MACROECONOMICS CHAPTER 6
The International Flows of Capital and Goods Open economies vs closed economies
● Key difference
● 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
● Closed economy: none of that
The Role of Net Exports National accounts identity in an open economy
● Y = Total expenditure on an economy’s output of
goods and services
● In a closed economy:
○ All output→ sold domestically
○ Expenditure→ divided into:
■ Consumption (C)
■ Investment (I)
■ Government purchases (G)
● In an open economy:
○ Some output→ sold domestically
○ Some output→ exported to be sold
abroad
○ Some goods and services included in
(C), (I) and (G) → produced abroad
and imported
● New National accounts identity:
○ Y =C + I + G+ X−ℑ
○ X =¿ exports
○ ℑ=¿ imports
■ Imports are subtracted because
they are included in domestic
spending (C+I+G) but not part of a
country’s output (Y)
Net exports
● NX = exports – imports
○ NX = X – IM
● New National accounts identity:
○ Y =C + I + G+ NX
How Y, C, I, G and NX are related
● NX =Y −(C+ I +G)
● Net exports = Output – Domestic Spending
● If Output > Domestic spending
○ The country exports the difference
○ Net exports are positive
● If Output < Domestic spending
○ The country imports the difference
○ Net exports are negative
, MACROECONOMICS CHAPTER 6
● This confirms→ In an open economy,
domestic spending need not equal the
output of goods and services
International Capital Flows and the Trade Balance Financial markets and goods markets
● Y =C + I + G+ NX
● Becomes (Y −C−G)=( I+ NX)
○ (Y −C−G)=¿ National Savings ( S)
■ AKA the sum of private and public
saving
○ Y −T −C (Private Saving)
○ T −G (Public Saving)
● So S=( I + NX) and S−I =NX
Trade balance
● Another name for net exports (NX)
● It tells us how a country’s trade in goods and
services departs from the benchmark of equal
imports (IM) and exports (X)
Net capital outflow
● The difference between domestic saving
and domestic investment → (S−I )
● Net capital outflow (S – I):
○ The amount that domestic residents lend
abroad minus the amount that foreigners
lend to us
● If net capital outflow→ positive
○ Saving (S) > Investment (I)
○ It’s lending the excess to foreigners.
● If net capital outflow→ negative
○ Investment (I) > Saving (S)
○ The economy finances this extra
investment by borrowing from abroad
○ This is called a capital inflow
● Conclusions→ net capital outflow reflects
the international flow of funds to finance
capital accumulation
● S−I =NX shows that net capital outflow (S – I)
always equals the trade balance (NX)
● Trade surplus→ If (S – I) and NX are positive
○ The country is a net lender in world
financial markets, and it exports more
than it imports.
● Trade deficit→ If (S – I) and NX are negative
○ The country is a net borrower in world
financial markets, and it imports more
than it exports.
● Balanced trade→ If (S – I) and NX are
exactly 0
○ The country’s imports and exports are
equal in value.
, MACROECONOMICS CHAPTER 6
The Irrelevance of Bilateral Trade Balances Bilateral trade balances
● A nation’s trade balance with another nation
● A nation can have large trade deficits and
surpluses with specific trading partners while
having balanced trade overall
Capital Mobility and the World Interest Rate What determines the real interest rate
● The real interest rate does not adjust to
equilibrate saving and investment in the model of
the international flows of capital and goods
● So what determines it?
● Consider a small open economy with perfect
capital mobility
○ Small open economy: the economy
is a small part of the world market→
minor effect on the world interest
rate
○ Perfect capital mobility: residents of
the country have full access to world
financial markets→ the government
does not impede international
borrowing / lending
● World interest rate ¿
○ Because of perfect capital mobility
assumption, the interest rate (r) in our
small open economy must equal the world
interest rate (r*)
● So the real interest rate prevailing in world
financial markets→ r = r*
● Small open economy residents never have to:
○ Borrow at any interest rate above r*
■ Because they can always get a
loan at r* from abroad.
○ Lend at any interest rate below r*
■ Because they can always earn r*
by lending abroad.
● Conclusion→ the world interest rate (r*)
determines the interest rate (r) in a small
open economy.
What determines the world real interest rate
● The equilibrium of world saving and world
investment
● A small open economy→ minor effect on
the world real interest rate (r*) because it
has a minor effect on both of those.
● Conclusion→ a small open economy takes
the world interest rate as exogenously
given
The model of the international flows of capital and goods 3 assumptions
The International Flows of Capital and Goods Open economies vs closed economies
● Key difference
● 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
● Closed economy: none of that
The Role of Net Exports National accounts identity in an open economy
● Y = Total expenditure on an economy’s output of
goods and services
● In a closed economy:
○ All output→ sold domestically
○ Expenditure→ divided into:
■ Consumption (C)
■ Investment (I)
■ Government purchases (G)
● In an open economy:
○ Some output→ sold domestically
○ Some output→ exported to be sold
abroad
○ Some goods and services included in
(C), (I) and (G) → produced abroad
and imported
● New National accounts identity:
○ Y =C + I + G+ X−ℑ
○ X =¿ exports
○ ℑ=¿ imports
■ Imports are subtracted because
they are included in domestic
spending (C+I+G) but not part of a
country’s output (Y)
Net exports
● NX = exports – imports
○ NX = X – IM
● New National accounts identity:
○ Y =C + I + G+ NX
How Y, C, I, G and NX are related
● NX =Y −(C+ I +G)
● Net exports = Output – Domestic Spending
● If Output > Domestic spending
○ The country exports the difference
○ Net exports are positive
● If Output < Domestic spending
○ The country imports the difference
○ Net exports are negative
, MACROECONOMICS CHAPTER 6
● This confirms→ In an open economy,
domestic spending need not equal the
output of goods and services
International Capital Flows and the Trade Balance Financial markets and goods markets
● Y =C + I + G+ NX
● Becomes (Y −C−G)=( I+ NX)
○ (Y −C−G)=¿ National Savings ( S)
■ AKA the sum of private and public
saving
○ Y −T −C (Private Saving)
○ T −G (Public Saving)
● So S=( I + NX) and S−I =NX
Trade balance
● Another name for net exports (NX)
● It tells us how a country’s trade in goods and
services departs from the benchmark of equal
imports (IM) and exports (X)
Net capital outflow
● The difference between domestic saving
and domestic investment → (S−I )
● Net capital outflow (S – I):
○ The amount that domestic residents lend
abroad minus the amount that foreigners
lend to us
● If net capital outflow→ positive
○ Saving (S) > Investment (I)
○ It’s lending the excess to foreigners.
● If net capital outflow→ negative
○ Investment (I) > Saving (S)
○ The economy finances this extra
investment by borrowing from abroad
○ This is called a capital inflow
● Conclusions→ net capital outflow reflects
the international flow of funds to finance
capital accumulation
● S−I =NX shows that net capital outflow (S – I)
always equals the trade balance (NX)
● Trade surplus→ If (S – I) and NX are positive
○ The country is a net lender in world
financial markets, and it exports more
than it imports.
● Trade deficit→ If (S – I) and NX are negative
○ The country is a net borrower in world
financial markets, and it imports more
than it exports.
● Balanced trade→ If (S – I) and NX are
exactly 0
○ The country’s imports and exports are
equal in value.
, MACROECONOMICS CHAPTER 6
The Irrelevance of Bilateral Trade Balances Bilateral trade balances
● A nation’s trade balance with another nation
● A nation can have large trade deficits and
surpluses with specific trading partners while
having balanced trade overall
Capital Mobility and the World Interest Rate What determines the real interest rate
● The real interest rate does not adjust to
equilibrate saving and investment in the model of
the international flows of capital and goods
● So what determines it?
● Consider a small open economy with perfect
capital mobility
○ Small open economy: the economy
is a small part of the world market→
minor effect on the world interest
rate
○ Perfect capital mobility: residents of
the country have full access to world
financial markets→ the government
does not impede international
borrowing / lending
● World interest rate ¿
○ Because of perfect capital mobility
assumption, the interest rate (r) in our
small open economy must equal the world
interest rate (r*)
● So the real interest rate prevailing in world
financial markets→ r = r*
● Small open economy residents never have to:
○ Borrow at any interest rate above r*
■ Because they can always get a
loan at r* from abroad.
○ Lend at any interest rate below r*
■ Because they can always earn r*
by lending abroad.
● Conclusion→ the world interest rate (r*)
determines the interest rate (r) in a small
open economy.
What determines the world real interest rate
● The equilibrium of world saving and world
investment
● A small open economy→ minor effect on
the world real interest rate (r*) because it
has a minor effect on both of those.
● Conclusion→ a small open economy takes
the world interest rate as exogenously
given
The model of the international flows of capital and goods 3 assumptions
