Macro Session 6

7/27/2019 Macro Session 6

1/23

Macroeconomics & The globaleconomy

Ace Institute of Management

Session 6: The open economy

InstructorRijan Dhakal

[email protected]

9851069004
mailto:[email protected]:[email protected]


2/23

Open Economy:

Open to foreigners

Contrary to Closed Economy: Export and Import some of its

goods and services to other countries including capital

mobility (depends on savings and investments in the

economy)


3/23

An Important

Macroeconomic Model

Relating toSaving and Investment and

Trade Balance


4/23

Y = Cd+ Id+ Gd+ EX

Consumption

of DomesticGoods and

Services

Investment in

DomesticGoods and

Services

Govt.

Purchase ofDomestic

Goods and

Services

Export of

DomesticGoods and

Services

Domestic Spending on

Domestic Goods and

Services

ForeignSpending on

Domestic

Goods and

Services


5/23

C = Cd +Cf

or, Cd = C - Cf

We know that,

Domestic Spending on all Goods and Services =Domestic Spending on Domestic Goods and Services +

Domestic Spending on Foreign Goods and Services

C = Total Consumption

Cd

= Consumption of Domestic goods & servicesCf= Consumption of Foreign goods & services

I = Id +If

or, Id = I - If

I = Total Investment

Id = Investment in Domestic goods & services

I

f

= Investment in Foreign goods & services

G = Gd +Gf

or, Gd = G - Gf

G = Total Govt. Purchase

Gd = Govt. Purchse. of Domestic goods & services

Gf= Govt. Purchse. of Foreign goods & services


6/23

Y = (C - Cf) + (I - If) + (G - Gf) + EX

Y = C + I + G + EX(Cf+If+Gf)

Expenditure

on ImportsY = C + I + G + EXIM

Y = C + I + G + NX Net Exportsor Trade

BalanceNX= Y(C + I + G)

Net Exports = Output Domestic Spending

If Output > Domestic Spending : NX Positive: Export more

If Output < Domestic Spending : NX Negative: Import more

Domestic

spending

need

not equal the

Output


7/23

Y = C + I + G + NX

YCG= I+ NX

S = I+ NX

S I = NX

NetExports

orTrade

Balance

Net Capital

Outflow orNet

Foreign

Investment

Net Capital Outflow = Trade BalanceIn Equilibrium,

If, Domestic S > Domestic I, NCO is

+ve ; Excess S will be loaned out toforeigners and economy experiences

Capital Outflow.

If, Domestic S < Domestic I, NCO is -

ve ; Deficit financing is done byborrowing from abroad and

economy experiences Capital Inflow.

Net Capital Outflow = Amount that

Domestic residents are lending

abroad Amount that foreigners are

lending to us


8/23

S I = NX Net Capital Outflow = Trade Balance

In Equilibrium,

Condition of Trade Surplus:

If S I is positive, NX is positive, implies Trade Surplus

Net Lender in International Financial Market

Condition of Trade Deficit

If S I is negative, NX is negative, implies Trade Deficit

Net Borrower from International Financial Market

Condition of Balance Trade

If S I exactly equals to NX

The national income account identity shows that the international

flow of funds to finance capital accumulation and the flow of goods

and services are two sides of the same coin.


9/23

Assumptions:

Small Economy:Economy that is a small part of the world

economy and can not affect the world interest rates.

Perfect Capital Mobility:Country has full access to world

financial markets. Domestic Interest rate (r) = World Interest Rate (r*) due to

perfect capital mobility

Determination of Interest Rates:

Domestic : Intersection of Domestic Savings and Investment

World: Intersection of World Savings and Investment


10/23

production function

consumption function

investment function

exogenous policy variables

Y Y F K L ( , )

C C Y T ( )

I I r ( )

G G T T ,

More Assumptions:


11/23

National saving: Thesupply of loanable funds

r

S, I

( )S Y C Y T G

S

More Assumptions:


12/23

Investment:

The demand for loanable funds

r*

but the exogenousworld interest rate

determines the

countrys level ofinvestment.

I(r*)

r

S, I

I(r)

More Assumptions:


13/23

If the economy were closed

r

S, I

I(r)

S

rc

cI

S

r

( )

the interest

rate would

adjust toequate

investment

and saving:

Explanations:


14/23

But in a small open economy

r

S, I

I(r)

S

rcr*

I1

the exogenous

world interest

rate determines

investment

and the

difference

between saving

and investmentdetermines net

capital outflow

and net exports

NX

Explanations:

Case of Trade

Surplus (S >I)


15/23

r

S, I

I(r)

S

rc

Explanations:

Trade Deficit

(S < I)

r*

I1

Or, Case of Trade Deficit


16/23

How do government policies affect Trade

Balance?

Three Cases:

Case 1: Starting from Trade Balance, What happens if theHome Government uses expansionary fiscal polices suchas increase in G or reduce T? (Fiscal policy at home)

Case 2: Starting from Trade Balance, What happens if theForeign Government uses expansionary fiscal policessuch as increase in G?(Fiscal policy abroad)

Case 3: Starting from Trade Balance, What happens if theInvestment increases in the home country?(An increasein investment demand)


17/23

Case 1: Starting from Trade Balance, What happens if the Home

Government uses expansionary fiscal polices such as increase in G

or reduce T?

How Policies Influence the TradeBalance?

As we know,

i) S = Y CG; When G increases, S decreases.

i) As T decreases due to tax cut, disposable income Y T

increase;

Stimulate consumption and C increases Which lowers S


18/23

Fiscal policy at home

r

S, I

I(r)

1SAn increase in G or

decrease in T

reduces saving.

1

*r

2S

- NX

I1

S < I

Country runs

trade deficit

Starting from Trade Balance, a change in fiscal policy that reduces

national savings causes Trade Deficit


19/23

Case 2: Starting from Trade Balance, What happens if the Foreign

Government uses expansionary fiscal polices such as increase in

G?


Considering the foreign economy is large enough

i) Increase in G by foreign government reduces world S

and world interest rate r* rises.

ii) Rise in r* increases costs of borrowing and reduces

domestic I.

iii) Since domestic S has not change, S>I and some of thesavings flow abroad as capital outflow.

iv) Again, as NX = SI; NX increases as I decreases that leads

to Trade Surplus.


20/23

Fiscal policy abroadr

S, I

I(r)

1SExpansionary

fiscal policy

abroad raises

the world

interest rate.

1

*r

NX2

2

*r

2( )*I r 1

( )*I r

S > I

Country runs

trade surplus

Starting from Trade Balance, an increase in the world interest rate due to

fiscal expansion abroad causes Trade Surplus


21/23

Case 3: Starting from Trade Balance, What happens if the

Investment increases in the home country in existing r?


i) Increase in I but no change in r*

ii) Since S has not changed, S


22/23

An increase in investment demand

r

S, I

I(r)1

- NX*r

I1 I2

S

I(r)2

S < I

Country runs

trade deficit

Starting from Trade Balance, an outward shift in the investment

schedule causes Trade Deficit


23/23

Thank You

Documents

Macro Session 6