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CHAPTER 3. CLASSICAL THEORY: THE OPEN ECONOMY IN THE

OVERVIEW
In Topic 2 we study the Classical theory for the closed economy in the long run.
Now we continue with the Classical theory for the open economy in the long run.
Accounting identities for the open economy
How the trade balance and exchange rate are determined?
How policies affect trade balance and exchange rate?

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THE NATIONAL INCOME IDENTITY IN AN

OPEN ECONOMY

Y = C + I + G + NX

or, NX = Y – (C + I + G )

domestic spending
net exports

output

INTERNATIONAL CAPITAL FLOWS

NX = Y – (C + I + G )
implies
NX = (Y – C – G ) – I
=S–I

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THE INTERNATIONAL FLOWS OF CAPITAL AND GOODS

S – I is called net capital outflow or net foreign investment
S – I = NFI = CO – CI
CO: Domestic residents’ lending abroad
CI: Foreigners’ lending to domestic country
If S > I: Lending the excess to abroad: country is a net lender
If S < I: Borrowing the shortage from abroad: country is a net borrower

THE NATIONAL INCOME IDENTITY IN AN OPEN ECONOMY

Since NX = S–I
Trade balance = Net foreign investment
The international flows of capital and the international flows of goods are in balance.
A country with a trade deficit (NX < 0) is a net borrower (S < I ).
A country with a trade surplus (NX > 0) is a net lender (S > I ).

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THE NOMINAL EXCHANGE RATE

e =nominal exchange rate, the relative price of domestic currency

in terms of foreign currency
(e.g. USD per VND)

THE REAL EXCHANGE RATE

ε= real exchange rate, the relative price of domestic goods

in terms of foreign goods
(e.g. how many kg U.S. rice per 1 kg Vietnamese rice)

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THE RELATION BETWEEN NOMINAL AND REAL EXCHANGE RATE

one good: rice

price of 1 kg rice in the U.S.
P* = USD 1.2
price of 1 kg rice in Vietnam
P = VND 20,000
nominal exchange rate
e = 1/ 23,000 USD/VND

(1/ 23,000)  20,000  0.72 1 kg of rice in Vietnam equals to 0.72 kg of rice in the U.S.
1.2
eP
P

THE REAL EXCHANGE RATE AND THE

TRADE BALANCE
If the real exchange rate decreases, domestic goods become relatively cheaper and thus exports incre
If the real exchange rate increases, domestic goods become relatively more expensive and thus expor
There is a negative relationship between the trade balance and the real exchange rate.
NX = NX (ε)

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THE SMALL OPEN ECONOMY MODEL

The assumptions:
 The economy’s output is fixed by the factors of production and available technology.
Y  F (K , L)  Y

 Consumption positively depends on disposable income.

C  CY  T 
Investment negatively depends on the real interest rate.
I = I(r)
Government spending and taxes are exogenous

G  GT  T
 Small economy with free capital mobility
r = r*

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THE SMALL OPEN ECONOMY MODEL: LOANABLE FUNDS MARKET

The loanable funds market:
Supply of loanable funds comes from national saving.
Demand for loanable funds comes from investment.

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THE SUPPLY OF LOANABLE FUNDS

r S Y  C (Y T )  G

National saving does not depend on the interest rate

S S, I

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THE DEMAND FOR LOANABLE FUNDS

r

Investment is a downward- sloping

function of the interest rate, but the exogenous world interest rate…
…determines the
I (r ) country’s level of
r*

investment.
I
I (r* )

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THE SMALL OPEN ECONOMY MODEL: LOANABLE FUNDS MARKET

r 𝑺¯
The exogenous world interest rate determines investment…

NX
r*
…and the difference between saving and investment determines net exports.

I(r*) S, I

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THE SMALL OPEN ECONOMY MODEL: LOANABLE FUNDS MARKET

The equilibrium of the loanable funds market is where
NX = S – I

or
NX  S  I (r*)
The trade balance is determined by the difference between saving and investment at the world int

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THE EFFECTS OF POLICY ON THE TRADE BALANCE

1. Fiscal policy at home

2.
3. Fiscal policy abroad
An increase in investment demand

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1. FISCAL POLICY AT HOME

r
Expansionary S2 1
fiscal policy at NX2

home. S
r*
Results:
• Investment is
unchanged.
• Net exports NX1
decrease. I
I (r*)
S, I

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1. FISCAL POLICY AT HOME

The loanable funds market is at initial equilibrium where: NX1 = S1 – I(r*)
Event: The government conducts an expansionary fiscal policy (government spending increases or tax decreases)
S↓ = Y – C↑ – G↑
→ National saving decreases → The supply of loanable funds curve shifts to the left.
The loanable funds market reaches a new equilibrium where: NX2 = S2 – I(r*)
NX2 < NX1 : Net exports decrease.
Conclusion: Expansionary fiscal policy leads to a decrease in net exports.

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2. FISCAL POLICY ABROAD

r
Expansionary NX2 S1
fiscal policy
abroad raises the 𝑟∗
2
world interest NX1
rate. 𝑟1∗

Results:
• Investment level
decreases.
• Net exports I
increase.
𝐼(𝑟2∗) 𝐼(𝑟∗1) S, I

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3. AN INCREASE IN INVESTMENT DEMAND

r
S
A grant of investment tax credits. NX2
r*

NX1
Results:
Investment level increases.
Net exports decrease.
I2
I1

𝐼1(𝑟∗) 𝐼2(𝑟∗) S, I

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THE SMALL OPEN ECONOMY MODEL: FOREIGN EXCHANGE MARKET

Foreign exchange market is the market for selling and buying domestic currency in exchange to foreign curren
NX represents the net demand for domestic currency to buy domestic goods. NX negatively depends on the real exchange
S – I that represents net capital outflow or the supply of domestic currency to be exchanged into foreign currency and inv
The real exchange rate is determined at the equilibrium of the foreign exchange market.
NX (ε )  S  I (r *)

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THE SMALL OPEN ECONOMY MODEL: FOREIGN EXCHANGE MARKET

S – I(r*)
ε
Real exchange rate is determined at the equilibrium of the foreign exchange market.

εE E

NX

S – I, NX
S – I = NX

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THE EFFECTS OF POLICY ON THE REAL EXCHANGE RATE

1. Fiscal policy at home

2.
3. Fiscal policy abroad
4. An increase in investment demand Trade policy

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1. FISCAL POLICY AT HOME

𝑺𝟐 — 𝑰(𝒓∗)𝑺𝟏 — 𝑰(𝒓 ∗)
ε
Expansionary fiscal policy at home.

ε2 E2

E1
Results: ε1
Real exchange rate increases.
Net exports decrease. NX

𝑆2 — 𝐼 = 𝑁𝑋2 𝑆1 — 𝐼 = 𝑁𝑋1 S – I, NX

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1. FISCAL POLICY AT HOME

Initially the foreign exchange market is at equilibrium E1:
ε = ε1 ; NX1 = S1 –I
Event: The government conducts an expansionary fiscal policy (government spending increases or tax decreases)
S↓ = Y – C↑ – G↑
National saving decreases → Supply of domestic currency curve shifts to the left.
The foreign exchange market reaches the equilibrium at E2:
ε = ε2 ; NX2 = S2 –I
ε2 > ε1 : Real exchange rate increases NX2 < NX1 : Net exports decrease
Conclusion: Expansionary fiscal policy leads to a higher real exchange rate and lower net exports.

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2. FISCAL POLICY ABROAD

𝑺 — 𝑰(𝒓𝟏∗ ) 𝑺 — 𝑰(𝒓𝟐∗ )
An increase in the world interest rate r*.
ε

ε1 E1

Results:
ε2
Real exchange rate decreases. E2
Net exports increase.
NX

𝑆— 𝐼 𝑟∗ S – I, NX
1 = 𝑁𝑋1 𝑆— 𝐼 𝑟∗
2 = 𝑁𝑋2

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3. AN INCREASE IN INVESTMENT DEMAND

𝑺 — 𝑰𝟐𝑺 — 𝑰𝟏
ε
A grant of an investment tax credits.

ε2 E2

Results: ε1 E1
Real exchange rate increases.
Net exports decrease. NX

S – I, NX
𝑆— 𝐼2 = 𝑁𝑋2 𝑆— 1𝐼 = 𝑁𝑋1

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4. TRADE POLICY

Tariff imposed on imported goods. 𝑺— 𝑰

ε

ε2 E2

Results: E1
ε1
Real exchange rate increases.
Net exports are unchanged. 𝑵𝑿𝟐
𝑵𝑿𝟏
S – I, NX

𝑆— 𝐼 = 𝑁𝑋

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THE DETERMINANTS OF THE NOMINAL EXCHANGE RATE

Start with the expression for the real exchange rate:

eP
ε
P*

Solve it for the nominal exchange rate:

ε  P *
e
P

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THE DETERMINANTS OF THE NOMINAL EXCHANGE RATE

εP *
e
P
We can rewrite this equation in terms of growth rates

e ε  P *  P ε   *  
e ε P* P ε
For a given value of ε, the growth rate of e equals the difference between foreign and domestic

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THE LARGE OPEN ECONOMY MODEL

The assumptions:
 The economy’s output is fixed by the factors of production and available technology.
Y  F (K , L)  Y

 Consumption positively depends on disposable income.

C  CY  T 
Investment negatively depends on the real interest rate.
I = I(r)
Government spending and taxes are exogenous

G  GT  T
 Large economy with free capital mobility
rr*

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THE LARGE OPEN ECONOMY MODEL

Net capital outflow:
NFI = NFI(r) = CO – CI
If the real domestic interest rate is higher, foreigners want to lend more to the domestic country CI↑ causing NFI t
If the real domestic interest rate is lower, domestic residents want to lend more overseas CO↑ causing NFI to rise.
Net capital outflow depends negatively on the real domestic interest rate.
If NFI > 0: Lend abroad (net lender)
If NFI < 0: Borrow from abroad (net borrower)

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THE LARGE OPEN ECONOMY MODEL

Consider 2 key markets:
The loanable funds market: where the real interest rate is determined.
The foreign exchange market: where the real exchange rate is determined.

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THE LARGE OPEN ECONOMY MODEL

The loanable funds market
Supply of loanable funds come from domestic saving: S.
Demand for loanable funds come from domestic investment and net foreign investment: I + NFI
At the equilibrium
S = I + NFI
S  I (r)  NFI (r)
The market equilibrium determines the real exchange rate.

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THE LOANABLE FUNDS MARKET

S
r
Real interest rate is determined at the equilibrium of the loanable funds market.

rE E

I + NFI

S, I + NFI
S = I + NFI

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THE LARGE OPEN ECONOMY MODEL

The foreign exchange market:
NX represents the demand for domestic currency.
NFI represents the supply of domestic currency.
At the equilibrium
NX = NFI NX(ε) = NFI
The market equilibrium determines the real exchange rate.

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THE FOREIGN EXCHANGE MARKET

ε NFI
Real exchange rate is determined at the equilibrium of the foreign exchange market.

εE E

NX

NFI, NX
NFI = NX

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THE LARGE OPEN ECONOMY MODEL

The open economy is in equilibrium when there is a simultaneous equilibrium in the two markets.
Equilibrium in the loanable funds market S = I + NFI
Equilibrium in the foreign exchange market NX = NFI
Equilibrium in the open economy will determine basic macroeconomic variables
Net exports
Net foreign investment
Real interest rate
Real exchange rate

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r S r

𝑟E E

I + NFI NFI

S, I + NFI NFI
S = I + NFI
𝜀 NFI
Loanable funds market

𝜀E E

NX

NFI = NX NX, NFI

Foreign exchange market

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POLICIES IN THE LARGE OPEN ECONOMY

1. Fiscal policy
2.
3. Investment policy
Trade policy

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1. EXPANSIONARY FISCAL POLICY

r𝑆2𝑆1r

𝑟2 𝐸2
𝑟1 𝐸1

I + NFI NFI

S, I + NFI NFI
Loanable funds market 𝜀 𝑁𝐹𝐼2 𝑁𝐹𝐼1

𝜀2 𝐸2
𝜀1 𝐸1

NX

𝑁𝐹𝐼2 = 𝑁𝑋2 𝑁𝐹𝐼1 = 𝑁𝑋1NX, NFI

Foreign exchange market

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EXPANSIONARY FISCAL POLICY

The economy is initially at equilibrium E1 : r = r1; ɛ = ɛ1
Event: The government conducts expansionary fiscal policy (G increases or T decreases).
↓S = Y – C↑ – G↑
In the loanable funds market: Decrease in national saving makes the supply of loanable funds curve shift to the left. The new established equilibrium E2 determ
r2 > r1 : real interest rate rises. Higher real interest rate causes net foreign investment to fall.
In the foreign exchange market: Decrease in net foreign investment makes the supply of domestic currency curve shift to the left. The new established equilibr
ɛ2 > ɛ1 : real exchange rate increases. A higher real exchange rate will
make domestic goods become relatively more expensive compared to foreign goods which leads to lower exports and higher imports, net exports decrease.
Conclusion: Expansionary fiscal policy leads to a higher real interest rate, a higher real exchange rate, lower net foreign investment and lower net exports.

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2. INVESTMENT ATTRACTION POLICY

r𝑆r

𝑟2 𝐸2
𝑟1
𝐸1 𝐼2 + 𝑁𝐹𝐼
𝐼1 + 𝑁𝐹𝐼
NFI

S, I + NFI NFI
Loanable funds market
𝜀𝑁𝐹𝐼2𝐼1 𝑁𝐹
Investment attraction policy. Results:
Real interest rate increases. 𝜀2 𝐸2
Real exchange rate increases. 𝐸1
𝜀
Net foreign investment decreases. 1
Net exports decrease.

NX

𝑁𝐹𝐼2 = 𝑁𝑋2 𝑁𝐹𝐼1 = 𝑁𝑋1NX, NFI

Foreign exchange market

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3. TRADE POLICY
r Sr

𝑟1 𝐸1

I + NFI NFI

S, I + NFI NFI
Loanable funds market 𝜀 NFI
𝐸2
Tariff imposed on imported goods. 𝐸1
Results: 𝜀2
Real interest rate is unchanged. 𝜀1
Real exchange rate increases.
Net foreign investment is unchanged. 𝑁𝑋2
Net exports are unchanged. 𝑁𝑋1

NFI = NX NX, NFI

Foreign exchange market

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