Open Economy

• Presence of foreign sector– Trade– Investment

Austria 52.21 52.58 Croatia 46.72 52.77Belgium 84.42 81.09 Czech Republic 71.05 73.79Finland 40.38 31.58 Denmark 45.59 39.18France 27.91 26.35 Iceland 40.48 40.95Germany 34.97 33.07 Sweden 46.45 40.56Greece .. .. Hungary 60.47 62.61Ireland 95.39 80.49 Latvia 45.52 54.19Italy 28.27 26.67 Lithuania 50.41 55.85Luxembourg .. .. Poland 29.12 33.01Netherlands 65.06 59.73Portugal 31.63 41.24Spain 29.92 31.40

China 25.83 23.41Japan 10.44 9.81Russian Federation 36.81 24.15Switzerland 45.47 41.13United Kingdom 27.12 29.28United States (2004:BEA) 10.00 15.32

2001 data. Source: WDI, WorldBank, 2003Exports % of

GDPImports %

of GDPExports %

of GDPImports %

of GDP

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

),( KLYMXGICY

At any given time period a country’s spending need not equal its output

NX<0 a country spends more than it produces, i.e. borrowingNX>0 a country’s production exceeds its spending, i.e. lending

Spending and Output in an open economy

National Savings in Open Economy

• NS = Y – C – G = I + NX• NX = NS – I

– NX>0 accumulation of foreign financial assets– NX<0 sale of domestic financial assets to

foreigners

• Trade balance = net capital flow• US BoP (www.bea.gov)

– Current Account – Trade– Financial Account – Investment

Small Open Economy

• Incapable of causing changes in the world’s 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.

I

S (domestic+foreign)r

Fiscal Policy in a small open economyMonetary Policy in a small open economy

example• Consider a closed economy with

– Y=20000– G=T=0– C=1000+0.8*(Y-T)– I=5000-500 r

-----------------------------------------------------------1. What is the level of interest rate?-----------------------------------------------------------Now, assume this is a small open economy and the global interest rate is 5%1. Would this country be a net borrower or lender?2. What would the level of net exports be?3. 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?

4. Now assume that G is reduced to 0, but T is reduced to -1000, what would be the level of NX?

5. Now assume that G=T=0, but the investment function changes to: I=8000-500r

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

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

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 > inflation d) then DC appreciates• If (inflation f < inflation d) then DC depreciates

• Tradable versus non-tradable internationally goods• Consumer preferences

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

Output/Employment/Inflation and the business cycle

• Recession

• Expansion

• Natural Unemployment

• Relationship between unemployment and inflation

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)

More on indicators

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

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

The Keynesian Cross

Plannedexpend

equilibrium

Real Income (Y)

Planned Expenditures

Actual Expenditures

Ap

Note: MPC is the slope of the Ep function

multiplier

Variable The multiplier Change in Y

G --- G * Multiplier

T --- - mpc * multiplier * (T)

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)

“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

Investment and Savings• I = I (r) Planned investment is a function of real interest

E(r1)

E(r2)

r1>r2

Y

Y

r

E

r1

r2

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

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

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

Real money balance

Ms/P

Md/P

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

equilibrium

rr

YRMB

L(Y1) L(Y2)Ms/P

Y2>Y1

LM

Y1 Y2

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)

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

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

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

Deriving ADLM1(P1)

LM2(P2)

IS

r

Y

Y

P

As P decreases the real Money supplyincreases, thus the LM curve shiftsoutwards, leading to a higher equilibriumlevel of Y

P1

P2

AD

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

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

Policy in Open Economy

• Assumptions– Small economy– No capital mobility restrictions

• Conclusion– Interest rate is fixed to the world interest rate

Monetary Policy

• Floating exchange rate regime:– Monetary expansion leads to currency

depreciation

• Fixed exchange rate regime:– Monetary policy is ineffective (EU12)

Fiscal Policy

• Floating exchange rate regime– Currency appreciation makes fiscal expansion

ineffective

• Fixed exchange rate regime– Fiscal expansion leads to monetary

expansion

The Economic Development

• Output per capita– Sources of growth:

• resources– Land– Capital– Human capital

• Technological progress• Institutional development

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

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 k• Capital evolution (formation) equation:

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 k

• Capital evolution (formation) equation:k = i - k

The Solow Growth Model – Part Isteady state

• Capital stock remains the same over time k = 0 sf(k) = k

- Convergence to the steady state

- The Golden Rule of Capital Stock- Maximization of consumption

- c = y – i in Steady State i = kc = f(k) – kMPk =