Download - Macro Session 6
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7/27/2019 Macro Session 6
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Macroeconomics & The globaleconomy
Ace Institute of Management
Session 6: The open economy
InstructorRijan Dhakal
9851069004
mailto:[email protected]:[email protected] -
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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)
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An Important
Macroeconomic Model
Relating toSaving and Investment and
Trade Balance
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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
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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
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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
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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
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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.
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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
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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:
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National saving: Thesupply of loanable funds
r
S, I
( )S Y C Y T G
S
More Assumptions:
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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:
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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:
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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)
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r
S, I
I(r)
S
rc
Explanations:
Trade Deficit
(S < I)
r*
I1
Or, Case of Trade Deficit
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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)
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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
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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
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Case 2: Starting from Trade Balance, What happens if the Foreign
Government uses expansionary fiscal polices such as increase in
G?
How Policies Influence the TradeBalance?
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.
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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
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Case 3: Starting from Trade Balance, What happens if the
Investment increases in the home country in existing r?
How Policies Influence the TradeBalance?
i) Increase in I but no change in r*
ii) Since S has not changed, S
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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
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Thank You