The

Open
Economy
 The International Flows
of Capital and Goods

The key macroeconomic difference between open and closed

economies is that, in an open economy, a country’s spending in
any given year need not equal its output of goods and services.

A country can spend more than it produces by borrowing from

abroad, or it can spend less than it produces and lend the
difference to foreigners.
 The Role of Net Exports
In an open economy, some output is sold domestically and some is exported to
be sold abroad.

The division of expenditure into these components is expressed in the identity

Here, DOMESTIC spending on DOMESTIC goods and services

FOREIGN spending on DOMESTIC goods and services

𝑫𝑶𝑴𝑬𝑺𝑻𝑰𝑪 𝒔𝒑𝒆𝒏𝒅𝒊𝒏𝒈=𝑫𝑶𝑴𝑬𝑺𝑻𝑰𝑪 𝒔𝒑𝒆𝒏𝒅𝒊𝒏𝒈𝑜𝑛 𝑫𝑶𝑴𝑬𝑺𝑻𝑰𝑪+ 𝑫𝑶𝑴𝑬𝑺𝑻𝑰𝑪 𝒔𝒑𝒆𝒏𝒅𝒊𝒏𝒈 𝑜𝑛𝑭𝑶𝑹𝑬𝑰𝑮𝑵

 The Role of Net Exports

We can write

We substitute these three equations into the identity (1):

 International Capital Flows and
the Trade Balance
In an open economy, as in the closed economy, financial markets and
goods markets are closely related.

Recall is national saving S, which equals the sum of private saving, ,

and public saving, , where T stands for taxes.

This form of the national income accounts identity shows that an

economy’s net exports must always equal the difference between its
saving and its investment.
 International Capital Flows and
the Trade Balance
 Another name for net exports is the trade balance,
because it tells us how our trade in goods and services
departs from the benchmark of equal imports and exports.

 The left-hand side of the identity is the difference between

domestic saving and domestic investment, , which we’ll
call net capital outflow. (It’s sometimes called net foreign
investment.)

 Net capital outflow equals the amount that domestic

residents are lending abroad minus the amount that
foreigners are lending to us.
 International Capital Flows and
the Trade Balance
 If net capital outflow is positive, the economy’s saving exceeds
its investment, and it is lending the excess to foreigners.

 If the net capital outflow is negative, the economy is

experiencing a capital inflow: investment exceeds saving, and
the economy is financing this extra investment by borrowing
from abroad.

 Thus, net capital outflow reflects the international flow of

funds to finance capital accumulation.
 International Capital Flows and
the Trade Balance
 If S − I and NX are positive, we have a trade surplus. In this case,
we are net lenders in world financial markets, and we are exporting
more goods than we are importing.

 If S − I and NX are negative, we have a trade deficit. In this case, we

are net borrowers in world financial markets, and we are importing
more goods than we are exporting.

 If S − I and NX are exactly zero, we are said to have balanced trade

because the value of imports equals the value of exports.

 The national income accounts identity shows that the international

flow of funds to finance capital accumulation and the international
flow of goods and services are two sides of the same coin.
 Saving and Investment in a
Small Open Economy

We present a model of the international flows of capital and goods.

Because the trade balance equals the net capital outflow, which in
turn equals saving minus investment, our model focuses on saving
and investment.

We DO NOT assume that the real interest rate equilibrates saving and
investment. Instead, we allow the economy to run a trade deficit and
borrow from other countries or to run a trade surplus and lend to
other countries.
 Capital Mobility and the
World Interest Rate
If the real interest rate does not adjust to equilibrate saving and investment in
this model, what does determine the real interest rate?

We answer this question here by considering the simple case of a small open
economy with perfect capital mobility.

By “small’’ we mean that this economy is a small part of the world market and
thus, by itself, can have only a negligible effect on the world interest rate.

By “perfect capital mobility’’ we mean that residents of the country have full
access to world financial markets. In particular, the government does not impede
international borrowing or lending.
 Capital Mobility and the
World Interest Rate
Because of this assumption of perfect capital mobility, the interest
rate in our small open economy, r, must equal the world interest
rate , the real interest rate prevailing in world financial markets:

Residents of the small open economy need never borrow at any

interest rate above r*, because they can always get a loan at r* from
abroad. Similarly, residents of this economy need never lend at any
interest rate below r* because they can always earn r* by lending
abroad. Thus, the world interest rate determines the interest rate
in our small open economy.
 The Model
To build the model of the small open economy, we take three assumptions.

 The economy’s output Y is fixed by the factors of production and the

production function. We write this as

 Consumption C is positively related to disposable income Y − T. We

write the consumption function as

■ Investment I is negatively related to the real interest rate r. We write the

investment function as
 The Model
We can now return to the accounting identity and write it as

Substituting the assumptions recapped above and the assumption that the
interest rate equals the world interest rate, we obtain

This equation shows that the trade balance NX depends on those variables
that determine saving S and investment I. Because saving depends on fiscal
policy (lower government purchases G or higher taxes T raise national
saving) and investment depends on the world real interest rate r* (a higher
interest rate makes some investment projects unprofitable), the trade
balance depends on these variables as well.
 The Model

In the closed economy studied in that chapter, the real interest rate adjusts to equilibrate saving and
investment—that is, the real interest rate is found where the saving and investment curves cross.

In the small open economy, however, the real interest rate equals the world real interest rate. The trade
balance is determined by the difference between saving and investment at the world interest rate.
 How Policies Influence the
Trade Balance
Suppose that the economy begins in a position of balanced trade. That is, at
the world interest rate, investment I equals saving S, and net exports NX
equal zero.

Consider first what happens to the small open economy if the government
expands domestic spending by increasing government purchases.

Even though some of the tax cut finds its way into private saving, public
saving falls by the full amount of the tax cut; in total, saving falls.
 Fiscal Policy at Home

Hence, starting from balanced trade, a change in fiscal

policy that reduces national saving leads to a trade deficit.
 Fiscal Policy Abroad
Consider now what happens to a small open economy when foreign
governments increase their government purchases.

If these foreign countries are a small part of the world economy, then
their fiscal change has a negligible impact on other countries.

But if these foreign countries are a large part of the world economy,
their increase in government purchases reduces world saving.
The decrease in world saving causes the world interest rate to rise,
just as in a closed-economy model.
 Fiscal Policy Abroad

Hence, reduced saving abroad leads to a

trade surplus at home.
 Shifts in Investment Demand

Consider what happens to our small open economy if its

investment schedule shifts outward—that is, if the demand for
investment goods at every interest rate increases.

Hence, starting from balanced trade, an outward shift in the

investment schedule causes a trade deficit.
Shifts in Investment Demand
 Evaluating Economic Policy

 Our model of the open economy shows that the flow of goods and
services measured by the trade balance is inextricably connected
to the international flow of funds for capital accumulation.

 The impact of economic policies on the trade balance can always

be found by examining their impact on domestic saving and
domestic investment.

 Policies that increase investment or decrease saving tend to cause

a trade deficit, and policies that decrease investment or increase
saving tend to cause a trade surplus.
 Evaluating Economic Policy
 When a country runs a trade deficit, policymakers must confront the question
of whether it represents a national problem.

 Most economists view a trade deficit not as a problem in itself, but perhaps as
a symptom of a problem. A trade deficit could be a reflection of low saving.

 In a closed economy, low saving leads to low investment and a smaller future
capital stock.

 In an open economy, low saving leads to a trade deficit and a growing foreign
debt, which eventually must be repaid.

 In both cases, high current consumption leads to lower future consumption,

implying that future generations bear the burden of low national saving.
 Evaluating Economic Policy

 Yet trade deficits are not always a reflection of an

economic malady.

 When poor rural economies develop into modern

industrial economies, they sometimes finance their high
levels of investment with foreign borrowing. In these
cases, trade deficits are a sign of economic development.

 For example, South Korea ran large trade deficits

throughout the 1970s, and it became one of the success
stories of economic growth.
The US Trade Deficit
 Nominal and Real Exchange Rates

The nominal exchange rate is the relative price of the

currencies of two countries.

Notice that an exchange rate can be reported in two ways. If

one dollar buys 120 yen, then one yen buys 0.00833 dollar.
We can say the exchange rate is 120 yen per dollar, or we can
say the exchange rate is 0.00833 dollar per yen. Because
0.00833 equals 1/120, these two ways of expressing the
exchange rate are equivalent.
 Nominal and Real Exchange Rates

In this chapter, we will express the exchange rate in units of foreign

currency per dollar. With this convention, a rise in the exchange
rate—say, from 120 to 125 yen per dollar—is called an appreciation
of the dollar; a fall in the exchange rate is called a depreciation.

When the domestic currency appreciates, it buys more of the foreign

currency; when it depreciates, it buys less. An appreciation is
sometimes called a strengthening of the currency, and a
depreciation is sometimes called a weakening of the currency.
 Nominal and Real Exchange Rates
The real exchange rate is the relative price of the goods of two countries.
That is, the real exchange rate tells us the rate at which we can trade the
goods of one country for the goods of another. The real exchange rate is
sometimes called the terms of trade.

To see the relation between the real and nominal exchange rates, consider
a single good produced in many countries: cars. Suppose an American car
costs $10,000 and a similar Japanese car costs 2,400,000 yen. To compare
the prices of the two cars, we must convert them into a common currency.
If a dollar is worth 120 yen, then the American car costs 1,200,000 yen.
Comparing the price of the American car (1,200,000 yen) and the price of
the Japanese car (2,400,000 yen), we conclude that the American car costs
one-half of what the Japanese car costs. In other words, at current prices,
we can exchange 2 American cars for 1 Japanese car.
 Nominal and Real Exchange Rates

This calculation of the real exchange rate for a single good suggests how we
should define the real exchange rate for a broader basket of goods.

Let e be the nominal exchange rate (the number of yen per dollar), P be
the price level in the United States (measured in dollars), and P* be the
price level in Japan (measured in yen). Then the real exchange rate e is
 The Real Exchange Rate and
the Trade Balance
Suppose first that the real exchange rate is low. In this case, because
domestic goods are relatively cheap, domestic residents will want to
purchase fewer imported goods.

The opposite occurs if the real exchange rate is high. Because

domestic goods are expensive relative to foreign goods, domestic
residents will want to buy many imported goods, and foreigners will
want to buy few of our goods.

We write this relationship between the real exchange rate and net
exports as
The Real Exchange Rate and
the Trade Balance
 The Determinants of the Real Exchange Rate

We can summarize the analysis as follows:

 The real exchange rate is related to net exports. When the real exchange
rate is lower, domestic goods are less expensive relative to foreign goods,
and net exports are greater.

 The trade balance (net exports) must equal the net capital outflow, which in
turn equals saving minus investment. Saving is fixed by the consumption
function and fiscal policy; investment is fixed by the investment function
and the world interest rate.
 Fiscal Policy
at Home

Because of the rise in the value of the

dollar, domestic goods become more
expensive relative to foreign goods,
which causes exports to fall and imports
to rise. The change in exports and the
change in imports both act to reduce net
exports.
 Fiscal Policy
Abroad

The equilibrium real exchange rate falls.

That is, the dollar becomes less
valuable, and domestic goods become
less expensive relative to foreign goods.
Shifts in Investment
Demand

The equilibrium real exchange rate

rises. As investment is more
attractive now, it also increases the
value of the U.S. dollars necessary
to make these investments. When
the dollar appreciates, domestic
goods become more expensive
relative to foreign goods, and net
exports fall.
 Trade policies, broadly defined, are policies
The designed to influence directly the amount of
Effects of goods and services exported or imported. Most
Trade often, trade policies take the form of protecting

Policies domestic industries from foreign competition—

either by placing a tax on foreign imports (a
tariff) or restricting the amount of goods and
services that can be imported (a quota).
The Effects of Trade Policies
 The Effects of Trade Policies

Although protectionist trade policies do not alter the trade balance, they do
affect the amount of trade. As we have seen, because the real exchange rate
appreciates, the goods and services we produce become more expensive
relative to foreign goods and services. We therefore export less in the new
equilibrium.

Because net exports are unchanged, we must import less as well. (The
appreciation of the exchange rate does stimulate imports to some extent, but
this only partly offsets the decrease in imports due to the trade restriction.)
Thus, protectionist policies reduce both the quantity of imports and the
quantity of exports.
 The Effects of Trade Policies

This equation states that the percentage change in the nominal exchange
rate between the currencies of two countries equals the percentage change
in the real exchange rate plus the difference in their inflation rates. If a
country has a high rate of inflation relative to the United States, a dollar will
buy an increasing amount of the foreign currency over time. If a country has
a low rate of inflation relative to the United States, a dollar will buy a
decreasing amount of the foreign currency over time.
 The Special Case of Purchasing-Power Parity

A famous hypothesis in economics, called the law of one price, states that the
same good cannot sell for different prices in different locations at the same time.

If a bushel of wheat sold for less in New York than in Chicago, it would be
profitable to buy wheat in New York and then sell it in Chicago. This profit
opportunity would become quickly apparent to astute arbitrageurs—people
who specialize in “buying low” in one market and “selling high” in another.

As the arbitrageurs took advantage of this opportunity, they would increase the
demand for wheat in New York and increase the supply of wheat in Chicago.
Their actions would drive the price up in New York and down in Chicago,
thereby ensuring that prices are equalized in the two markets.
 The Special Case of Purchasing-Power Parity

The law of one price applied to the international marketplace is called

purchasing-power parity. It states that if international arbitrage is
possible, then a dollar (or any other currency) must have the same
purchasing power in every country.

The argument goes as follows. If a dollar could buy more wheat

domestically than abroad, there would be opportunities to profit by
buying wheat domestically and selling it abroad. Profit-seeking
arbitrageurs would drive up the domestic price of wheat relative to the
foreign price.

We can interpret the doctrine of purchasing-power parity using our

model of the real exchange rate.
The Special Case of Purchasing-Power Parity

The quick action of these international arbitrageurs implies

that net exports are highly sensitive to small movements in
the real exchange rate.

A small decrease in the price of domestic goods relative to

foreign goods—that is, a small decrease in the real exchange
rate—causes arbitrageurs to buy goods domestically and sell
them abroad. Similarly, a small increase in the relative price
of domestic goods causes arbitrageurs to import goods from
abroad.
 The Special Case of
Purchasing-Power
Parity

Therefore, as in Figure 5-14, the net-

exports schedule is very flat at the real
exchange rate that equalizes purchasing
power among countries: any small
movement in the real exchange rate
leads to a large change in net exports.
This extreme sensitivity of net exports
guarantees that the equilibrium real
exchange rate is always close to the level
that ensures purchasing-power parity.
 The Special Case of Purchasing-Power Parity

Purchasing-power parity has two important implications.

First, because the net-exports schedule is flat, changes in saving or

investment do not influence the real or nominal exchange rate.

Second, because the real exchange rate is fixed, all changes in the
nominal exchange rate result from changes in price levels.
 The Special Case of Purchasing-Power Parity

Is this doctrine of purchasing-power parity realistic?

Most economists believe that, despite its appealing logic, purchasing-power

parity does not provide a completely accurate description of the world.

First, many goods are not easily traded.

Second, even tradable goods are not always perfect substitutes. Some
consumers prefer Toyotas, and others prefer Fords. Thus, the relative price
of Toyotas and Fords can vary to some extent without leaving any profit
opportunities.

For these reasons, real exchange rates do in fact vary over time.
 The Large Open Economy
Net Capital Outflow

The key difference between the small and large open economies is the
behavior of the net capital outflow.

In the model of the small open economy, capital flows freely into or out of
the economy at a fixed world interest rate r*.

The model of the large open economy makes a different assumption

about international capital flows. To understand this assumption, keep in
mind that the net capital outflow is the amount that domestic investors
lend abroad minus the amount that foreign investors lend here.
 The Large Open Economy
Net Capital Outflow

Because of the behavior of both domestic and foreign investors, the net
flow of capital to other countries, which we’ll denote as CF, is negatively
related to the domestic real interest rate r. As the interest rate rises, less
of our saving flows abroad, and more funds for capital accumulation flow
in from other countries. We write this as

Notice that CF can be either positive or negative, depending on whether

the economy is a lender or borrower in world financial markets.
The Large Open Economy
Closed and Small Open Economy
 The Closed Economy

The closed economy is the special case shown in panel (a) of Figure
5-16.

In the closed economy, there is no international borrowing or

lending, and the interest rate adjusts to equilibrate domestic saving
and investment. This means that at all interest rates.

This situation would arise if investors here and abroad were

unwilling to hold foreign assets, regardless of the return. It might
also arise if the government prohibited its citizens from transacting
in foreign financial markets, as some governments do.
 The Large Open Economy

Why isn’t the interest rate of a large open economy such as the United
States fixed by the world interest rate?

There are two reasons.

The first is that the United States is large enough to influence world
financial markets.

The more the United States lends abroad, the greater is the supply of loans in
the world economy, and the lower interest rates become around the world.

The more the United States borrows from abroad (that is, the more negative
CF becomes), the higher are world interest rates.
 The Large Open Economy
There is, however, a second reason the interest rate in an economy may not
be fixed by the world interest rate: capital may not be perfectly mobile.
That is, investors here and abroad may prefer to hold their wealth in
domestic rather than foreign assets.

Such a preference for domestic assets could arise because of imperfect

information about foreign assets or because of government impediments to
international borrowing and lending. In either case, funds for capital
accumulation will not flow freely to equalize interest rates in all countries.

Instead, the net capital outflow will depend on domestic interest rates
relative to foreign interest rates. The large-open-economy model, therefore,
may apply even to a small economy if capital does not flow freely into and
out of the economy.
The Model

The interest rate

To understand how
and the exchange
the large open
rate are two prices
economy works, we
that guide the
need to consider
allocation of
two key markets:
resources.

The market for The market for

loanable funds foreign exchange
(where the (where the
interest rate is exchange rate is
determined) determined).
 The Market for Loanable Funds

An open economy’s saving S is used in two ways:

i. To finance domestic investment I and to finance the net capital outflow CF.
We can write

Consider how these three variables are determined.

National saving is fixed by the level of output, fiscal policy, and the consumption function.
Investment and net capital outflow both depend on the domestic real interest rate.

We can write
The Market for •The supply of loanable funds is national saving.

Loanable Funds •The demand for loanable funds is the sum of the demand for
domestic investment and the demand for foreign investment
(net capital outflow).

•The interest rate adjusts to equilibrate supply and demand.

 The Market for Foreign Exchange
Consider the relationship between the net capital outflow and the trade
balance. The national income accounts identity tells us

Because NX is a function of the real exchange rate, and because CF = S − I,

We can write

The last variable we should consider is the nominal exchange rate. As

before, the nominal exchange rate is the real exchange rate times the ratio
of the price levels:
The Market for
Foreign Exchange •The real exchange rate and the price levels are
determined by monetary policies here and abroad.

•Forces that move the real exchange rate or the

price levels also move the nominal exchange rate.
The Large Open Economy
 Fiscal Policy at
Home

•As in the closed economy, a fiscal expansion

in a large open economy raises the interest
rate and crowds out investment.

•As in the small open economy, a fiscal

expansion causes a trade deficit and an
appreciation in the exchange rate.
 Fiscal Policy at Home
One way to see how the three types of economy are related is to consider
the identity

In all three cases, expansionary fiscal policy reduces national saving S.

In the closed economy, the fall in S coincides with an equal fall in I, and
NX stays constant at zero.

In the small open economy, the fall in S coincides with an equal fall in NX,
and I remains constant at the level fixed by the world interest rate.

The large open economy is the intermediate case: both I and NX fall, each
by less than the fall in S.
Shifts in Investment Demand

𝑰↑→𝑫𝒆𝒎𝒂𝒏𝒅𝒇𝒐𝒓𝒍𝒐𝒂𝒏 𝒃𝒍𝒆𝒇𝒖𝒏𝒅𝒔↑→𝒓↑→𝑪𝑭↓→𝑺𝒖𝒑 𝒍𝒚𝒐𝒇𝒅𝒐𝒎𝒆𝒔𝒕𝒊𝒄 𝒖𝒓 𝒆𝒏𝒄𝒚→𝝐↑→𝑵𝑿↓

Trade Policies

Trade Policies shows the effect of a

trade restriction, such as an
import quota.

In the end, the trade restriction

does not affect the trade balance.
Shifts in Net Capital Outflow
One reason is fiscal policy abroad.
Another reason the CF schedule
might shift is political instability
abroad.

The reduced demand for loanable

funds lowers the equilibrium
interest rate. The lower interest
rate tends to raise net capital
outflow, but because this only
partly mitigates the shift in the CF
schedule, CF still falls. The reduced
level of net capital outflow reduces
the supply of domestic currency in
the market for foreign exchange.
The exchange rate appreciates, and
net exports fall.