Economics 3307

Main Points of Chapter 8: The Open Economy

1. Y = C + I + G + NX, where NX = net exports = exports - imports. Remember that C, I, and G include spending on imports.

2. We will sometimes also refer to NX as the trade balance. NX > 0 means EX > IM, exports exceed imports, and the economy has a trade surplus. If NX < 0, then EX < IM, imports exceed exports, and the economy has a trade deficit.

3. NX = Y - (C+I+G). If domestic spending exceeds output (C+I+G > Y), then NX is negative and a country has a trade deficit. If output exceeds domestic spending (Y > C+I+G), then NX is positive and a country has a trade surplus (NX > 0).

4. The difference between domestic saving (S) and domestic investment (I) is called net foreign investment. So, net foreign investment = (S - I). But (S - I) also equals NX, so net foreign investment is equal to the trade balance.

a. If S > I, then net foreign investment and NX are positive. That is, part of domestic savings goes to fund foreign investment. An economy with positive net foreign investment will necessarily have a trade surplus. Japan has been in this position for the last several years.

b. If S < I, then net foreign investment and NX are negative. Domestic savings is less than domestic investment, so part of domestic investment is funded with foreign savings. An economy with negative net foreign investment will necessarily have a trade deficit. This has been the case for the US in the last several years.

5. In talking about international trade, economists use the term “small country” to refer to a country that can borrow or lend any amount at the prevailing world interest rate (r*). More generally, a small country is the international trade theory equivalent of a perfectly competitive firm: it can take all prices as given, assuming that its buying and selling decisions have no effect on prices.

6. The world real interest rate (r*) is determined by equilibrium between world savings and world investment.

7. NX = S - I(r*). In a small open economy, the world real interest rate (r*) determines the level of investment. K and L determine Y, which in turn determines C and S. NX > 0 if S > I, and NX < 0 if S < I. The trade balance is determined by the difference between saving and investment at the world real interest rate.

8. If the world real interest rate (r*) is above the rate that would prevail if the economy were closed, then S>I and the economy will have a trade surplus. If the world real interest rate (r*) is below the rate that would prevail if the economy were closed, then S<I and the economy will have a trade deficit.

9. A fiscal expansion (that is, an increase in government purchases or a decrease in taxes) reduces national saving. A fiscal expansion by a country’s government makes NX for that country decrease. If NX = 0 before the policy change, then the fiscal expansion creates a trade deficit. If NX < 0 initially, the fiscal expansion worsens the trade deficit. If NX > 0 initially, the fiscal expansion reduces (and possible eliminates) the trade surplus. This is what happened in the U.S. in the early 1980s.

10. More generally, ANY exogenous decrease in national saving will reduce NX. NX is also reduced by an exogenous increase in investment spending (a rightward shift in the investment schedule, which is caused by any event -- such as a technological advance -- that increases I at any given r).

11. Conversely, ANY exogenous increase in national saving (including those due to contractionary fiscal policy with lower G or higher T) or exogenous decrease in investment spending will increase NX.

12. Anything that increases the world interest rate (r*), which includes expansionary fiscal policy abroad, will increase NX in a small open economy.

13. A trade deficit can be bad or good. BAD if it reflects low domestic saving. GOOD if it reflects high domestic investment opportunities.

14. The nominal exchange rate is the price of one country’s currency in terms of another country’s currency. That is, it is the rate at which the currency of one country can be exchanged for the currency of another country. When currency A gains value against currency B, currency A is said to appreciate against currency B and currency B is said to depreciate against currency A.

15. The real exchange rate is the rate at which the goods of one country can be exchanged for the goods of another country. The real exchange rate depends on the nominal exchange rate and on the relative price levels in the two countries. e = e x (P/P*).

16. NX depends negatively on e. Other things equal, a rise in e causes NX to decrease. A fall in e causes NX to increase. Recent declines in the value of the dollar against the yen have caused great difficulties for Japanese exporters and helped US exporters.

17. The real exchange rate is determined by supply and demand in the foreign exchange market: NX(e) = (S-I). We can think of (S-I) as the quantity of dollars supplied for net foreign investment and NX as the quantity of dollars demanded for the net export of goods and services. This is a bit tricky, because it is possible for NX to equal (S-I) at zero or negative values of NX and (S-I).

18. e increases with (1) exogenous decreases in home S (including those caused by higher G and/or lower T), (2) exogenous increases in home I, (3) decreases in the world real interest rate r*, which could be due to contractionary fiscal policy abroad, and (4) exogenous increases in NX (example: protectionist trade policy). e decreases with the opposite changes.

19. For any given real exchange rate, the nominal exchange rate reflects the real exchange rate and the ratio of the price levels of the two countries: e = e x (P*/P). e is determined as explained in point #18 above. As chapter 6 showed, P* is determined by the foreign money supply and P is determined by the domestic money supply. This means that: %De = %De + %DP* - %DP, which can be expressed as %De = %De + (p * - p). The percentage change in the nominal exchange rate equals the percentage change in the real exchange rate plus the inflation rate difference.

20. Other things equal, p * > p implies nominal appreciation for the home country currency. Other things equal, p * < p implies nominal depreciation for the home country currency. This implies that the currencies of high-inflation countries should depreciate over time relative to the currencies of low inflation countries, and data from 1970-91 show that this has in fact been the case.

21. The law of one price says that the same good should have the same cost everywhere. Consider a good we’ll call “good A.” You can obtain good A in two ways: (1) buy it from a domestic producer at price P, and (2) buy foreign currency at price e and then use the foreign currency to buy the good from a foreign producer at price P*. If the costs are the same, then P = P*/e. If we divide both sides of this equation, we have 1 = e x (P/P*). Recall, however, that e = e x (P/P*). Thus the law of one price implies that the real exchange rate is 1.0, which means that one unit of domestic goods can be traded for one unit of foreign goods.

22. Economists use the term Purchasing Power Parity (PPP) to denote a situation in which the law of one price holds. Technically, the condition that e x (P*/P) = e = 1 is known as STATIC purchasing power parity. Static PPP does not hold in the real world because of (1) transportation costs, (2) barriers to trade such as import taxes and import quotas, and (3) the fact that not all goods and services are traded internationally.

23. Even if static PPP does not hold so that e is not equal to 1.0, it may be the case that the factors that make e differ from 1.0 are constant over time. In this case, e will be constant. The condition of a constant e is called DYNAMIC Purchasing Power Parity. Static PPP implies dynamic PPP, but dynamic PPP does not necessarily imply static PPP.

24. If static or dynamic PPP holds, the real exchange rate is constant so that %De = 0. This implies that %De = (p * - p). That is, the appreciation or depreciation of the nominal exchange rate is determined entirely by the inflation differential.

25. Static PPP does not hold in the real world. Dynamic PPP does appear to hold in the long-run, and it is often a reasonable model for short-term changes in the nominal exchange rate when applied to the exchange rate between a low-inflation country and a high-inflation country.

26. The inflation differential between two low-inflation countries is usually quite small relative to observed changes in the nominal exchange rate between the currencies of the two countries. Thus changes in the nominal exchange rate (which is what the media reports and discusses) usually are associated with changes in the real exchange rate in the same direction.

27. In fact, the U.S. is not exactly like a theoretical “small” economy: it’s actions do sometimes have an effect on world prices and interest rates. To allow for this, we simply combine our “closed economy” analysis of Chapter 3 with the open economy analysis of this chapter.

28. In a large open economy, a fiscal expansion increases the interest rate and reduces investment (as in Chapter 3), and it causes a trade deficit and an appreciation of the real exchange rate (as in Chapter 8).