chapter 5: the open economy
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Chapter 5: The Open Economy. International Trade. A country’s participation is measured by the value of its export as a percentage of GDP Import as a percentage of GDP - PowerPoint PPT PresentationTRANSCRIPT
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Chapter 5:The Open EconomyChapter 5:The Open Economy
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International Trade
A country’s participation is measured by the value of its – export as a percentage of GDP– Import as a percentage of GDP
Data indicate that while international trade is important in the U.S., it is even more vital for other countries such as Canada and France.
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International Trade
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National Income Accounting
The GDP for an open economy:Y = C + I + G + NX
Consumption = CInvestment = IGovernment purchases = GNet Exports = NX (Exports less Imports)
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National Income Identity
Y = C + I + G + NX
Y – C – G = I + NX
S = I + NX
Where S = Y - C - G is National Savings
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Saving Investment Identity
Equilibrium in the product market: S – I(r) = NX
Net Foreign Investment = Trade BalanceIf S>I: foreign capital outflow; hence NX>0: trade surplusIf S<I: foreign capital inflow; hence NX<0: trade deficit
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Twin Deficits
The federal budget deficit (G>T), reduces national savings (S = Y – C – G)
Reduced national savings foreign capital inflow, hence causing a trade deficit (NX<0)
So, budget deficit causes trade deficit
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Saving Investment: Small Open Economy
For a small open economy, r = r*, where
r = domestic real interest rater* = world real interest rate
So, S – I(r*) = NX
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Determination of Real Interest Rate
I
I(r*)
r
S
Domestic real interest rate
r
r*
r*
NX>0
NX<0
If r<r*, then S>I for capital outflow and a trade surplus. If r>r*, then S<I for capital inflow and a trade deficit.
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Fiscal Policy at Home
Investment, Saving
I(r*)
S1
r*
An increase in G or a decrease in T results in a lower S. Now S<I induces capital outflow and a trade deficit.
S2
NX<0
Real interest rate
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Fiscal Policy Abroad
Investment, Saving
I(r*)
S
r1*
An increase in G or a decrease in T inthe U.S. results in a higher r* causing S>I and a trade surplus.
Real interest rate
r2*NX<0
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Increase in Investment Demand
Investment, Saving
I1(r*)
S
r*
An increase in I(r*) results in S<I and a trade deficit.
Real interest rate
I2(r*)NX<0
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Exchange Rate
Nominal exchange rate = e: the relative price of the currency of two countries; e.g., $1 = 120 yen or 1 yen = $0.00834
Real exchange rate = ε: nominal exchange rate adjusted for the foreign price difference
ε = e (P/P*)where P = domestic price levelP* = foreign price level
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Real Exchange Rate and Trade Balance
NX
ε
0
NX<0
NX>0
- +
The lower the real exchange rate, the less expensive are domestic goods relative toforeign goods, thus the greater is the net export.
NX(ε)
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Determinants of Real Exchange Rate
Equilibrium value of ε is determined by:Net Foreign Investment = Trade Balance
S – I = NXHere, the quantity of dollars supplied for net foreign investment equals the quantity of dollars demanded for the net export of goods and services.
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Determinants of Real Exchange Rate
I
NX(ε)
ε S - I
Equilibrium real exchange rate
ε
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Fiscal Policy at Home
Net export
NX(ε)
S1 - I An increase in G or a decrease in T reduces S, shifting S-I line to the left. This shift causes ε to increase, but NX to decrease.
S2 - I
Real exchange rate
ε1
ε2
NX1NX2
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Fiscal Policy Abroad
Net export
NX(ε)
S2 - IS1 - I
Real exchange rate
ε2
ε1
NX2NX1
An increase in G or a decrease in T inthe U.S. results in a higher r* causing Ito decrease. This shift causes ε to decrease, but NX to increase
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Increase in Investment Demand
Net export
NX(ε)
S – I1
An increase in I shifts S-I line to the left. This shift causes ε to increase, but NX to decrease.
S – I2
Real exchange rate
ε1
ε2
NX1NX2
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Effect of Trade Protectionism
Net export
NX(ε)1
Real exchange rate
S - I
ε1
NX(ε)2
ε2
NX1 = NX2
Protectionism reduces the demand for imports, increasing net export.A higher NX line causes ε to increase,with no net change in net export.
Here the value of foreign trade is unchanged becausethe rise in the real exchangerate discourages exports, which offsets the decline in imports.
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Determinants of Real Exchange Rate
From ε = e * (P/P*), write e = ε (P*/P)Take percentage rate:%Δe = %Δε + %ΔP* - %ΔP%Δe = %Δε + (* - )
Where ( * - ) is the difference in inflation rates of the two countries
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Inflation and Nominal Exchange Rate
Countries with relatively high inflation tend to have depreciating currencies.
Countries with relatively low inflation tend to have appreciating currencies.
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Inflation and Nominal Exchange Rate