Review of the previous lecture
Nominal interest rate
equals real interest rate + inflation rate.
Fisher effect: nominal interest rate moves one-for-one w/ expected
inflation.
is the opp. cost of holding money
Money demand
depends on income in the Quantity Theory
more generally, it also depends on the nominal interest rate;
if so, then changes in expected inflation
affect the current price level.
Review of the previous lecture
Costs of inflation
Expected inflation
shoeleather costs, menu costs,
tax & relative price distortions,
inconvenience of correcting figures for inflation
Unexpected inflation
all of the above plus arbitrary redistributions of wealth between
debtors and creditors
Review of the previous lecture
Hyperinflation
caused by rapid money supply growth when money printed to finance
govt budget deficits
stopping it requires fiscal reforms to eliminate govts need for printing
money
Lecture 21
Open economy - I
Instructor: Prof.Dr.Qaisar Abbas
Course code: ECO 400
Lecture Outline
1. Open economy
2. Saving and investment
3. Three experiment
Open economy
spending need not equal output
saving need not equal investment
Preliminaries
C Cd Cf
I I
G Gd Gf
superscripts:
d =spending on
domestic
goods
f = spending on
foreign goods
EX = exports = foreign spending on domestic goods
IM = imports = C f + I f + G f = spending on foreign goods
NX = net exports (a.k.a. the trade balance) = EX IM
Open economy
GDP = expenditure on domestically produced g & s
Y Cd I
G d EX
(C C ff) (I I ) (G G f ) EX
C I G EX (C ff I G f )
C I G EX I M
C I G NX
Open economy
The national income identity in an open economy
Y = C + I + G + NX
or,
NX = Y (C + I + G )
domestic
spending
net exports
output
Open economy
Trade surpluses and deficits
NX = EX IM = Y (C + I + G )
trade surplus
output > spending and exports > imports
Size of the trade surplus = NX
trade deficit
spending > output and imports > exports
Size of the trade deficit = NX
Open economy
International capital flows
Net capital outflows
=S I
=net outflow of loanable funds
=net purchases of foreign assets
the countrys purchases of foreign assets
minus foreign purchases of domestic assets
When S > I, country is a net lender
When S < I, country is a net borrower
Link between trade & cap. flows
The link between trade & cap. flows
NX = Y (C + I + G )
implies
NX
= (Y C G ) I
=
S
I
trade balance = net capital outflows
Thus,
Thus,
aacountry
countrywith
withaatrade
tradedeficit
deficit((NX
NX<<
00))
isisaanet
netborrower
borrower((SS<<II).).
Saving and Investment in a Small Open Economy
An open-economy version of the loanable funds model includes
production function:
Y Y F (K , L)
consumption function:
C C (Y T )
investment function:
I I (r )
exogenous policy variables: G G , T T
Saving and Investment
National Saving:
The Supply of Loanable Funds
Saving and Investment
Assumptions re: capital flows
a. domestic & foreign bonds are perfect substitutes (same risk, maturity, etc.)
b. perfect capital mobility:
no restrictions on international trade in assets
c. economy is small:
cannot affect the world interest rate, denoted r*
aa &
& bb imply
imply rr =
= r*
r*
cc implies
implies r*
r* is
is exogenous
exogenous
Saving and Investment
Investment:
The Demand for Loanable Funds
Investment is still a
downward-sloping
function
of but
the the
interest
rate,
exogenous
world interest rate
determines the
countrys level of
investment.
Saving and Investment
If the economy were closed
the interest
rate would
adjust to
equate
investment
and saving:
Saving and Investment
But in a small open economy
the exogenous world
interest rate
determines
investment
and the difference
between saving and
investment
determines net
capital outflows and
net exports
Three experiments
Three experiments
Fiscal policy at home
Fiscal policy abroad
An increase in investment demand
1. Fiscal policy at home
An increase in G
or decrease in T
reduces saving.
Results:
I 0
NX S 0
Three experiments
2. Fiscal policy abroad
Expansionary fiscal
policy abroad raises
the world interest rate.
Results:
I 0
NX I 0
Three experiments
3. An increase in investment demand
EXERCISE:
Use the model to
determine the impact
of an increase in
investment demand on
NX, S, I, and net
capital outflow.
Three experiments
An increase in investment demand
ANSWERS:
I > 0,
S = 0,
net capital
outflows and
net exports
fall by the
amount I
Summary
Net exports--the difference between
exports and imports
a countrys output (Y )
and its spending (C + I + G)
Net capital outflow equals
purchases of foreign assets
minus foreign purchases of the countrys assets
the difference between saving and investment
