Business, Government, and the World Economy

1
Business, Government, and the World Economy

• International Intro

2
Production Current Account vs. Capital Account

• Current
• surplus or deficit on goods surplus or deficit
  on services surplus or deficit on net
  investment income unilateral transfers
• Capital
• net inflow of foreign capital minus net outflow
  of domestic capital
• By definition the current and capital account are
  equal in size with the opposite sign.

3
Open economy IS LM

• Open Economy IS Curve
• Goods Market Equilib
• Y CdIdGNX
• Y C I G NX, Y-Cd -G Sd
• Rearrange Sd Id NX
• Upward sloping curve is Desired Saving less
  Desired Investment
• Downward sloping curve is Net Exports
• Left hand is Real interest rate (domestic)

4
Small open economy

• An economy too small to impact the world real
  interest rate (the rate in international capital
  markets)
• This implies that the interest rate is fixed (the
  residents can borrow or lend at the world
  interest rate

5
Lending vs. Borrowing

• IF the intersection of the S and I curves is
  below the world real interest rate, the country
  is lending abroad.
• If the intersection of the S and I curves is
  above the world interest rate the country will be
  borrowing from abroad.

6
Two large open economies

• What it both economies are large and can
  influence the world level of interest?
• Now equilibrium occurs when desired lending by
  one country is equal to desired lending by the
  other.

7
Shocks to saving of investment

• Given that the economy is too small to impact the
  world level of interest rates, if there is a
  shock in the S or I curves it will cause a change
  in the level of borrowing or lending account
• For example assume the country is a net lender
  and there is an adverse supply shock so Savings
  shifts left the amount of lending decreases
  (current account surplus falls).

8
Derivation of IS

• An increase in output
• causes a shift to the right in the S-I curve
• Causes a shift to the left in the NX curve
  (spending on imports will increase)
• The combination of real interest rate at each
  level of Y creates the IS.

9
Shifts in IS

• Anything that caused a shift in the IS curve
  before still does.
• Additionally
• An increase in foreign output shifts IS up
  (right) (increased demand for home country
  exports)
• An increase in the foreign real interest rate
  shifts IS up (right) (depreciation of real
  exchange rates raises net exports)
• An increase in demand for domestic goods relative
  to foreign shifts IS up (right) (increase in net
  exports)

10
Exchange Rates

• Nominal Exchange Rate
• The rate at which two currencies can be traded.
  It does not account for changes in purchasing
  power simply units of currency exchange for
  each other.
• Floating vs. Fixed Flexible Exchange rtes are
  determined by supply and demand for the currency,
  fixed have the rate of exchanges held constant.

11
Real Exchange Rates

• Nominal Exchange Rates does not fully explain
  changes in purchasing power between countries
• Real exchange rates compares the price of
  identical goods in a base currency.

12
Real Exchange Rate Example

• Assume that currently the nominal exchange rate
  is 110 Yen per dollar.
• Also assume that the price of a hamburger in the
  US is 2 and the price in Japan is 1100 Yen.
• For 2 you could buy a hamburger in the US or
  get 220 Yen, however this is not enough to buy a
  hamburger in Japan.

13
Real Exchange Rate Example Continued

• The real exchange rate would be the number of
  foreign hamburgers that could be exchanged for
  one US hamburger, or