Mankiw 5/e Chapter 5: The Open Economy

Imports and Exports as a percentage of output: 2000 Percentage40 of GDP 35 30 25 20 15 10 5 0 Canada France Germany Imports Exports Italy Japan U.K. U.S. slide 1 Three experiments 1. Fiscal policy at home 2. Fiscal policy abroad 3. An increase in investment demand slide 2

1. Fiscal policy at home r An increase in G or decrease in T reduces saving. * 1 S 2 S1 NX2 r NX1 Results: I 0 I (r ) NX S 0 I1 S, I slide 3 NX and the Government Budget Deficit Budget deficit (right scale) Net exports (left scale)

slide 4 2. Fiscal policy abroad Expansionar y fiscal policy abroad raises the world interest rate. Results: r NX2 r2* S1 NX * 1 r 1 I 0 I (r ) NX I 0 *

2 I (r ) I (r1* ) S, I slide 5 3. An increase in investment demand r S r* EXERCISE: Use the model to determine the impact of an increase in investment demand on NX, S, I, and net capital outflow. NX 1 I (r )1 I1 S, I slide 6 3. An increase in investment demand

r ANSWERS: I > 0, S = 0, net capital outflows and net exports fall by the amount I S NX r* 2 NX I (r )2 1 I (r )1 I1 I2 S, I slide 7 2 140

1 120 0 100 -1 80 -2 60 -3 40 -4 20 -5 0 1975 1980 1985

1990 1995 1998:2 = 100 Percent of GDP U.S. Net Exports and the Real Exchange Rate, 1975-2002 2000 Net exports (left scale) Real exchange rate (right scale) slide 8 Four experiments 1. Fiscal policy at home 2. Fiscal policy abroad 3. An increase in investment demand 4. Trade policy to restrict imports slide 9 1. Fiscal policy at home A fiscal expansion reduces national saving, net capital outflows, and the supply of dollars in the foreign exchange

market causing the real exchange rate to rise and NX to fall. S 2 I (r *) S1 I (r *) 2 1 NX 2 NX 1 NX( ) NX slide 10 2. Fiscal policy abroad An increase in r* reduces investment, increasing net capital outflows and the supply of dollars in the foreign exchange market

causing the real exchange rate to fall and NX to rise. S1 I (r1*) S1 I (r2* ) 1 2 NX 1 NX 2 NX( ) NX slide 11 3. An increase in investment demand An increase in investment reduces net capital outflows and the supply of dollars in the foreign

exchange market causing the real exchange rate to rise and NX to fall. S1 I 2 S1 I 1 2 1 NX 2 NX 1 NX( ) NX slide 12 4. Trade policy to restrict imports At any given value of , an import quota IM NX demand for dollars shifts right

Trade policy doesnt affect S or I , so capital flows and the supply of dollars remains fixed. S I 2 1 NX ( )2 NX ( )1 NX1 NX slide 13 4. Trade policy to restrict imports Results: > 0 (demand increase) NX = 0 (supply fixed) IM < 0 (policy) EX < 0 (rise in )

S I 2 1 NX ( )2 NX ( )1 NX1 NX slide 14 Inflation and nominal exchange rates Percentage10 change 9 in nominal exchange 8 rate 7 6 5 4 3 2 1 South Africa Depreciation relative to U.S. dollar Italy New Zealand

Australia Spain Sweden Ireland Canada Belgium 0 -1 Germany Netherlands -2 Switzerland -3 Japan -4 -3 -2 -1 0 UK France Appreciation relative to U.S. dollar 1 2 3 4

5 6 7 8 Inflation differential slide 15 CASE STUDY The Reagan Deficits revisited 1970 s 1980 s actual change closed economy small open economy GT 2.2 3.9

S 19.6 17.4 r 1.1 6.3 no change I 19.9 19.4

no change NX -0.3 -2.0 no change no change 115.1 129.4 Data: decade averages; all except r and are expressed as a percent of GDP; is a trade-weighted index. slide 16