Transcript International Finance

Chapter 10
Macroeconomics in an Open
Economy
The Aggregate Demand for the Aggregate
Output

Households, firms, government and the rest
of the world interact in goods market,
financial market and foreign exchange
market.

The three markets are required to be in
equilibrium: the supply should equal demand
in all those markets. Otherwise, the economy
will face problems such as unemployment,
inflation etc.
The consumption function

Consumption (C) is the largest part of the
aggregate demand. Basically, it is a function
of disposable income (Yd).
C = C(Yd)

If disposable income increases, so do
consumption expenditures. This equation is
also called “behavioral equation” because it
captures behavior of consumers.
Consumption and disposable income
Consumption
C = c0 + c1 Yd
ΔC
c0
ΔYd
Slope = ΔC/ΔY = c1
0
Yd
C = c0 + c1 Y

C is the total consumption, c0 is called
“autonomous consumption”. People must
consume even their income level is zero.

c1 is the slope of the function, it is called
“Marginal propensity to consume” (MPC).

MPC measures the increased consumption due
to the increased disposable income.
The savings function
Saving
S = -s0 + s1Yd
0
-s0
Yd
S = -s0 + s1 Y

s0 is called dissaving. If people don’t have
income, they have to borrow or withdraw
their saving to spend.

Saving depends on the disposable income.
Marginal propensity to save (MPS) is the
fraction of a change in income that is saved.

s1 is the MPS.
MPS = ΔS/ΔYd
MPC +MPS + MPM = 1

The total spending line plots various
components of demand against output.

Investment, government spending and
exports are all assumed to be given. That is,
they do not depend on income.

The total spending line is parallel to the
consumption function. The slope of the line
is the MPC.
The demand for domestic products and
imports
Aggregate demand (AD)
AD = C + I + G + X
500
B
C = c0 + c1 Yd
400
300
200
A
100
0
45º
100
200
300
400
500
Aggregate output (Y)
The export and import function

The demand for exports depends on foreign
income. Changes in domestic output has no
direct impacts on exports.

Imports are the function of income. Marginal
propensity to imports (MPM) measures the
increase in imports due to the increase in
income.
MPM = ΔM/ΔYd
The total spending line in an open economy
Aggregate demand (AD)
AD = C + I + G + X
500
B
AD = C + I + G + X - M
400
300
A
200
100
0
45º
100
200
300
400
500
Aggregate output (Y)
Investment spending curve
Interest rate (i)
A
4%
B
3%
Investment spending
0
200
300
Investment (I)
IS, LM and BP Curves in an Open Economy

The IS curve represents the equilibrium
condition in goods market.

Each point on the IS curve shows the
equilibrium point in the goods market for
the given interest rate.

Changes in the components of the aggregate
demand shifts the IS curve.
IS curve
interest rate (i)
i0
A
B
IS’
IS
0
Y0
Y1
Aggregate output (Y)

Money demand is a decreasing function of the
interest rate.

LM curve represents the equilibrium
condition in the money market.

LM curve is upward sloping. Each point on the
LM curve shows equilibrium in the money
market for the given value of the aggregate
output (Y).
LM curve
interest rate (i)
LM
LM’
i0
A
B
0
Y0
Y1
Aggregate output (Y)
IS-LM diagram
interest rate (i)
Expansionary monetary policy
and contractionary fiscal
policy
LM
A
LM’
i0
B
IS’
i1
IS
0
Y0
Y1
Aggregate output (Y)

BP is the balance of payments which is
defined as:
BP = CA + KA

BP curve represents the set of aggregate
output – interest rate combination that
maintain a balance-of-payment equilibrium.

The high level of income causes makes BOP
worsening and low level of income improves
BOP status.
BP curve
interest rate (i)
BP
B
i0
A
C
0
Y0
Y1
Aggregate output (Y)
The IS-LM-BP model
BOP deficit
BOP surplus
Interest rate (i)
Interest rate (i)
BP
i0
LM
A
BP
i0
A
IS
0
Y0
(Y)
LM
IS
0
Y0
(Y)
Equilibrium in three markets
interest rate (i)
LM
BP
A
i0
IS
0
Y0
Aggregate output (Y)