the classical model in an open economy

ECON 1220 Principles of Macroeconomics Semester 2, 2011/12

1

The Classical Model in the Open Economy

1. The Goods Market Equilibrium (Open Economy)

Recall that in the classical model in the closed economy:

o Supply side: the labor market reaches the full employment and therefore the economy

produces its potential output automatically in the long run.

o Demand side: the loanable funds market clears, which ensures that the total leakages are

equal to the total injections. Therefore, Say’s law hold and domestic demand equals to

domestic output supply (goods market equilibrium).

The key difference between open and closed economy is that, in an open economy, a

country’s domestic spending need not equal its output.

The planned expenditure in the open economy:

NXGICE pp

In an open economy, the goods market is in equilibrium when the supply of output (i.e.

potential GDP) equals total demand for output (planned expenditure):

NXGICY p

NXGICY p )(

In an open economy, domestic demand need not equal the supply of output.

o If output exceeds domestic planned expenditure, the country exports the difference, NX >

0.

o If output falls short of domestic planned expenditure, the country imports the difference,

NX < 0.

Therefore, the goods market equilibrium condition can be rewritten as:

XGIMTS p

o The left hand side (S + T + M) is the leakages out of households spending.

o The right hand side (Ip + G + X) is the injections.

The goods market will be in equilibrium if and only if total leakages are equal to total

injections.

o What is the mechanism that ensures leakages = injections in an open economy?

2. The Loanable Funds Market in an Open Economy

As in the closed economy, the goods market and the loanable funds market are closely related.

In an open economy, the goods market equilibrium condition can be written as:

NXTGIS p )(

NXTGIS p )]([


2

o The left hand side of the equation is the difference between household saving, i.e.

domestic supply of loanable funds and the firms planned investment expenditure plus

government budget deficit, i.e. domestic demand for loanable funds.

What would happen when the economy’s supply of loanable funds exceeds its

demand?

Net capital outflow is the amount that domestic residents are lending abroad (say by

buying foreign bonds or other financial assets), i.e. net foreign lending.

o The right hand side of the equation is the net export, which is also called trade balance.

Trade surplus, when NX > 0.

Trade deficit, when NX < 0.

Balanced trade, when NX = 0.

When a country runs a trade surplus, there is an excess supply in the domestic loanable funds

market, resulting in a net capital outflow (lending to foreigners) equal to its trade surplus.

o What is the intuition behind?

Suppose that an American sells an exported an iPhone to a Japanese consumer for 20,000 yen.

The transaction increases U.S. NX. But what will the exporter do with the 20,000 yen received?

o Buy Japanese goods

o Buy Japanese financial assets – such as Japanese bonds.

o Trade the Japanese to a bank for US dollars.

The bank may sell the Japanese yen to another U.S. resident for the purpose of

buying Japanese goods or financial assets.

The bank may also sell the Japanese yen to the central bank, which will increase the

central bank’s foreign exchange reserves (in forms of holding foreign assets).

In any case above, it ensures that net capital outflow equals to net exports.

o What if the country runs a trade deficit?

3. The Loanable Funds Market Equilibrium

To show how loanable funds market is related to international trade and lending or borrowing,

we examine the case of small open economy with perfect capital mobility.

o Small economy refers to an economy that is a small part of the world loanable funds

market and therefore cannot affect the world interest rate.

o Perfect capital mobility means that residents have free access to world financial markets.

For a small open economy with perfect capital mobility, the real interest rate in our small

open economy must equal to the world real interest rate, rw.

o The world interest rate is determined by the total demand and supply of loanable funds

market in the world.

What would happen if rw > r

* (domestic equilibrium real interest rate)? What if r

w < r

*?


3

In an open economy, domestic supply of loanable funds need not equal domestic demand in

equilibrium.

Notice that when the loanable funds market is in equilibrium in an open economy, i.e. S – [Ip

+ (G – T)] = NX, it implies:

XGIMTS p

That is, the goods market will also be in equilibrium as the total leakages are equal to total

injections, which ensures Say’s law to hold in an open economy.

Loanable Funds

Real interest rate (r)

S

[Ip + (G – T)]

S

r*

Ip + (G – T)

Foreign borrowing = NX (< 0)

rw

Loanable Funds


S

[Ip + (G – T)]

S

r*

Ip + (G – T)

Foreign lending = NX (>0)

r

w


4

4. Fiscal Policy

For a small open economy, an increase in government spending (for a country with trade

surplus) will not affect world interest rate, but will result in a decrease in net export.

This is the reason why many economists suggest that the government budget deficit may be

the primary cause of the trade deficits.

o The phrase “twin deficits” conveys the idea that the government budget deficit and the

trade deficit are closely linked.

What would you expect to be the impact of an increase in budget deficit for a large open

economy (for which its demand or supply for loanable funds is large enough to affect the

world loanable funds market, thus world interest rate)?

Readings:

Chapter 20 Appendix: The Appendix is a much simplified version (in some parts misleadingly

simplified) of the analysis of the classical model in the open economy.

Loanable Funds


S

[Ip + (G – T)]

1

S Ip + (G – T)

Foreign lending = NX (>0)

rw

[Ip + (G – T)]

2

Sep 19th 2003 | from the print edition

Growing economies, gaping deficitsThe world economy is recovering its strength, but not itsbalance

THE International Monetary Fund (IMF)enters its annual meeting in Dubai thisweekend expecting the world economy togrow by 4.1% next year. The IMF issued thesame projection in April, but five monthsdown the road, with the Iraq war over,deflation at bay, and economies finallyresponding to macroeconomic policy, theprediction can be held with moreconfidence. The threats to world growth have receded—though theyhave not disappeared.

Much of this renewed confidence is inspired by America’s gatheringmomentum. But the country’s surprisingly strong recovery in thesecond quarter was eclipsed, even more surprisingly, by Japan’s. Japangrew by 3.9% in the quarter (at an annualised rate), America by 3.1%.The IMF has duly revised upwards its growth projection for Japan, butat 1.4% for 2004, it still looks conservative compared, for example,with the 2.6% growth predicted by J.P. Morgan.

Nonetheless, the guiding theme of the IMF’s outlook on the worldeconomy remains correct: America is still the main motor of globalgrowth. If the Japanese economy has four cylinders, America has ten:growth of 3% in America’s vast ten-trillion-dollar economy adds muchmore to world output than 3% growth in Japan’s four-trillion-dollareconomy. Besides, Japan tends to follow the world economy, not leadit. It relies on foreigners to buy much of what it produces, whereas

America relies on foreigners to finance much of what it buys.

Therein lies the principal threat to the IMF’s projections: will the rest ofthe world, principally East Asia, continue to finance America’s tradedeficit, and, if not, how will that deficit unwind? Will it close via awelcome rise in foreign demand, an unwelcome fall in Americandemand, or through a realignment of currencies, switching demandtowards American goods and away from the goods of its tradingpartners?

American demand, of course, has already fallen from the heady peaksof the last decade. But the current-account deficit has continued towiden. Why? In so far as the private sector has slowed its spending(and households have not slowed much), the American government hastaken over. The IMF forecasts a deficit of over 6% of GDP this year inthe combined federal and state budgets. Over half of America’simpressive second-quarter growth was driven by military spending.“The United States has the best recovery that money can buy,” saidKenneth Rogoff, the IMF’s chief economist.

Who is financing America’s overspend? The foreign investors, many ofthem European, who used to buy up American equities have largelywithdrawn. Asian central banks, buying American Treasuries andagency debt, have taken their place. Asia holds about $1.66 trillion inforeign-exchange reserves, most of them in dollar assets. If America’stwin deficits, a current-account deficit matched by a budget deficit, arereminiscent of the 1980s, the rapid accumulation of dollars in foreigncapitals is somewhat reminiscent of the slow demise of the BrettonWoods era in the late 1960s and early 1970s.

The appetite of Asian creditors for American assets is preventing thebroad weakening of the dollar that the IMF and many in America wouldlike to see. From its peak in early 2002 to mid-May, the dollar fell by amodest 12% in trade-weighted terms. Exports have begun to respond,with volumes growing by more than 20% over the past three months.But some reckon the dollar would have to fall by as much as half to getAmerica’s current-account deficit back under control.

Can the dollar fall again? The euro has borne the brunt of its fall so far,appreciating by 20% against the dollar since early 2002. Indeed, astrengthening euro is slowing recovery in Europe, according to the IMF.Exports have led Europe out of previous recessions; but their pull hasbeen weak this time round. In previous recoveries, by this stage euromembers would expect their exports to have grown by over 13% from

from the print edition

their lows. But they have grown by less than 10%. The IMF cautionsthe European Central Bank (ECB) to stand ready to cut interest ratesagain if the euro strengthens further. Inflation across the euro area as awhole is a healthy 2.1%, slightly above the ECB’s ceiling. But if thataverage disguises near-deflation in Germany, it may not be the bestguide to ECB policy, the IMF warns.

Japan is also worried about the fallingdollar. Its monetary authorities spent$78 billion between January and Augustthis year selling yen and buying dollars.The IMF supports Japan’s strategy ofholding the yen down as a way to reflateits economy, but not everyone is sosympathetic. On Thursday, just daysbefore Japan’s finance minister was tomeet the other leaders of the G7economies in Dubai, the yenstrengthened to under 115 to the dollar for the first time in two-and-a-half years. Some speculate that Japan is letting the yen appreciate todeflect criticism of its weak yen policy at this weekend’s meetings.

Japan will not be the only country whose exchange rate is in thespotlight at Dubai. China, not yet a member of the G7, is nonetheless afavourite topic of conversation. As the dollar has weakened, China’syuan has tracked its fall. China is now running a conspicuous tradesurplus with America at a time when the latter is fast losingmanufacturing jobs. John Snow, America’s treasury secretary, visitedBeijing this month to impress upon China the case for loosening itscurrency peg of 8.3 yuan to the dollar. He and other finance ministerswill likely repeat this call in a planned unofficial meeting with Chineseofficials on the margins of the G7 meeting. To appease Mr Snow, Chinamight soften its peg slightly, allowing the yuan to bobble within aslightly wider band.

But that will not be enough to realign the dollar, let alone to halt thetectonic shifts going on in the geography of manufacturingemployment. To make a real difference to the dollar, according torecent calculations by Goldman Sachs, the yuan would have toappreciate by 15% and other Asian currencies would have to followsuit. That is about as likely as Snow descending on Dubai.

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the classical model in an open economy

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