Chapter 7: The open economy

Aims of the chapter

This chapter revises the basic tools employed in the analysis of aggregate demand in an open economy: the balance of payments, nominal and real exchange rates, the trade balance, the Marshall–Lerner condition, and the uncovered interest parity (UIP) condition. Particular attention is given to the determinants of aggregate demand in an open economy and the effects of fiscal and exchange rate policies on output and the trade balance in the
short run.

• recall the components of the external equilibrium condition
• discuss the components arising from the national income identity in an open economy
• discuss the determinants of nominal and real exchange rates
• describe the determinants of the trade balance and the Marshall–Lerner condition
• explain the uncovered interest parity condition in the financial market
• analyse how fiscal and exchange rate policies affect output and the trade balance in the short run.

This chapter covers the section of the syllabus on aggregate demand in an open economy, with special attention given to exchange rate regimes and the links between international trade and capital flows. The initial focus is on the composition of the balance of payments, the national income identity in an open economy, and a description of nominal and real exchange rates. Next, we focus on the determinants of international trade by describing aggregate demand in an open economy, and then assess how fiscal policy and variations in the exchange rate affect output and the trade balance in the short run. Finally, the chapter looks at the determinants of international capital flows by examining the equilibrium condition in the international financial market (the UIP condition).

Be careful with the two alternative ways of quoting the nominal exchange rate. If you are using Dornbusch et al., then the nominal exchange rate is quoted as the price of foreign currency in terms of domestic currency – so that an increase corresponds to a depreciation of the domestic currency. If you are using Blanchard and Johnson, then the nominal exchange rate is quoted as the price of domestic currency in terms of foreign currency – so that an increase corresponds to an appreciation of the domestic currency. The subject guide follows the Blanchard and Johnson and Mankiw definition.

The balance of payments

In an open economy, households, firms and the government (domestic residents) can trade goods, services and financial assets with households, firms and governments of other countries (foreign residents). These transactions are recorded in the balance of payments (BP), which is divided into two parts: the current account and the capital account.

The **current account (NX)** is equal to the sum of the trade balance (exports minus imports), net investment income received from abroad, and net transfers from abroad.

The **capital account (CA)** includes two sections: the net capital inflow and changes to foreign currency reserves.

The **net capital inflow (CF)** is the balance between sales of domestic assets to foreigners and purchases of foreign assets by domestic residents.

Changes to **foreign currency reserves (FCR)** occur through purchases and sales of foreign currency (and gold) carried out by the domestic central bank and purchases and sales of domestic assets by foreign central banks. Apart from a statistical discrepancy, the current account and the capital account sum to zero by construction, which implies a fundamental external equilibrium condition. Apart from a statistical discrepancy, the current account and the capital account sum to zero by construction, which implies a fundamental external equilibrium condition:

BP = NX + CA = 0. (7.1)

Equation (7.1) shows the existence of a fundamental link between international trade and capital flows. A current account surplus corresponds to an outflow of domestic capital to the rest of the world. This is because the current account surplus means that receipts from exports exceeds payments for imports, and this excess income is lent to the rest of the world. Vice-versa, a current account deficit leads to an inflow of foreign capital into the domestic economy, since, if payments for imports exceed receipts from exports, the gap has to be financed by borrowing from the rest of the world (or selling assets held abroad). In other words, a country experiencing a current account surplus is a net lender to the rest of the world, whereas a country with a current account deficit is a net borrower from the rest of the world.

Since the capital account includes the net capital inflow and changes to foreign currency reserves, CA = CF − ∆ FCR , the equilibrium condition in equation (7.1) can also be written as:

NX + CF = ∆ FCR, (7.2)

which shows the links between international trade, private capital flows and changes to foreign currency reserves, namely that the sum of the current account and the net capital inflow must be equal to the change in the foreign reserves.

National income accounting in an open economy

In an open economy, aggregate demand must include net foreign demand for goods and services. Consequently, the income identity can be written as:

Y = C + I + G + NX,

where C + I denotes the domestic private-sector demand, G is the public-sector demand, and NX is the net demand from the external sector. Since disposable income, YD = Y – T, can be either consumed or saved, YD = C + S, the national income identity in an open economy can equivalently be written as:

S – I = BD + NX,

where the term BD = G – T indicates the primary budget deficit. Equation (7.3) shows that, in an open economy, the private sector excess of saving over investment, S – I, equals the sum of the budget deficit, BD, and the trade surplus. In other words, any saved income that is not employed to finance investment, S – I > 0, can be loaned to finance the government’s excess of spending over taxation, BD > 0, or can be loaned abroad to finance the purchase by foreigners of domestic goods and services.

Alternatively, equation (7.3) can also be written as:

S = BD + NX + I, (7.4)

which shows that domestic saving can be loaned to the public sector, to the foreign sector, or to domestic investors. Equation (7.4) can be employed to speculate about the likely effects of changes in the main macroeconomic aggregates. For instance, equation (7.4) shows that an increase in investment spending must lead to either a reduction in the budget deficit, or a reduction in the trade (current account) surplus, or an increase in domestic saving.

Nominal exchange rates

The **nominal exchange rate** is the relative price between two currencies. The nominal exchange rate can be quoted in one of two ways: the price of the domestic currency in terms of foreign currency; and the price of foreign currency in terms of the domestic currency.

For example, consider the US dollar (USD) and the Chinese yuan (CNY). If the USA is the home country and the nominal exchange rate is 7.52 CNY/USD, then the price of one dollar is 7.52 CNY. An increase in the nominal exchange rate means that the USD (home currency) gains value, in the sense that one unit of the home currency can buy more units of the foreign currency. But we could equally quote the exchange rate in its inverse form, as 0.14 USD/CNY. Given this definition, an increase in the nominal exchange rate means that the USD loses value because one CNY can buy more USD.

Therefore whenever you look at nominal exchange rates it is fundamental to understand how they are quoted. If the nominal exchange rate quotes the price of the domestic currency in terms of the foreign currency, an appreciation of the domestic currency corresponds to an increase in the exchange rate. Consequently, a depreciation of the domestic currency corresponds to a decrease in the exchange rate. In contrast, if the nominal exchange rate quotes the price of the foreign currency in terms of the domestic currency, then an increase in the exchange rate corresponds to a depreciation of the domestic currency (the foreign currency has become more expensive). Conversely, a reduction in the nominal exchange rate corresponds to an appreciation of the domestic currency. Note that in this subject guide we will use, as in Blanchard, the first way of quoting exchange rates, while Dornbusch et al. and Mankiw employ the second.

Exchange rate arrangements currently in place among world countries can be classified according to their degree of flexibility and their implications for domestic monetary policy. 2 However, for the purpose of this course we will simply distinguish between fixed and flexible exchange rates. Under a fixed exchange rate regime two countries maintain a constant exchange rate or, equivalently, central parity between their currencies. In this case increases in the fixed rate are termed revaluations, whereas reductions are called devaluations. In contrast, under a floating exchange rate regime the relative price between two currencies is free to fluctuate, and there is no explicit commitment to maintain a specific parity.

Figure 7.1 plots the exchange rate of the USD in terms of the Chinese yuan (CNY), the Singapore dollar (SGD), and the British pound (GBP), over the period 1960–2011. The figure illustrates two important features of the evolution of exchange rates over this period:

1. Until 1973, most world economies operated under a fixed exchange rate regime. This was the outcome of the 1944 Bretton Woods agreement, which fixed the price of the US dollar in terms of gold, while all other world currencies were fixed in value against the dollar. Exchange rates were almost completely fixed, except for a small margin of movement of 0.5 per cent above and below the central parity.

2. In 1973, the Bretton Woods system was abandoned, and since then most countries have adopted a floating regime. Since then the dollar has appreciated relative to the British pound, with large appreciations occurring in the mid-1970s and in the first half of the 1980s. However, this appreciation is small by comparison with what has occurred to the Chinese yuan since 1980. After a period of slow depreciation during the 1970s, the US dollar steadily appreciated relative to the yuan until the mid-1990s, and then settled at a level of 8.27 for around a decade, until 2005. Since then the dollar has depreciated again, with the dollar worth 6.46 yuan by 2011. In contrast, the US dollar has depreciated relative to the Singapore dollar through almost the entire period: in 1973 a US dollar was worth about 3.06 Singapore dollars, whereas in 2011 it was worth 1.26.

Real exchange rate

A key variable in determining whether to trade in the domestic or in a foreign market is the real exchange rate, defined as the relative price of foreign goods in terms of domestic goods. The real exchange rate, ε, depends on the nominal exchange rate (E), the domestic price level (P), and the foreign price level (P*). Analytically it is defined as:

ε = EP/P^* (7.5)

which is the ratio of the domestic price level, converted into foreign currency, to the foreign price level.

Note that since P and P* are price indices computed over baskets of goods, the real exchange rate measures the price of a basket of goods in the home country, relative to a similar basket of goods in the foreign country. For example, if P and P* are consumer price indices (CPIs), then the real exchange rate measures the price of domestic goods consumed in the home country in terms of goods consumed in the foreign country. If P and P* refer to the GDP deflator, then the real exchange rate measures the price of goods produced in the home country, in terms of goods produced in the foreign country.

A real appreciation occurs when the relative price of domestic goods, in terms of foreign goods, increases. This corresponds to an increase in the real exchange rate. In contrast, a real depreciation occurs when the relative price of domestic goods, in terms of foreign goods, reduces, which corresponds to a decrease in the real exchange rate.

Figure 7.3 plots the evolution of the US real exchange rate from 1960– 2011, again by comparison with China, Singapore and the UK. For any given year the series gives the cost of a basket of goods in the USA, relative to an equivalent basket of goods in each of the other three countries. It shows that goods in Singapore and the USA have generally cost around the same as their US equivalents throughout the sample period, though there has been a small, gradual real appreciation of US goods relative to UK goods since the 1960s.

This change is dwarfed, however, by the huge movements in the Chinese real exchange rate that have been seen since the 1980s. From a real exchange rate of around 2 in 1980, US goods have more than doubled in cost relative to their Chinese equivalents by 1986, when the real exchange rate between the two countries peaked at over 4.7. Since then US goods have once more depreciated in relative price, particularly since the dollar began to depreciate in nominal terms relative to the Chinese yuan from the mid-2000s onwards (see Figure 7.1). By 2011 the US–Chinese real exchange rate stood at just 1.63 – its lowest level since the early 1960s.

The trade balance

As described in the first section, the net trade position of a country is given by the difference between exports, X, and imports, M. Exports are quoted in the domestic currency and depend upon foreign income, Y * , and the real exchange rate, ε. Analytically, exports are written as:

X = X ( Y * ε ). (7.6)
	+   -

The signs are to indicate that an increase (fall) in foreign income raises(reduces) exports, whereas a real appreciation (depreciation) reduces (increases) exports. Imports depend upon domestic income and the real exchange rate. Analytically, imports are written as:

M = M ( Y , ε ), (7.7)
	+   +

which states that an increase (fall) in domestic income raises (reduces) imports, whereas a real appreciation (depreciation) increases (decreases) imports.

Note that the value of imports M is implicitly being expressed here in terms of foreign currency, and it needs to be converted into units of domestic goods in order to be compared with exports. This conversion is obtained by multiplying the quantity of imports, M, by the price of imports, 1/ε. This highlights how a real depreciation has two effects on the trade balance. The first is a quantity effect due to an increase in exports and a fall in imports, which tends to increase the trade balance. The second is a price effect, due to the increase in the relative price of imports, which tends to reduce the trade balance. Even though the final effect of a real depreciation (appreciation) on the trade balance is in principle ambiguous, most economists believe that the quantity effect dominates, at least in the medium term. When this is true the Marshall–Lerner condition is said to be satisfied, implying that a real depreciation ultimately improves the trade balance. The J-Curve describes the intertemporal adjustment in the trade balance following a real depreciation. The quantity effect of a real depreciation generally takes some time to be felt. As a result, the immediate consequence is to worsen the trade balance due to the price effect. In the medium run, the quantity effect of the real depreciation begins to take action, reducing imports and raising exports. If the Marshall–Lerner condition holds, the short run deterioration is followed by a period of gradual recovery, ultimately an improvement in the trade balance.

After combining equations (7.6) and (7.7), and assuming that the Marshall–Lerner condition holds, the net trade position is described as:

NX = NX ( Y , Y*, ε ),
	  -   +   -

which shows that the net trade position deteriorates as a result of a domestic expansion or a real appreciation, and it improves as a result of the economic expansion of a trade partner.

The goods market in an open economy

In an open economy it is important to distinguish the aggregate demand for domestic goods from the aggregate domestic demand for goods. The aggregate demand for domestic goods, Z, is obtained by adding up the domestic demand for goods, C + I + G, and the trade balance:

Z = C ( Y − T )  + I ( Y , r ) + G + NX ( Y , Y^* , ε ) . .
          +            +   -     +        -   +     -

Exports change the position of the aggregate demand curve without affecting its slope, since they do not depend on domestic income. But this is not true of imports: an increase in domestic income raises demand for both domestic and foreign goods. As a result the domestic demand for goods increases more than the demand for domestic goods. Therefore, adding imports to the domestic demand for goods has the effect of shifting aggregate demand as a function of Y downwards and reducing its slope.

Recall that the slope of the aggregate demand curve as a function of Y reflects the magnitude of the income multiplier. In a closed economy, an increase in domestic income can only raise demand for domestic goods. In an open economy, an increase in domestic income also has the effect of increasing the domestic demand for foreign goods. Therefore the income multiplier in an open economy is smaller than that in a closed economy, and the aggregate demand curve is flatter than that in a closed economy.

Figure 7.4 shows that the position of the demand for domestic goods relative to the domestic demand for goods at any specific level of income determines the net trade level of a country. When income is at Y 1 the demand for domestic goods exceeds the domestic demand, implying a trade surplus. When income is at Y 2 demand for domestic goods equals domestic demand (i.e. net trade is in balance). Finally, at Y 3 the demand for domestic goods is lower than domestic demand. Consequently, the trade position is in deficit.

Note that the relationship between the aggregate demand for domestic goods and the domestic demand for goods does not define goods market equilibrium in an open economy. In fact, the equilibrium condition is obtained when domestic output equals demand for domestic goods, that is:

Y = C ( Y − T ) + I ( Y , r ) + G + NX ( Y , Y* , ε ).
          +            +  -     +        -   +    -

Graphically, the goods market equilibrium in an open economy is realised at the intersection between aggregate demand for domestic goods and the 45-degree line, as depicted in Figure 7.5. Consequently, in an open economy goods market equilibrium is consistent with any net trade position: deficit (panel A), balance (panel B) or surplus (panel C).

Domestic demand, foreign demand and the real exchange rate

The model developed in the previous section can be used to assess how changes in domestic and foreign fiscal policy, as well as the real exchange rate, are likely to affect the equilibrium level of income and the trade balance. These effects are summarised in Table 7.1 below, and for further comments you can refer to Chapter 19 in Blanchard and Johnson.

		Domestic expansion 	Foreign expansion	Real depreciation
Domestic output + 			+		 	+
Trade balance 	- 			+ 			+

Table 7.1: Effects of fiscal and exchange rate policy on output and trade balance.

Note that Table 7.1 suggests that policy coordination between trade partners can be an essential instrument with which to increase output during recessions. Suppose two countries are trade partners and they are both in recession. A unilateral fiscal expansion is likely to increase output in both countries. However, the country that runs the expansionary policy bears the entire cost of the economic recovery, as it worsens both its net trade position and its budget deficit. This may lead to a situation of policy paralysis, in the sense that each country may decide to wait for the other economy to expand, thus prolonging the duration of the recession in both countries. In contrast, if both countries coordinate their policies by simultaneously pursuing fiscal expansions, then output is likely to increase in both countries, with smaller negative effects on the trade balance and the budget deficit of each country. However, fiscal policy coordination may be difficult to achieve if one country has a budget deficit and the other has a budget surplus, since the former may be comparatively unwilling to spend, and further increase its deficit. In addition, once an agreement has been negotiated each country has an incentive to renege on its commitment, in order to benefit from the other country’s expansion and to improve its trade balance.

Table 7.1 also suggests that if policy coordination is either unfeasible or undesirable in an open economy, the government can still attempt to achieve specific policy targets unilaterally through appropriate fiscal and exchange rate policy mixes. If an economy is in recession, an expansionary fiscal policy increases output but also deteriorates the trade balance. By contrast, if the trade position of a country is in deficit then a depreciation improves the trade position and increases output, though the latter is not always a desirable outcome if the economy is already close to full employment. If the government can control the exchange rate, then an appropriate exchange rate and fiscal policy mix may be necessary in order to achieve joint targets in terms of output and the trade balance.

Uncovered interest parity condition

In an open economy domestic residents can trade financial assets, such as stocks and bonds, with foreign firms and governments. The choice of whether to purchase either a domestic or a foreign asset depends on the relative returns between home and foreign assets.

The UIP condition is an equilibrium outcome from this type of choice, under the assumption that domestic and foreign assets are perfect substitutes and there is free capital mobility. Perfect asset substitutability implies that:
1. Financial assets are equally risky, meaning that domestic and foreign financial assets carry the same risk in terms of restrictions to asset
transfers and default.
2. Financial transaction costs are zero or negligible.
3. Taxes on interest and capital gains are similar in all jurisdictions.

Perfect capital mobility means that investors can quickly purchase and sell any assets and in unlimited amounts.

Under these assumptions, the UIP condition should hold. It states that the returns from investing in domestic and foreign asset markets must be the same:

1 + i t = ( 1 + i t )(E t /E t+1 ^e)

where i t and i *t are end-of-period interest rates on domestic and foreign bonds respectively, E t is the current exchange rate between the domestic and foreign currencies (price of the domestic currency in terms of the foreign currency), and E e t+1 is the investor’s expectation of the future exchange rate. The UIP condition can be approximated as:

i t − i t ≅ − ((E t + 1 ^ e − E t) / Et)

which shows that the interest rate differential between domestic and foreign bonds must be equal to the expected rate of depreciation of the domestic currency. Note that, since the expected depreciation rate of the domestic currency is equal to the expected appreciation rate of the foreign currency, equation (7.10) also implies that the interest rate differential between domestic and foreign bonds must be equal to the expected appreciation rate of the foreign currency. If i t − i *t = 0.05, equation (7.10) implies that investors are indifferent between domestic and foreign bonds only if they expect the foreign currency to appreciate by 5 per cent in the following period.

The UIP condition yields two fundamental results:
1. To the extent that perfect asset substitutability and mobility hold, international capital movements should be determined by interest rate
differentials across countries.
2. Interest rate differentials can be regarded as a measure of markets’ expectations about future exchange rates between currencies.

Blanchard, O., Johnson, D.R., (2013) Macroeconomics (sixth edition), Pearson

Chapter 18: Openness in Goods and Financial Markets

18-1 Openness in Goods Markets

Belgium’s 81% ratio of exports to GDP raises an odd possibility: Can a country have exports larger than its GDP; in other words, can a country have an export ratio greater than one? The answer is: yes. It would seem that the answer must be no: A country cannot export more than it produces, so that the export ratio must be less than one. Not so.
The key to the answer is to realize that exports and imports may include exports and imports of intermediate goods. Hence, exports can exceed GDP. This is actually the case for a number of small countries where most economic activity is organized around a harbor and import–export activities. This is even the case for small countries such as Singapore, where manufacturing plays an important role. In 2010, the ratio of exports to GDP in Singapore was 211%!

Nominal exchange rates between two currencies can be quoted in one of two ways:
* As the price of the domestic currency in terms of the foreign currency.
* As the price of the foreign currency in terms of the domestic currency.

Either definition is fine; the important thing is to remain consistent. In this book, we shall adopt the first definition.

* An increase in the real exchange rate—that is, an increase in the relative price of domestic goods in terms of foreign goods—is called a real appreciation.
* A decrease in the real exchange rate—that is, a decrease in the relative price of domestic goods in terms of foreign goods—is called a real depreciation.

* The nominal and the real exchange rate can move in opposite directions.

18-2 Openness in Financial Markets

Openness in financial markets allows financial investors to hold both domestic assets and foreign assets, to diversify their portfolios, to speculate on movements in foreign interest rates versus domestic interest rates, on movements in exchange rates, and so on.

A country’s transactions with the rest of the world, including both trade flows and financial flows, are summarized by a set of accounts called the balance of payments. Transactions are referred to either as above the line or below the line. Above the line are transactions on the current account, below the line is transactions on the capital account.

The transactions above the line record payments to and from the rest of the world.
They are called current account transactions.
* The first two lines record the exports and imports of goods and services.
* Income balance; Income on holdings of foreign assets, minus and foreign residents receive income on their holdings of local assets.
* Countries give and receive foreign aid; the net value of these payments is recorded as net transfers received

The sum of net payments to and from the rest of the world is called the current account balance. If net payments from the rest of the world are positive, the country is running a current account surplus; if they are negative, the country is running a current account deficit.

GDP measures value added domestically. GNP measures the value added by domestic factors of production. When the economy is closed, the two measures are the same. When the economy is open, however, they can differ: Some of the income from domestic production goes to foreigners; and domestic residents receive some foreign income. Thus, to go from GDP to GNP, one must start from GDP, add income received from the rest of the world, and subtract income paid to the rest of the world. Put another way, GNP is equal to GDP plus net payments from the rest of the world. More
formally, denoting these net income payments by NI,

GNP = GDP + NI

The choice of holding domestic money versus foreign money, and the choice of holding domestic interest-paying assets versus foreign interest-paying assets. Arbitrage by investors implies that the domestic interest rate must be equal to the foreign interest rate minus the expected appreciation rate of the domestic currency.

18-3 Conclusions and a Look Ahead

* Openness in goods markets allows people and firms to choose between domestic goods and foreign goods. Openness in financial markets allows financial investors to hold domestic financial assets or foreign financial assets.

* The nominal exchange rate is the price of the domestic currency in terms of foreign currency. From the viewpoint of the United States, the nominal exchange rate between the United States and the United Kingdom is the price of a dollar in terms of pounds.

* A nominal appreciation (an appreciation, for short) is an increase in the price of the domestic currency in terms of foreign currency. In other words, it corresponds to an increase in the exchange rate. A nominal depreciation (a depreciation, for short) is a decrease in the price of the domestic currency in terms of foreign currency. It corresponds to a decrease in the exchange rate.

* The real exchange rate is the relative price of domestic goods in terms of foreign goods. It is equal to the nominal exchange rate times the domestic price level divided by the foreign price level.

* A real appreciation is an increase in the relative price of domestic goods in terms of foreign goods (i.e., an increase in the real exchange rate). A real depreciation is a decrease in the relative price of domestic goods in terms of foreign goods (i.e., a decrease in the real exchange rate).

* The multilateral real exchange rate, or real exchange rate for short, is a weighted average of bilateral real exchange rates, with the weight for each foreign country equal to its share in trade.

* The balance of payments records a country’s transactions with the rest of the world. The current account balance is equal to the sum of the trade balance, net income, and net transfers the country receives from the rest of the world. The capital account balance is equal to capital flows from the rest of the world minus capital flows to the rest of the world.

* The current account and the capital account are mirror images of each other. Leaving aside statistical problems, the current account plus the capital account must sum to zero.

* A current account deficit is financed by net capital flows from the rest of the world, thus by a capital account surplus. Similarly, a current account surplus corresponds to a capital account deficit.

* Uncovered interest parity, or interest parity for short, is an arbitrage condition stating that the expected rates of return in terms of domestic currency on domestic bonds and foreign bonds must be equal. Interest parity implies that the domestic interest rate approximately equals the foreign interest rate minus the expected appreciation rate of the domestic currency.

Chapter 19: The Goods Market in an Open Economy

19-1 The IS Relation in the Open Economy

In an open economy, the demand for domestic goods, Z is given by
Z K C + I + G - I IM/e + X (19.1)

The first three terms—consumption, C, investment, I, and government spending, G— constitute the domestic demand for goods. If the economy were closed, C + I + G would also be the demand for domestic goods. This is why, until now, we have only looked at C + I + G. But now we have to make two adjustments:

First, we must subtract imports—that part of the domestic demand that falls on foreign goods rather than on domestic goods.

We must be careful here: Foreign goods are different from domestic goods, so we cannot just subtract the quantity of imports, II M. If we were to do so, we would be subtracting apples (foreign goods) from oranges (domestic goods). We must first express the value of imports in terms of domestic goods. This is what IM>P in equation (19.1) stands for: Recall from Chapter 18 that P, the real exchange rate, is defined as the price of domestic goods in terms of foreign goods.

Second, we must add exports—that part of the demand for domestic goods that comes from abroad. This is captured by the term X in equation (19.1).

Domestic demand: C + I + G = C(Y - T )+ + I(Y, r)+.- + G

We write imports as
IM = IM(Y, e) +, +

An increase in domestic income, Y (equivalently, an increase in domestic output—income and output are still equal in an open economy) leads to an increase in imports. This positive effect of income on imports is captured by the positive sign under Y

An increase in the real exchange rate, e, leads to an increase in imports, IM. This positive effect of the real exchange rate on imports is captured by the positive sign under P in equation.

An increase in foreign income, Y *, leads to an increase in exports.
An increase in the real exchange rate, e, leads to a decrease in exports.

19-2 Equilibrium Output and the Trade Balance

The goods market is in equilibrium when domestic output equals the demand—both domestic and foreign—for domestic goods:
Y = Z
Collecting the relations we derived for the components of the demand for domestic goods, Z, we get
Y = C(Y - T) + I(Y, r) + G - IM(Y, e)/e + X(Y*, e)

19-3 Increases in Demand, Domestic or Foreign

An increase in government spending leads to an increase in output and to a trade deficit.

Not only does government spending now generate a trade deficit, but the effect of government spending on output is smaller than it would be in a closed economy; the multiplier is smaller in the open economy.

An increase in foreign demand leads to an increase in output and to a trade surplus.

Fiscal Policy Revisited
We have derived two basic results so far:
* An increase in domestic demand leads to an increase in domestic output but leads also to a deterioration of the trade balance. (We looked at an increase in government spending, but the results would have been the same for a decrease in taxes, an increase in consumer spending, and so on.)
* An increase in foreign demand (which could come from the same types of changes taking place abroad) leads to an increase in domestic output and an improvement in the trade balance.

19-4 Depreciation, the Trade Balance, and Output

Return to the definition of net exports:
NX := X - IM/e

Replace X and IM by their expressions from equations (19.2) and (19.3):
NX = X(Y*, e) - IM(Y, e)/e

As the real exchange rate P enters the right side of the equation in three places, this makes it clear that the real depreciation affects the trade balance through three separate channels:

* Exports, X, increase. The real depreciation makes U.S. goods relatively less expen- sive abroad. This leads to an increase in foreign demand for local. goods—an increase in exports.
* Imports, IM, decrease. The real depreciation makes foreign goods relatively more expensive in the United States. This leads to a shift in domestic demand toward domestic goods and to a decrease in the quantity of imports.
* The relative price of foreign goods in terms of domestic goods, 1/P, increases. This increases the import bill, IM>P. The same quantity of imports now costs more to buy (in terms of domestic goods).

For the trade balance to improve following a depreciation, exports must increase enough and imports must decrease enough to compensate for the increase in the price of imports. The condition under which a real depreciation leads to an increase in net exports is known as the Marshall-Lerner condition.

The depreciation leads to a shift in demand, both foreign and domestic, toward domestic goods. This shift in demand leads, in turn, to both an increase in domestic output and an improvement in the trade balance.

19-5 Looking at Dynamics: The J-Curve

A real depreciation leads initially to a deterioration and then to an improvement of the trade balance.

19-6 Saving, Investment, and the Current Account Balance

* An increase in investment must be reflected in either an increase in private saving or public saving, or in a deterioration of the current account balance—a smaller current account surplus, or a larger current account deficit, depending on whether the current account is initially in surplus or in deficit.

* A deterioration in the government budget balance—either a smaller budget surplus or a larger budget deficit—must be reflected in an increase in either private saving, or in a decrease in investment, or else in a deterioration of the current account balance.

* A country with a high saving rate (private plus government) must have either a high investment rate or a large current account surplus.

Summary

* In an open economy, the demand for domestic goods is equal to the domestic demand for goods (consumption, plus investment, plus government spending) minus the value of imports (in terms of domestic goods), plus exports.

* In an open economy, an increase in domestic demand leads to a smaller increase in output than it would in a closed economy because some of the additional demand falls on imports. For the same reason, an increase in domestic demand also leads to a deterioration of the trade balance.

* An increase in foreign demand leads, as a result of increased exports, to both an increase in domestic output and an improvement of the trade balance.

* Because increases in foreign demand improve the trade balance and increases in domestic demand worsen the trade balance, countries might be tempted to wait for increases in foreign demand to move them out of a recession. When a group of countries is in recession, coordination can, in principle, help their recovery.

*If the Marshall-Lerner condition is satisfied—and the empirical evidence indicates that it is—a real depreciation leads to an improvement in net exports.

* A real depreciation leads first to a deterioration of the trade balance, and then to an improvement. This adjustment process is known as the J-curve.

* The condition for equilibrium in the goods market can be rewritten as the condition that saving (public and private) minus investment must be equal to the current account balance. A current account surplus corresponds to an excess of saving over investment. A current account deficit
usually corresponds to an excess of investment over saving.

APPENDIX: Derivation of the Marshall-Lerner Condition

Start from the definition of net exports NX := X - IM/e

To derive this condition, first multiply both sides of the equation above by e to get

eNX = eX - IM

Now consider a change in the real exchange rate of delta e.

e (delta NX) = (delta e)X + e(delta X) - (delta IM)

Divide both sides by eX

Simplify, and use the fact that, if trade is initially balanced, eX = IM to replace eX by IM in the last term on the right.

deltaNX/X = delta e/e + delta X/X + delta IM/IM

The change in the trade balance (as a ratio to exports) in response to a real depreciation is equal to the sum of three terms:

* The first term is equal to the proportional change in the real exchange rate. It is negative if there is a real depreciation.
* The second term is equal to the proportional change in exports. It is positive if there is a real depreciation.
* The third term is equal to minus the proportional change in the imports. It is positive if there is a real depreciation.

The Marshall-Lerner condition is the condition that the sum of these three terms be positive. If it is satisfied, a real depreciation leads to an improvement in the trade balance.

Dornbusch, R., S. Fischer and R. Startz Macroeconomics (2011)

Chaper 12: International Linkages

• Economies are linked internationally through trade in goods and through financial markets. The exchange rate is the price of a foreign currency in terms of the dollar. A high exchange rate—a weak dollar— reduces imports and increases exports, stimulating aggregate demand.

• Under fixed exchange rates, central banks buy and sell foreign currency to peg the exchange rate. Under floating exchange rates, the market determines the value of one currency in terms of another.

• If a country wishes to maintain a fixed exchange rate in the presence of a balance of payments deficit, the central bank must buy back domestic currency, using its reserves of foreign currency and gold or borrowing reserves from abroad. If the balance of payments deficit persists long enough for the country to run out of reserves, it must allow the value of its currency to fall.

• In the very long run, exchange rates adjust so as to equalize the real cost of goods across countries.

• With perfect capital mobility and fixed exchange rates, fiscal policy is powerful. With perfect capital mobility and floating exchange rates, monetary policy is powerful.

12-1 Balance of Payments

The balance of payments is the record of the transactions of the residents of a country with the rest of the world. There are two main accounts in the balance of payments: the current account and the capital account.

The simple rule for balance-of-payments accounting is that any transaction that gives rise to a payment by a country’s residents is a deficit item in that country’s bal- ance of payment

The current account records trade in goods and services, as well as transfer payments.

The capital account records purchases and sales of assets, such as stocks, bonds, and land.

Current account + capital account = 0

The increase in official reserves is also called the overall balance-of-payments surplus . We can summarize our discussion in the following statement:

Balance-of-payments surplus = increase in official exchange reserves = current account surplus + net private capital inflow

In a fixed exchange rate system foreign central banks stand ready to buy and sell their currencies at a fixed price in terms of dollars.

Intervention is the buying or selling of foreign exchange by the central bank.

If a country persistently runs deficits in the balance of payments, the central bank eventually will run out of reserves of foreign exchange and will be unable to continue its intervention.

In a flexible (floating) exchange rate system , by contrast, the central banks allow the exchange rate to adjust to equate the supply and demand for foreign currency.

In a system of clean floating , central banks stand aside completely and allow exchange rates to be freely determined in the foreign exchange markets.

Under managed floating, central banks intervene to buy and sell foreign currencies in attempts to influence exchange rates.

A devaluation takes place when the price of foreign currencies under a fixed rate regime is increased by official action. A currency depreciates when, under floating rates, it becomes less expensive in terms of foreign currencies.

12-Exchange Rates in the Long Run

The real exchange rate is the ratio of foreign to domestic prices, measured in the same currency. It measures a country’s competitiveness in international trade.

12-3 Trade in Goods

The marginal propensity to import measures the fraction of an extra dollar of income spent on imports. T

Effects of Disturbance on Income and Next Exports
	Increase in Domestic Spending	Increase in Foreign Income	Real Depreciation
Income		+				+				+
Net Exports	-				+				+

12-4 Capital Mobility

Capital is perfectly mobile internationally when investors can purchase assets in any country they choose, quickly, with low transaction costs (EDIT: or zero?), and in unlimited amounts.

			Surplus				Surplus
Domestic		unemployment			overemployment
Interest
Rate

			Deficit				Surplus
			unemployment			overemployment

0								Y

				Domestic income, output

12-5 The Murray Fleming Model

The analysis extending the standard IS-LM model to the open economy under perfect capital mobility has a special name, the Mundell-Fleming model .

Under perfect capital mobility, the slightest interest differential provokes infinite capital flows. It follows that with perfect capital mobility, central banks cannot conduct an independent monetary policy under fixed exchange rates

Under fixed exchange rates and perfect capital mobility, a country cannot pursue an independent monetary policy. 18 Interest rates cannot move out of line with those prevailing in the world market. Any attempt at independent monetary policy leads to capital flows and a need to intervene until interest rates are back in line with those in the world market.

12-6 Perfect Capital Mobility and Flexible Exchange Rates

Under fully flexible exchange rates the absence of intervention implies a zero balance of payments. Any current account deficit must be financed by private capital inflows: A current account surplus is balanced by capital outflows. Adjustments in the exchange rate ensure that the sum of the current and capital accounts is zero.

Under fixed rates, the monetary authorities cannot control the nominal money stock. The fact that the central bank can control the money stock under flexible rates is a key aspect of that exchange rate system.

SUMMARY
* The balance-of-payments accounts are a record of the international transactions of the economy. The current account records trade in goods and services as well as transfer payments. The capital account records purchases and sales of assets. Any transaction that gives rise to a payment by a U.S. resident is a deficit item for the United States.

* The overall balance-of-payments surplus is the sum of the current and capital accounts surpluses. If the overall balance is in deficit, we have to make more payments to foreigners than they make to us. The foreign currency for making these payments is supplied by central banks.

* Under fixed exchange rates, the central bank holds constant the price of foreign currencies in terms of the domestic currency. It does this by buying and selling foreign exchange at the fixed exchange rate. It has to keep reserves of foreign currency for that purpose.

* Under floating, or flexible, exchange rates, the exchange rate may change from moment to moment. In a system of clean floating, the exchange rate is determined by supply and demand without central bank intervention. Under dirty floating, the central bank intervenes by buying and selling foreign exchange in an attempt to influence but not fix the exchange rate.

* The introduction of trade in goods means that some of the demand for our output comes from abroad and that some spending by our residents is on foreign goods. The demand for our goods depends on the real exchange rate as well as on the levels of income at home and abroad. A real depreciation or increase in foreign income increases net exports and shifts the IS curve out to the right. There is equilibrium in the goods market when the demand for domestically produced goods is equal to the output of those goods.

* The introduction of capital flows points to the effects of monetary and fiscal policy on the balance of payments through interest rate effects on capital flows. An increase in the domestic interest rate relative to the world interest rate leads to a capital inflow that can finance a current account deficit.

* When capital mobility is perfect, interest rates in the home country cannot diverge from those abroad. This has major implications for the effects of monetary and fiscal policy under fixed and floating exchange rates. These effects are summarized in Table 12-6

POLICY 			FIXED EXCHANGE RATES 			FLEXIBLE EXCHANGE RATES
Monetary expansion 	No output change; reserve losses 	Output expansion; trade balance
			equal to money increase 		improves; exchange depreciation

Fiscal expansion 	Output expansion; trade balance		No output change; reduced net
			worsens 				exports; exchange appreciation

* Under fixed exchange rates and perfect capital mobility, monetary policy is powerless to affect output. Any attempt to reduce the domestic interest rate by increasing the money stock would lead to a huge outflow of capital, tending to cause a depreciation that the central bank would then have to offset by buying domestic money in exchange for foreign money. This reduces the domestic money stock until it returns to its original level. Under fixed exchange rates with capital mobility, the central bank cannot run an independent monetary policy.

* Fiscal policy is highly effective under fixed exchange rates with complete capital mobility. A fiscal expansion tends to raise the interest rate, thereby leading the central bank to increase the money stock to keep the exchange rate constant, reinforcing the expansionary fiscal effect.

* Under floating rates, monetary policy is highly effective and fiscal policy is ineffective in changing output. A monetary expansion leads to depreciation, increased exports, and increased output. Fiscal expansion, however, causes an appreciation and completely crowds out net exports.

* If an economy with floating rates finds itself with unemployment, the central bank can intervene to depreciate the exchange rate and increase net exports and thus aggregate demand. Such policies are known as beggar-thy-neighbor policies because the increase in demand for domestic output comes at the expense of demand for foreign output.

Mankiw, N. G. Macroeconomics. (Worth, 2009)

Chapter 5

5-1 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

In an open economy, some output is sold domestically and some is exported to be sold abroad. We can divide expenditure on an open economy’s output Y into four components:
C d , consumption of domestic goods and services,
I d , investment in domestic goods and services,
G d , government purchases of domestic goods and services,
X, exports of domestic goods and services.
The division of expenditure into these components is expressed in the identity
Y = C d + I d + G d + X.

The sum of the first three terms, C d + I d + G d , is domestic spending on domestic goods and services. The fourth term, X, is foreign spending on domestic goods and services.

A bit of manipulation can make this identity more useful. Note that domestic spending on all goods and services equals domestic spending on domestic goods and services plus domestic spending on foreign goods and services. Hence, total consumption C equals consumption of domestic goods and services C d plus consumption of foreign goods and services C f ; total investment I equals investment in domestic goods and services I d plus investment in foreign goods and ser- vices I f ; and total government purchases G equals government purchases of domestic goods and services G d plus government purchases of foreign goods and services G f .

Defining net exports to be exports minus imports (NX = X − IM ), the identity becomes
Y = C + I + G + NX.

The national income accounts identity shows how domestic output, domestic spending, and net exports are related. In particular,
NX = Y − (C + I + G)

Net Exports = Output − Domestic Spending.

This equation shows that in an open economy, domestic spending need not equal the output of goods and services. If output exceeds domestic spending, we export the difference: net exports are positive. If output falls short of domestic spending, we import the difference: net exports are negative.

Begin with the identity
Y = C + I + G + NX.
Subtract C and G from both sides to obtain
Y − C − G = I + NX.

Recall from Chapter 3 that Y − C − G is national saving S, which equals the sum of private saving, Y − T − C, and public saving, T − G, where T stands for taxes. Therefore,
S = I + NX.

Subtracting I from both sides of the equation, we can write the national income accounts identity as
S − I = NX.

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.

The left-hand side of the identity is the difference between domestic saving and domestic investment, S − I, 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. 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.

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.

5-2 Saving and Investment in a Small Open Economy

Because of this assumption of perfect capital mobility, the interest rate in our small open economy, r, must equal the world interest rate r *, the real interest rate prevailing in world financial markets:
r = r *

Saving and Investment in a Small Open Economy : In a closed economy, the real interest rate adjusts to equilibrate saving and investment. In a small open economy, the interest rate is determined in world financial markets. The difference between saving and investment determines the trade balance. Here there is a trade surplus, because at the world interest rate, saving exceeds investment.

The trade balance is determined by the difference between saving and investment at the world interest rate.

A Fiscal Expansion at Home in a Small Open Economy : An increase in government purchases or a reduction in taxes reduces national saving and thus shifts the saving schedule to the left, from S 1 to S 2 . The result is a trade deficit.

Starting from balanced trade, a change in fiscal policy that reduces national saving leads to a trade deficit.

A Fiscal Expansion Abroad in a Small Open Economy A fiscal expansion in a foreign economy large enough to influence world saving and investment rais- es the world interest rate from r * 1 to r * 2 . The higher world interest rate reduces investment in this small open economy, causing a trade surplus.

A Shift in the Investment Schedule in a Small Open Economy: An outward shift in S the investment schedule from I(r) 1 to I(r) 2 increases the amount of investment at the world interest rate r*. As a result, investment now exceeds saving, which means the economy is borrowing from abroad and running a trade deficit.

Starting from balanced trade, an outward shift in the investment schedule causes a trade deficit.

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.

Yet trade deficits are not always a reflection of an economic malady. When poor rural economies develop into modern industrial economies, they some- times 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 lesson is that one cannot judge economic performance from the trade balance alone. Instead, one must look at the underlying causes of the international flows.

5-3 Exchange Rates

Economists distinguish between two exchange rates: the nominal exchange rate and the real exchange rate. Let’s discuss each in turn and see how they
are related.

The Nominal Exchange Rate The nominal exchange rate is the relative price of the currencies of two countries.

The Real Exchange Rate 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.

If the real exchange rate is high, foreign goods are relatively cheap, and domestic goods are relatively expensive. If the real exchange rate is low, foreign goods are relatively expensive, and domestic goods are relatively cheap.

We write this relationship between the real exchange rate and net exports as NX = NX(e).
This equation states that net exports are a function of the real exchange rate

Net Exports and the Real Exchange Rate: The figure shows the relationship between the real exchange rate and net exports: the lower the real exchange rate, the less expensive are domestic goods relative to foreign goods, and thus the greater are our net exports. Note that a portion of the horizontal axis measures negative values of NX: because imports can exceed exports, net exports can be less than zero.

* 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.

How the Real Exchange Rate Is Determined : The real exchange rate is determined by the intersection of the vertical line representing saving minus
investment and the downward-sloping net-exports schedule. At this intersection, the quantity of dollars supplied for the flow of capital abroad equals the quantity of dollars demanded for the net export of goods and services.

At the equilibrium real exchange rate, the supply of dollars available from the net capital outflow balances the demand for dollars by foreigners buying our net exports.

The Impact of Expansionary Fiscal Policy at Home on the Real Exchange Rate: Expansionary fiscal policy at home, such as an increase in government purchases or a cut in taxes, reduces national saving. The fall in saving reduces the supply of dollars to be exchanged into foreign currency, from S 1 − I to S 2 − I. This shift raises the equilibrium real exchange rate from e 1 to e 2 .

The Impact of Expansionary Fiscal Policy Abroad on the Real Exchange Rate: Expansionary fiscal policy abroad reduces world saving and raises the world interest rate from r * 1 to r *.2 The increase in the world interest rate reduces investment at home, which in turn raises the supply of dollars to be exchanged into foreign currencies. As a result, the equilibrium real exchange rate falls from e 1 to e 2 .

The Impact of an Increase in Investment Demand on the Real Exchange Rate : An increase in investment demand raises the quantity of domestic investment from I 1 to I 2 . As a result, the supply of dollars to be exchanged into foreign currencies falls from S − I 1 to S − I 2 .

This fall in supply raises the equilibrium real exchange rate from e 1 to e 2 .

The Impact of Protectionist Trade Policies on the Real Exchange Rate: A protectionist trade policy, such as a ban on
imported cars, shifts the net- exports schedule from NX(e) 1 to NX(e) 2 , which raises the real exchange rate from e 1 to e 2 . Notice that, despite the shift in the net-exports schedule, the equilibrium level of net exports is unchanged.

We can write the nominal exchange rate as e = e × (P */P).

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 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.

Purchasing-Power Parity : The law of one price applied to the international marketplace suggests that net exports are highly sensitive to small movements in the real exchange rate. This high sensitivity is reflected here with a very flat net-exports schedule.

5-3 Conclusion: The United States as a Large Open Economy

Summary
1. Net exports are the difference between exports and imports. They are equal to the difference between what we produce and what we demand for con-
sumption, investment, and government purchases.
2. The net capital outflow is the excess of domestic saving over domestic investment. The trade balance is the amount received for our net exports of
goods and services. The national income accounts identity shows that the net capital outflow always equals the trade balance.
3. The impact of any policy on the trade balance can be determined by examining its impact on saving and investment. Policies that raise saving or
lower investment lead to a trade surplus, and policies that lower saving or raise investment lead to a trade deficit.
4. The nominal exchange rate is the rate at which people trade the currency of one country for the currency of another country. The real exchange rate
is the rate at which people trade the goods produced by the two countries. The real exchange rate equals the nominal exchange rate multiplied by the
ratio of the price levels in the two countries.
5. Because the real exchange rate is the price of domestic goods relative to foreign goods, an appreciation of the real exchange rate tends to reduce net exports. The equilibrium real exchange rate is the rate at which the quantity of net exports demanded equals the net capital outflow.
6. The nominal exchange rate is determined by the real exchange rate and the price levels in the two countries. Other things equal, a high rate of inflation leads to a depreciating currency.