Macroeconomics I

Chapter 6: The Open Economy

CHAPTER 6 The Open Economy 1

 INTRODUCTION
 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 6.1 shows the importance of trade for selected countries.
 We begin our study of open-economy macroeconomics by studying the questions of
measurement.
 To understand how an 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. We will also 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

2
 Imports and exports of selected countries, 2010
60

Exports
50 Imports
Percent of GDP

40

30

20

10

0
Australia China Germany Greece S. Korea Mexico United
States
Imports and exports of selected countries, 2021
60

50

40

30

20

10

0
Australia Argentina China Germany Greece Korea, Rep. Turkiye United States Mexico

export/GDP Import/GDP
 In an open economy,
Two important properties of an open economy:
1. spending need not equal output
2. saving need not equal investment
 To understand how this happens let’s go back to
the national income accounting equations in
Ch.2

CHAPTER 6 The Open Economy 5

 Preliminaries superscripts:
C C d C f d = spending on
domestic goods
I Id If f = spending on
foreign goods
G G d G f
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
CHAPTER 6 The Open Economy 6
 GDP = expenditure on
domestically produced g & s

Y  C d  I d  G d  EX
f f f
 (C  C )  (I  I )  (G  G )  EX

 C  I  G  EX  (C f  I f  G f )

 C  I  G  EX  IM

 C  I  G  NX

CHAPTER 6 The Open Economy 7

 The national income identity
In an open economy
in an open economy domestic spending
need not equal the
output of goods and
Y = C + I + G + NX services.
If output exceeds
domestic spending, we
export the difference:
or, NX = Y – (C + I + G ) net exports are
positive.
If output falls short of
domestic spending, we
domestic import the difference:
net exports are
net exports spending negative.

output

CHAPTER 6 The Open Economy 8

 Trade surpluses and deficits

NX = EX – IM = Y – (C + I + G )

 trade surplus:
output > spending and exports > imports
Size of the trade surplus = NX
 trade deficit:
spending > output and imports > exports
Size of the trade deficit = –NX

CHAPTER 6 The Open Economy 9

 International capital flows
 In an open economy, 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

CHAPTER 6 The Open Economy 10

 International capital flows
 Recall from Chapter 3 that Y - C - G is national saving S,
which equals the sum of private saving, Y - T -C, and
public saving, T - G, where T stands for taxes. Therefore
we have
S=I+NX
 Subtracting I from both sides of the equation, we can
write the national income accounts identity as
S-I=NX
 This national income identity shows that an economy’s
net exports are equal to the gap between its savings and
investment.

CHAPTER 6 The Open Economy 11

 International capital flows
 The right hand side of this equation is the net exports of goods and
services or the trade balance.
 Trade balance tells us how our trade in goods and services departs from
the benchmark of equal imports and exports.
 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.
(sometimes called net foreign investment.)
 Net capital outflow equals the amount that domestic residents are lending
abroad minus the amount that foreigners are lending to us.
 If net capital outflow is positive, the economy’s saving exceeds its
investment, and it is lending the excess to foreigners.
 If the net capital outflow is negative, the economy is experiencing a capital
inflow: investment exceeds saving, and the economy is financing this extra
investment by borrowing from abroad.
 Thus, net capital outflow reflects the international flow of funds to finance
capital accumulation.

CHAPTER 6 The Open Economy 12

 International capital flows
 Net capital outflow
=S –I
= net outflow of “loanable funds”
= net purchases of foreign assets
the country’s purchases of foreign assets
minus foreign purchases of domestic assets

 When S > I, country is a net lender

 When S < I, country is a net borrower

CHAPTER 6 The Open Economy 13

 The link between trade & cap. flows

NX = Y – (C + I + G )
implies
NX = (Y – C – G ) – I
= S – I
trade balance = net capital outflow

Thus,
a country with a trade deficit ( NX < 0)
is a net borrower (S < I ).

CHAPTER 6 The Open Economy 14

 International capital flows
 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.
 Thus, the national income accounts identity shows that the
international flow of funds to finance capital accumulation and the
international flow of goods and services are two sides of the same
coin.
 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.
 make6 loans
CHAPTER ThetoOpen
us. Economy 15
 Saving, investment, and the trade balance
1960–2012
25% 15%
investment
Saving, Investment (% of GDP)

20% 10%

Trade Balance (% of GDP)

15% 5%
saving
10% 0%

5% -5%
trade balance
(right scale)
0% -10%
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
 U.S.: The world’s largest debtor nation
 Every year since 1980s: huge trade deficits and
net capital inflows, i.e. net borrowing from abroad
 As of 12/31/2011:
 U.S. residents owned $21.1 trillion worth of
foreign assets
 Foreigners owned $25.1 trillion worth of
U.S. assets
 U.S. net indebtedness to rest of the world:
$4.0 trillion—higher than any other country,
hence U.S. is the “world’s largest debtor nation”
CHAPTER 6 The Open Economy 17
 Turkiye: NX/GDP

40

35

30

25

20

15

10

0
75 977 979 981 983 985 987 989 991 993 995 997 999 001 003 005 007 009 011 013 015 017 019 021
19 1 1 1 1 1 1 1 1 1 1 1 1 2 2 2 2 2 2 2 2 2 2 2
-5

-10

Exports/GDP Imports/GDP Net exports/GDP

CHAPTER 6 The Open Economy 18

 Turkiye: External Debt Stock to GDP
ratio

70

60

50

40

30

20

10

0
70 73 76 79 82 85 88 91 94 97 00 03 06 09 12 15 18 21
19 19 19 19 19 19 19 19 19 19 20 20 20 20 20 20 20 20

CHAPTER 6 The Open Economy 19

Saving and investment in a small open economy
 Our next step is to develop a model that explains the behavior
of these variables.
 An open-economy version of the loanable funds model from
Chapter 3.
 We can then use the model to answer questions such as how
the trade balance responds to changes in policy.
 Unlike with 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.

CHAPTER 6 The Open Economy 20

Saving and investment in a small open economy
 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.

CHAPTER 6 The Open Economy 21

Saving and investment in a small open economy
 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

CHAPTER 6 The Open Economy 22

Saving and investment in a small open economy
 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, it has a negligible effect on
world saving and world investment.
 Hence, our small open economy takes the world interest rate as
exogenously given.
 Includes many of the same elements:
 production function Y  Y  F (K , L )
 consumption function C  C (Y  T )
 investment function I  I (r )
 exogenous policy variables
G  G , T T

CHAPTER 6 The Open Economy 23

Saving and investment in a small open economy
 We can now return to the accounting identity and write it as
NX = (Y - C - G) - I
NX = S –I
 Substituting the Chapter 3 assumptions recapped
above and the assumption that the interest rate
equals the world interest rate, we obtain

CHAPTER 6 The Open Economy 24

 National saving:
The supply of loanable funds
r S  Y  C (Y  T )  G

As in Chapter 3,
national saving does
not depend on the
interest rate

S S, I
CHAPTER 6 The Open Economy 25
 Assumptions about capital flows

a. domestic & foreign bonds are perfect substitutes

(same risk, maturity, etc.)
b. perfect capital mobility:
no restrictions on international trade in assets
c. economy is small:
cannot affect the world interest rate, denoted r*

a & b imply r = r*
c implies r* is exogenous
CHAPTER 6 The Open Economy 26
 Investment:
The demand for loanable funds
r Investment is still a
downward-sloping function
of the interest rate,
but the exogenous
world interest rate…
r*
…determines the
country’s level of
investment.
I (r )

I (r* ) S, I
CHAPTER 6 The Open Economy 27
 If the economy were closed…
r S
…the interest
rate would
adjust to
equate
investment
and saving: rc
I (r )

I (rc ) S, I
S
CHAPTER 6 The Open Economy 28
 But in a small open economy…
r
the exogenous S
world interest
rate determines
investment… NX
r*
…and the
difference rc
between saving
and investment I (r )
determines net
capital outflow
I1 S, I
and net exports
CHAPTER 6 The Open Economy 29
 Next, three experiments:
1. Fiscal policy at home

2. Fiscal policy abroad

3. An increase in investment demand

(exercise)

CHAPTER 6 The Open Economy 30

 1. Fiscal policy at home
r S 2 S1
An increase in G
or decrease in T NX2
reduces saving. r1
*

NX1
Results:
I  0
NX  S  0 I (r )

I1 S, I

CHAPTER 6 The Open Economy 31

NX and the federal budget deficit
(% of GDP), 1965–2012
10% 2%
Budget deficit
8% (left scale)
0%
6%

4%
-2%
2%

0%
-4%
Net exports
-2%
(right scale)
-4% -6%
1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
 2. Fiscal policy abroad
r S1
Expansionary NX2
fiscal policy
abroad raises r2*
NX1
the world
r1
*
interest rate.

Results:
I  0 I (r )
NX  I  0 S, I
I (r )
2
*
I (r1* )

CHAPTER 6 The Open Economy 33

NOW YOU TRY
3. An increase in investment demand
r
Use the S
model to
determine r *

the impact of
an increase
NX1
in investment
demand on
NX, S, I, and I (r )1

net capital I1 S, I
outflow.
34
ANSWERS
3. An increase in investment demand
r
S
I > 0, NX2
S = 0, r *

net capital
outflow and
NX fall NX1
by the I (r )2
amount I
I (r )1

I1 I2 S, I

35
 The nominal exchange rate
• Having examined the international flows of capital and of goods and
services, we now extend the analysis by considering the prices that apply to
these transactions.
• The exchange rate between two countries is the price at which residents of
those countries trade with each other.
• Economists distinguish between two exchange rates: the nominal exchange
rate and the real exchange rate.
• e = nominal exchange rate. The relative price of domestic currency in
terms of foreign currency (e.g. yen per dollar)
• For example, if the exchange rate between the U.S. dollar and the
Japanese yen is 80 yen per dollar, then you can exchange one dollar for 80
yen in world markets for foreign currency.
• A Japanese who wants to obtain dollars would pay 80 yen for each dollar
he bought.
• For the most recent nominal exchange rates
https://www.x-rates.com/

CHAPTER 6 The Open Economy 36

 The nominal exchange rate
• Notice that an exchange rate can be reported in two ways. If one dollar
buys 80 yen, then one yen buys 0.0125 dollar.
• We can say the exchange rate is 80 yen per dollar, or we can say the
exchange rate is 0.0125 dollar per yen.
• Because 0.0125 equals 1/80, these two ways of expressing the exchange
rate
are equivalent.
• The convention used in this book always expresses the exchange rate in
units of foreign currency per dollar.(domestic currency)
• With this convention, a rise in the exchange rate—say, from 80 to 100 yen
per dollar—is called an appreciation of the dollar; a fall in the exchange rate
is
called a depreciation.
• When the domestic currency appreciates, it buys more of the foreign
currency; when it depreciates, it buys less.
• An appreciation is sometimes called a strengthening of the currency, and a
depreciation
CHAPTER 6 TheisOpen
sometimes called a weakening of the currency.
Economy 37
A few exchange rates, as of 5/24/2012
country exchange rate
Euro area 0.79 euro/$
Indonesia 9,437 rupiahs/$
Japan 79.6 yen/$
Mexico 14.0 pesos/$
Russia 31.79 rubles/$
South Africa 8.35 rand/$
U.K. 0.63 pounds/$
 The real exchange rate
• The real exchange rate is the relative price of the goods of
two countries.
• That is, the real exchange rate tells us the rate at which we
can trade the goods of one country for the goods of another.
• The real exchange rate is sometimes called the terms of
trade.
ε = real exchange rate,
the relative price of
the domestic goods
lowercase in terms of foreign goods
Greek letter
epsilon (e.g. Japanese Big Macs per U.S. Big
Mac)
CHAPTER 6 The Open Economy 39
 Understanding the units of ε
• To see the relation between the real and nominal exchange
rates, consider a single good produced in many countries:
cars.
• Suppose an American car costs $25,000 and a similar
Japanese car costs 4,000,000 yen.
• To compare the prices of the two cars, we must convert them
into a common currency.
• If a dollar is worth 80 yen, then the American car costs 80 x
25,000, or 2,000,000 yen.
• Comparing the price of the American car (2,000,000 yen) and
the price of the Japanese car (4,000,000 yen), we conclude
that the American car costs one-half of what the Japanese car
costs.
• In other words, at current prices, we can exchange two
American cars for one Japanese car.
CHAPTER 6 The Open Economy 40
 Understanding the units of ε
We can summarize our calculation as follows:

At these prices and this exchange rate, we obtain one-half of a Japanese car per
American car. More generally, we can write this calculation as

CHAPTER 6 The Open Economy 41

 Understanding the units of ε
• The rate at which we exchange foreign and domestic goods depends on
the prices of the goods in the local currencies and on the rate at which
the currencies are exchanged.
• This calculation of the real exchange rate for a single good suggests how
we should define the real exchange rate for a broader basket of goods.
• Let e be the nominal exchange rate (the number of yen per dollar), P be
the price level in the United States (measured in dollars), and P * be the
price level in Japan (measured in yen).
• Then the real exchange rate

• The real exchange rate between two countries is computed from the nominal
exchange rate and the price levels in the two countries.
• If the real exchange rate is high, foreign goods are relatively cheap, and
domestic goods are relatively expensive.
• If the real exchange rate is low, foreign goods are relatively expensive, and
domestic goods are relatively cheap.
CHAPTER 6 The Open Economy 42
 ~ McZample ~
 one good: Big Mac
 price in Japan:
P* = 200 Yen
 price in USA:
P = $2.50
 nominal exchange rate
e = 120 Yen/$ To buy a U.S. Big Mac,
e P someone from Japan
𝝐 P * would have to pay an
120  $2.50 amount that could buy
  1.5 1.5 Japanese Big Macs.
200 Yen
CHAPTER 6 The Open Economy 43
 The Real Exchange rate and the trade
balance
 What macroeconomic influence does the real exchange rate exert?
 The real exchange rate is nothing more than a relative price.
 Just as the relative price of hamburgers and pizza determines which
you choose for lunch, the relative price of domestic and foreign goods
affects the demand for these goods.
 Suppose first that the real exchange rate is low. In this case, because
domestic goods are relatively cheap, domestic residents will want to
purchase fewer imported goods.
 For the same reason, foreigners will want to buy many of our goods.
As a result of both of these actions, the quantity of our net exports
demanded will be high.

CHAPTER 6 The Open Economy 44

 The Real Exchange rate and the trade
balance
 The opposite occurs if the real exchange rate is high.
 Because domestic goods are expensive relative to foreign
goods, domestic residents will want to buy many imported
goods, and foreigners will want to buy few of our goods.
 Therefore, the quantity of our net exports demanded will be
low.
 We write this relationship between the real exchange rate
and net exports as

 This net exports function reflects this inverse relationship

between NX and
CHAPTER 6 The Open Economy 45
 U.S. net exports and the real exchange rate,
1973–2012
4% 140
Trade-weighted real
2%
exchange rate index 120

Index (March 1973 = 100)

100
NX (% of GDP)

0%
80
-2%
60
-4%
40

-6% Net exports

20
(left scale)
-8% 0
1970.00 1975.75 1981.50 1987.25 1993.00 1998.75 2004.50 2010.25
 The NX curve for the U.S.

so U.S. net
When is exports will
relatively low, be high
U.S. goods are
relatively 1

inexpensive
NX ()
0
NX(1) NX
CHAPTER 6 The Open Economy 47
 The NX curve for the U.S.

𝝐 At high enough
values of ε,
2
U.S. goods become
so expensive that
US exports
less than it
imports.

NX ()

NX(2) 0 NX
CHAPTER 6 The Open Economy 48
 How is determined
 We now have all the pieces needed to construct a model that explains
what factors determine the real exchange rate.
 In particular, we combine the relationship between net exports and the
real exchange rate we just discussed with the model of the trade
balance we developed earlier in the chapter.
 We can summarize the analysis as follows:
 The real value of a currency is inversely related to net exports. When
the real exchange rate is lower, domestic goods are less expensive
relative to foreign goods, and net exports are greater.
 The trade balance (net exports) must equal the net capital outflow,
which in turn equals saving minus investment. (Previous class)
 Saving is fixed by the consumption function and fiscal policy;
investment is fixed by the investment function and the world interest
rate.

CHAPTER 6 The Open Economy 49

 How is determined

 The accounting identity says NX = S – I

 We saw earlier how S – I is determined:
 S depends on domestic factors (output, fiscal
policy variables, etc.)
 I is determined by the world interest
rate r *
 So, must adjust to ensure
NX (ε )  S  I (r *)

CHAPTER 6 The Open Economy 50

 How is determined

Neither S nor I S 1  I (r *)
depends on , ε
so the net capital
outflow curve is
vertical.

ε1
adjusts to
equate NX NX(ε )
with net capital
outflow, S - I. NX
NX 1

CHAPTER 6 The Open Economy 51

 Interpretation: supply and demand
in the foreign exchange market
demand: S 1  I (r *)
ε
Foreigners need Equilibrium
dollars to buy real exchange
U.S. net exports. rate: Supply of
dollars=demand
for dollars
supply: ε1
Net capital
outflow (S - I ) NX(ε )
is the supply of
NX
dollars to be NX 1
invested abroad.
CHAPTER 6 The Open Economy 52
 Next, four experiments:
1. Fiscal policy at home
2. Fiscal policy abroad
3. An increase in investment demand
(exercise)
4. Trade policy to restrict imports

CHAPTER 6 The Open Economy 53

 1. Fiscal policy at home

A fiscal expansion S 2  I (r *)
reduces national ε S 1  I (r *)
saving, net capital
outflow, and the supply
of dollars ε2
in the foreign exchange
market or to be invested
abroad. ε1

NX(ε )
causing the real exchange rate to
rise. Domestic goods become more NX
expensive compared to foreign NX 2 NX 1
goods thus exports fall imports rise
NX falls
CHAPTER 6 The Open Economy 54
 2. Fiscal policy abroad
If foreign governments
increase government
purchases or cut taxes? S 1  I (r1 *)
Either change in fiscal
policy reduces world ε S 1  I (r2 *)
saving and raises the
world interest rate.
An increase in r* reduces ε1
investment, increasing
net capital outflow and
the supply of dollars in ε2
the foreign exchange
market.
NX(ε )
Causing the real exchange rate to
fall. The dollar becomes less NX
valuable, and domestic goods NX 1 NX 2
become less expensive relative to
foreign goods and NX to rise.
CHAPTER 6 The Open Economy 55
NOW YOU TRY
3. Increase in investment demand

Determine the ε S1  I 1
impact of an
increase in
investment
demand on net
exports, net ε1
capital outflow,
NX(ε )
and the real NX
exchange rate. NX 1

56
 ANSWERS
3. Increase in investment demand
S1  I 2
An increase in
ε S1  I 1
investment reduces
net capital outflow
and the supply ε2
of dollars in the
foreign exchange
market.
ε1

NX(ε )

NX
This causes the real exchange NX 2 NX 1
rate to rise making the US
dollar more valuable and
hence NX to fall. 57
 4. Trade policy to restrict imports

• Trade policies, broadly defined, are policies designed to directly

influence the amount of goods and services exported or
imported.
• Most often, trade policies take the form of protecting domestic
industries from foreign competition either by placing a tax on
foreign imports (a tariff) or restricting the amount of goods and
services that can be imported (a quota).
• For an example of a protectionist trade policy, consider what
would happen if the government prohibited the import of foreign
cars.
• For any given real exchange rate, imports would now be lower,
implying that net exports (exports minus imports) would be
higher. Thus, the net-exports schedule would shift outward

CHAPTER 6 The Open Economy 58

 4. Trade policy to restrict imports
 The real exchange rate appreciates because the quota has raised the
net demand for dollars associated with any given value of the
exchange rate.
 But the equilibrium level of net exports doesn’t change, because the
supply of dollars in the foreign exchange market (S-I) has not been
affected by the trade policy. (Remember, S = Y-C-G, and the trade
policy does not affect Y, C, or G; the policy also does not affect I,
because I = I(r*) and r* is exogenous.)
 The appreciation causes exports to fall.
 And, since exports are lower but NX is unchanged, it must be the case
that IM is lower too, which is what you’d expect from a trade policy
that restricts imports.

CHAPTER 6 The Open Economy 59

 4. Trade policy to restrict imports

At any given value of

ε, an import quota ε S I
 IM 
NX
ε
 demand for 2

ε1
dollars shifts
NX (ε )2
Trade right
policy doesn’t
affect S or I , so NX (ε )1
capital flows and the
NX
supply of dollars NX1
remain fixed.
CHAPTER 6 The Open Economy 60
 4. Trade policy to restrict imports

Results:
ε S I
ε > 0
(demand
increase) ε2
NX = 0
(supply fixed) ε1
IM < 0 NX (ε )2
(policy)
NX (ε )1
EX < 0
(rise in ε ) NX
NX1

CHAPTER 6 The Open Economy 61

4. Trade policy to restrict imports
 Although protectionist trade policies do not alter the trade balance,
they do affect the amount of trade.
 As we have seen, because the real exchange rate appreciates, the
goods and services we produce become more expensive relative to
foreign goods and services.
 We therefore export less in the new equilibrium.
 Because net exports are unchanged, we must import less as well.
(The appreciation of the exchange rate does stimulate imports to
some extent, but this only partly offsets the decrease in imports due to
the trade restriction.)
 Thus, protectionist policies reduce both the quantity of imports and the
quantity of exports.

CHAPTER 6 The Open Economy 62

4. Trade policy to restrict imports
 This fall in the total amount of trade is the reason economists usually
oppose protectionist policies.
 International trade benefits all countries by allowing each country to
specialize in what it produces best and by providing each country with
a greater variety of goods and services.
 Protectionist policies diminish these gains from trade. Although these
policies benefit certain groups within society-for example, a ban on
imported cars helps domestic car producers.
 Society on average is worse off when policies reduce the amount of
international trade.

CHAPTER 6 The Open Economy 63

The determinants of the nominal exchange rate

 Start with the expression for the real exchange

rate: e P
ε 
P*
 Solve for the nominal exchange rate:
P*
e  ε 
P

CHAPTER 6 The Open Economy 64

 The determinants of the
nominal exchange rate
 So e depends on the real exchange rate and the
price levels at home and abroad.
 Given the value of the real exchange rate, if the
domestic price level P rises, then the nominal
exchange rate e will fall: because a dollar is worth
less, a dollar will buy fewer yen.
 However, if the Japanese price level P * rises, then
the nominal exchange rate will increase: because the
yen is worth less, a dollar will buy more yen.

CHAPTER 6 The Open Economy 65

 The determinants of the
nominal exchange rate
P*
e  ε 
P
 Rewrite this equation in growth rates
(see “arithmetic tricks for working with percentage
changes,” Chapter 2 ):

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 inflation rates.
CHAPTER 6 The Open Economy 66
 The determinants of the
nominal exchange rate

e ε P * P ε
     *  
e ε P *
P ε

• This equation states that the percentage change in the nominal

exchange rate between the currencies of two countries equals the
percentage change in the real exchange rate plus the difference in
their inflation rates.
• If a country has a high rate of inflation relative to the United States, a
dollar will buy an increasing amount of the foreign currency over time.
• If a country has a low rate of inflation relative to the United States, a
dollar will buy a decreasing amount of the foreign currency over time.

CHAPTER 6 The Open Economy 67

 The determinants of the
nominal exchange rate

e ε P * P ε
     *  
e ε P *
P ε

This analysis shows how monetary policy affects the nominal exchange rate.
High growth in the money supply leads to high inflation.
We have just seen that one consequence of high inflation is a depreciating
currency: high implies falling e.
In other words, just as growth in the amount of money raises the price of goods
measured in terms of money, it also tends to raise the price of foreign currencies
measured in terms of the domestic currency.

CHAPTER 6 The Open Economy 68

 The determinants of the
nominal exchange rate
 So e depends on the real exchange rate and
the price levels at home and abroad…
…and we know how each
of them is determined: M*
 L *
(r *   *, Y *
)
P *

P*
e  ε 
P
M
 L (r *   , Y )
NX (ε )  S  I (r *) P
CHAPTER 6 The Open Economy 69
 Inflation differentials and nominal exchange
rates for a cross section of countries
% change 8%
in nominal Iceland
6% Pakistan
exchange
rate 4% Mexico

2% U.K. S. Africa
Sweden S. Korea
0%
Japan Denmark
-2%
Canada
Singapore
-4% Australia
Switzerland New Zealand
-6%
-4% -2% 0% 2% 4% 6% 8%

inflation differential
 Law of One Price
 A famous hypothesis in economics, called the law of one price, states that
the same good cannot sell for different prices in different locations at the
same time.
 If a bushel of wheat sold for less in New York than in Chicago, it would be
profitable to buy wheat in New York and then sell it in Chicago.
 This profit opportunity would become quickly apparent to arbitrageurs—
people who specialize in “buying low” in one market and “selling high” in
another.
 As the arbitrageurs took advantage of this opportunity, they would increase
the demand for wheat in New York and increase the supply of wheat in
Chicago.
 Their actions would drive the price up in New York and down in Chicago,
thereby ensuring that prices are equalized in the two markets

CHAPTER 6 The Open Economy 71

Purchasing Power Parity (PPP)
 The law of one price applied to the international marketplace is called
purchasing-power parity.
 It states that if international arbitrage is possible, then a dollar (or any
other currency) must have the same purchasing power in every country.
 If a dollar could buy more wheat domestically than abroad, there would
be opportunities to profit by buying wheat domestically and selling it
abroad.
 If a dollar could buy more wheat abroad than domestically, the
arbitrageurs 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
 Similarly, a small increase in the relative price of domestic goods causes
arbitrageurs to import goods from abroad.

CHAPTER 6 The Open Economy 72

 Purchasing Power Parity (PPP)

 PPP: e P = P* Cost of a basket of

foreign goods, in
foreign currency.

Cost of a basket of Cost of a basket of

domestic goods, in domestic goods, in
foreign currency. domestic currency.

 Solve for e : e = P*/ P

 PPP implies that the nominal exchange rate
between two countries equals the ratio of the
countries’ price levels.
CHAPTER 6 The Open Economy 73
 Purchasing Power Parity (PPP)

 If e = P*/P,
P P *
P
thenε  e  *   * 1
P P P
and the NX curve is horizontal:
ε
S -I Under PPP,
changes in
(S – I ) have no
ε =1 NX impact on ε or e.

NX
CHAPTER 6 The Open Economy 74
 Purchasing Power Parity (PPP)
Two definitions:
 A doctrine that states that goods must sell at the
same (currency-adjusted) price in all countries.
 The nominal exchange rate adjusts to equalize the
cost of a basket of goods across countries.
Reasoning:
 arbitrage, the law of one price

CHAPTER 6 The Open Economy 75

 Does PPP hold in the real world?
No, for two reasons:
1. International arbitrage not possible.
 nontraded goods
 transportation costs
2. Different countries’ goods not perfect substitutes.

Yet, PPP is a useful theory:

 It’s simple & intuitive.
 In the real world, nominal exchange rates
tend toward their PPP values over the long run.

CHAPTER 6 The Open Economy 76