程序代写代做代考 case study finance Mankiw 6e PowerPoints

Mankiw 6e PowerPoints

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The Open Economy
6
CHAPTER

CHAPTER 6 The Open Economy
Chapter 6 extends the long-run analysis of Chapters 3 and 5 to a small open economy.

This PowerPoint presentation contains a slide explaining why the U.S. is often called “the world’s largest debtor nation.” This material will help motivate what students will learn in the rest of the chapter, including the definition and meaning of trade surpluses and trade deficits, the link between the trade balance and net capital outflows, and the determination of real and nominal exchange rates.

The PowerPoint presentation contains a time series graph on the “twin deficits” (budget and trade) and data on U.S. net indebtedness to the rest of the world.

These data suggest some questions: How did it come to this? Why has the U.S. had such huge trade deficits? What can the government do about this? These are among the many topical questions that students will better understand as they study this chapter.

IN THIS CHAPTER, YOU WILL LEARN:
Accounting identities for the open economy
The small open economy model
what makes it “small”
how the trade balance and exchange rate are determined
how policies affect trade balance & exchange rate

CHAPTER 6 The Open Economy

Imports and exports of selected countries, 2013

CHAPTER 6 The Open Economy
In dollar terms, U.S. trade is huge, but as a percentage of GDP, it is smaller than that of many other countries.

Source: World Development Indicators, World Bank
http://databank.worldbank.org/ddp/home.do?Step=3&id=4

Exports Australia China Germany Greece S. Korea Mexico United States 19.8826518267602 26.4119234167633 45.5645528709939 30.2278034181475 53.9246347409957 31.748827 9547765 13.4910932067438 Imports Australia China Germany Greece S. Korea Mexico United States 21.1130718816735 23.848277653838 39.7538690433816 33.1920981374494 48.8616669935133 32.4106766509843 16.5218480328719
Percent of GDP

In an open economy,
spending need not equal output
saving need not equal investment

CHAPTER 6 The Open Economy

“Spending need not equal output”
Residents of an open economy can spend more than the country’s output simply by importing foreign goods. Residents can spend less than output, and the extra output will be exported.

“Saving need not equal investment”
If individuals in an open economy want to save more than domestic firms want to borrow, no problem. The savers simply send their extra funds abroad to buy foreign assets. Similarly, if domestic firms want to borrow more than individuals are willing to save, then the firms simply borrow from abroad (i.e., sell bonds to foreigners).

Preliminaries
EX = exports =
foreign spending on domestic goods
IM = imports = C f + I f + G f
= spending on foreign goods
NX = net exports (a.k.a. the “trade balance”)
= EX – IM

superscripts:
d = spending on domestic goods
f = spending on foreign goods

CHAPTER 6 The Open Economy

Before displaying the second and subsequent lines, explain the first one:

Total consumption expenditure is the sum of consumer spending on domestically produced goods and foreign produced goods.

EX: The value of the goods we export to other countries equals their expenditure on our output.

IM: The value of our imports equals the portion of our country’s expenditure (the portion of C + I + G) used to purchase foreign products.

GDP = Expenditure on
domestically produced g&s

CHAPTER 6 The Open Economy

A country’s GDP is total expenditure on its output of final goods & services. The first line adds up all sources of spending on domestically produced goods & services.

The second & subsequent lines present an algebraic derivation of the national income accounting identity for an open economy.

The national income identity
in an open economy
Y = C + I + G + NX
or, NX = Y – (C + I + G )
net exports

domestic spending

output

CHAPTER 6 The Open Economy

Solving this identity for NX yields the second equation, which says:
A country’s net exports—its net outflow of goods—equals the difference between its output and its expenditure.

Example: If we produce $500b worth of goods, and only buy $400b worth, then we export the remainder.
Of course, NX can be a negative number, which would occur if our spending exceeds our income/output.

Trade surpluses and deficits
Trade surplus:
output > spending and exports > imports
Size of the trade surplus = NX
Trade deficit:
spending > output and imports > exports
Size of the trade deficit = –NX
NX = EX – IM = Y – (C + I + G )

CHAPTER 6 The Open Economy

International capital flows
Net capital outflow
= S – I
= net outflow of “loanable funds”
= net purchases of foreign assets
the country’s purchases of foreign assets
minus foreign purchases of domestic assets
When S > I, country is a net lender
When S < I, country is a net borrower CHAPTER 6 The Open Economy In Chapter 3, we examined a closed economy model of the loanable funds market. Savers could only lend money to domestic borrowers. Firms borrowing to finance their investment could only borrow from domestic savers. Thus, S = I. But in an open economy, S need not equal I. A country’s supply of loanable funds can be used to finance domestic investment or to finance foreign investment (e.g., buying bonds from a foreign company that needs funding to build a new factory in its country). Similarly, domestic firms can finance their investment projects by borrowing loanable funds from domestic savers or by borrowing them from foreign savers. International borrowing and lending is called “international capital flows” even though it’s not the physical capital that is flowing abroad—we don’t see factories uprooted and shipped to Mexico. Rather, what can flow internationally is “loanable funds,” or financial capital, which of course is used to finance the purchase of physical capital. Note: Foreign investment might involve the purchase of financial assets—stocks and bonds and so forth—or physical assets, such as direct ownership in office buildings or factories. In either case, a person in one country ends up owning/financing part of the capital stock of another country. The equation “net capital outflow = S – I” shows that, if a country’s savers supply more funds than its firms wishes to borrow for investment, the excess of loanable funds will flow abroad in the form of net capital outflow (the purchase of foreign assets). Alternatively, if firms wish to borrow more than domestic savers wish to lend, then the firms borrow the excess on international financial markets; in this case, there’s a net inflow of loanable funds, and S < I. The link between trade & cap. flows NX = Y – (C + I + G ) implies NX = (Y – C – G ) – I = S – I trade balance = net capital outflow Thus, a country with a trade deficit (NX < 0) is a net borrower (S < I ). CHAPTER 6 The Open Economy This equation says that the net outflow of goods & services (net exports) equals the net outflow of financial capital (or loanable funds). While the identity and its derivation are very simple, we learn a very important lesson from it: A country (such as the U.S.) with persistent, large trade deficits (NX < 0) also has low saving, relative to its investment, and is a net borrower of assets. Saving, investment, and the trade balance 1960–2014 trade balance (right scale) saving investment CHAPTER 6 The Open Economy Notice that investment > saving pretty consistently beginning in the early 1980s.

The trade balance is measured on the right-hand scale; note that the location of 0% is different on the two scales.

Source: Federal Reserve Bank of St. Louis
Notes: Investment was constructed as the sum of Gross Private Domestic Investment (GPDI), Federal Government Defense Investment (DGI), Federal Government Nondefense Investment (NDGI), and State & Local Investment (SLINV).
Saving is simply Gross Saving (GSAVE). The Trade Balance was constructed as saving minus investment.

S/Y 1960 1960.25 1960.5 1960.75 1961 1961.25 1961.5 1961.75 1962 1962.25 1962.5 1962.75 1963 1963.25 1963.5 1963.75 1964 1964.25 1964.5 1964.75 1965 1965.25 1965.5 1965.75 1966 1966.25 1966.5 1966.75 1967 1967.25 1967.5 1967.75 1968 1968.25 1968.5 1968.75 1969 1969.25 1969.5 1969.75 1970 1970.25 1970.5 1970.75 1971 1971.25 1971.5 1971.75 1972 1972.25 1972.5 1972.75 1973 1973.25 1973.5 1973.75 1974 1974.25 1974.5 1974.75 1975 1975.25 1975.5 1975.75 1976 1976.25 1976.5 1976.75 1977 1977.25 1977.5 1977.75 1978 1978.25 1978.5 1978.75 1979 1979.25 1979.5 1979.75 1980 1980.25 1980.5 1980.75 1981 1981.25 1981.5 1981.75 1982 1982.25 1982.5 1982.75 1983 1983.25 1983.5 1983.75 1984 1984.25 1984.5 1984.75 1985 1985.25 1985.5 1985.75 1986 1986.25 1986.5 1986.75 1987 1987.25 1987.5 1987.75 1988 1988.25 1988.5 1988.75 1989 1989.25 1989.5 1989.75 1990 1990.25 1990.5 1990.75 1991 1991.25 1991.5 1991.75 1992 1992.25 1992.5 1992.75 1993 1993.25 1993.5 1993.75 1994 1994.25 1994.5 1994.75 1995 1995.25 1995.5 1995.75 1996 1996.25 1996.5 1996.75 1997 1997.25 1997.5 1997.75 1998 1998.25 1998.5 1998.75 1999 1999.25 1999.5 1999.75 2000 2000.25 2000.5 2000.75 2001 2001.25 2001.5 2001.75 2002 2002.25 2002.5 2002.75 2003 2003.25 2003.5 2003.75 2004 2004.25 2004.5 2004.75 2005 2005.25 2005.5 2005.75 2006 2006.25 2006.5 2006.75 2007 2007.25 2007.5 2007.75 2008 2008.25 2008.5 2008.75 2009 2009.25 2009.5 2009.75 2010 2010.25 2010.5 2010.75 2011 2011.25 2011.5 2011.75 2012 2012.25 2012.5 2012.75 2013 2013.25 2013.5 2013.75 2014 2014.25 2014.5 0.244984354868397 0.232909526441865 0.232783882783883 0.224542598410645 0.228430115405752 0.228022963760316 0.236888419570574 0.241231086657497 0.237903225806452 0.235811483571192 0.237040682414698 0.237481650627956 0.239601734382528 0.243589743589744 0.23984496124031 0.24282223579719 0.241245715988675 0.239424206815511 0.240184757505774 0.247422680412371 0.251251390433815 0.249453850354997 0.244201546254332 0.239166990040098 0.243697478991597 0.241328047571853 0.237938596491228 0.241106719367589 0.233569739952719 0.227940312536717 0.232864066466651 0.235960144927536 0.22741740752936 0.22855922247143 0.226189226084217 0.228223894443872 0.230962427164959 0.228495155230374 0.230717054263566 0.224079946190064 0.215662078785002 0.214746285393888 0.212310519062931 0.205863490609253 0.209702935489541 0.20976367086424 0.211048038634246 0.212550268096515 0.213405738369266 0.209038658373356 0.216184881743701 0.226876876876877 0.229086695154632 0.228908013544018 0.235871380846325 0.244540599012913 0.238107981534756 0.225589883978621 0.221376487143405 0.217716781035558 0.203754013336626 0.19898575223376 0.210234566460497 0.211280366951696 0.215127432173198 0.215089665571652 0.212906638455435 0.208161370202229 0.206875784190715 0.220464032618192 0.226912928759895 0.226080140176142 0.227690496672251 0.231704185568775 0.233940556088207 0.236524051244863 0.240914836467056 0.235871951924188 0.23030257639305 0.226315596733438 0.22023958519578 0.215936283438694 0.217482517482517 0.227158844162352 0.226770547289099 0.22751239225839 0.238317183858702 0.235419521851683 0.226281385545849 0.229520007204395 0.217486858127172 0.197781559950701 0.199264431227193 0.196383726770467 0.191425398802914 0.203840783962488 0.219203639337559 0.21813200498132 0.220531389147135 0.217812710965378 0.210785933443474 0.207028798549613 0.197719929003777 0.19831128876513 0.199123176051192 0.191934492448191 0.182223569140185 0.183278365528762 0.190469152485115 0.192678626983304 0.196735027038057 0.201783901089056 0.202903390562999 0.205983447587227 0.207585621285027 0.205960056903209 0.208416253573109 0.197178594271907 0.193168289095875 0.189003019051254 0.18800502478441 0.190 737610256582 0.184161207396965 0.184749223847393 0.199127978992221 0.186926232176574 0.181364981345684 0.183109582278279 0.182046138415246 0.181476518337107 0.17145676763076 0.17044911610129 0.16823745591417 0.171825582757409 0.166188696735321 0.172804572858605 0.17321300954276 0.179055819967537 0.178352352325123 0.180226570545829 0.185545969013823 0.183710502439217 0.186764419645754 0.189973716263863 0.192889992525117 0.193822489611115 0.195930873881603 0.198103075864898 0.20255650373121 0.207123563184789 0.209438781380151 0.209437547648578 0.21508037391588 0.213181095534037 0.21433335155524 0.207984387230985 0.215462946300981 0.207879041540232 0.203319502074689 0.203060617966774 0.21337852656764 0.206668417929035 0.206837623341765 0.197664314429495 0.204023562775383 0.200001879981952 0.192377461346868 0.182660050648052 0.185529424795097 0.182298716025899 0.177927172898678 0.179623192060376 0.172910303559185 0.173744800232176 0.170708208961643 0.174268837587164 0.172733642521104 0.176006041998457 0.178950006872741 0.172024008533537 0.176623457705425 0.176127823895299 0.176306662425977 0.183610330603216 0.195107298024017 0.191336106320381 0.189157709314448 0.188441960985042 0.180071944467864 0.17807145878258 0.168617061435719 0.164477402572641 0.161612718496905 0.154107878215081 0.151674189853803 0.150585227389879 0.146754357302262 0.141565088839921 0.138604431281763 0.147969656403391 0.145002758648875 0.147623013580861 0.155548324113244 0.154502238972568 0.152036959260815 0.152326190583989 0.159195745199556 0.164013354196626 0.173227211481215 0.17373421064077 0.171382207770654 0.180848002449105 0.177549932131084 0.18189202849716 0.182239528694962 0.182014603327029 0.176067824454353 0.181674957583592 0.181740701598882 I/Y 1960 1960.25 1960.5 1960.75 1961 1961.25 1961.5 1961.75 1962 1962.25 1962.5 1962.75 1963 1963.25 1963.5 1963.75 1964 1964.25 1964.5 1964.75 1965 1965.25 1965.5 1965.75 1966 1966.25 1966.5 1966.75 1967 1967.25 1967.5 1967.75 1968 1968.25 1968.5 1968.75 1969 1969.25 1969.5 1969.75 1970 1970.25 1970.5 1970.75 1971 1971.25 1971.5 1971.75 1972 1972.25 1972.5 1972.75 1973 1973.25 1973.5 1973.75 1974 1974.25 1974.5 1974.75 1975 1975.25 1975.5 1975.75 1976 1976.25 1976.5 1976.75 1977 1977.25 1977.5 1977.75 1978 1978.25 1978.5 1978.75 1979 1979.25 1979.5 1979.75 1980 1980.25 1980.5 1980.75 1981 1981.25 1981.5 1981.75 1982 1982.25 1982.5 1982.75 1983 1983.25 1983.5 1983.75 1984 1984.25 1984.5 1984.75 1985 1985.25 1985.5 1985.75 1986 1986.25 1986.5 1986.75 1987 1987.25 1987.5 1987.75 1988 1988.25 1988.5 1988.75 1989 1989.25 1989.5 1989.75 1990 1990.25 1990.5 1990.75 1991 1991.25 1991.5 1991.75 1992 1992.25 1992.5 1992.75 1993 1993.25 1993.5 1993.75 1994 1994.25 1994.5 1994.75 1995 1995.25 1995.5 1995.75 1996 1996.25 1996.5 1996.75 1997 1997.25 1997.5 1997.75 1998 1998.25 1998.5 1998.75 1999 1999.25 1999.5 1999.75 2000 2000.25 2000.5 2000.75 2001 2001.25 2001.5 2001.75 2002 2002.25 2002 .5 2002.75 2003 2003.25 2003.5 2003.75 2004 2004.25 2004.5 2004.75 2005 2005.25 2005.5 2005.75 2006 2006.25 2006.5 2006.75 2007 2007.25 2007.5 2007.75 2008 2008.25 2008.5 2008.75 2009 2009.25 2009.5 2009.75 2010 2010.25 2010.5 2010.75 2011 2011.25 2011.5 2011.75 2012 2012.25 2012.5 2012.75 2013 2013.25 2013.5 2013.75 2014 2014.25 2014.5 0.242223449291368 0.225354707941773 0.225641025641026 0.208464239512105 0.216156805275692 0.219949766774309 0.230200633579725 0.231258596973865 0.235215053763441 0.230003318951211 0.231791338582677 0.22573805251998 0.229484502970933 0.229819563152897 0.233178294573643 0.232590103848503 0.232752197884071 0.230611045828437 0.229792147806005 0.231529209621993 0.240127919911012 0.237438558164937 0.240069314849374 0.236968050704954 0.245955098457293 0.24207135777998 0.240497076023392 0.242064917954246 0.237234042553192 0.227940312536717 0.231710131548581 0.233129528985507 0.231149160355614 0.233365374345829 0.2259792082327 0.227089990722606 0.234980912196102 0.229780502274076 0.230135658914729 0.219659844335543 0.21556 7157095396 0.215213531445659 0.215066605420303 0.20870361887311 0.2175250483389 0.220545109539417 0.221299669575532 0.215231233243968 0.221267628464905 0.226596330997559 0.225846344102643 0.226951951951952 0.232128630404867 0.235468397291196 0.228911469933185 0.234669731593537 0.227002073994782 0.230413244687785 0.223295381860049 0.225077978789769 0.202148678686095 0.194699347983579 0.204574629478352 0.20731638258112 0.217922718553028 0.221498195917928 0.220576567045755 0.21956252579447 0.226750313676286 0.234880108727308 0.239257444402563 0.237746115184212 0.239235749535926 0.246340837113755 0.250990037100338 0.253686246072033 0.251066519197346 0.252821757386648 0.251273217495506 0.247592192478119 0.246844269622743 0.23357977 0706097 0.22006993006993 0.230633038249541 0.244523915958873 0.238436523221671 0.244695204219306 0.242211055276382 0.225578838047529 0.225197370395942 0.222892102996644 0.20916720464816 0.209780766025917 0.21795301077069 0.223952549901146 0.23621611654066 0.249105499897771 0.251232876712329 0.252703430053335 0.249975889671135 0.240193533160255 0.243056039792669 0.238679288217358 0.24383014080079 0.241790846489383 0.239265015806112 0.23424105983202 0.232321069088105 0.236180904522613 0.234014310899098 0.231711049892868 0.239890895335178 0.228283502926963 0.229083856596962 0.226568544202283 0.226430432131838 0.229547345949271 0.225374884514249 0.222617130051124 0.220651004615331 0.220258708494602 0.218119738229535 0.214180280288581 0.206398485879833 0.200729987283027 0.19885734748356 0.199890647111797 0.202841081012215 0.197012913741224 0.201900713152504 0.20018219084491 0.201594601051123 0.2033579324857 0.203203701534497 0.200950146287767 0.205792856330338 0.20813306615473 0.213953616330573 0.211348829617943 0.215054770152607 0.216399613004122 0.21221843811227 0.208901576591189 0.210795563818193 0.211577200339537 0.215406562054208 0.220137271724476 0.217868735745918 0.220456790564264 0.224499818753727 0.225108723164362 0.224366487261473 0.229130341856306 0.225877461171579 0.228666703110479 0.230202558521076 0.233606080172751 0.231244114261798 0.232849067677069 0.23495632725844 0.232638819659057 0.239115417919306 0.236 294823025084 0.234647594129274 0.225464165738811 0.224535644457813 0.220311104845153 0.211852765551849 0.216384848261094 0.216281962175806 0.215255819010428 0.215151569732884 0.215091584224539 0.213847872162664 0.216815339222888 0.220465777537066 0.21941209836175 0.225515950547556 0.22685705507087 0.229052236073299 0.232040706431398 0.229619010181824 0.230708649491875 0.236436599509775 0.236934844566229 0.235561384947608 0.232965452780674 0.228004322356822 0.22551499311469 0.22621911900321 0.223443173160738 0.218987695178171 0.213956532409806 0.211030851279282 0.20761301623661 0.198743633976866 0.181793533047366 0.172784580625366 0.16947879950779 0.176439089692102 0.178794504498982 0.184570745402523 0.187618294958725 0.184665992567399 0.181193563628727 0.18445239281025 0.183850748375259 0.192109114175847 0.192316610785573 0.193666237954109 0.191813828839073 0.18907699372417 0.190014785728136 0.192067006835467 0.196037291892629 0.195681068958854 0.192971133536728 0.198214471208781 0.198757940431141 NX/Y 1960 1960.25 1960.5 1960.75 1961 1961.25 1961.5 1961.75 1962 1962.25 1962.5 1962.75 1963 1963.25 1963.5 1963.75 1964 1964.25 1964.5 1964.75 1965 1965.25 1965.5 1965.75 1966 1966.25 1966.5 1966.75 1967 1967.25 1967.5 1967.75 1968 1968.25 1968.5 1968.75 1969 1969.25 1969.5 1969.75 1970 1970.25 1970.5 1970.75 1971 1971.25 1971.5 1971.75 1972 1972.25 1972.5 1972.75 1973 1973.25 1973.5 1973.75 1974 1974.25 1974.5 1974.75 197 5 1975.25 1975.5 1975.75 1976 1976.25 1976.5 1976.75 1977 1977.25 1977.5 1977.75 1978 1978.25 1978.5 1978.75 1979 1979.25 1979.5 1979.75 1980 1980.25 1980.5 1980.75 1981 1981.25 1981.5 1981.75 1982 1982.25 1982.5 1982.75 1983 1983.25 1983.5 1983.75 1984 1984.25 1984.5 1984.75 1985 1985.25 1985.5 1985.75 1986 1986.25 1986.5 1986.75 1987 1987.25 1987.5 1987.75 1988 1988.25 1988.5 1988.75 1989 1989.25 1989.5 1989.75 1990 1990.25 1990.5 1990.75 1991 1991.25 1991.5 1991.75 1992 1992.25 1992.5 1992.75 1993 1993.25 1993.5 1993.75 1994 1994.25 1994.5 1994.75 1995 1995.25 1995.5 1995.75 1996 1996.25 1996.5 1996.75 1997 1997.25 1997.5 1997.75 1998 1998.25 1998.5 1998.75 1999 1999.25 1999.5 1999.75 2000 2000.25 2000.5 2000.75 2001 2001.25 2001.5 2001.75 2002 2002.25 2002.5 2002.75 2003 2003.25 2003.5 2003.75 2004 2004.25 2004.5 2004.75 2005 2005.25 2005.5 2005.75 2006 2006.25 2006.5 2006.75 2007 2007.25 2007.5 2007.75 2008 2008.25 2008.5 2008.75 2009 2009.25 2009.5 2009.75 2010 2010.25 2010.5 2010.75 2011 2011.25 2011.5 2011.75 2012 2012.25 2012.5 2012.75 2013 2013.25 2013.5 2013.75 2014 2014.25 2014.5 0.00276090557702927 0.00755481850009215 0.00714285714285712 0.01607835889854 0.0122733101300604 0.00807319698600645 0.00668778599084827 0.00997248968363137 0.00268817204301075 0.00580816461998007 0.005249343832021 0.0117435981079758 0.0101172314115946 0.0137701804368471 0.00666666666666665 0.0102321319486866 0.00849351810460442 0.00881316098707405 0.0103926096997691 0.0158934707903781 0.0111234705228031 0.0120152921900601 0.00413223140495869 0.00219893933514426 -0.00225761946569672 -0.000743310208126846 -0.00255847953216373 -0.00095819858665705 -0.00366430260047279 0 0.00115393491807061 0.00283061594202899 -0.00373175282625399 -0.00480615187439925 0.000210017851517391 0.00113390372126584 -0.00401848503114327 -0.00128534704370181 0.000581395348837222 0.00442010185452099 9.49216896060923e-5 -0.000467246051770842 -0.00275608635737254 -0.00284012826385707 -0.00782211284935841 -0.0107814386751768 -0.0102516309412861 -0.00268096514745306 -0.00786189009563948 -0.0175576726242028 -0.00966146235894264 -7.50750750750651e-5 -0.00304193525023538 -0.00656038374717835 0.00695991091314033 0.00987086741937665 0.0111059075399746 -0.00482336070916437 -0.00191889471664319 -0.00736119775421085 0.00160533465053103 0.00428640425018115 0.00565993698214493 0.00396398437057591 -0.00279528637983012 -0.00640853034627606 -0.00766992859032004 -0.011401155592241 -0.0198745294855709 -0.0144160761091156 -0.0123445156426687 -0.0116659750080693 -0.0115452528636754 -0.0146366515449799 -0.0170494810121306 -0.0171621948271694 -0.0101516827302892 -0.01694980546246 -0.0209706411024566 -0.0212765957446809 -0.0266046844269623 -0.0176434872674024 -0.00258741258741257 -0.00347419408718888 -0.0177533686697745 -0.010924130963281 -0.00637802036060345 -0.00679153342469924 0.000702547498319994 0.00432263680845313 -0.00540524486947225 -0.0113856446974588 -0.0105163347987243 -0.0215692840002232 -0.0325271510982314 -0.0323753325781724 -0.0299018605602126 -0.0331008717310088 -0.0321720409061996 -0.0321631787057575 -0.0294075997167807 -0.036027241243056 -0.0409593592135803 -0.0455188520356605 -0.0426676704381906 -0.0473305233579207 -0.0520174906918348 -0.0490427035593438 -0.0457117520374984 -0.0413356839157938 -0.0349760228548107 -0.0381069942461226 -0.0253801123639649 -0.0231004090097356 -0.0189829229172564 -0.020470375228629 -0.0211310923761624 -0.0281962902423424 -0.029448840955249 -0.0316479855640768 -0.0322536837101922 -0.0273821279729526 -0.0300190728916162 -0.0216492620324407 -0.00160200829080578 -0.0119311153069861 -0.0185256657661135 -0.0197314987339353 -0.0149667753259779 -0.0204241948153967 -0.0287254232141502 -0.0311454849498328 -0.0351204765715302 -0.031378118777088 -0.0347614495524463 -0.0329882834717325 -0.0349200566119698 -0.0348977963630361 -0.0329964772928199 -0.0348281996067784 -0.0308536439902986 -0.0285079356730529 -0.0221371569454357 -0.0208218475543304 -0.0186872078144202 -0.0215840724430937 -0.0242063978428729 -0.0197656598810199 -0.0179002868330536 -0.0173762555689379 -0.0156699417842104 -0.0149289396128944 -0.0140499679404254 -0.0126963656375421 -0.0143333515552397 -0.0222181712900908 -0.0181431338717702 -0.0233650727215654 -0.0295295656023805 -0.0318957092916654 -0.0192602930914166 -0.0324469999902708 -0.0294571996833182 -0.0369832796997794 -0.0214406029634282 -0.024533764475861 -0.0279336434982847 -0.0291927149037967 -0.0308554234659972 -0.0339832461499067 -0.0373286461117504 -0.0355283776725085 -0.0421812806653547 -0.040103071930488 -0.046107130261245 -0.0461969399499018 -0.0466784558406459 -0.0495099085490994 -0.047907048198129 -0.0570282275397621 -0.055417248725973 -0.0534911862865247 -0.0544019870658973 -0.0528262689065583 -0.0418275465422122 -0.0442252786272265 -0.0438077434662257 -0.0395623613717795 -0.0454430486468257 -0.048147660220630 6 -0.0548261117250184 -0.0545102926055307 -0.0523438139129012 -0.0569229730642003 -0.0559388263828067 -0.0481584065869868 -0.0350391757451039 -0.0312194917854453 -0.0308743682260274 -0.0284694332887104 -0.0337917458501066 -0.0369477318216622 -0.0320699708454811 -0.0301637535948313 -0.0291566043679126 -0.0321262022262611 -0.024655003175703 -0.0280957599792212 -0.0190893993043587 -0.0199320273133392 -0.0204316210684189 -0.00822899127506504 -0.0124648535970525 -0.0101749783383075 -0.0137977631976672 -0.0136664656318252 -0.016903309082375 -0.016539513625189 -0.0170172388322594
Saving, Investment (% of GDP)

Trade Balance (% of GDP)

U.S.: the world’s largest debtor nation
Every year since the 1980s: huge trade deficits and net capital inflows, i.e., net borrowing from abroad
As of 12/31/2014:
U.S. residents owned $24.7 trillion worth of foreign assets
Foreigners owned $31.6 trillion worth of
U.S. assets
U.S. net indebtedness to rest of the world:
$6.9 trillion—higher than any other country, hence U.S. is the “world’s largest debtor nation”

CHAPTER 6 The Open Economy

Servicing this huge debt, of course, uses up some of our GDP each year, though fortunately relatively little: the U.S., so far, has been able to borrow from abroad at lower interest rates than it lends to abroad.

However, this may well change. Just as credit card companies raise your interest rate when your balance rises above a certain level, the countries that hold U.S. assets may well require higher interest rates to make them willing to continue to finance our trade deficits.

How did it get to this point? Why do we have such huge trade deficits year after year? How do government policies affect the trade deficit? These are the questions your students will learn about in the rest of this chapter.

Source: Bureau of Economic Analysis, http://www.bea.gov
Look for “International Investment Position” under “International” or “International Economic Accounts”

Saving and investment in a
small open economy
An open-economy version of the loanable funds model from Chapter 3.
Includes many of the same elements:
production function
consumption function
investment function
exogenous policy variables

CHAPTER 6 The Open Economy

National saving:
The supply of loanable funds

r
S, I
As in Chapter 3,
national saving does not depend on the interest rate

CHAPTER 6 The Open Economy

Assumptions about capital flows
a. Domestic & foreign bonds are perfect substitutes (same risk, maturity, etc.)
b. Perfect capital mobility:
no restrictions on international trade in assets
c. Economy is small:
cannot affect the world interest rate, denoted r*
a & b imply r = r*
c implies r* is exogenous

CHAPTER 6 The Open Economy

This slide is the first on which students see a foreign variable, in this case, the foreign interest rate r*. In general, a star or asterisk “*” on a variable denotes the foreign or world version of that variable.

Thus, Y* = foreign GDP, P* = foreign price level, etc.

The assumption that domestic & foreign bonds are perfect substitutes is implicit in the text, but necessary for the equality of the domestic and foreign interest rate.

Students will realize that assumption a is unrealistic, and c is unrealistic for the U.S. (as well as Japan and the Euro zone). However, these assumptions keep our model simple, and we can still learn A LOT about how the world works (just as the model of supply and demand in perfectly competitive markets is often not realistic, yet teaches us a great deal about how the world works). At the end of the chapter, there’s a brief section discussing how the results we are about to derive differ in a large open economy. And you may wish to have your students read the appendix to Chapter 5, which presents a formal model of the large open economy.

Investment:
The demand for loanable funds
Investment is still a
downward-sloping function
of the interest rate,
r *
but the exogenous
world interest rate…
…determines the
country’s level of
investment.
I (r* )

r
S, I

I (r )

CHAPTER 6 The Open Economy

If the economy were closed . . .

r
S, I

I (r )

rc

. . . the interest rate would adjust to
equate
investment
and saving.

CHAPTER 6 The Open Economy

But in a small open economy…

r
S, I

I (r )

rc

r*

I 1
the exogenous world interest rate determines investment…
…and the difference between saving and investment determines net capital outflow and net exports

NX

CHAPTER 6 The Open Economy

This graph really determines net capital outflow, not NX. But, the national accounting identities say that NX = net capital outflow, so we write “NX” on the graph as shown.

A little bit later in the chapter, we will see that it is the adjustment of the exchange rate that ensures that NX = net capital outflow. For now, though, students will just have to trust the accounting identities.

Three experiments:
1. Fiscal policy at home
2. Fiscal policy abroad
3. An increase in investment demand
(exercise)

CHAPTER 6 The Open Economy

In the textbook, NX = 0 in the economy’s initial equilibrium for each of these three experiments.

In these slides, NX > 0 in the initial equilibrium.

For completeness, you might have your students repeat the three experiments for the case of NX < 0 in the initial equilibrium. This would be a good homework or in-class exercise. 1. Fiscal policy at home r S, I I (r ) I 1 An increase in G or decrease in T reduces saving. NX1 NX2 Results: CHAPTER 6 The Open Economy In a small open economy, the fixed world interest rate pins down the value of investment, regardless of fiscal policy changes. Thus, a $1 decrease in saving causes a $1 decrease in NX and net capital outflow. Note that the analysis on this slide applies to ANYTHING that causes a decrease in saving. Other examples: A shift in consumer preferences regarding the tradeoff between saving and consumption, or a change in the tax laws that reduces the incentive to save. Our model generates a prediction: The government’s budget deficit and the country’s trade balance should be negatively related. Does this prediction come true in the real world? Let’s look at the data . . . NX and the federal budget deficit (% of GDP), 1965–2014 Budget deficit (left scale) Net exports (right scale) CHAPTER 6 The Open Economy Our model implies a negative relationship between NX and the budget deficit. We observe this negative relationship during most periods. There are some exceptions. For example, from 1991 to 2001, NX and the budget deficit fell, due to a long expansion: rising incomes increased imports and tax revenues. And, in 2008-2009, NX and the budget deficit rose as the economy faltered: falling incomes reduce both tax revenue and imports. Source: Department of Commerce. Obtained from: http://research.stlouisfed.org/fred2/ Federal budget deficit (% of GDP) 1965 1965.25 1965.5 1965.75 1966 1966.25 1966.5 1966.75 1967 1967.25 1967.5 1967.75 1968 1968.25 1968.5 1968.75 1969 1969.25 1969.5 1969.75 1970 1970.25 1970.5 1970.75 1971 1971.25 1971.5 1971.75 1972 1972.25 1972.5 1972.75 1973 1973.25 1973.5 1973.75 1974 1974.25 1974.5 1974.75 1975 1975.25 1975.5 1975.75 1976 1976.25 1976.5 1976.75 1977 1977.25 1977.5 1977.75 1978 1978.25 1978.5 1978.75 1979 1979.25 1979.5 1979.75 1980 1980.25 1980.5 1980.75 1981 1981.25 1981.5 1981.75 1982 1982.25 1982.5 1982.75 1983 1983.25 1983.5 1983.75 1984 1984.25 1984.5 1984.75 1985 1985.25 1985.5 1985.75 1986 1986.25 1986.5 1986.75 1987 1987.25 1987.5 1987.75 1988 1988.25 1988.5 1988.75 1989 1989.25 1989.5 1989.75 1990 1990.25 1990.5 1990.75 1991 1991.25 1991.5 1991.75 1992 1992.25 1992.5 1992.75 1993 1993.25 1993.5 1993.75 1994 1994.25 1994.5 1994.75 1995 1995.25 1995.5 1995.75 1996 1996.25 1996.5 1996.75 1997 1997.25 1997.5 1997.75 1998 1998.25 1998.5 1998.75 1999 1999.25 1999.5 1999.75 2000 2000.25 2000.5 2000.75 2001 2001.25 2001.5 2001.75 2002 2002.25 2002.5 2002.75 2003 2003.25 2003.5 2003.75 2004 2004.25 2004.5 2004.75 2005 2005.25 2005.5 2005.75 2006 2006.25 2006.5 2006.75 2007 2007.25 2007.5 2007.75 2008 2008.25 2008.5 2008.75 2009 2009.25 2009.5 2009.75 2010 2010.25 2010.5 2010.75 2011 2011.25 2011.5 2011.75 2012 2012.25 2012.5 2012.75 2013 2013.25 2013.5 2013.75 2014 2014.25 2014.5 0.00125139043381536 0.00273074822501365 0.0125299920021327 0.0124175397749321 0.00501693214599273 0.00706144697720517 0.0095029239766082 0.0123368068032099 0.0228132387706856 0.023968981318294 0.0216939764597277 0.0220788043478261 0.0185490066952036 0.0198654277475168 0.0106059015016276 0.00958664055252034 -0.00221016676712881 0.00148309274273285 0.00833333333333333 0.0121072355145575 0.0211675367821547 0.0304644425754602 0.0362884703720717 0.0408612001832341 0.0399894533309896 0.0451957909263412 0.0438024231127679 0.0449061662198391 0.0370400389041984 0.0404692543894181 0.0314577214407173 0.0433933933933934 0.0290432389367712 0.0287810383747178 0.0254732739420935 0.0225136907578933 0.0236167792868134 0.0247034284969365 0.02309069975694 0.0331877729257642 0.0463694739441837 0.0799323834822507 0.0523398296183919 0.0513619117730336 0.0442861057824061 0.0410361354946416 0.0420523670986512 0.0428188196450681 0.0362358845671268 0.0322298805941171 0.034442140972484 0.0350440355973625 0.0353601666138452 0.0252075665496876 0.0220934595022719 0.0198211264201112 0.0156422815610681 0.0151007357756462 0.0167765128819653 0.0198850111692973 0.0227069551224745 0.0312154005500196 0.0350699300699301 0.031301152497077 0.0229261127785938 0.0238689104284406 0.025328100085858 0.0345058626465662 0.0406866638157493 0.0418155074595503 0.0522111015413857 0.0616820235929338 0.0594776312386863 0.0560299123835035 0.0588792893318528 0.0513421669608282 0.0459261909629932 0.0470734744707348 0.0478054508978813 0.0494743948307455 0.0396034930375265 0.0504613811217256 0.0446229463432394 0.0452493768386068 0.0446161681022076 0.0492184755883386 0.0497662135249805 0.0417826701503405 0.0411089058739073 0.0293477133672094 0.0313029282726253 0.0324725745117168 0.0321769536007544 0.029917237936133 0.0285309934899519 0.029301457682857 0.0246770633570937 0.0281074550493924 0.0286259541984733 0.0292362147343582 0.0331364161064711 0.0337590171891476 0.0326229372253089 0.0348480069065131 0.0304051264265306 0.0397324044534149 0.043306959989708 0.0457535075565748 0.0508870361083249 0.05104508417664 0.0522128596371366 0.0493460344003822 0.0504727186508995 0.0448049666159072 0.0459430491584832 0.0403111136389489 0.0373442820509227 0.0325731106770475 0.0346286196156305 0.0343600786443217 0.0336633400925079 0.0317821404620705 0.0318172970868747 0.0285018270401949 0.0282651936501501 0.0223159461638653 0.020786861134943 0.0170626636579745 0.0143654562549839 0.0119856406178744 0.00790400147265239 0.00827236211781574 0.00254226801804334 0.000978353919530385 -0.00237249221013503 -0.00219822640659682 -0.00502799800997131 -0.00657109971748456 -0.00736179895596306 -0.00854313375847512 -0.0175655468049048 -0.0142436005954292 -0.014839631567768 -0.0143044030442214 -0.0123714087227948 -0.00871371634832308 0.0122374171718596 0.00324259669385963 0.021044081813483 0.024371730621502 0.0250881119134555 0.0279724058430447 0.0296880704535133 0.0353364348720835 0.0406448116575341 0.034180150294496 0.0367855593740616 0.0330175513487776 0.0301672906037501 0.0302972409291366 0.0244191763503126 0.0239014652268751 0.0233086464628107 0.0215295629820051 0.0177743261361721 0.0176959086363571 0.0168314340151706 0.0133154183017687 0.0150212179973583 0.0174660075022708 0.019691551644852 0.0211027353884496 0.0278830683646478 0.0526902045500574 0.0447079431381796 0.046928157581839 0.072316965496145 0.093072717636886 0.0932209870621033 0.0878453986887722 0.0920843805981841 0.0898942815308357 0.0876163026225785 0.085704718257147 0.0811371272574549 0.0849368406755105 0.0789948098106768 0.0757540243137603 0.0672578572995331 0.0682274289051675 0.0677488951312012 0.0638604010408694 0.0452116055846422 0.033768171753153 0.0444397029450638 0.0315780844697657 0.0328620042243605 0.0345448459736153 0.0353469925794611 Net exports (% of GDP) (Right Axis) 1965 1965.25 1965.5 1965.75 1966 1966.25 1966.5 1966.75 1967 1967.25 1967.5 1967.75 1968 1968.25 1968.5 1968.75 1969 1969.25 1969.5 1969.75 1970 1970.25 1970.5 1970.75 1971 1971.25 1971.5 1971.75 1972 1972.25 1972.5 1972.75 1973 1973.25 1973.5 1973.75 1974 1974.25 1974.5 1974.75 1975 1975.25 1975.5 1975.75 1976 1976.25 1976.5 1976.75 1977 1977.25 1977.5 1977.75 1978 1978.25 1978.5 1978.75 1979 1979.25 1979.5 1979.75 1980 1980.25 1980.5 1980.75 1981 1981.25 1981.5 1981.75 1982 1982.25 1982.5 1982.75 1983 1983.25 1983.5 1983.75 1984 1984.25 1984.5 1984.75 1985 1985.25 1985.5 1985.75 1986 1986.25 1986.5 1986.75 1987 1987.25 1987.5 1987.75 1988 1988.25 1988.5 1988.75 1989 1989.25 1989.5 1989.75 1990 1990.25 1990.5 1990.75 1991 1991.25 1991.5 1991.75 1992 1992.25 1992.5 1992.75 1993 1993.25 1993.5 1993.75 1994 1994.25 1994.5 1994.75 1995 1995.25 1995.5 1995.75 1996 1996.25 1996.5 1996.75 1997 1997.25 1997.5 1997.75 1998 1998.25 1998.5 1998.75 1999 1999.25 1999.5 1999.75 2000 2000.25 2000.5 2000.75 2001 2001.25 2001.5 2001.75 2002 2002.25 2002.5 2002.75 2003 2003.25 2003.5 2003.75 2004 2004.25 2004.5 2004.75 2005 2005.25 2005.5 2005.75 2006 2006.25 2006.5 2006.75 2007 2007.25 2007.5 2007.75 2008 2008.25 2008.5 2008.75 2009 2009.25 2009.5 2009.75 2010 2010.25 2010.5 2010.75 2011 2011.25 2011.5 2011.75 2012 2012.25 2012.5 2012.75 2013 2013.25 2013.5 2013.75 2014 2014.25 2014.5 0.00639599555061179 0.0102403058438012 0.00653159157557985 0.00711421549605484 0.005518625360592 0.00644202180376611 0.00268031189083821 0.00431189363995688 0.00543735224586288 0.00528727529080014 0.0033464112624048 0.00249094202898551 0.00120733179672923 0.00202926412474634 0.00136511603486296 0.00113390372126585 0.000200924251557163 0.00118647419418628 0.000968992248062015 0.00317094263476506 0.00322733744660655 0.00504625735912532 0.00349104271933854 0.00293174530462666 0.00386711197046933 -0.000172503018802829 -8.47242226552572e-5 -0.00142426273458445 -0.00283676446749878 -0.00338556019211086 -0.00200958417066007 -0.00232732732732733 -0.00101397841674513 0.00176354401805869 0.0044543429844098 0.00608478128591711 0.00428179567806249 -0.00175987485334376 -0.00447742100550083 0 0.0101877006668313 0.0130403284230862 0.00700198389543704 0.00781471204484965 0.00257604823239244 -0.000269265980935968 -0.00216873842898704 -0.00340486999587288 -0.0105897114178168 -0.0102417241044559 -0.00970599321522805 -0.0136487296537096 -0.017521619051931 -0.00967217324317384 -0.00992121388969944 -0.00660704214003706 -0.00718912940432928 -0.00855194730151393 -0.00861294188136608 -0.00981433332112645 -0.0128017164312534 -0.00542876531304689 0.00192307692307692 -0.0022381827292467 -0.00456606424420461 -0.00426230543365011 -0.00233043051637434 -0.00450738541190802 -0.0049789235750504 -0.0013208056914718 -0.00879094769980102 -0.00868595574857679 -0.00703962302100394 -0.0126681176404933 -0.0176583701216044 -0.0188087774294671 -0.0242792884890615 -0.0259775840597758 -0.0253951167001027 -0.0259909345163468 -0.0215482652820392 -0.0265904283755201 -0.0266008282892641 -0.0299566594058072 -0.027898943825698 -0.0282973305233579 -0.0300891852108408 -0.0286118130809098 -0.0298129301972045 -0.0304884372083377 -0.0296908478726661 -0.0289485734764171 -0.0243586217734648 -0.0204696891141963 -0.0187376167562978 -0.0198976481238569 -0.0182726055650034 -0.0156705280363869 -0.0131486798795434 -0.0143665197626401 -0.0150234263597474 -0.0115152225216329 -0.0124388423584045 -0.0131323360948317 -0.00777882376257246 -0.00377628751871867 -0.00339315579570307 -0.00367875400124218 -0.00321276328986961 -0.00505213868736811 -0.00584528960753056 -0.00703236980410893 -0.00825405293263389 -0.00925383624223966 -0.00990701312244721 -0.0104368103742464 -0.0112943682300352 -0.0124625161627555 -0.0131795492566952 -0.0136290074498107 -0.0139557075265397 -0.0143986114215835 -0.00965418802309738 -0.00894929162125777 -0.0112503325689526 -0.0116231470569993 -0.0139968133349675 -0.0107154493127873 -0.0129491436664643 -0.00996269834773559 -0.0111369336616121 -0.0133131549901574 -0.0152086122141355 -0.0180439592204298 -0.0190892691193353 -0.0191621004321391 -0.022070264949032 -0.0256775138641833 -0.028427869814565 -0.0298707448041023 -0.0351709699930216 -0.034986330424292 -0.0375094135593875 -0.038425178805038 -0.0372760061286056 -0.0337738757707926 -0.0344659053526951 -0.0333604328446077 -0.0346396662482463 -0.0380436770677104 -0.0391044749073579 -0.0434986220933374 -0.0446656752833902 -0.0440957900569006 -0.043001780629844 -0.0433027553990928 -0.0455940742717961 -0.0499121611637415 -0.0515859860766351 -0.0544490614701247 -0.0528184677337537 -0.0531135107637524 -0.0553864328229361 -0.0588494649369283 -0.0569423176959315 -0.0566385020072755 -0.0579214149620736 -0.0511431496331684 -0.0511831492566675 -0.0508240710566276 -0.0488754058079439 -0.0477075715170953 -0.0515939025387909 -0.0512657800580571 -0.0521188438994812 -0.0414023464078791 -0.027384784376977 -0.0238277872304817 -0.0281978017394206 -0.0302474856691724 -0.0332876964260171 -0.0351409803473799 -0.0355299946206924 -0.033072448162204 -0.0369133242335153 -0.0379602739814629 -0.036722674519314 -0.0378896821726543 -0.0385297527653307 -0.0365648319011849 -0.0332966580408018 -0.0323404255319149 -0.0319953461314718 -0.03201116 78059112 -0.0302211316773647 -0.02710457129808 -0.0315653602440742 -0.0316940016851144 -0.0293469243968681 2. Fiscal policy abroad r S, I I (r ) Expansionary fiscal policy abroad raises the world interest rate. NX1 NX2 Results: CHAPTER 6 The Open Economy It might be worth taking a moment to explain that the world interest rate r* is determined by saving and investment in the world loanable funds market. S* is the sum of all countries’ saving; I* the sum of all countries’ investment. r* adjusts to equate I* with S*, just like in Chapter 3, because the world as a whole is a closed economy. A fiscal expansion in other countries would reduce S* and raise r* (same results as in Chapter 3). The higher world interest rate reduces investment in our small open economy, and hence reduces the demand for loanable funds. The supply of loanable funds (national saving) is unchanged, so there’s an increase in the amount of funds flowing abroad. NOW YOU TRY 3. An increase in investment demand r S, I I (r )1 Use the model to determine the impact of an increase in investment demand on NX, S, I, and net capital outflow. NX1 I 1 S CHAPTER 6 The Open Economy Have students get out a piece of paper, draw this graph on it, and then do the analysis. A couple minutes should suffice. It might be useful to have them compare their answers with the results from the closed economy case. ANSWERS 3. An increase in investment demand r S, I I (r )1 ΔI > 0,
ΔS = 0,
net capital outflow and NX fall
by the
amount ΔI
NX2

NX1

I 1

I 2

S
I (r )2

CHAPTER 6 The Open Economy
In contrast to a closed economy, investment is not constrained by the fixed (domestic) supply of loanable funds. Hence, the increase in a firm’s demand for loanable funds can be satisfied by borrowing abroad, which reduces net outflow of financial capital. And since net capital outflow = NX, we see a fall in NX equal to the increase in investment.

The nominal exchange rate
e = nominal exchange rate,
the relative price of
domestic currency
in terms of foreign currency
(e.g., yen per dollar)

CHAPTER 6 The Open Economy

Warning to students: Some textbooks and newspapers define the exchange rate as the reciprocal of the one here (e.g., dollars per yen instead of yen per dollar). The one here is easier to use, because a rise in “e” corresponds to an “appreciation” of the country’s currency. Using the reciprocal would mean that a rise in “e” is a depreciation, which seems counterintuitive.

So it would be worthwhile to point out to students that a country’s “e” is simply the price (measured in foreign currency) of a unit of that country’s currency.

A few exchange rates, as of 1/13/2015
country exchange rate
Euro area 0.85 euro/$
Indonesia 12,576 rupiahs/$
Japan 118.0 yen/$
Mexico 14.6 pesos/$
Russia 65.85 rubles/$
South Africa 11.50 rand/$
U.K. 0.66 pounds/$

CHAPTER 6 The Open Economy

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

The real exchange rate
= real exchange rate,
the relative price of
domestic goods
in terms of foreign goods
(e.g. Japanese Big Macs per U.S. Big Mac)

the lowercase Greek letter epsilon
ε

CHAPTER 6 The Open Economy

Understanding the units of ε

ε

CHAPTER 6 The Open Economy

Students often have trouble understanding the units of the real exchange rate. It’s worth explaining each line carefully, and making sure students understand it before displaying the next line.

Note: The examples here and in the text are in terms of one good, i.e., Big Macs. But P and P* are the overall price levels of the domestic & foreign countries. Thus, they each measure the price of a basket of goods.

When you get to the bottom line, emphasize that the real exchange rate measures the amount of purchasing power in Japan that must be sacrificed for each unit of purchasing power in the U.S.

One good: Big Mac
Price in Japan:
P* = 200 Yen
Price in USA:
P = $2.50
Nominal exchange rate
e = 120 Yen/$
To buy a U.S. Big Mac, someone from Japan
would have to pay an amount that could buy
1.5 Japanese Big Macs.

ε

~ McZample ~

CHAPTER 6 The Open Economy

ε in the real world & our model
In the real world:
We can think of ε as the relative price of
a basket of domestic goods in terms of a basket of foreign goods.
In our macro model:
There’s just one good, “output.”
So ε is the relative price of one country’s output in terms of the other country’s output.

CHAPTER 6 The Open Economy

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

How NX depends on ε
If ε rises:
U.S. goods become more expensive relative to foreign goods
exports fall, imports rise
net exports fall

CHAPTER 6 The Open Economy

U.S. net exports and the real exchange rate, 1973-2014
NX
(% of GDP)
Index
(March 1973 = 100)

Trade-weighted real exchange rate index

Net exports
(left scale)

CHAPTER 6 The Open Economy
The real exchange rate here is a broad index. Source: Federal Reserve Statistical Release H.10, Board of Governors.
http://www.federalreserve.gov/releases/h10/summary/indexbc_m.txt

NX as a percent of GDP was computed from NX and GDP source data from Department of Commerce, Bureau of Economic Analysis, obtained at: http://research.stlouisfed.org/fred2/

The RER data are monthly and the NX and Y data are quarterly, so the RER series shown in the graph is a quarterly series where each value is an average of the three monthly values from that quarter.

Var 1 (Next Exports) 1970 1970.25 1970.5 1970.75 1971 1971.25 1971.5 1971.75 1972 1972.25 1972.5 1972.75 1973 1973.25 1973.5 1973.75 1974 1974.25 1974.5 1974.75 1975 1975.25 1975.5 1975.75 1976 1976.25 1976.5 1976.75 1977 1977.25 1977.5 1977.75 1978 1978.25 1978.5 1978.75 1979 1979.25 1979.5 1979.75 1980 1980.25 1980.5 1980.75 1981 1981.25 1981.5 1981.75 1982 1982.25 1982.5 1982.75 1983 1983.25 1983.5 1983.75 1984 1984.25 1984.5 1984.75 1985 1985.25 1985.5 1985.75 1986 1986.25 1986.5 1986.75 1987 1987.25 1987.5 1987.75 1988 1988.25 1988.5 1988.75 1989 1989.25 1989.5 1989.75 1990 1990.25 1990.5 1990.75 1991 1991.25 1991.5 1991.75 1992 1992.25 1992.5 1992.75 1993 1993.25 1993.5 1993.75 1994 1994.25 1994.5 1994.75 1995 1995.25 1995.5 1995.75 1996 1996.25 1996.5 1996.75 1997 1997.25 1997.5 1997.75 1998 1998.25 1998.5 1998.75 1999 1999.25 1999.5 1999.75 2000 2000.25 2000.5 2000.75 2001 2001.25 2001.5 2001.75 2002 2002.25 2002.5 2002.75 2003 2003.25 2003.5 2003.75 2004 2004.25 2004.5 2004.75 2005 2005.25 2005.5 2005.75 2006 2006.25 2006.5 2006.75 2007 2007.25 2007.5 2007.75 2008 2008.25 2008.5 2008.75 2009 2009.25 2009.5 2009.75 2010 2010.25 2010.5 2010.75 2011 2011.25 2011.5 2011.75 2012 2012.25 2012.5 2012.75 2013 2013.25 2013.5 2013.75 2014 2014.25 2014.5 -0.00101397841674513 0.00176354401805869 0.0044543429844098 0.00608478128591711 0.00428179567806249 -0.00175987485334376 -0.00447742100550083 0 0.0101877006668313 0.0130403284230862 0.00700198389543704 0.00781471204484965 0.00257604823239244 -0.000269265980935968 -0.00216873842898704 -0.00340486999587288 -0.0105897114178168 -0.0102417241044559 -0.00970599321522805 -0.0136487296537096 -0.017521619051931 -0.00967217324317384 -0.00992121388969944 -0.00660704214003706 -0.00718912940432928 -0.00855194730151393 -0.00861294188136608 -0.00981433332112645 -0.0128017164312534 -0.005 42876531304689 0.00192307692307692 -0.0022381827292467 -0.00456606424420461 -0.00426230543365011 -0.00233043051637434 -0.00450738541190802 -0.0049789235750504 -0.0013208056914718 -0.00879094769980102 -0.00868595574857679 -0.00703962302100394 -0.0126681176404933 -0.0176583701216044 -0.0188087774294671 -0.0242792884890615 -0.0259775840597758 -0.0253951167001027 -0.0259909345163468 -0.0215482652820392 -0.0265904283755201 -0.0266008282892641 -0.0299566594058072 -0.027898943825698 -0.0282973305233579 -0.0300891852108408 -0.0286118130809098 -0.0298129301972045 -0.0304884372083377 -0.0296908478726661 -0.0289485734764171 -0.0243586217734648 -0.0204696891141963 -0.0187376167562978 -0.0198976481238569 -0.0182726055650034 -0.0156705280363869 -0.0131486798795434 -0.0143665197626401 -0.0150234263597474 -0.0115152225216329 -0.0124388423584045 -0.0131323360948317 -0.00777882376257246 -0.00377628751871867 -0.00339315579570307 -0.00367875400124218 -0.00321276328986961 -0.00505213868736811 -0.00584528960753056 -0.00703236980410893 -0.00825405293263389 -0.00925383624223966 -0.00990701312244721 -0.0104368103742464 -0.0112943682300352 -0.0124625161627555 -0.0131795492566952 -0.0136290074498107 -0.0139557075265397 -0.0143986114215835 -0.00965418802309738 -0.00894929162125777 -0.0112503325689526 -0.0116231470569993 -0.0139968133349675 -0.0107154493127873 -0.0129491436664643 -0.00996269834773559 -0.0111369336616121 -0.0133131549901574 -0.0152086122141355 -0.0180439592204298 -0.0190892691193353 -0.0191621004321391 -0.022070264949032 -0.0256775138641833 -0.028427869814565 -0.0298 707448041023 -0.0351709699930216 -0.034986330424292 -0.0375094135593875 -0.038425178805038 -0.0372760061286056 -0.0337738757707926 -0.0344659053526951 -0.0333604328446077 -0.0346396662482463 -0.0380436770677104 -0.0391044749073579 -0.0434986220933374 -0.0446656752833902 -0.0440957900569006 -0.043001780629844 -0.0433027553990928 -0.0455940742717961 -0.0499121611637415 -0.0515859860766351 -0.0544490614701247 -0.0528184677337537 -0.0531135107637524 -0.0553864328229361 -0.0588494649369283 -0.0569423176959315 -0.0566385020072755 -0.0579214149620736 -0.0511431496331684 -0.0511831492566675 -0.0508240710566276 -0.0488754058079439 -0.0477075715170953 -0.0515939025387909 -0.0512657800580571 -0.0521188438994812 -0.0414023464078791 -0.027384784376977 -0.0238277872304817 -0.0281978017394206 -0.0302474856691724 -0.0332876964260171 -0.0351409803473799 -0.0355299946206924 -0.033072448162204 -0.0369133242335153 -0.0379602739814629 -0.036722674519314 -0.0378896821726543 -0.0385297527653307 -0.0365648319011849 -0.0332966580408018 -0.0323404255319149 -0.0319953461314718 -0.0320111678059112 -0.0302211316773647 -0.02710457129808 -0.0315653602440742 -0.0316940016851144 -0.0293469243968681 Var 2 RTWDI 1970 1970.25 1970.5 1970.75 1971 1971.25 1971.5 1971.75 1972 1972.25 1972.5 1972.75 1973 1973.25 1973.5 1973.75 1974 1974.25 1974.5 1974.75 1975 1975.25 1975.5 1975.75 1976 1976.25 1976.5 1976.75 1977 1977.25 1977.5 1977.75 1978 1978.25 1978.5 1978.75 1979 1979.25 1979.5 1979.75 1980 1980.25 1980.5 1980.75 1981 1981.25 1981.5 1981.75 1982 1982.25 1982.5 1982.75 1983 1983 .25 1983.5 1983.75 1984 1984.25 1984.5 1984.75 1985 1985.25 1985.5 1985.75 1986 1986.25 1986.5 1986.75 1987 1987.25 1987.5 1987.75 1988 1988.25 1988.5 1988.75 1989 1989.25 1989.5 1989.75 1990 1990.25 1990.5 1990.75 1991 1991.25 1991.5 1991.75 1992 1992.25 1992.5 1992.75 1993 1993.25 1993.5 1993.75 1994 1994.25 1994.5 1994.75 1995 1995.25 1995.5 1995.75 1996 1996.25 1996.5 1996.75 1997 1997.25 1997.5 1997.75 1998 1998.25 1998.5 1998.75 1999 1999.25 1999.5 1999.75 2000 2000.25 2000.5 2000.75 2001 2001.25 2001.5 2001.75 2002 2002.25 2002.5 2002.75 2003 2003.25 2003.5 2003.75 2004 2004.25 2004.5 2004.75 2005 2005.25 2005.5 2005.75 2006 2006.25 2006.5 2006.75 2007 2007.25 2007.5 2007.75 2008 2008.25 2008.5 2008.75 2009 2009.25 2009.5 2009.75 2010 2010.25 2010.5 2010.75 2011 2011.25 2011.5 2011.75 2012 2012.25 2012.5 2012.75 2013 2013.25 2013.5 2013.75 2014 2014.25 2014.5 103.5542 99.0408 95.8256 97.4663 97.5677 94.0783 95.6641 95.2298 93.0373 92.6193 95.8816 96.2696 94.8461 94.5274 94.118 94.5517 94.0881 93.8278 92.7727999999999 90.8453 88.8677 89.0176 85.8969 85.4289 86.8667 88.9848 88.1212 89.6865 90.3436 90.7978 88.3119 89.5608 91.3961 96.2055 100.7804 97.9461 100.7904 104.3794 109.8755 109.354 107.0455 109.711 112.5841 112.9269 113.5285 114.9934 120.3292 122.7943 127.077 125.2951 121.8671 116.6878 111.865 107.5694 104.9707 105.1762 101.3849 98.6242 99.5229 95.0954 91.9669 90.9998 94.367 90.9567 91.8091 94.7035 94.8952 93.774 93.3053 93.4413 90.418 87.7265 88.2127 91.3442 90.9962 88.1627999999999 88.2068 88.206 85.6550999999999 89.073 90.4703 88.2745 88.609 89.1595 91.0001 90.0687 87.7824 86.9758 88.7575 84.4302 85.5931 87.2666 88.2386 88.522 88.4353 88.8665 91.1828999999999 91.792 93.275 96.6579 100.8523 101.0245 103.5029 99.4214 99.9624 100.9669 100.64 99.7876 100.8938 103.4298 104.6885 107.4573 108.5199 110.7803 110.3703 110.7896 112.3772 110.558 108.6942 109.4596 107.2772 103.2944 103.5983 100.3027 98.4908 100.8046 99.9398 96.709 95.6266 96.8453 97.9124 98.9242 97.4818 96.3204 96.2885 94.7787 94.7777 92.9168 90.9648 87.8594 86.0109 84.534 86.7007 93.8983 95.8483 92.4025 89.7492 87.5436 87.9978 88.6945 87.4558 84.332 83.1698666666666 81.700 9333333333 80.9975 81.6902333333333 83.9917333333333 84.7308666666667 83.8149333333333 84.2399666666667 85.7128 84.9443333333333 83.9329666666667 83.5214666666667 83.9121 84.2581 84.9165333333333

The net exports function
The net exports function reflects this inverse relationship between NX and ε :
NX = NX(ε )

CHAPTER 6 The Open Economy

The NX curve for the U.S.

0
NX
ε

NX(ε)
ε1
When ε is relatively low,
U.S. goods are relatively inexpensive
NX(ε1)

so U.S. net exports will be high.

CHAPTER 6 The Open Economy

The NX curve for the U.S.

0
NX
ε

NX(ε)
ε2
At high enough values of ε,
U.S. goods become so expensive that
NX(ε2)

we export less than we import.

CHAPTER 6 The Open Economy

How ε is determined
The accounting identity says NX = S – I
We saw earlier how S – I is determined:
S depends on domestic factors (output, fiscal policy variables, etc.)
I is determined by the world interest
rate r *
So, ε must adjust to ensure

CHAPTER 6 The Open Economy

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

How ε is determined
Neither S nor I depends on ε,
so the net capital outflow curve is vertical.

ε
NX

NX(ε)

ε adjusts to equate NX
with net capital outflow, S – I.

ε1
NX 1

CHAPTER 6 The Open Economy

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

In fact, the zero on the horizontal axis may well be to the right of the vertical S – I line. (This is the case, for example, in the U.S.)

Interpretation: supply and demand
in the foreign exchange market
Demand:
Foreigners need dollars to buy U.S. net exports.

ε
NX

NX(ε)

Supply:
Net capital outflow (S – I )
is the supply of dollars to be invested abroad.

ε1
NX 1

CHAPTER 6 The Open Economy

WARNING: Don’t let your students confuse the demand for dollars in the foreign exchange market with demand for real money balances (Chapter 4), or the supply of dollars in the foreign exchange market with the supply of money (Chapter 4).

If you and your students are as anal, er, I mean, as detail-oriented as me: NX is actually the net demand for dollars: foreign demand for dollars to purchase our exports minus our supply of dollars to purchase imports. Net capital outflow is the net supply of dollars: the supply of dollars from U.S. residents investing abroad minus the demand for dollars from foreigners buying U.S. assets.

Four experiments:
1. Fiscal policy at home
2. Fiscal policy abroad
3. An increase in investment demand
(exercise)
4. Trade policy to restrict imports

CHAPTER 6 The Open Economy

1. Fiscal policy at home
A fiscal expansion reduces national saving, net capital outflow, and the supply of dollars
in the foreign exchange market…
…causing the real exchange rate to rise and NX to fall.

ε
NX

NX(ε )

ε1
NX 1
NX 2

ε2

CHAPTER 6 The Open Economy

2. Fiscal policy abroad
An increase in r* reduces investment, increasing net capital outflow and the supply of dollars in the foreign exchange market…
…causing the real exchange rate to fall and NX to rise.

ε
NX

NX(ε )

NX 1

ε1

ε2
NX 2

CHAPTER 6 The Open Economy

NOW YOU TRY
3. Increase in investment demand

NX(ε )

ε1

NX 1

ε
NX
Determine the impact of an increase in investment demand on net exports, net capital outflow,
and the real exchange rate.

CHAPTER 6 The Open Economy
The previous “now you try” exercise also considered the effects of an increase in investment demand; this is a continuation of that exercise.

ANSWERS
3. Increase in investment demand

An increase in investment reduces net capital outflow and the supply
of dollars in the foreign exchange market…

NX(ε )

ε1

NX 1

NX 2

ε2

ε
NX
…causing the real exchange rate to rise and NX to fall.

CHAPTER 6 The Open Economy

4. Trade policy to restrict imports

ε
NX

NX(ε)1

NX1
ε1

NX(ε)2

At any given ε,
an import quota reduces IM, increases NX, increases demand for dollars.
Trade policy doesn’t affect S or I , so capital flows and the supply of dollars remain fixed.

ε2

CHAPTER 6 The Open Economy

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

4. Trade policy to restrict imports

ε
NX

NX(ε)1

NX1
ε1

NX(ε)2
Results:
Δε > 0
(demand increase)
ΔNX = 0
(supply fixed)
ΔIM < 0 (policy) ΔEX < 0 (rise in ε ) ε2 CHAPTER 6 The Open Economy In this slide’s text box, the remarks in parentheses after each result are an abbreviated explanation for that result. The real exchange rate appreciates because the quota has raised the net demand for dollars associated with any given value of the exchange rate. But the equilibrium level of net exports doesn’t change because the supply of dollars in the foreign exchange market (S - I) has not been affected by the trade policy. (Remember, S = Y – C - G, and the trade policy does not affect Y, C, or G; the policy also does not affect I, because I = I(r*) and r* is exogenous.) The appreciation causes exports to fall. And, since exports are lower but NX is unchanged, it must be the case that IM is lower too, which is what you’d expect from a trade policy that restricts imports. The determinants of the nominal exchange rate Start with the expression for the real exchange rate: Solve for the nominal exchange rate: CHAPTER 6 The Open Economy The determinants of the nominal exchange rate So e depends on the real exchange rate and the price levels at home and abroad . . . and we know how each of them is determined: CHAPTER 6 The Open Economy It’s important here for students to learn the (logical, not necessarily chronological) order in which the variables are determined. I.e., what causes what. The determinants of the nominal exchange rate Rewrite this equation in growth rates (see “arithmetic tricks for working with percentage changes,” Chapter 2 ): For a given value of ε, the growth rate of e equals the difference between foreign and domestic inflation rates. CHAPTER 6 The Open Economy Here we again see the Classical Dichotomy in action. The real exchange rate is determined by real factors, and nominal variables only affect nominal variables. Suppose the U.S. is the home country and Mexico is the foreign (starred) country, and suppose that Mexico’s inflation rate (pi*) is higher than that of the U.S. This equation implies: the greater Mexico’s inflation is relative to the U.S., the faster the dollar should rise relative to the peso. The next slide presents cross-country data consistent with this implication. Inflation differentials and nominal exchange rates for a cross section of countries % change in nominal exchange rate inflation differential CHAPTER 6 The Open Economy Figure 6-13 on p. 164. The horizontal axis measures the country’s inflation rate minus the U.S. inflation rate. The vertical axis measures the percentage change in the U.S. dollar exchange rate with that country (positive values mean the country’s currency depreciates relative to the dollar). All variables are annual averages over the period 2001-2010. This figure shows a positive relationship between the inflation differential and the rate of dollar appreciation: The higher a country’s inflation relative to U.S. inflation, the faster the U.S. dollar will appreciate against that country’s currency. Source: International Financial Statistics Note: Due to space constraints on this slide, Norway’s point is not labeled; it is virtually identical to Canada’s point. Avg ch. in nom. ex. Rate (%) Australia Canada Denmark Iceland Japan S. Korea Mexico New Zealand Norway Pakistan Singapore S. Africa Sweden Switzerland U.K. 0.0058 -0.0041 -0.00334 0.0334 -0.02661 0.00543 0.024 0.00069 -0.00474 0.06345 -0.00304 0.03421 -0.01013 -0.01748 -0.00172 -0.034544 -0.026249 -0.025356 0.0483 -0.003309 0.001611 0.025702 -0.039649 -0.028691 0.052478 -0.023749 0.03746 -0.022043 -0.043292 0.000136 Purchasing Power Parity (PPP) Two definitions: A doctrine that states that goods must sell at the same (currency-adjusted) price in all countries. The nominal exchange rate adjusts to equalize the cost of a basket of goods across countries. Reasoning: arbitrage, the law of one price CHAPTER 6 The Open Economy Purchasing Power Parity (PPP) PPP: e × P = P* Cost of a basket of domestic goods, in foreign currency. Cost of a basket of domestic goods, in domestic currency. Cost of a basket of foreign goods, in foreign currency. Solve for e: e = P*/ P PPP implies that the nominal exchange rate between two countries equals the ratio of the countries’ price levels. CHAPTER 6 The Open Economy PPP implies that the cost of a basket of goods (even a basket with just one good, like a Big Mac or a latte) should be the same across countries. e P = the foreign-currency cost of a basket of goods in the U.S., while P* the cost of a basket of foreign goods. PPP implies that the baskets cost the same in both countries: eP = P*, which implies that e = P*/P. Purchasing Power Parity (PPP) If e = P*/P, then and the NX curve is horizontal: ε NX NX ε = 1 S - I Under PPP, changes in (S – I ) have no impact on ε or e. CHAPTER 6 The Open Economy Revisiting our model, PPP implies that the NX curve should be horizontal at  = 1. Intuition for the horizontal NX curve: Under PPP, different countries’ goods are perfect substitutes, and international arbitrage is possible. If the relative price of U.S. goods falls even a tiny bit below 1, then there’s a profit opportunity: buy U.S. goods and sell them abroad. Hence, the tiniest drop in the U.S. real exchange rate causes a massive increase in NX. Similarly, if the relative price of U.S. goods rises even a tiny amount above 1, then it is profitable to buy foreign goods and sell them in the U.S., so this arbitrage causes a massive increase in imports—and decrease in NX. Thus, under PPP, the real exchange rate equals 1 regardless of net capital outflow S - I. Changes in S or I have no impact on the real exchange rate. Does PPP hold in the real world? No, for two reasons: 1. International arbitrage not possible nontraded goods transportation costs 2. Different countries’ goods not perfect substitutes Yet, PPP is a useful theory: It’s simple & intuitive. In the real world, nominal exchange rates tend toward their PPP values over the long run. CHAPTER 6 The Open Economy no change no change i h i h h i no change no change i h h i i h i h 129.4 -2.0 19.4 6.3 17.4 3.9 115.1 -0.3 19.9 1.1 19.6 2.2 closed economy small open economy actual change ε NX I r S G – T 1980s 1970s Data: Decade averages; all except r and ε are expressed as a percent of GDP; ε is a trade-weighted index. CASE STUDY: The Reagan Deficits Revisited CHAPTER 6 The Open Economy This is a continuation of the case study that began in Chapter 3 (both the textbook and the PowerPoint presentation). It is placed here to motivate the last topic of Chapter 5: the U.S. as a large open economy. As we saw in Chapter 3, the closed economy model correctly predicted that national saving would fall and the interest rate would rise. But, the closed economy model predicted that investment would fall as much as saving; actually, investment fell by much less than saving. Also, the closed economy model by definition could not have predicted the effects on the trade balance or exchange rate. The small open economy model correctly predicted what would happen to NX and the real exchange rate, but incorrectly predicted that the interest rate and investment would not change. In order to explain the U.S. experience, we need to combine the insights of the closed & small open economy models. The U.S. as a large open economy So far, we’ve learned long-run models for two extreme cases: closed economy (Chapter 3) small open economy (Chapter 5) A large open economy—like the U.S.—falls between these two extremes. The results from large open economy analysis are a mixture of the results for the closed & small open economy cases. For example . . . CHAPTER 6 The Open Economy NX I r large open economy small open economy closed economy A fiscal expansion in three models falls, but not as much as in small open economy falls no change falls, but not as much as in closed economy no change falls rises, but not as much as in closed economy no change rises A fiscal expansion causes national saving to fall. The effects of this depend on openness & size. CHAPTER 6 The Open Economy In the table, there’s a cell for NX in the closed economy column. Instead of putting “N.A.” in this cell, I put “no change.” Why? In a closed economy, EX = IM = NX = 0. After a change in saving, NX = 0 still. Hence, it is not incorrect to say “no change.” More importantly we are trying to show students how the results for a large open economy are in between the results for the closed & small open cases. Looking at the items in the last row of the table, “falls, but not as much as in small open economy” seems to be in between “no change” and “falls,” but does not seem to be in between “N.A.” and “falls.” It would be completely understandable if you still feel that “N.A.” should be in the closed economy NX cell of the table, so please feel free to edit that cell. CHAPTER SUMMARY Net exports—the difference between: exports and imports a country’s output (Y ) and its spending (C + I + G) Net capital outflow equals: purchases of foreign assets minus foreign purchases of the country’s assets the difference between saving and investment CHAPTER 6 The Open Economy CHAPTER SUMMARY National income accounts identities Y = C + I + G + NX trade balance NX = S – I net capital outflow Impact of policies on NX NX increases if policy causes S to rise or I to fall NX does not change if policy affects neither S nor I. Example: trade policy CHAPTER 6 The Open Economy CHAPTER SUMMARY Exchange rates nominal: the price of a country’s currency in terms of another country’s currency real: the price of a country’s goods in terms of another country’s goods The real exchange rate equals the nominal rate times the ratio of prices of the two countries. CHAPTER 6 The Open Economy CHAPTER SUMMARY How the real exchange rate is determined NX depends negatively on the real exchange rate, other things equal The real exchange rate adjusts to equate NX with net capital outflow CHAPTER 6 The Open Economy CHAPTER SUMMARY How the nominal exchange rate is determined: e equals the real exchange rate times the country’s price level relative to the foreign price level. For a given value of the real exchange rate, the percentage change in the nominal exchange rate equals the difference between the foreign & domestic inflation rates. CHAPTER 6 The Open Economy df CCC =+ df III =+ df GGG =+ ddd YCIGEX =+++ ()()() fff CCIIGGEX =-+-+-+ () fff CIGEXCIG =+++-++ CIGEXIM =+++- CIGNX =+++ YYFKL == (,) CCYT =- () IIr = () GGTT == , () SYCYTG =--- S S c I S r = () S 1 S 1 * r 2 S 0 I D= 0 NXS D=D< 0 I D< 0 NXI D=-D>

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