Open Economy

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Open Economy

• Presence of foreign sector
• Trade
• Investment

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(No Transcript)
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Trade

• Y C I G X M
• M imports
• Consumer spending on foreign output
• Investment spending on foreign output
• Government spending on foreign output
• X exports
• Foreign spending on domestic output

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Spending and Output in an open economy
At any given time period a countrys spending
need not equal its output NXlt0 ? a country spends
more than it produces, i.e. borrowing NXgt0 ? a
countrys production exceeds its spending, i.e.
lending
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National Savings in Open Economy

• NS Y C G I NX
• NX NS I
• NXgt0 ? accumulation of foreign financial assets
• NXlt0 ? sale of domestic financial assets to
  foreigners
• Trade balance net capital flow
• US BoP (www.bea.gov)
• Current Account Trade
• Financial Account Investment

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Small Open Economy

• Incapable of causing changes in the worlds
  financial markets, i.e. is a price taker in
  financial markets, unable to influence the price
  of loanable funds in the global markets
  interest rate.

S (domesticforeign)
r
I
Fiscal Policy in a small open economy Monetary
Policy in a small open economy
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example

• Consider a closed economy with
• Y20000
• GT0
• C10000.8(Y-T)
• I5000-500 r
• --------------------------------------------------
  ---------
• What is the level of interest rate?
• --------------------------------------------------
  ---------
• Now, assume this is a small open economy and the
  global interest rate is 5
• Would this country be a net borrower or lender?
• What would the level of net exports be?
• Now, assume that the level of government spending
  increases to 3000, would this country be a net
  borrower or lender? And what would the level of
  NX be?
• Now assume that G is reduced to 0, but T is
  reduced to -1000, what would be the level of NX?
• Now assume that GT0, but the investment
  function changes to I8000-500r

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Exchange Rate

• Translating Factor
• Nominal Exchange Rate
• Simple conversion
• Demand for the currency
• Exports
• Foreign investment into domestic economy
• Central banks expanding their holdings of
  domestic currency
• Supply of the currency
• Imports
• Domestic investment overseas
• Central banks selling holdings of the domestic
  currency
• Purchasing Price Parity
• Real Exchange Rate
• NX and the terms of trade

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Real exchange rate

• Real Exchange rate
• Terms of exchange (terms of trade)
• Relative price
• RE NE Pd/Pf
• Overvalued versus undervalued currency and the
  real exchange rate
• Net Exports and the real exchange rate
• Fiscal expansion
• Decline in National Savings ?Increase in influx
  of foreign investment ? appreciation of the
  currency ? deterioration of trade balance
• Monetary expansion
• Increase in domestic money supply ? inflation ?
  deterioration of trade balance ? influx of
  foreign investment
• Trade restrictions
• Net exports function increases ? the real
  exchange rate appreciates by the impact of the
  trade restriction on the relative price

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Purchasing Price Parity

• same things should cost the same price world
  over
• Price of oil
• Real exchange rate 1
• REd NEd Pd/Pf 1 ? NEd Pf/Pd (absolute
  PPP)
• Nominal exchange rate is driven by the difference
  in the rates of inflation
• change in NE inflation f inflation d
  relative PPP
• If (inflation f gt inflation d) then DC
  appreciates
• If (inflation f lt inflation d) then DC
  depreciates
• Tradable versus non-tradable internationally
  goods
• Consumer preferences

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Business Cycle

• Short-run versus Long-run macroeconomics
• Sticky Prices
• Contractual arraignments and wages
• 2001-present airfares and the price of oil
• Output/Employment adjustments and the profit
  equation

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Output/Employment/Inflation and the business cycle

• Recession
• Expansion
• Natural Unemployment
• Relationship between unemployment and inflation

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Indicators of future/current change in the
business cycle

• Leading Indicators
• Business inventories
• Average Work hours in manufacturing
• Average weekly claims for unemployment insurance
• New orders for non-defense capital goods
• Sales tax receipts
• Construction employment
• Residential permits
• Stock index (index futures)
• Growth in wage rate
• Interest rate spread (e.g. 10 year versus 1 year
  bond)

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More on indicators

• Coincident indicators
• Total hours worked
• Value of unemployment claims
• Total tax revenues
• Corporate income tax receipts

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The simple Keynesian Theory of Income
Determination

• Planned versus unplanned expenditures
• Planned
• long-run equilibrium
• A situation where all sectors (households, firms,
  government, foreigners) want to spend exactly the
  amount of income that is being generated by the
  current level of production
• C, Ip, G, NX ? Ep C Ip NX
• Unplanned
• Short-run equilibrium
• Iu change in business inventories (unintended
  inventory investment)
• Autonomous versus induced expenditures
• Consumption function

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The Keynesian Cross
Actual Expenditures
Planned expend
Planned Expenditures
equilibrium
Ap
Real Income (Y)
Note MPC is the slope of the Ep function
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multiplier
Variable The multiplier Change in Y
G --- DG Multiplier
T --- - mpc multiplier (DT)
t 1 / 1 mpc ( 1 t ) Changes in t change the multiplier (increases in t reduces the multiplier)
nx 1/1-mpc(1-t)nx Changes in nx change the multiplier (increases in nx reduce the multiplier)
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Always true versus Equilibrium
Always true Equilibrium condition
Expenditure to be equal to income Actual expenditure Planned expenditure
Amount of unintended inventory investment Can be any amount (positive ? slowdown, negative ? expansion) Must be zero
GDP identity Y E Ep Iu Y Ep
Position in the Keynesian Cross diagram Any point on the 45 degree line At the point where the Ep function crosses the 45 degree line
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Investment and Savings

• I I (r) ? Planned investment is a function of
  real interest

E(r2)
E
r1gtr2
E(r1)
Y
r
r1
r2
Y
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The mechanics of the IS curve

• Functional form of the IS curve
• Y f (r, other factors)
• Movement along the curve
• Changes in the interest rate
• Shifts of the IS curve
• Anything (other than the interest rate) that
  changes the autonomous planned expenditures
• Rotation of the curve
• Changes in the multiplier
• The greater is the multiplier, the flatter is the
  IS curve (more sensitive to the interest rate
  changes)
• Sensitivity of the Investment component to
  changes in the interest rate

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Simple review questions

• What should happen to the IS curve in each of the
  following cases?
• Government spending increases
• Autonomous taxes increase
• mpc increases
• mps decreases
• Income tax rate increases
• Autonomous consumption increases

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Money Market (review)

• Equilibrium in the money market
• Real Money Demand Md/P f (r, Y, P)
• Interest rate!!! Recall the opportunity cost of
  money
• Y!!! Recall the transactional demand for money
• Real Money Supply Ms/P f (Policy, Price level)
• NOT a function of the interest rate

r
Ms/P
Md/P
Real money balance
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Liquidity and Money

• Combinations of Y and r for which the money
  market is in equilibrium

r
r
Ms/P
LM
L(Y2)
L(Y1)
Y2gtY1
Y
RMB
Y1
Y2
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Dynamics of the LM curve

• Shifts in the LM
• Money Supply changes
• Changes in the Price Level (P)
• Rotation
• Anything that makes the demand for money less
  sensitive to the interest rate makes both, the
  money demand and the LM curve steeper (rotating
  it upward around the horizontal intercept)

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Monetary Policy

• Strong Monetary Policy
• Flat IS curve
• Strong dependency of investment and consumption
  on the interest rate
• Steep LM curve
• Weak responsiveness of the demand for money to
  interest rate changes thus, large changes in the
  interest rate are needed to readjust the money
  market. The larger is the change in the interest
  the stronger is the stimulus to I and C, and
  hence the effect on the IS curve, and the GDP.
• Weak Monetary Policy
• Steep IS Curve
• Weak dependency of I and C on the interest rate
• Flat LM curve
• High responsiveness of the demand for money to
  interest rate changes
• small changes in the interest rate have large
  impact on the asset allocation of the household
  (between money (M1) and less liquid, interest
  earning assets)
• Horizontal LM curve and the Liquidity Trap

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Fiscal Policy

• Strong Fiscal Policy
• Flat LM curve
• Strong sensitivity of the demand for money to
  interest rate changes, hence no large interest
  rate changes needed to readjust the money market,
  hence limited crowding out effect
• Steep IS curve
• Low sensitivity of I and C to interest rate
  changes, hence limited crowding out effect
• Weak Fiscal Policy
• Flat IS curve
• Strong crowding out effect
• Steep LM curve
• Low sensitivity of money demand to interest rate
  changes requires large change in the interest
  rate to readjust the money market to

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Aggregate Demand Aggregate Supply and Inflation

• Aggregate Demand
• Shows different combinations of the price level
  and real output at which the money and commodity
  markets are both in equilibrium
• Summarizes the effects of changing prices on the
  level of real income.
• Is derived from the IS-LM equilibrium
• Recall IS represents equilibrium in the
  commodity market and LM represents equilibrium in
  the money market

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Deriving AD
LM1(P1)
r
LM2(P2)
As P decreases the real Money supply increases,
thus the LM curve shifts outwards, leading to a
higher equilibrium level of Y
IS
Y
P
P1
P2
AD
Y
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AD curve continued

• Shifts of the AD curve
• Shifts in the IS curve
• Shifts in the LM curve
• Slope of the AD
• Slope of the IS (multiplier)
• Slope of the LM curve

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Aggregate Supply

• Long-Run
• Capacity based, full price flexibility
• Short-Run
• Horizontal all prices fixed
• Upward slopped sticky-wages model
• Input costs are assumed to be fixed
• If output prices change real input prices change,
  causing changes in firms behavior

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Policy in Open Economy

• Assumptions
• Small economy
• No capital mobility restrictions
• Conclusion
• Interest rate is fixed to the world interest rate

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Monetary Policy

• Floating exchange rate regime
• Monetary expansion leads to currency depreciation
• Fixed exchange rate regime
• Monetary policy is ineffective (EU12)

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Fiscal Policy

• Floating exchange rate regime
• Currency appreciation makes fiscal expansion
  ineffective
• Fixed exchange rate regime
• Fiscal expansion leads to monetary expansion

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The Economic Development

• Output per capita
• Sources of growth
• resources
• Land
• Capital
• Human capital
• Technological progress
• Institutional development

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The Solow Growth Model Part Isupply side

• Y F (K,L)
• To convert to per-worker output measure we must
  assume CRTS
• zY F (zK, zL)
• Per Capita (per worker) output measure
• y f (k)
• Assume diminishing MPK property

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The Solow Growth Model Part Idemand side

• Output is allocated between consumption and
  investment (savings translate into investment)
• y c i i sY, where s represents the
  savings rate
• Consumption of fixed capital, i.e. depreciation
  dk
• Capital evolution (formation) equation

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The Solow Growth Model Part Idemand side

• Output is allocated between consumption and
  investment (savings translate into investment)
• y c i i sY, where s represents the
  savings rate
• Consumption of fixed capital, i.e. depreciation
  dk
• Capital evolution (formation) equation
• Dk i - dk

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The Solow Growth Model Part Isteady state

• Capital stock remains the same over time
• Dk 0 ? sf(k) dk
• Convergence to the steady state
• The Golden Rule of Capital Stock
• Maximization of consumption
• c y i in Steady State i dk
• c f(k) dk
• MPk d