econ chap 28
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OPEN ECONOMY
MACROECONOMICSChapter 28
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Foreign Trade and Economic Activity
Net Exports and Output in the Open Economy
Open Economy Macroeconomics- Study of how economies behave when the trade
and financial linkages among nations are considered.
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Exports
-g/s produced domestically and purchased by
foreigners
Posit ive net exports: Net foreign investments
Negative net expo rts: Foreign indebtedness isgrowing
Net Exports = exports of g/s imports of g/s
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Total Domestic Output = GDP Domestic expenditures + Net exports = C + I +G +X
Domestic expenditures
equal to consumption plus domestic investment plus
govt purchases.
Difference between GDP and Domestic expenditures:
1. Some part of domestic expenditures will be on goods
produced abroad.
2. Some part of domestic production will be sold abroad asexports
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Variables that Influence Net Exports
Consumers preferences for foreign and domestic goods
Prices of goods at home and abroad
Incomes of consumers at home and abroad
The exchange rates at which foreign currency trades fordomestic currency
Transportation costs
Govt policies
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Short Run Impact of Trade on GDP
Two new macroeconomic elements in international trade:1. Net exports
2. An open economy has two different multipliers for privateinvestments and govt domestic spending
Equilibrium output in an open economy occurs where total netdomestic product and foreign spending equals total domesticoutput
Elements of Imports:
Exogenous materials like prices andexchange rates
Domestic Income and output
Elements of Exports
Exogenous materials like prices andexchange rates
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Marginal Propensity to Import and the
Spending line
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The Open Economy Multiplier
=1
+
The effect of a sustained increase in governmentspending (or investment) on incomethat is, the
multiplieris smaller in an open economy than in a
closed economy. The reason: When government
spending (or investment) increases and income andconsumption rise, some of the extra consumption
spending that results is on foreign products and not on
domestically produced goods and services
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The Monetary Transmission Mechanism
in an Open Economy
Overvalued Currenc y: one whose value is high relative
to its long-run or sustainable level.
US dollar was overvalued in 1985
High mob i l ity o f f inancia l capi tal: when financial
investments can flow easily among countries and the
regulatory barriers to financial investments are low.
United States, Japan, countries of the European Union
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Fixed Exchange Rates
Interest rates of countries with fixed exchange rates and
high capital mobility must be very closely aligned.
Any divergence between two countries will attract speculators who
will sell one currency and buy the other until the interest rates are
equalized.
Fiscal policy is highly effective.
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Flexible Exchange Rates
Has a reinforcing effect on monetary policy
Monetary Easing
Monetary Tightening
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Monetary Easing
MonetaryEasing
Lowerinterestrates
Depreciationof the
currency
StimulatesExports anddiscourages
imports
Net exportsurplus
Increasedomestic
investment
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Monetary Easing
Net export expansion
0
500
1000
1500
2000
2500
3000
3500
4000
4500
1000 2000 3000 4000
C + I + G + X(e*)
C + I + G + X(e**)
Q* Q**
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Monetary Tightening
Monetarytightening
Highinterestrates
Appreciation of thecurrency
Increasein export
prices anddecreasein import
prices
Net exportdeficit
Recession
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SAVING AND INVESTMENT IN A
SMALL OPEN ECONOMYSmall open economy: an economy too small to affect theworld real interest rate
World real interest rate (rw): the real
interest rate in the international capitalmarket
Key assumption: Residents of thesmall open economy can borrow or lend
at the expected world real interest rate
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National saving and investment in a small open
economy
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A small open economy that lends abroad
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A small open economy that borrows
abroad
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Result: rwmay be such that Sd> Id, Sd= Id, orSd< Id
Ifrw= r1, then Sd> Id, so the excess of desiredsaving over desired investment is lentinternationally (net foreign lending is positive)and NX> 0
Ifrw= r2, then Sd= Id, so there is no net foreignlending and NX= 0
Ifrw= r3, then Sd< Id, so the excess of desiredinvestment over desired saving is financed by
borrowing internationally (net foreign lending isnegative) and NX< 0
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Saving and Investment in Large Open
EconomiesLarge open economy: an economy largeenough to affect the world real interest rate Suppose there are just two economies in the world
The home or domestic economy (saving S,investment I)
The foreign economy, representing the rest ofthe world (saving SFor, investment IFor)
The world real interest rate moves to equilibrate desired
international lending by one country with desired internationalborrowing by the other
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Equivalent statement: The equilibrium world real interest rate isdetermined such that a current account surplus in one country is
equal in magnitude to the current account deficit in the otherChanges in the equilibrium world real interest rate: Any factor that
increases desired international lending of a country relative todesired international borrowing causes the world real interest rateto fall
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ECONOMIC GROWTH IN THE OPEN
ECONOMY
Small open economies International trade
International finance
Other issues Trade policies
Intellectual property rights
Policies toward direct investment
Overall macroeconomic climate
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PROMOTING GROWTH IN THE
OPEN ECONOMY
Best-practice techniques in production processes
Low tariffs and other barriers to trade
Most successful open economies:
Europe: Netherlands, Luxembourg
Asia: Taiwan, Hong Kong
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Not only physical but also intangible capital
Development of intellectual property rights
Stable macroeconomic climate
-taxes are reasonable and predictable and thatinflation is low, so lenders need not worry about
inflation confiscating their investments.
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Low-Risk Country High-Risk Country
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INTERNATIONAL ECONOMIC ISSUES
Two of the central issues that have concerned nations in
recent years:
1. COMPETITIVENESS and PRODUCTIVITY
2. Birth of European Monetary Union
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The Deindustrialization of America
During 1980s and later surfaced in the 2000s the
appreciation of dollar produced severe hardships in many
US sectors exposed to international trade.
COMPETITIVENESSextent to which a nations goods
can compete in the marketplace
PRODUCTIVITY measured by the output per unit of
input
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Trends in Productivity
Importance of COMPETITION and OUTWARD
ORIENTATION
Theory of Comparative Advantage nations are not
inherently uncompetitive
HIGH PRODUCTIVITY and HIGH LIVING STANDARDS =
expose domestic industries to world markets and
encourage them to adopt the most advanced technologies
in the world
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The European Monetary Union
IDEAL EXCHANGE RATE SYSTEM allows high levelsof predictability of relative prices while stabilizing the
economy in the face of economic shocks
Fixed exchange rate system subject of intense
speculative attacks EU countries took the giant step of linking their economic
fortunes through European Monetary Union, which forged
a common currency, the Euro.
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Toward a Common Currency: The Euro This economic integration would not only foster economic
ties but also resolve the problem of unstable currencies that
plagued the earlier fixed-exchange-rate systems.
11 European countries joined the EMU in 1999, these
countries adopted the Euro as their unit of account and
medium of exchange.
European Central Bank conducts monetary policy for
countries in the accord and thereby determine the interest
rates for the Euro.
PRIMARY OBJECTIVE of ECB: To pursue price stability
Price Stability increase in Euroland consumer prices of
below 2% per year over the medium term
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Costs and Benefits of Monetary UnionBENEFITS
Exchange rate volatility will be reduced to zero
More efficient allocation of capital across countries
Political integration and stability of Western Europe
COSTS
Individual countries will lose the use of both monetarypolicy and exchange rates as tools for macroeconomicadjustments
OPTIMAL CURRENCY AREA is one whose regionhave high labor mobility or have common andsynchronous aggregate supply or demand shocks
The creation of the Euro has removed the intra-European
exchange rate movements
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FINAL ASSESSMENT
Robust economic performance- It is the period which these countries avoided deep
depression and the cancer of hyperinflation
The emerging monetary system
- Major economic regions with flexible exchange rate rates,while smaller countries either float or have hard fixed
exchange rates
The reemergence of free markets
- Market-oriented countries of the West prospered whilecentrally planned command economies collapsed
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