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Review of the previous lecture
• Nominal interest rate equals 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 demand depends on income in the Quantity Theory more 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 lecture
• Costs of inflation Expected inflation
shoeleather costs, menu costs, tax & relative price distortions, inconvenience of correcting figures for inflation
Unexpected inflationall of the above plus arbitrary redistributions of wealth between debtors and creditors
Review of the previous lecture
• Hyperinflation caused by rapid money supply growth when money printed to finance
govt budget deficits stopping it requires fiscal reforms to eliminate govt’s need for printing
money
Lecture 21
Open economy - IInstructor: Prof.Dr.Qaisar Abbas
Course code: ECO 400
Lecture Outline
1. Open economy
2. Saving and investment
3. Three experiment
Open economy•spending 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
d fC C C d fI I I
d fG G G
superscripts:d =spending on
domestic goods
f = spending on foreign goods
Open economyGDP = expenditure on domestically produced g & s
d d dY C I G EX
( ) ( ) ( )ff fC C I I G G EX
( )ff fC I G EX C I G
C I G EX IM
C I G NX
Open economyThe national income identity in an open economy
YY = = CC + + II + + GG + + NXNX
or, NX = Y – (C + I + G )
net exports
output
domestic spending
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 economy
International capital flows •Net capital outflows
=S – I
=net outflow of “loanable funds”
=net purchases of foreign assets the country’s 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. flows
The link between trade & cap. flows
NX = Y – (C + I + G )
implies
NX = (Y – C – G ) – I
= S – Itrade balance = net capital outflows
Thus, Thus,
a country with a trade deficit (a country with a trade deficit (NXNX < < 00) )
is a net borrower (is a net borrower (SS < < I I ).).
Thus, Thus, a country with a trade deficit (a country with a trade deficit (NXNX < <
00) )
is a net borrower (is a net borrower (SS < < I I ).).
Saving and Investment in a Small Open EconomySaving and Investment in a Small Open Economy
An open-economy version of the loanable funds model includes
production function: ( , )Y Y F K L
consumption function: ( )C C Y T
investment function: ( )I I r
exogenous policy variables: ,G G T T
Saving and InvestmentSaving and InvestmentNational Saving: National Saving:
The Supply of Loanable FundsThe Supply of Loanable Funds
Saving and InvestmentSaving and InvestmentAssumptions re: capital flowsa. domestic & 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*
aa & & bb imply imply rr = = r*r*
cc implies implies r*r* is exogenousis exogenous
aa & & bb imply imply rr = = r*r*
cc implies implies r*r* is exogenousis exogenous
Saving and InvestmentSaving and InvestmentInvestment:
The Demand for Loanable Funds
Investment is still a downward-sloping function of the interest rate,but the exogenous
world interest rate……determines the country’s level of investment.
Saving and InvestmentSaving and InvestmentIf the economy were closed…
…the interest rate would adjust to equate investment and saving:
Saving and InvestmentSaving and InvestmentBut in a small open economy…
the exogenous world interest rate determines investment…
…and the difference between saving and investment determines net capital outflows and net exports
Three experimentsThree experiments
• Fiscal policy at home•Fiscal policy abroad•An increase in investment demand
1. Fiscal policy at home
An increase in G or decrease in T reduces saving.
Results:
0I
0NX S
Three experiments2. Fiscal policy abroad
Expansionary fiscal policy abroad raises the world interest rate.
Results: 0I
0NX I
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 experiments
An increase in investment demand
ANSWERS:I > 0,
S = 0,
net capital outflows and net exports fall by the amount I
Summary
• Net exports--the difference between exports and imports a country’s output (Y )
and its spending (C + I + G)
• Net capital outflow equals purchases of foreign assets
minus foreign purchases of the country’s assets the difference between saving and investment