Worth: Mankiw Economics 5e CHAPTER FIVE The Open Economy No nation was ever ruined by tr Benjamin Franklin Even if you never leave your home town, you are an active participant in a global conomy. When you go to the grocery store, for instance, you might choose be- tween apples grown locally and grapes grown in Chile. When you make a de posit into your local bank, the bank might lend those funds to your next-door neighbor or to a Japanese company building a factory outside Tokyo. Because our economy is integrated with many others around the world, consumers have more goods and services from which to choose, and savers have more opportuni- ties to invest their wealth In previous chapters we simplified our analysis by assuming a closed In actuality, however, most economies are open: they export goods and services abroad, they import goods and services from abroad, and they borrow and lend n world financial markets. Figure 5-1 gives some sense of the importance of these international interactions by showing imports and exports as a percentage of GDP for seven major industrial countries. As the figure shows, imports and exports in the United States are more than 10 percent of GDP. Trade is even more important for many other countries-in Canada and the United King dom, for instance, imports and exports are about a third of GDP. In these coun- tries, international trade is central to analyzing economic developments and formulating economic policies This chapter begins our study of open-economy macroeconomics. We begin in Section 5-1 with questions of measurement. To understand how the open economy works, we must understand the key macroeconomic variables that measure the interactions among countries. Accounting identities reveal a key in- sight: the flow of goods and services across national borders is always matched by an equivalent fow of funds to finance capital accumulation In section 5-2 we examine the determinants of these international fows. We develop a model of the small open economy that corresponds to our model of he closed economy in Chapter 3. The model shows the factors that determine hether a country is a borrower or a lender in world markets, and how policies at home and abroad affect the flows of capital and goods 114 User JoENA: Job EFFo1460: 6264_ ch05: Pg 114: 19201#/eps at 100s wed,Feb13,20029:264M
User JOEWA:Job EFF01460:6264_ch05:Pg 114:19201#/eps at 100% *19201* Wed, Feb 13, 2002 9:26 AM Even if you never leave your home town, you are an active participant in a global economy.When you go to the grocery store, for instance, you might choose between apples grown locally and grapes grown in Chile.When you make a deposit into your local bank, the bank might lend those funds to your next-door neighbor or to a Japanese company building a factory outside Tokyo. Because our economy is integrated with many others around the world, consumers have more goods and services from which to choose, and savers have more opportunities to invest their wealth. In previous chapters we simplified our analysis by assuming a closed economy. In actuality, however, most economies are open: they export goods and services abroad, they import goods and services from abroad, and they borrow and lend in world financial markets. Figure 5-1 gives some sense of the importance of these international interactions by showing imports and exports as a percentage of GDP for seven major industrial countries. As the figure shows, imports and exports in the United States are more than 10 percent of GDP. Trade is even more important for many other countries—in Canada and the United Kingdom, for instance, imports and exports are about a third of GDP. In these countries, international trade is central to analyzing economic developments and formulating economic policies. This chapter begins our study of open-economy macroeconomics.We begin in Section 5-1 with questions of measurement. To understand how the open economy works, we must understand the key macroeconomic variables that measure the interactions among countries.Accounting identities reveal a key insight: the flow of goods and services across national borders is always matched by an equivalent flow of funds to finance capital accumulation. In Section 5-2 we examine the determinants of these international flows. We develop a model of the small open economy that corresponds to our model of the closed economy in Chapter 3.The model shows the factors that determine whether a country is a borrower or a lender in world markets, and how policies at home and abroad affect the flows of capital and goods. The Open Economy 5CHAPTER No nation was ever ruined by trade. — Benjamin Franklin FIVE 114 |
Worth: Mankiw Economics 5e n Economy 115 of gDp Canada France Germany Italy Japan U.K. Imports and Exports as a Percentage of Output: 2000 While international trade important for the United States, it is even more vital for other countries. Source: OECD In Section 5-3 we extend the model to discuss the prices at which a country makes exchanges in world markets. We examine what determines the price of domestic goods relative to foreign goods. We also examine what determines the rate at which the domestic currency trades for foreign currencies. Our model shows how protectionist trade policies-policies designed to protect domestic industries from foreign competition--influence the amount of international trade and the exchange rate. 5-1 The International Flows of Capital and goods The key macroeconomic difference between open and closed economies 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 pro duces by borrowing from abroad, or it can spend less than it produces and lend the difference to foreigners. To understand this more fully, let's take another look at national income accounting which we first discussed User JOENA: Job EFF01460: 6264_ch05: Pg 115: 19203#/eps at 100sg wed,Feb13,20029:264M
User JOEWA:Job EFF01460:6264_ch05:Pg 115:19203#/eps at 100% *19203* Wed, Feb 13, 2002 9:26 AM In Section 5-3 we extend the model to discuss the prices at which a country makes exchanges in world markets. We examine what determines the price of domestic goods relative to foreign goods.We also examine what determines the rate at which the domestic currency trades for foreign currencies. Our model shows how protectionist trade policies—policies designed to protect domestic industries from foreign competition—influence the amount of international trade and the exchange rate. 5-l 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. To understand this more fully, let’s take another look at national income accounting, which we first discussed in Chapter 2. CHAPTER 5 The Open Economy | 115 figure 5-1 Percentage of GDP 40 35 30 25 20 15 10 5 0 Canada France Germany Italy Japan U.K. U.S. Imports Exports Imports and Exports as a Percentage of Output: 2000 While international trade is important for the United States, it is even more vital for other countries. Source: OECD
Worth: Mankiw Economics 5e 116 PART 11 Classical Theory: The Economy in the Long Run The Role of Net Exports Consider the expenditure on an economy's output of goods and services. In a closed economy, all output is sold domestically, and expenditure is divided into three components: consumption, investment, and government purchases. 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 > C, consumption of domestic goods and services lent purchases of domestic goods and services, >EX, exports of domestic goods and services. The division of expenditure into these components is expressed in the identity The sum of the first three terms, cd+rd +g, is domestic spen n domes- tic goods and services. The fourth term, EX, is foreign domestic goods and services. We now want to make this identity more useful. To do this, note that domestic ending on all goods and services is the sum of domestic spending on domestic goods and services and on foreign goods and services. Hence, total consumption C equals consumption of domestic goods and services C plus consumption of foreign goods and services C; total investment I equals investment in domestic goods and services Id plus investment in foreign goods and services I' and total government purchases G equals government purchases of domestic goods and services g plus government purchases of foreign goods and services G. Thu C=C+C I=rd+if G=O We substitute these three equations into the identity above Y=(C-C)+(1-1)+(G-G)+EX We can rearrange to obtain Y=C+I+G+EX-(C+I+G) The sum of domestic spending on foreign goods and services(C+I+G) expenditure on imports(IM). We can thus write the national income accounts identity as Y=C+I+G+EX-IM Because spending on imports is included in domestic spending(C+I+G), and because goods and services imported from abroad are not part of a country's User JoENA: Job EFFo1460: 6264_ ch05: Pg 116: 19204#/eps at 100s wed,Feb13,20029:264M
User JOEWA:Job EFF01460:6264_ch05:Pg 116:19204#/eps at 100% *19204* Wed, Feb 13, 2002 9:26 AM The Role of Net Exports Consider the expenditure on an economy’s output of goods and services. In a closed economy, all output is sold domestically, and expenditure is divided into three components: consumption, investment, and government purchases. 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: ➤ Cd , consumption of domestic goods and services, ➤ I d , investment in domestic goods and services, ➤ Gd , government purchases of domestic goods and services, ➤ EX, exports of domestic goods and services. The division of expenditure into these components is expressed in the identity Y = Cd + I d + Gd + EX. The sum of the first three terms, Cd + I d + Gd , is domestic spending on domestic goods and services. The fourth term, EX, is foreign spending on domestic goods and services. We now want to make this identity more useful.To do this, note that domestic spending on all goods and services is the sum of domestic spending on domestic goods and services and on foreign goods and services. Hence, total consumption C equals consumption of domestic goods and services Cd plus consumption of foreign goods and services Cf ; total investment I equals investment in domestic goods and services I d plus investment in foreign goods and services If ; and total government purchases G equals government purchases of domestic goods and services Gd plus government purchases of foreign goods and services Gf .Thus, C = Cd + Cf , I = I d + If , G = Gd + Gf . We substitute these three equations into the identity above: Y = (C − Cf ) + (I − If ) + (G − Gf ) + EX. We can rearrange to obtain Y = C + I + G + EX − (Cf + If + Gf ). The sum of domestic spending on foreign goods and services (Cf + If + Gf ) is expenditure on imports (IM).We can thus write the national income accounts identity as Y = C + I + G + EX − IM. Because spending on imports is included in domestic spending (C + I + G), and because goods and services imported from abroad are not part of a country’s 116 | PART II Classical Theory: The Economy in the Long Run
Worth: Mankiw Economics 5e 117 output, this equation subtracts spending on imports. Defining net exports to Y=C+I+G+NX This equation states that expenditure on domestic output is the sum of con- sumption, investment, government purchases, and net exports. This is the most common form of the national income accounts identity; it should be familiar from Chapter 2. The national income accounts identity shows how domestic output, domestic ending, and net exports are related. In particular, NX= Y -C+I+ G) Net Exports =Output- Domestic Spending. his 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. International Capital Flows and the Trade balance In an open economy, as in the closed economy we discussed in Chapter 3, finan- cial markets and goods markets are closely related. To see the relationship, we must rewrite the national income accounts identity in terms of saving and invest- ment. Begin with the ide entity 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, the sum of private saving, Y-T-C, and public saving, T-G.Therefore, S=I+NX Subtracting I from both sides of the equation, we can write the national income accounts identity as S-IENX 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 Let's look more closely at each part of this identity. The easy part is the right hand side, NX, which is our net export of goods and services. Another name for let exports is the trade balance, because it tells us how our trade in goods and services departs from the benchmark of equal imports and exports User JOENA: Job EFF01460: 6264_ch05: Pg 117: 19205#/eps at 100sgm wed,Feb13,20029:264M
User JOEWA:Job EFF01460:6264_ch05:Pg 117:19205#/eps at 100% *19205* Wed, Feb 13, 2002 9:26 AM output, this equation subtracts spending on imports. Defining net exports to be exports minus imports (NX = EX − IM ), the identity becomes Y = C + I + G + NX. This equation states that expenditure on domestic output is the sum of consumption, investment, government purchases, and net exports.This is the most common form of the national income accounts identity; it should be familiar from Chapter 2. 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. International Capital Flows and the Trade Balance In an open economy, as in the closed economy we discussed in Chapter 3, financial markets and goods markets are closely related. To see the relationship, we must rewrite the national income accounts identity in terms of saving and investment. 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, the sum of private saving, Y − T − C, and public saving, T − G.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. Let’s look more closely at each part of this identity.The easy part is the righthand side, NX, which is our net export of goods and services.Another name for net exports is the trade balance, because it tells us how our trade in goods and services departs from the benchmark of equal imports and exports. CHAPTER 5 The Open Economy | 117
Worth: Mankiw Economics 5e 118 PART 11 Classical Theory: The Economy in the Long Run 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 some times called net foreign investment If net capital outflow is positive, our saving exceeds our investment, and we are lending the excess to foreigners. If the net capital outflow is negative, our investment exceeds our saving, and we are financ ing this extra investment by borrowing from abroad. Thus, net capital outflow equals the amount that domestic residents are lending abroad minus the amount that foreigners are lending to us. It reflects the international flow of funds to fi nance capital accumulation The national income accounts identity shows that net capital outflow always quals the trade balance. TI Net Capital Outflow Trade Balance NX 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. In this case, we are net borrowers in world financial markets, and we are importing more goods than we are exporting. If s- I and NX are exactly zero, we are said to have balanced trade because the value of imports equals the value of exports The national income accounts identity shows that the international flow of funds to fi- nance capital accumulation and the international flow of goods and services are two sides of the same coin. On the one hand, if our saving exceeds our investment, the saving that is not invested domestically is used to make loans to foreigners. Foreigners require these loans because we are providing them with more goods and services han they are providing us. That is, we are running a trade surplus. On the other hand, if our investment exceeds our saving, the extra investment must be fi nanced by borrowing from abroad. These foreign loans enable us to import more table 5-1 International Flows of Goods and Capital: Summary This table shows the three outcomes that an open economy can experience Trade Surplus Balanced trade Trade Deficit Exports >Imports Exports=Imports mports Net Exports >0 Net Exports =0 Net ExportsC+I+G Savings > Investment Saving= Investment Saving Investment Net Capital Outflow >0 Net Capital Outow=0 Net Capital Outflow <0 User JOENA: Job EFF01460: 6264_ch05: Pg 118: 26239#/eps at 100sg wed,Feb13,20029:264M
User JOEWA:Job EFF01460:6264_ch05:Pg 118:26239#/eps at 100% *26239* Wed, Feb 13, 2002 9:26 AM 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.) If net capital outflow is positive, our saving exceeds our investment, and we are lending the excess to foreigners. If the net capital outflow is negative, our investment exceeds our saving, and we are financing this extra investment by borrowing from abroad. Thus, net capital outflow equals the amount that domestic residents are lending abroad minus the amount that foreigners are lending to us. It reflects the international flow of funds to fi- nance capital accumulation. The national income accounts identity shows that net capital outflow always equals the trade balance.That is, Net Capital Outflow = Trade Balance S − I = NX. 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. In this case, we are net borrowers in world financial markets, and we are importing more goods than we are exporting. If S − I and NX are exactly zero, we are said to have balanced trade because the value of imports equals the value of exports. The national income accounts identity shows that the international flow of funds to fi- nance capital accumulation and the international flow of goods and services are two sides of the same coin. On the one hand, if our saving exceeds our investment, the saving that is not invested domestically is used to make loans to foreigners. Foreigners require these loans because we are providing them with more goods and services than they are providing us.That is, we are running a trade surplus. On the other hand, if our investment exceeds our saving, the extra investment must be fi- nanced by borrowing from abroad. These foreign loans enable us to import more 118 | PART II Classical Theory: The Economy in the Long Run This table shows the three outcomes that an open economy can experience. Trade Surplus Balanced Trade Trade Deficit Exports > Imports Exports = Imports Exports 0 Net Exports = 0 Net Exports C + I + G Y = C + I + G Y Investment Saving = Investment Saving 0 Net Capital Outflow = 0 Net Capital Outflow < 0 International Flows of Goods and Capital: Summary table 5-1
Worth: Mankiw Economics 5e n Economy 119 International Flows of Goods and Capital An Example The equality of net exports and net capital outflow The opposite situation occurs in Japan. When is an identity: it must hold by the way the numbers the Japanese consumer buys a copy of the win- are added up. But it is easy to miss the intuition i dows operating system, Japan's purchases of behind this important relationship. The best wayi goods and services(C+I+G)rise, but there is no to understand it is to consider an example change in what Japan has produced(Y). The Imagine that Bill Gates sells a copy of the transaction reduces Japan's saving(S=Y-C-G Windows operating system to a Japanese con-i for a given level of investment(D). While the U.S umer for 5,000 yen. Because Mr Gates is a U.S. experiences a net capital outflow, Japan experi resident, the sale represents an export of the i ences a net capital inflow United States. Other things equal, U.Snet ex- Now let's change the example. Suppose that ports rise. What else happens to make the iden-i instead of investing his 5,000 yen in a Japanese tity hold? It depends on what Mr. Gates does asset, Mr Gates uses it to buy something made with the 5,000 yen. in Japan, such as a Sony Walkman. In this case, Suppose Mr. Gates decides to stuff the 5,000 imports into the United State rise. Together, the yen in his mattress. In this case, Mr Gates has al- Windows export and the Walkman import repre- located some of his saving to an investment in i sent balanced trade between Japan and the the Japanese economy (in the form of the Japan-! United States.Be ates. Because exports and imports rise ese currency)rather than to an investment in the i equally, net exports and net capital outflow are U.S. economy. Thus, U.S. saving exceeds U.S. in-i both unchanged estment. The rise in U.S. net exports is matched A final possibility is that Mr. Ga ates exchanges by a rise in the U.S. net capital outflow his 5,000 yen for U.S. dollars at a local bank. But If Mr Gates wants to invest in Japan, however, this doesn't change the situation: the bank now he is unlikely to make currency his asset of i has to do something with the 5,000 yen. It can choice. He might use the 5,000 yen to buy somei buy Japanese assets(a U.S. net capital outflow); stock in, say, the Sony Corporation, or he might it can buy a Japanese good (a U.S. import); or it buy a bond issued by the Japanese government.i can sell the yen to another American who wants In either case, some of U.S. saving is flowing i to make such a transaction. If you follow the abroad. Once again, the U.S. net capital outflow money, you can see that, in the end, U.S. net ex- exactly balances U.S. net exports ports must equal U.S. net capital outflow goods and services than we export. That is, we are running a trade deficit. Table 5-1 summarizes these lessons Note that the international How of capital can take many forms. It is easiest to assume-as we have done so far--that when we run a trade deficit, foreigners make loans to us. This happens, for example, when the Japanese buy the debt is- sued by U.S. corporations or by the U.S. government. But the flow of capital car also take the form of foreigners buying domestic assets, such as when a citizen of Germany buys stock from an American on the New York Stock Exchange Whether foreigners are buying domestically issued debt or domestically owned cases, foreigners end up owning some of the domestic capital stoc pital. In both assets, they are obtaining a claim to the future returns to domestic cap User JOENA: Job EFF01460: 6264_ch05: Pg 119: 26240#/eps at 100s wed,Feb13,20029:264M
User JOEWA:Job EFF01460:6264_ch05:Pg 119:26240#/eps at 100% *26240* Wed, Feb 13, 2002 9:26 AM goods and services than we export.That is, we are running a trade deficit.Table 5-1 summarizes these lessons. Note that the international flow of capital can take many forms. It is easiest to assume—as we have done so far—that when we run a trade deficit, foreigners make loans to us.This happens, for example, when the Japanese buy the debt issued by U.S. corporations or by the U.S. government. But the flow of capital can also take the form of foreigners buying domestic assets, such as when a citizen of Germany buys stock from an American on the New York Stock Exchange. Whether foreigners are buying domestically issued debt or domestically owned assets, they are obtaining a claim to the future returns to domestic capital. In both cases, foreigners end up owning some of the domestic capital stock. CHAPTER 5 The Open Economy | 119 FYI The equality of net exports and net capital outflow is an identity: it must hold by the way the numbers are added up. But it is easy to miss the intuition behind this important relationship. The best way to understand it is to consider an example. Imagine that Bill Gates sells a copy of the Windows operating system to a Japanese consumer for 5,000 yen. Because Mr. Gates is a U.S. resident, the sale represents an export of the United States. Other things equal, U.S. net exports rise. What else happens to make the identity hold? It depends on what Mr. Gates does with the 5,000 yen. Suppose Mr. Gates decides to stuff the 5,000 yen in his mattress. In this case, Mr. Gates has allocated some of his saving to an investment in the Japanese economy (in the form of the Japanese currency) rather than to an investment in the U.S. economy. Thus, U.S. saving exceeds U.S. investment. The rise in U.S. net exports is matched by a rise in the U.S. net capital outflow. If Mr. Gates wants to invest in Japan, however, he is unlikely to make currency his asset of choice. He might use the 5,000 yen to buy some stock in, say, the Sony Corporation, or he might buy a bond issued by the Japanese government. In either case, some of U.S. saving is flowing abroad. Once again, the U.S. net capital outflow exactly balances U.S. net exports. International Flows of Goods and Capital: An Example The opposite situation occurs in Japan. When the Japanese consumer buys a copy of the Windows operating system, Japan’s purchases of goods and services (C + I + G) rise, but there is no change in what Japan has produced (Y). The transaction reduces Japan’s saving (S = Y − C − G) for a given level of investment (I). While the U.S. experiences a net capital outflow, Japan experiences a net capital inflow. Now let’s change the example. Suppose that instead of investing his 5,000 yen in a Japanese asset, Mr. Gates uses it to buy something made in Japan, such as a Sony Walkman. In this case, imports into the United State rise. Together, the Windows export and the Walkman import represent balanced trade between Japan and the United States. Because exports and imports rise equally, net exports and net capital outflow are both unchanged. A final possibility is that Mr. Gates exchanges his 5,000 yen for U.S. dollars at a local bank. But this doesn’t change the situation: the bank now has to do something with the 5,000 yen. It can buy Japanese assets (a U.S. net capital outflow); it can buy a Japanese good (a U.S. import); or it can sell the yen to another American who wants to make such a transaction. If you follow the money, you can see that, in the end, U.S. net exports must equal U.S. net capital outflow
Worth: Mankiw Economics 5e 120 PART 11 Classical Theory: The Economy in the Long Run 5-2 Saving and Investment in a Small Open Economy So far in our discussion of the international flows of goods and capital, we have merely rearranged accounting identities. That is, we have defined some of the variables that measure transactions in an open economy, and we have shown the nks among these variables that follow from their definitions. Our next step is to develop a model that explains the behavior of these variables. We can then use he model to answer questions such as how the trade balance responds to Capital Mobility and the World Interest Rate In a moment we present a model of the international flows of capital and goods Because the trade balance equals the net capital outflow, which in turn equals saving minus investment, our model focuses on saving and investment. To de velop this model, we use some elements that should be familiar from Chapter 3, but in contrast to the Chapter 3 model, we do not assume that the real interest rate equilibrates saving and investment. 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 this model, what does determine the real interest rate? We answer this question here by considering the simple case of a small open economy with perfect capital mobility. By"small"we mean that this economy is a small part of the world market and thus, by itself, can have only a negligible effect on the world interest rate. By "perfect capital mobility we mean that residents of the country have full access to world financial markets. In particular, the government does not impede international borrowing or lending 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 idents of the small open economy need never borrow at any interest rate above r, because they can always get a loan at r*from abroad. Similarly, residents of this economy need never lend at any interest rate below r because they can always earn r* by lending abroad. Thus, the world interest rate determines the in- terest rate in our small open economy Let us discuss for a moment what determines the world real interest rate. In a closed economy, the equilibrium of domestic saving and domestic investment determines the interest rate. Barring interplanetary trade, the world economy is a losed economy. Therefore, the equilibrium of world saving and world invest ment determines the world interest rate. Our small open economy has a negligi ble effect on the world real interest rate because, being a small part of the world User JOENA: Job EFF01460: 6264_ch05: Pg 120: 26241#/eps at 100s wed,Feb13,20029:264M
User JOEWA:Job EFF01460:6264_ch05:Pg 120:26241#/eps at 100% *26241* Wed, Feb 13, 2002 9:26 AM 5-2 Saving and Investment in a Small Open Economy So far in our discussion of the international flows of goods and capital, we have merely rearranged accounting identities. That is, we have defined some of the variables that measure transactions in an open economy, and we have shown the links among these variables that follow from their definitions. Our next step is to develop a model that explains the behavior of these variables.We can then use the model to answer questions such as how the trade balance responds to changes in policy. Capital Mobility and the World Interest Rate In a moment we present a model of the international flows of capital and goods. Because the trade balance equals the net capital outflow, which in turn equals saving minus investment, our model focuses on saving and investment. To develop this model, we use some elements that should be familiar from Chapter 3, but in contrast to the Chapter 3 model, we do not assume that the real interest rate equilibrates saving and investment. 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? We answer this question here by considering the simple case of a small open economy with perfect capital mobility. By “small’’ we mean that this economy is a small part of the world market and thus, by itself, can have only a negligible effect on the world interest rate. By “perfect capital mobility’’ we mean that residents of the country have full access to world financial markets. In particular, the government does not impede international borrowing or lending. 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*. Residents of the small open economy need never borrow at any interest rate above r*, because they can always get a loan at r* from abroad. Similarly, residents of this economy need never lend at any interest rate below r* because they can always earn r* by lending abroad.Thus, the world interest rate determines the interest rate in our small open economy. Let us discuss for a moment what determines the world real interest rate. In a closed economy, the equilibrium of domestic saving and domestic investment determines the interest rate. Barring interplanetary trade, the world economy is a closed economy. Therefore, the equilibrium of world saving and world investment determines the world interest rate. Our small open economy has a negligible effect on the world real interest rate because, being a small part of the world, 120 | PART II Classical Theory: The Economy in the Long Run
Worth: Mankiw Economics 5e CHAPTER 5 The Open Economy 121 has a negligible effect on world saving and world investment. Hence, our small open economy takes the world interest rate as exogenously given The Model To build the model of the small open economy, we take three assumptions from The economys output Y is fixed by the factors of production and the pro- duction function We write this as Y=Y=FK. L Consumption C is positively related to disposable income Y-T. We write the consumption function as C=C(Y-T Investment I is negatively related to the real interest rate r. We write the investment function as These are the three key parts of our model. If you do not understand these rela tionships, review Chapter 3 before continuing. We can now return to the accounting identity and write it as XX=S-I Substituting our three assumptions from Chapter 3 and the condition that the interest rate equals the world interest rate, we obtain NX=Y-C(Y-T)-G-I(r) I(r*) This equation shows what determines saving S and investment I-and thus the trade balance NX. Remember that saving depends on fiscal policy: lower govern- ment purchases G or higher taxes T raise national saving Investment depends on the world real interest rate r*: high interest rates make some investment projects unprofitable. Therefore, the trade balance depends on these variables as well. In Chapter 3 we graphed saving and investment as in Figure 5-2 In the closed economy studied in that chapter, the real interest rate adjusts to equilibrate saving and investment--that is the real interest rate is found where the saving and in- vestment curves cross. In the small open economy, however, the real interest rate equals the world real interest rate. The trade balance is determined by the difference be tween saving and investment at the world interest rate. 6 At this point, you might wonder about the mechanism that causes the trade ance to equal the net capital outflow. The determinants of the capital flows are User JoNA:JobE01460:6264ch05:9121:262424#/epat100|lⅢ wed,Feb13,20029:264M
User JOEWA:Job EFF01460:6264_ch05:Pg 121:26242#/eps at 100% *26242* Wed, Feb 13, 2002 9:26 AM it has a negligible effect on world saving and world investment. Hence, our small open economy takes the world interest rate as exogenously given. The Model To build the model of the small open economy, we take three assumptions from Chapter 3: ➤ The economy’s output Y is fixed by the factors of production and the production function.We write this as Y = Y _ = F(K _ , L _ ). ➤ Consumption C is positively related to disposable income Y − T. We write the consumption function as C = C(Y − T). ➤ Investment I is negatively related to the real interest rate r. We write the investment function as I = I(r). These are the three key parts of our model. If you do not understand these relationships, review Chapter 3 before continuing. We can now return to the accounting identity and write it as NX = (Y − C − G) − I NX = S − I. Substituting our three assumptions from Chapter 3 and the condition that the interest rate equals the world interest rate, we obtain NX = [Y _ − C(Y _ − T) − G] − I(r*) = S _ − I(r*). This equation shows what determines saving S and investment I—and thus the trade balance NX. Remember that saving depends on fiscal policy: lower government purchases G or higher taxes T raise national saving. Investment depends on the world real interest rate r*: high interest rates make some investment projects unprofitable.Therefore, the trade balance depends on these variables as well. In Chapter 3 we graphed saving and investment as in Figure 5-2. In the closed economy studied in that chapter, the real interest rate adjusts to equilibrate saving and investment—that is, the real interest rate is found where the saving and investment curves cross. In the small open economy, however, the real interest rate equals the world real interest rate.The trade balance is determined by the difference between saving and investment at the world interest rate. At this point, you might wonder about the mechanism that causes the trade balance to equal the net capital outflow. The determinants of the capital flows are CHAPTER 5 The Open Economy | 121
Worth: Mankiw Economics 5e 22 PART I1 Classical Theory: The Economy in the Long Run figure 5-2 Real interest S Saving and Investment in a rate, r Trade surplus 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 de- termined in world financial mar est kets. The difference between rate saving and investment deter mines the trade balance. Here nterest there is a trade surplus, because rate if the at the world interest rate, saving I(r exceeds investment were closed easy to understand. When saving falls short of investment, investors borrow from exceeds invest le what causes those who import and export to behave in a way that ensures that the international flow of goods exactly balances this international flow of capital For now we leave this question unanswered, but we return to it in Section 5-3 when we discuss the determination of exchange rates How Policies influence the trade balance Suppose that the economy begins in a position of balanced trade. That is, at the world interest rate, investment Equals saving S, and net exports NX equal zero. Let's use our model to predict the effects of government policies at home and abroad. Fiscal Policy at Home Consider first what happens to the small open econ- omy if the government expands domestic spending by increasing government purchases. The increase in G reduces national saving, because S=Y-C-G With an unchanged world real interest rate, investment remains the same. There fore, saving falls below investment, and some investment must now be financed by borrowing from abroad. Because NX=S-L, the fall in S implies a fall in NX. The economy now runs a trade deficit. The same logic applies to a decrease in taxes. a tax cut lowers T, raises able income Y-T, stimulates consumption, and reduces national saving chough some of the tax cut finds its way into private saving, public saving falls by he full amount of the tax cut; in total, saving falls. Because NX=S-I, the duction in national saving in turn lowers NX. Figure 5-3 illustrates these effects. A fiscal-policy change that increases private consumption C or public consumption G reduces national saving(Y-C-G) and, therefore, shifts the vertical line that represents saving from S, to S2. Because NX is the distance between the saving schedule and the investment schedule at the world interest rate, this shift reduces NX. Hence, starting from balanced trade, a change in fiscal policy that reduces national saving leads to a trade deficit User JoENA: Job EFFo1460: 6264_ ch05: Pg 122: 26243#/eps at 100sl I wed,Feb13,20029:264M
User JOEWA:Job EFF01460:6264_ch05:Pg 122:26243#/eps at 100% *26243* Wed, Feb 13, 2002 9:26 AM easy to understand.When saving falls short of investment, investors borrow from abroad; when saving exceeds investment, the excess is lent to other countries. But what causes those who import and export to behave in a way that ensures that the international flow of goods exactly balances this international flow of capital? For now we leave this question unanswered, but we return to it in Section 5-3 when we discuss the determination of exchange rates. How Policies Influence the Trade Balance Suppose that the economy begins in a position of balanced trade. That is, at the world interest rate,investment I equals saving S,and net exports NX equal zero.Let’s use our model to predict the effects of government policies at home and abroad. Fiscal Policy at Home Consider first what happens to the small open economy if the government expands domestic spending by increasing government purchases.The increase in G reduces national saving, because S = Y − C − G. With an unchanged world real interest rate, investment remains the same.Therefore, saving falls below investment, and some investment must now be financed by borrowing from abroad. Because NX = S − I, the fall in S implies a fall in NX. The economy now runs a trade deficit. The same logic applies to a decrease in taxes.A tax cut lowers T, raises disposable income Y − T, stimulates consumption, and reduces national saving. (Even though some of the tax cut finds its way into private saving, public saving falls by the full amount of the tax cut; in total, saving falls.) Because NX = S − I, the reduction in national saving in turn lowers NX. Figure 5-3 illustrates these effects. A fiscal-policy change that increases private consumption C or public consumption G reduces national saving (Y − C − G) and, therefore, shifts the vertical line that represents saving from S1 to S2. Because NX is the distance between the saving schedule and the investment schedule at the world interest rate, this shift reduces NX. Hence, starting from balanced trade, a change in fiscal policy that reduces national saving leads to a trade deficit. 122 | PART II Classical Theory: The Economy in the Long Run figure 5-2 Real interest rate, r* r* NX S Investment, Saving, I, S I(r) World interest rate Trade surplus Interest rate if the economy were closed 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
Worth: Mankiw Economics 5e Real interest A Fiscal Expansion at Home in a rate, r 2 but when a Small Open Economy An increase n government purchases or a re- reduces saving duction in taxes reduces nationa saving and thus shifts the saving 1. This economy schedule to the left, from St to S The result is a trade deficit balanced trade deficit results (r) 1. S Fiscal Policy Abroad Consider now what happens to a small open economy when foreign governments increase their government purchases. If these foreign countries are a small part of the world economy, then their fiscal change has a gligible impact on other countries. But if these foreign countries are a large art of the world economy, their increase in government purchases reduces world saving and causes the world interest rate to rise The increase in the world interest rate raises the cost of borrowing and, thus, reduces investment in our small open economy. Because there has been no hange in domestic saving, saving S now exceeds investment I, and some of our saving begins to flow abroad. Since NX=S-L the reduction in I must also in- crease NX. Hence, reduced saving abroad leads to a trade surplus at home. cro igure 5-4 illustrates how a small open economy starting from balanced trade onds to a foreign fiscal expansion. Because the policy change is occurring figure 5-4 Real interest A Fiscal Expansion Abroad in a Small Open Economy A fiscal ex- pansion in a foreign economy large enough to influence world a trade surplus saving and investment raises the world interest rate from ri to r2 The higher world interest rate 1. An reduces investment in open economy, causing a trade surplus. Interest rate nvestment, Saving, ,S User JoNA:JobE01460:6264ch05:9123:26248#/epat100|l川ⅢⅢ wed,Feb13,20029:264M
User JOEWA:Job EFF01460:6264_ch05:Pg 123:26248#/eps at 100% *26248* Wed, Feb 13, 2002 9:26 AM Fiscal Policy Abroad Consider now what happens to a small open economy when foreign governments increase their government purchases. If these foreign countries are a small part of the world economy, then their fiscal change has a negligible impact on other countries. But if these foreign countries are a large part of the world economy, their increase in government purchases reduces world saving and causes the world interest rate to rise. The increase in the world interest rate raises the cost of borrowing and, thus, reduces investment in our small open economy. Because there has been no change in domestic saving, saving S now exceeds investment I, and some of our saving begins to flow abroad. Since NX = S − I, the reduction in I must also increase NX. Hence, reduced saving abroad leads to a trade surplus at home. Figure 5-4 illustrates how a small open economy starting from balanced trade responds to a foreign fiscal expansion. Because the policy change is occurring CHAPTER 5 The Open Economy | 123 figure 5-3 Real interest rate, r r* NX S1 Investment, Saving, I, S I(r) S2 2. . . . but when a fiscal expansion reduces saving . . . 1. This economy begins with balanced trade, . . . 3. . . . a trade deficit results. 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 S1 to S2. The result is a trade deficit. figure 5-4 Real interest rate, r r*2 r*1 NX S Investment, Saving, I, S I(r) 1. An increase in the world interest rate . . . 2. . . . reduces investment and leads to a trade surplus. A Fiscal Expansion Abroad in a Small Open Economy A fiscal expansion in a foreign economy large enough to influence world saving and investment raises the world interest rate from r1 * to r2 *. The higher world interest rate reduces investment in this small open economy, causing a trade surplus
