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,Feb13,20029:264MUser 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 pro￾duction 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 rela￾tionships, 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 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. 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