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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
The national income accounts identity shows
how domestic output, domestic spending,
and net exports are related. In particular,
NX =Y− (C + I + G)
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.
NX = Y – (C + I + G )
implies
NX = (Y – C – G ) – I
= S – I
trade balance = net capital outflows
Thus, a country with trade (NX<0), is a net
borrower (S<I)
The marginal propensity to import is the
increase in the dollar value of imports for
each $1 increase in GDP
Because a fraction of any income increase leaks
into imports in an open economy, the open-
economy multiplier is smaller than that of a
closed economy.
Open-economy multiplier
1
MPS + MPm
We do not assume that the real interest rate
equilibrates saving and investment.
National saving does
r S not depend on the
interest rate
I, S
Investment curve is
r downward-sloping
and depends on
interest rate: when
the interest rate
rises, fewer
investment projects
are profitable.
r2
r1
I(r)
I(r2) I(r1) I, S
r S
Interest rate in a
closed economy
I(r)
I, S
Instead, we allow the economy to run a trade
deficit and borrow from other countries, or to
run a trade surplus and lend to other
countries.
If the real interest rate does not adjust to
equilibrate saving and investment in this model,
what does determine the real interest rate?
Interest rate in a
closed economy
I(r)
I, S
Our small open economy has a negligible
effect on the world real interest rate because,
being a small part of the world, it has a
negligible effect on world saving and world
investment.
Hence, our small open economy takes the
world interest rate as exogenously given.
r*
I(r)
…determines the
country’s level of
investment
I(r*) I, S
r S
S – I = NX
r*
Interest rate in a
closed economy
I(r)
I(r*) I, S
r S
NX
r*
I(r)
I(r*) I, S
r S
NX
r*
Because S > I, there is trade
surplus. The excess is lent to
other countries.
I(r)
I(r*) I, S
Case 1: Increasing government purchases.
reduces national saving, because S = Y − C − G.
Taking into account; unchanged world real
interest rate, investment remains the same
NX = S − I, the fall in S implies a fall in NX.
є = e × (P/P*)
e = є × (P*/P)
Given the value of the real exchange rate, if
the domestic price level P rises, then the
nominal exchange rate e will fall
However, if the Japanese price level P* rises,
then the nominal exchange rate will increase
Exchange rate equation:
% Change in e = % Change in є + % Change in P*− % Change in
P
ᴖ % Change in є = change in the real exchange rate
ᴖ % Change in P = domestic inflation rate π
ᴖ % Change in P* = foreign country’s inflation rate π *
Thus,
% Change in e = % Change in є + (π* − π)
If a [foreign] country has a high rate of
inflation relative to the domestic country, a
domestic currency will buy an increasing
amount of the foreign currency over time. If a
country has a low rate of inflation relative to
the domestic country, a domestic currency will
buy a decreasing amount of the foreign
currency over time.
If a dollar could buy more wheat domestically
than abroad, there would be opportunities to profit by
buying wheat domestically and selling it abroad. Profit-
seekers would drive up the domestic price of wheat
relative to the foreign price. Similarly, if a dollar could
buy more wheat abroad than domestically, the profit-
seekers would buy wheat abroad and sell it
domestically, driving down the domestic price relative
to the foreign price. Thus, profit-seeking by
international arbitrageurs causes wheat prices to be
the same in all countries.
Any small movement in the real exchange rate leads to a large
change in net exports → guarantees that the equilibrium real
exchange rate is always close to the level ensuring purchasing-power
parity