+

Chapter 4

Open economy

References:

N. Gregory Mankiw, “Principles of Macroeconomics”,

chapters 18,19- eight edition
+
Outline

 Open-economy macroeconomics basic concept

 Market for loanable funds in open economy

 Equilibrium in the Open economy

+
Basic concepts

 What is open economy?

 The flow of goods and financial resources

 Saving-investment in open economy and the international flows

 Purchasing power parity

 What is open economy
+

Economy that interacts freely with other economies around the world

It buys and sells It buys and sells capital

goods and services assets in world financial
in world product markets
markets
Purchase of foreign
Import assets by domestic residents
Flow of Flow of
goods capital
Purchase of domestic
Export assets by foreigners
+ The Flow of Goods
 Exports
Goods and services that are produced domestically and sold abroad

 Imports
Goods and services that are produced abroad and sold domestically

 Net exports (Trade balance) (NX)

NX = Exports - Imports

Trade surplus (Positive net exports): Exports are greater than imports
Trade deficit (Negative net exports): Imports are greater than exports
Balanced trade: Exports equal imports
The international Flow of Financial
+
Resources
• Capital outflow: Purchase of foreign assets by domestic
residents (Invest capital to abroad)
• Foreign direct investment (FDI)
• Foreign portfolio investment

• Capital inflow: Purchase of domestic assets by

foreigners (receive foreign capital from abroad)
• Foreign direct investment (FDI)
• Foreign portfolio investment

• Net capital outflow (NCO) (net foreign investment)

NCO = Capital outflow – Capital inflow

 The international Flows of trade and capital
+ • Net exports (NX): Balance/ Imbalance between a country’s exports
and its imports

• Net capital outflow (NCO): Balance/ Imbalance between Amount of

foreign assets bought by domestic residents and the amount of
domestic assets bought by foreigners

Identity: NCO = NX

Net Exports = Net Capital Outflow

+ Why
Net Exports = Net Capital Outflow

NX > 0 NCO > 0

Selling more
goods and services to Capital is flowing
foreigners than it is out of the country
buying from them

Receives foreign Buy foreign assets

currency
+ Why
Net Exports = Net Capital Outflow

NX < 0 NCO < 0

Buying more
goods and services Capital is flowing
from foreigners than it into the country
is selling to them

Needs financed Sell assets abroad

foreign currency
 Saving and Investment
+ in open economy

• Open economy: Y = C + I + G + NX

Therefore, I + NX = Y – C – G (1)

• National Saving: S=Y–C–G (2)

From (1) and (2): S = I + NX (3)

• NX = NCO (4)
From (3) and (4): S = I + NCO

National Saving = Domestic investment + Net

capital outflow
 The US’s National Saving and Domestic
+ Investment,

 Panel shows national saving and domestic investment as a percentage of GDP. You can see
from the figure that national saving has been lower since 1980 than it was before 1980. This
fall in national saving has been reflected primarily in reduced net capital outflow rather than
in reduced domestic investment.
 The US’s Net Capital Outflow 1960 -2015
+

 Panel shows net capital outflow as a percentage of GDP. You can see from
the figure that net capital outflow has been lower since 1980 than it was
before 1980.
12
International Flows of Good and Capital
+
– the summary
Three possible outcomes for an open economy.

Balanced
Trade surplus Trade deficit
trade
(Ex > Im) (Ex < Im)
(Ex = Im)

Nx > 0 Nx = 0 Nx < 0

NCO > 0 NCO = 0 NCO < 0

Y > C + I +G Y = C + I +G Y < C + I +G

S>I S=I S<I

+
Market for Loanable Funds in open
economy
 + In an open economy:

S = I + NCO
(Saving = Domestic investment + Net capital outflow)

•Supply of loanable funds

–From national saving (S)

•Demand for loanable funds

–From domestic investment (I)
–And net capital outflow (NCO)

When NCO > 0 When NCO < 0

(net outflow of capital) (net inflow of capital)
Net purchase of capital overseas Capital resources coming from
adds to the demand for abroad reduce the demand for
domestically generated loanable domestically generated loanable
funds funds
+ real
Model of Loanable Supply and Demand
real
interest interest Demand of loanable
rate Supply of rate funds (I and NCO)
loanable
funds (saving)
r1 r1

r0 r0

Qs0 Qs1 Quantity of Loanable Qd1 Qd0 Quantity of Loanable

funds funds

higher interest rate

Encourages people to save - Discourages investment
è increases quantity of - Discourages capital outflow;
loanable funds supplied Encourages capital inflow  reduce NCO
 Decreases quantity of loanable
funds demanded

Supply of loanable funds curve: Slopes Demand of loanable funds curve: Slopes
upward downward
 The Market for Loanable Funds

+
Real
Interest Supply of loanable funds
Rate (from national saving)

Equilibrium
real interest
rate Demand for loanable
funds (for domestic
investment and net
capital outflow)
Equilibrium Quantity of
quantity Loanable Funds

 - The interest rate in an open economy is determined by the supply

and demand for loanable funds.

- At the equilibrium interest rate, the amount that people want to save
exactly balances the amount that people want to borrow for the
purpose of buying domestic capital and foreign assets.
+

FOREIGN CURRENCY EXCHANGE

Nominal
+ exchange rate
Nominal exchange rate is a rate at which a person can trade
currency of one country for currency of another

Example
Exchange rate = 23.000 VND per USD

Appreciation (strengthen) Depreciation (weaken)

Increase in the value of a Decrease in the value of a
currency as measured by the currency as measured by the
amount of foreign currency it amount of foreign currency it
can buy can buy
(Buy more foreign currency) (Buy less foreign currency)

Example: dollar appreciation; VND depreciation

Exchange rate (old) = 20.000 VND per USD
Exchange rate (new) = 23.000 VND per dollar
Real
+ exchange rate
You want to buy a pair of shoes and taking a search on internet...
 Real exchange rate
+
Real exchange rate is the relative price between goods&services of
one country and goods &services of another

• Real exchange rate (R) = E.Pf/Pd

• E: nominal exchange rate (1 foreign currency = E Domestic
currency)
Pf: price index for foreign basket
Pd: price index for domestic basket

A rise in real exchange rate A fall in real exchange rate

Vietnam’s goods (domestic goods) Vietnam’s goods (domestic goods)
become cheaper relative to foreign become more expensive compared to
goods foreign goods
Consumers at home and abroad buy Consumers at home and abroad - buy
more Vietnam’s goods and fewer fewer Vietnam’s goods and more
goods from other countries goods from other countries
Higher exports Lower imports Lower exports Higher imports
Higher net exports Lower net exports
Real
+ exchange rate
You want to buy a pair of shoes and taking a search on internet...

Assume that there is no shipping cost

If exchange rate is 23.000 VND per USD will you buy shoes in US or Vietnam?

If exchange rate is 35.000 VND per USD will you buy shoes in US or Vietnam?
 +
• Real exchange rate = (E ˣ Pf) / Pd
E: nominal exchange rate (1 foreign currency = E Domestic currency)
Pd: price index for domestic basket
Pf: price index for foreign basket

A rise in real exchange rate: A fall in real exchange rate

Vietnam’s goods Vietnam’s goods (domestic
(domestic goods) become goods) become more
cheaper relative to A expensive compared to
foreign goods good foreign goods
must sell
Consumers at home and for the
Consumers at home and
abroad buy more same abroad - buy fewer
Vietnam’s goods and price in Vietnam’s goods and more
all
fewer goods from other goods from other countries
locations
countries Lower exports Higher
Higher exports imports
Lower imports the law of one price Lower net exports
Higher net exports
 How to determine equilibrium exchange rate

 Purchasing Power Parity Theory

 Uncovered Interest Parity

 A simple approach – supply and demand analysis

24
+
Purchasing-Power Parity
(1920s–Gustav Cassell)
+Theory of purchasing-power parity (PPP): Basic logic of
Nominal exchange rate between the purchasing-power
currencies of two countries must reflect parity Based on the
law of one price: A
the price levels in those countries good must sell for
the same price in all
locations
Arbitrage forces will lead to the equalization of goods prices
internationally once the price of goods are measured in the
same currency

Then, real exchange rate is equal 1 (R = E.Pf/Pd =1)

Then nominal exchange rate is equal to the ratio of prices in

two countries ( E = Pd/Pf)
 Absolute PPP

 Relative
PPP

Conclusion:
1. %Pd increase or %Pf decrease -> % E increase -> Changing rate of (E) > 0:
depreciation of domestic currency
2.%Pd decrease or %Pf increase -> % E decrease -> Changing rate of (E) < 0:
appreciation of domestic currency
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 Uncovered interest parity condition (UIP)
 UIP says that the expected rate of depreciation of domestic currency is
equal to the interest rate differential between domestic and foreign bonds
 This condition is to ensure the indifference between holding domestic
and foreign assets, i.e. the same rate of return.

%(En) = id – if

28
 Supply-demand approach: Exchange rate/price of
foreign currency is determined by the supply of and
demand for foreign currency.
 The demand for foreign currency comes from domestic residents who want to
buy foreign goods or assets

 The supply of foreign currency comes from foreign residents who want to buy
domestic goods or assets

29
 (R) = E.Pf/Pd

 When price of foreign currency goes up (E increases), the domestic

goods and assets become cheaper in the eye of foreigners ->
foreigners buy more domestic goods and assets -> more foreign
currency is supplied to buy domestic goods and assets

-> The supply curve of foreign currency, therefore, is upward sloping

30
 (R) = E.Pf/Pd

 When price of foreign currency goes up (E increases), the foreign

goods and assets become more expensive in the eye of domestic
residents. They don’t want to buy foreign goods and assets, so
demand for foreign currency decreases.

 The demand curve for foreign currency, therefore, is downward

sloping

31
Exchange rate
(VND/USD)

SUSD
Exchange rate E: 1 USD = VND
Susd ‘s sources are: export; foreign investment flows in to
Vietnam, foreign tourists visit Vietnam..

E0

DUSD
Exchange rate E: 1 USD = VND
Dusd ‘s sources are: import; investment to other countries,
travel to abroad…

QUSD 32
+ Practice:
Explain how does each of the following transactions
influence supply and demand in foreign exchange
market?
1. Vietnam students go abroad for university study

2. More foreigners choose Vietnam as a best destination for tourists

3. Vietnam companies invest more abroad

4. BIDV opens new branch in Laos

5. A new bridge is built using ODA funds from Japan

6. Vietnam government has a support of USD 1 million for Cuba for

economic development
+
Practice:
True – False question

1. Vietnam’s price of goods increase lead to an appreciation in

VND

2. More foreigners choose Vietnam as a best destination for

tourists

3. A fall in FDI will causes VND appreciate.

Exchange rate mechanisms

35
Three exchange rate mechanisms

 Flexible/floating exchange rate mechanism

 Fixed exchange rate mechanism

 Partially flexible exchange rate mechanism (managed floating ex

rate)

36
 Flexible/floating exchange rate mechanism

 Under flexible exchange rate mechanism, exchange rate is

completely determined the foreign exchange market without any
intervention of Central bank.

 Exchange rate easily varies in day-to-day trading due to

expectations and speculations rather than fundamental factors.

37
Exchange rate
(VND/USD)

SUSD: exchange from USD to RMB

E0

DUSD: exchange from RMB to USD

QUSD 38
 Fixed exchange rate mechanism

 Under fixed exchange rate mechanism, the central bank fixes its
exchange rate by exchange rate intervention – buying or selling
foreign currency to maintain the equilibrium of the market at the
fixed exchange rate.

39
 Tomaintain the initial Exchange rate

exchange rate 22500

(VND/USD)
SUSD
vnd/usd, Central bank S’USD
must sell foreign CB sells USD

currency/buy
domestic currency 24000

B
 Itsforeign reserves can 22500
A
be run out of
 Money base reduces 
DUSD
Shortage of USD
tightening monetary
policy QUSD

40
 Tomaintain the initial Exchange rate Surplus of USD
(VND/USD)

exchange rate 22500 SUSD

vnd/usd, Central bank

must buy foreign 22500
A
currency/sell domestic
B

currency
22000

CB buys USD
 Its
foreign reserves D’USD
increase DUSD

Money base increases 

expanding monetary QUSD

policy 41
 Exchange rate
(RMB/USD)

SUSD: exchange from USD to RMB

E0 + 5%

E0

E0 – 5%

DUSD: exchange from RMB to USD

QUSD 42
 Advantages:
 Stable exchange rate makes trade and investment easier
 Allow government to achieve certain objectives such as trade balance,
economic growth, external debt

43
 Disadvantages
 Government intervention can be harmful for the economy (inflation,
running out of foreign reserves)
 Limitations on a Central bank’s actions
 Fixed exchange rates can become unfixed when it is largely deviated
from long-run equilibrium exchange rate, then it can create enormous
monetary instability

44
• If there is a fundamental • If there is speculation on currency or
too large adjustment in currency’s
misalignment in exchange
value in a short time or adjustments
rate, policymakers allow won’t achieve balance of payments

private forces to determine goals, the policymakers have

interventions, either supporting or
it – flexible exchange pushing down currency’s value – fixed
rate exchange rate

45