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Review of the previous lectureNominal interest rateequals real interest rate + inflation rate. Fisher effect: nominal interest rate moves one-for-one w/ expected inflation. is the opp. cost of holding money
Money demanddepends on income in the Quantity Theorymore generally, it also depends on the nominal interest rate; if so, then changes in expected inflation affect the current price level.
Review of the previous lectureCosts of inflationExpected inflation shoeleather costs, menu costs, tax & relative price distortions, inconvenience of correcting figures for inflation
Unexpected inflation all of the above plus arbitrary redistributions of wealth between debtors and creditors
Review of the previous lectureHyperinflationcaused by rapid money supply growth when money printed to finance govt budget deficitsstopping it requires fiscal reforms to eliminate govts need for printing money
Lecture 21
Open economy - IInstructor: Prof.Dr.Qaisar AbbasCourse code: ECO 400
Lecture Outline
Open economy
Saving and investment
Three experiment
Open economyspending need not equal output
saving need not equal investment
Preliminaries
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
superscripts:d =spending on domestic goodsf =spending on foreign goods
Open economyGDP = expenditure on domestically produced g & s
Open economyThe national income identity in an open economy
Y = C + I + G + NXor, NX = Y (C + I + G )
Open economyTrade surpluses and deficits
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
NX = EX IM = Y (C + I + G )
Open economyInternational capital flows Net capital outflows=S I
=net outflow of loanable funds
=net purchases of foreign assets the countrys 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
Link between trade & cap. flowsThe link between trade & cap. flows
NX = Y (C + I + G )implies
NX = (Y C G ) I
= S Itrade balance = net capital outflows
Thus, a country with a trade deficit (NX < 0) is a net borrower (S < I ).
Saving and Investment in a Small Open EconomyAn open-economy version of the loanable funds model includes
Saving and InvestmentNational Saving: The Supply of Loanable Funds
Saving and InvestmentAssumptions re: capital flowsdomestic & 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
Saving and InvestmentInvestment: The Demand for Loanable Funds
Investment is still a downward-sloping function of the interest rate,but the exogenous world interest ratedetermines the countrys level of investment.
Saving and InvestmentIf the economy were closed
the interest rate would adjust to equate investment and saving:
Saving and InvestmentBut in a small open economy
the exogenous world interest rate determines investmentand the difference between saving and investment determines net capital outflows and net exports
Three experimentsThree experiments Fiscal policy at homeFiscal policy abroadAn increase in investment demand
1. Fiscal policy at home
An increase in G or decrease in T reduces saving.
Three experiments2. Fiscal policy abroad
Expansionary fiscal policy abroad raises the world interest rate.Results:
Three experiments3. An increase in investment demand
EXERCISE:Use the model to determine the impact of an increase in investment demand on NX, S, I, and net capital outflow.
Three experimentsAn increase in investment demand
ANSWERS: I > 0, S = 0,net capital outflows and net exports fall by the amount I
SummaryNet exports--the difference between exports and importsa countrys output (Y ) and its spending (C + I + G)
Net capital outflow equalspurchases of foreign assets minus foreign purchases of the countrys assetsthe difference between saving and investment