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Intermediate Macroeconomics Unit 4: The Open Economy and Exchange Rates

This unit extends the classical model to trade and capital flows, showing what determines the trade balance and the exchange rate and how policy changes them in the long run.

Covers: Capital flows and the trade balance, The small open economy and the world interest rate, Real and nominal exchange rates, Fiscal and trade policy in the open economy, Purchasing-power parity, Large open economies

Study guide

In an open economy, spending need not equal output. The identity Y = C + I + G + NX can be rearranged into S − I = NX, where S = Y − C − G is national saving. The left side, S − I, is net capital outflow: what residents lend abroad or the foreign assets they buy, net. The right side is the trade balance. A country with a trade deficit invests more than it saves and finances the gap by borrowing from abroad, a net capital inflow. A trade surplus means the country saves more than it invests and lends the rest to foreigners. The trade balance and capital flows are two sides of the same coin.

In a small open economy with perfect capital mobility, the domestic real interest rate equals the world real interest rate r*. Output is fixed by factors and technology, consumption depends on disposable income, and investment is I(r*). So national saving and investment are both determined, and the trade balance is NX = S − I(r*). Domestic saving no longer limits investment: if investment demand exceeds saving, the economy borrows the rest abroad. A fall in national saving, from a tax cut or more government purchases, does not raise the interest rate; it lowers net exports instead.

The nominal exchange rate e is the price of domestic currency in foreign currency (for example, yen per dollar). The real exchange rate ε = e × P/P* is the rate at which domestic goods trade for foreign goods. A higher ε makes domestic goods relatively expensive, so net exports fall: the NX(ε) schedule slopes downward. In equilibrium, ε adjusts so that NX(ε) equals S − I(r*). Policies that lower saving or raise investment shift the vertical S − I line left and appreciate the currency; policies that shift the NX schedule, such as tariffs or quotas, change ε but leave net exports unchanged, because S − I is unchanged.

Nominal and real exchange rates are linked by %Δe = %Δε + π* − π. A country with higher inflation than its trading partners sees its currency depreciate in nominal terms, even if the real rate is steady. Purchasing-power parity is the extreme case where arbitrage keeps ε constant, so nominal rates move only to offset inflation differences. PPP is a useful long-run guide, but many goods are not easily traded, so real exchange rates do move. If the NX schedule were horizontal under strict PPP, saving and investment shifts would change NX without moving ε.

Large economies such as the United States are between the closed and small-open cases. Their saving and investment affect world rates, so net capital outflow depends on the domestic interest rate: CF(r) falls as r rises, because a higher r attracts foreign funds. A fiscal expansion in a large open economy raises r, though by less than in a closed economy, and reduces both investment and net exports. The 1980s U.S. twin deficits illustrate this: large budget deficits lowered national saving, raised interest rates, appreciated the dollar and produced a large trade deficit.

Key ideas

• Net capital outflow S − I always equals net exports NX.
• In a small open economy, r = r*, and investment does not depend on domestic saving.
• Lower national saving reduces net exports and raises the real exchange rate in a small open economy.
• Higher world interest rates lower investment, raise NX and depreciate the currency.
• Tariffs and quotas raise the real exchange rate but do not change the trade balance.
• Nominal exchange rates move to offset inflation differences: %Δe = %Δε + π* − π.
• In a large open economy, fiscal expansion crowds out both investment and net exports.

Formulas and rules

Common mistakes

• Thinking a small open economy's fiscal expansion raises its interest rate.
• Concluding that tariffs or quotas reduce the trade deficit in the long-run model.
• Mixing up exchange rate conventions: be clear whether e is foreign currency per domestic unit or the reverse.
• Equating a trade deficit with a budget deficit; low private saving or high investment can also cause it.
• Forgetting the inflation terms when converting real exchange rate changes into nominal ones.

Before the test, make sure you can

• Use S − I = NX to relate saving, investment, capital flows and the trade balance.
• Solve the small-open-economy model for investment, NX and the real exchange rate.
• Calculate real exchange rates and PPP exchange rates from prices and nominal rates.
• Use %Δe = %Δε + π* − π to find nominal exchange rate changes.
• Analyze domestic fiscal policy, foreign fiscal policy, investment shifts and trade policy in the small open economy.
• Explain why protectionism does not change the trade balance in the long run.
• Compare fiscal policy effects in closed, small open and large open economies.

Words to know

Net capital outflow

S − I: net lending abroad or net purchases of foreign assets; equals NX.

Trade balance

Net exports, exports minus imports.

Trade deficit

Imports exceed exports; investment exceeds national saving.

Small open economy

An economy too small to affect the world interest rate, with perfect capital mobility.

Perfect capital mobility

Residents can borrow and lend freely in world markets, so r = r*.

World interest rate (r*)

The real interest rate prevailing in world financial markets.

Nominal exchange rate (e)

The relative price of two currencies, such as yen per dollar.

Real exchange rate (ε)

e × P/P*: the rate at which domestic goods trade for foreign goods.

Appreciation

A rise in the value of a currency, so it buys more foreign currency or goods.

Depreciation

A fall in the value of a currency relative to others.

Purchasing-power parity

The theory that a currency buys the same basket of goods in every country, keeping ε constant.

Law of one price

Arbitrage makes the same good sell for the same price everywhere, in a common currency.

Protectionism

Trade restrictions such as tariffs and quotas that shift the NX schedule.

Capital flight

A sudden outflow of funds when investors lose confidence, raising domestic interest rates.

Twin deficits

The pairing of budget deficits and trade deficits, as in the U.S. in the 1980s.

Large open economy

An economy big enough that its saving and investment affect world interest rates.

Sample practice questions

30 more questions like these, from level 1 to 5, are in the practice set.