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 Exports<0 Y>C+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 < Imports Net Exports > 0 Net Exports = 0 Net Exports < 0 Y > C + I + G Y = C + I + G Y < C + I + G Savings > Investment Saving = Investment Saving < Investment Net Capital Outflow > 0 Net Capital Outflow = 0 Net Capital Outflow < 0 International Flows of Goods and Capital: Summary table 5-1