the reciprocal of the one here (e.g.,
dollars per yen instead of yen per dollar).  The one here is easier to use, because a rise in “e”
corresponds to an “appreciation” of the country’s currency.  Using the reciprocal would mean that a
rise in “e” is a depreciation, which seems counter-intuitive.
So it would be worthwhile to point out to students that a country’s “e” is simply the price
(measured in foreign currency) of a unit of that country’s currency.

cover R1,C4
slide ‹#›
CHAPTER 5   The Open Economy
CHAPTER 5   The Open Economy
A few exchange rates, as of 7/11/07
country
exchange rate
Euro
0.73 Euro/$
Indonesia
9,037 Rupiahs/$
Japan
122.3 Yen/$
Mexico
10.8 Pesos/$
Russia
25.9 Rubles/$
South Africa
7.0 Rand/$
U.K.
0.49 Pounds/$

If you’d like to update these figures before your lecture, you can find good exchange rate data
at:  http://www.xe.net/ict/

cover R1,C4
slide ‹#›
CHAPTER 5   The Open Economy
CHAPTER 5   The Open Economy
The real exchange rate
§    = real exchange rate,
the relative price of
domestic goods
in terms of foreign goods
§ (e.g. Japanese Big Macs per U.S. Big Mac)
the lowercase Greek letter epsilon
ε

cover R1,C4
slide ‹#›
CHAPTER 5   The Open Economy
CHAPTER 5   The Open Economy
Understanding the units of ε
ε

Students often have trouble understanding the units of the real exchange rate.
It’s worth explaining each line carefully, and making sure students understand it before displaying
the next line.
Note:  The examples here and in the text are in terms of one good, i.e. Big Macs.  But P and P* are
the overall price levels of the domestic & foreign countries.  Thus, they each measure the price of
a basket of goods.
When you get to the bottom line, emphasize that the real exchange rate measures the amount of
purchasing power in Japan that must be sacrificed for each unit of purchasing power in the U.S.

§one good:  Big Mac
§price in Japan:
   P* = 200 Yen
§price in USA:
   P  =  $2.50
§nominal exchange rate
   e = 120 Yen/$
To buy a U.S. Big Mac, someone from Japan
would have to pay an amount that could buy
1.5 Japanese Big Macs.
RF4475248
ε
~ McZample ~
CHAPTER 5   The Open Economy
slide 28

cover R1,C4
slide ‹#›
CHAPTER 5   The Open Economy
CHAPTER 5   The Open Economy
ε in the real world & our model
§In the real world:
We can think of ε  as the relative price of
a basket of domestic goods in terms of a basket of foreign goods
§In our macro model:
There’s just one good, “output.”
So ε  is the relative price of one country’s output in terms of the other country’s output

A good candidate for the basket of goods mentioned here is the CPI basket.  Perhaps a better
candidate would be a basket including all goods & services that comprise GDP.  Then, the real
exchange rate would measure how many units of foreign GDP trade for one unit of domestic GDP.

cover R1,C4
slide ‹#›
CHAPTER 5   The Open Economy
CHAPTER 5   The Open Economy
How NX depends on ε
§ε  Þ U.S. goods become more expensive relative to foreign goods
§     Þ  ¯EX,  IM
§     Þ  ¯NX

cover R1,C4
slide ‹#›
CHAPTER 5   The Open Economy
CHAPTER 5   The Open Economy
U.S. net exports and the
real exchange rate, 1973-2007
Net exports
(left scale)
-7%
-6%
-5%
-4%
-3%
-2%
-1%
0%
1%
2%
3%
1973
1978
1983
1988
1993
1998
2003
2008
0
20
40
60
80
100
120
140
Trade-weighted real exchange rate index

The real exchange rate here is a broad index.  Source:  Federal Reserve Statistical Release H.10,
Board of Governors.
(To find it, simply google “Federal Reserve Statistical Release H.10”)
NX as a percent of GDP was computed from NX and GDP source data from Department of Commerce, Bureau
of Economic Analysis, obtained at:
http://research.stlouisfed.org/fred2/

cover R1,C4
slide ‹#›
CHAPTER 5   The Open Economy
CHAPTER 5   The Open Economy
The net exports function
§The net exports function reflects this inverse relationship between NX and ε :
§ NX  = NX(ε )

>

cover R1,C4
slide ‹#›
CHAPTER 5   The Open Economy
CHAPTER 5   The Open Economy
The NX curve for the U.S.
0
NX
ε
NX (ε)
ε1
When ε  is relatively low,
U.S. goods are relatively inexpensive
NX(ε1)
so U.S. net exports will
be high

cover R1,C4
slide ‹#›
CHAPTER 5   The Open Economy
CHAPTER 5   The Open Economy
The NX curve for the U.S.
0
NX
ε
NX (ε)
ε2
At high enough values of ε,
U.S. goods become so expensive that
NX(ε2)
we export less than we import

cover R1,C4
slide ‹#›
CHAPTER 5   The Open Economy
CHAPTER 5   The Open Economy
How ε  is determined
§The accounting identity says NX = S – I
§We saw earlier how S – I  is determined:
§S  depends on domestic factors (output, fiscal policy variables, etc)
§I  is determined by the world interest
rate r *
§So, ε  must adjust to ensure

In the equation, ε is the only endogenous variable, hence this equation determines the value of ε.

cover R1,C4
slide ‹#›
CHAPTER 5   The Open Economy
CHAPTER 5   The Open Economy
How ε  is determined
§Neither S nor I depend on ε,
so the net capital outflow curve is vertical.
ε
NX
NX(ε )
ε  adjusts to equate NX
with net capital outflow, S - I.
ε 1
NX 1

*** Note ***
At the lower left corner (origin) of this graph, NX does NOT NECESSARILY EQUAL ZERO!!!

cover R1,C4
slide ‹#›
CHAPTER 5   The Open Economy
CHAPTER 5   The Open Economy
Interpretation:  Supply and demand
in the foreign exchange market
§demand:
§Foreigners need dollars to buy U.S. net exports.
ε
NX
NX(ε )
supply:
Net capital outflow (S - I )
is the supply of dollars to be invested abroad.
ε 1
NX 1

WARNING:  Don’t let your students confuse the demand for dollars in the foreign exchange market
with demand for real money balances (chapter 4), or the supply of dollars in the foreign exchange
market with the supply of money (chapter 4).
If you and your students are into details:
NX is actually the net demand for dollars:  foreign demand for dollars to purchase our exports
minus our supply of dollars to purchase imports.  Net capital outflow is the net supply of
dollars:  The supply of dollars from U.S. residents investing abroad minus the demand for dollars
from foreigners buying U.S. assets.

cover R1,C4
slide ‹#›
CHAPTER 5   The Open Economy
CHAPTER 5   The Open Economy
Next, four experiments:
§1. Fiscal policy at home
§2. Fiscal policy abroad
§3. An increase in investment demand
§4. Trade policy to restrict imports

>

cover R1,C4
slide ‹#›
CHAPTER 5   The Open Economy
CHAPTER 5   The Open Economy
1.  Fiscal policy at home
§A fiscal expansion reduces national saving, net capital outflow, and the supply of dollars
in the foreign exchange market…
…causing the real exchange rate to rise and NX  to fall.
ε
NX
NX(ε )
ε 1
NX 1
NX 2
ε 2

cover R1,C4
slide ‹#›
CHAPTER 5   The Open Economy
CHAPTER 5   The Open Economy
2.  Fiscal policy abroad
§An increase in r* reduces investment, increasing net capital outflow and the supply of dollars in
the foreign exchange market…
…causing the real exchange rate to fall and NX to rise.
ε
NX
NX(ε )
NX 1
ε 1
ε 2
NX 2

cover R1,C4
slide ‹#›
CHAPTER 5   The Open Economy
CHAPTER 5   The Open Economy
3. Increase in investment demand
§An increase in investment reduces net capital outflow and the supply
of dollars in the foreign exchange market…
ε
NX
NX(ε )
…causing the real exchange rate to rise and NX  to fall.
ε 1
NX 1
NX 2
ε 2

Suggestion:  Have your students do this experiment as an in-class exercise.  Have them take out a
piece of paper, draw the graph, then show what happens when there’s an increase in the country’s
investment demand (perhaps in response to an investment tax credit).

cover R1,C4
slide ‹#›
CHAPTER 5   The Open Economy
CHAPTER 5   The Open Economy
4.  Trade policy to restrict imports
ε
NX
NX (ε )1
NX1
ε 1
NX (ε )2
§At any given value of ε, an import quota
§  IM   NX
§  demand for dollars shifts right
Trade policy doesn’t affect S or I , so capital flows and the supply of dollars remain fixed.
ε 2

The analysis here applies for import restrictions (tariffs, quotas) as well as export subsidies.
It also applies for exogenous changes in preferences regarding domestic vs. foreign goods.

cover R1,C4
slide ‹#›
CHAPTER 5   The Open Economy
CHAPTER 5   The Open Economy
4.  Trade policy to restrict imports
ε
NX
NX (ε )1
NX1
ε 1
NX (ε )2
Results:
ε > 0
(demand increase)
NX  = 0
(supply fixed)
IM < 0
(policy)
EX < 0
(rise in ε )
ε 2

In the text box, the remarks in parentheses after each result are an abbreviated explanation for
that result.
The real exchange rate appreciates because the quota has raised the net demand for dollars
associated with any given value of the exchange rate.
But the equilibrium level of net exports doesn’t change, because the supply of dollars in the
foreign exchange market (S-I) has not been affected by the trade policy.  (Remember, S = Y-C-G, and
the trade policy does not affect Y, C, or G; the policy also does not affect I, because I = I(r*)
and r* is exogenous.)
The appreciation causes exports to fall.
And, since exports are lower but NX is unchanged, it must be the case that IM is lower too, which
is what you’d expect from a trade policy that restricts imports.

cover R1,C4
slide ‹#›
CHAPTER 5   The Open Economy
CHAPTER 5   The Open Economy
The determinants of the
nominal exchange rate
§Start with the expression for the real exchange rate:
§Solve for the nominal exchange rate:

cover R1,C4
slide ‹#›
CHAPTER 5   The Open Economy
CHAPTER 5   The Open Economy
The determinants of the
nominal exchange rate
§So e  depends on the real exchange rate and the price levels at home and abroad…
§…and we know how each
of them is determined:

It’s important here for students to learn the (logical, not necessarily chronological) order in
which the variables are determined.  I.e., what causes what.

cover R1,C4
slide ‹#›
CHAPTER 5   The Open Economy
CHAPTER 5   The Open Economy
The determinants of the
nominal exchange rate
§Rewrite this equation in growth rates
(see “arithmetic tricks for working with percentage changes,” Chap 2 ):
§For a given value of ε,
the growth rate of e  equals the difference between foreign and domestic inflation rates.

Here we again see the Classical Dichotomy in action.  The real exchange rate is determined by real
factors, and nominal variables only affect nominal variables.
Suppose the U.S. is the home country and Mexico is the foreign (starred) country, and suppose that
Mexico’s inflation rate (pi*) is higher than that of the U.S.  This equation implies:  the greater
is Mexico’s inflation relative to the U.S., the faster the dollar should rise relative to the peso.
The next slide presents cross-country data consistent with this implication.

cover R1,C4
slide ‹#›
CHAPTER 5   The Open Economy
CHAPTER 5   The Open Economy
Inflation differentials and nominal exchange rates
U.K.
South Africa
Iceland
Mexico
South Korea
Canada
Singapore
Japan

Figure 5-13 on p.141.   The horizontal axis measures the country’s inflation rate minus the U.S.
inflation rate.  The vertical axis measures the percentage change in the U.S. dollar exchange rate
with that country.   All variables are annual averages over the period 1972-2004.
This figure shows a very clear relationship between the inflation differential and the rate of
dollar appreciation.   The higher a country’s inflation relative to U.S. inflation, the faster the
U.S. dollar will appreciate against that country’s currency.  Or, for the few countries like Japan
that have lower inflation than the U.S., we see the U.S. exchange rate depreciating relative to
those countries’ currencies.
Source:  International Financial Statistics

cover R1,C4
slide ‹#›
CHAPTER 5   The Open Economy
CHAPTER 5   The Open Economy
Purchasing 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 of one price

>

cover R1,C4
slide ‹#›
CHAPTER 5   The Open Economy
CHAPTER 5   The Open Economy
Purchasing 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 nominal exchange rate between two countries equals the ratio of the
countries’ price levels.

PPP implies that the cost of a basket of goods (even a basket with just one good, like a Big Mac or
a latte) should be the same across countries.
e P = the foreign-currency cost of a basket of goods in the U.S., while P* the cost of a basket of
foreign goods.
PPP implies that the baskets cost the same in both countries:   eP = P*,
which implies that e = P*/P.

cover R1,C4
slide ‹#›
CHAPTER 5   The Open Economy
CHAPTER 5   The Open Economy
Purchasing Power Parity (PPP)
§If e = P*/P,
then
and the NX curve is horizontal:
ε
NX
NX
ε = 1
S - I
Under PPP, changes in
(S – I ) have no impact on ε  or e.

Revisiting our model, PPP implies that the NX curve should be
 horizontal at  = 1.
Intuition for the horizontal NX curve:
Under PPP, different countries’ goods are perfect substitutes, and international arbitrage is
possible.  If the relative price of U.S. goods falls even a tiny bit below 1, then there’s a profit
opportunity:  buy U.S. goods and sell them abroad.  Hence, the tiniest drop in the U.S. real
exchange rate causes a massive increase in NX.  Similarly, if the relative price of U.S. goods
rises even a tiny amount above 1, then it is profitable to buy foreign goods and sell them in the
U.S., so this arbitrage causes a massive increase increase in imports---and decrease in NX.
Thus, under PPP, the real exchange rate equals 1 regardless of net capital outflow S-I.  Changes in
S or I have no impact on the real exchange rate.

cover R1,C4
slide ‹#›
CHAPTER 5   The Open Economy
CHAPTER 5   The Open Economy
Does PPP hold in the real world?
§No, for two reasons:
§1. International arbitrage not possible.
§nontraded goods
§transportation costs
§2. Different countries’ goods not perfect substitutes.
§Nonetheless, PPP is a useful theory:
§It’s simple & intuitive
§In the real world, nominal exchange rates
tend toward their PPP values over the long run.

>

cover R1,C4
slide ‹#›
CHAPTER 5   The Open Economy
CHAPTER 5   The Open Economy
no change
no change
¯

¯


¯
no change
no change
¯


¯
¯

¯

129.4
-2.0
19.4
6.3
17.4
3.9
115.1
-0.3
19.9
1.1
19.6
2.2
closed economy
small open economy
actual change
ε
NX
I
r
S
G – T
1980s
1970s
Data: decade averages; all except r  and ε  are expressed as a percent of GDP; ε  is a
trade-weighted index.
CASE STUDY:
The Reagan deficits revisited

This is a continuation of the case study begun in Chapter 3 (both the textbook and the PowerPoint
presentation).   It is placed here to motivate the last topic of Chapter 5:  the U.S. as a large
open economy.
As we saw in chapter 3, the closed economy model correctly predicted that national saving would
fall and the interest rate would rise.  But, the closed economy model predicted that investment
would fall as much as saving; actually, investment fell by much less than saving.  Also, the closed
economy model by definition could not have predicted the effects on the trade balance or exchange
rate.
The small open economy model correctly predicted what would happen to NX and the real exchange
rate, but incorrectly predicted that the interest rate and investment would not change.
In order to explain the U.S. experience, we need to combine the insights of the closed & small open
economy models.

cover R1,C4
slide ‹#›
CHAPTER 5   The Open Economy
CHAPTER 5   The Open Economy
The U.S. as a large open economy
§So far, we’ve 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. – falls
between these two extremes.
§The results from large open economy analysis
are a mixture of the results for the
closed & small open economy cases.
§For example…

>

cover R1,C4
slide ‹#›
CHAPTER 5   The Open Economy
CHAPTER 5   The Open Economy
NX
I
r
large open
economy
small open economy
closed economy
A fiscal expansion in three models
falls, but not as much as in small open economy
falls
no
change
falls, but not as much
as in closed economy
no
change
falls
rises, but not as much
as in closed economy
no
change
rises
A fiscal expansion causes national saving to fall.
The effects of this depend on openness & size:

In the table, there’s a cell for NX in the closed economy column.  Instead of putting “N.A.” in
this cell, I put “no change.”   Why?  In a closed economy, EX = IM = NX = 0.  After a change in
saving, NX = 0 still.  Hence, it is not incorrect to say “no change”.  More importantly we are
trying to show students how the results for a large open economy are in between the results for the
closed & small open cases.  Looking at the items in the last row of the table, “falls, but not as
much as in small open economy” seems to be in between “no change” and “falls,” but does not seem to
be in between “N.A.” and “falls”.
It would be completely understandable if you still feel that “N.A.” should be in the closed economy
NX cell of the table, so please feel free to edit that cell.

Chapter Summary
§Net exports--the difference between
§exports and imports
§a country’s output (Y )
   and its spending (C + I + G)
§Net capital outflow equals
§purchases of foreign assets
minus foreign purchases of the country’s assets
§the difference between saving and investment
CHAPTER 5   The Open Economy
slide 55
cover R3,C1

>

Chapter Summary
§National income accounts identities:
§Y  = C  + I  + G  + NX
§trade balance NX  = S  - I  net capital outflow
§
§Impact of policies on NX :
§NX  increases if policy causes S  to rise
or I  to fall
§NX  does not change if policy affects
neither S  nor I.   Example:  trade policy
CHAPTER 5   The Open Economy
slide 56
cover R3,C1

>

Chapter Summary
§Exchange rates
§nominal:  the price of a country’s currency in terms of another country’s currency
§real:  the price of a country’s goods in terms of another country’s goods
§The real exchange rate equals the nominal rate times the ratio of prices of the two countries.
CHAPTER 5   The Open Economy
slide 57
cover R3,C1

>

Chapter Summary
§How the real exchange rate is determined
§NX  depends negatively on the real exchange rate, other things equal
§The real exchange rate adjusts to equate
NX  with net capital outflow
CHAPTER 5   The Open Economy
slide 58
cover R3,C1

>

Chapter Summary
§How the nominal exchange rate is determined
§e equals the real exchange rate times the country’s price level relative to the foreign price
level.
§For a given value of the real exchange rate, the percentage change in the nominal exchange rate
equals the difference between the foreign & domestic inflation rates.
CHAPTER 5   The Open Economy
slide 59
cover R3,C1

>