Transcript Open Economy

Open Economy
• Presence of foreign sector
– Trade
– Investment
2001 data. Source: WDI, WorldBank, 2003
Exports % of Imports %
GDP
of GDP
Austria
Belgium
Finland
France
Germany
Greece
Ireland
Italy
Luxembourg
Netherlands
Portugal
Spain
China
Japan
Russian Federation
Switzerland
United Kingdom
United States (2004:BEA)
52.21
84.42
40.38
27.91
34.97
..
52.58
81.09
31.58
26.35
33.07
..
95.39
28.27
..
80.49
26.67
..
65.06
31.63
29.92
59.73
41.24
31.40
25.83
10.44
36.81
45.47
27.12
10.00
23.41
9.81
24.15
41.13
29.28
15.32
Croatia
Czech Republic
Denmark
Iceland
Sweden
Hungary
Latvia
Lithuania
Poland
Exports % Imports %
of GDP
of GDP
46.72
71.05
45.59
40.48
46.45
60.47
45.52
50.41
29.12
52.77
73.79
39.18
40.95
40.56
62.61
54.19
55.85
33.01
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
Spending and Output in an open economy

Y  C  I  G  X  M Y ( L, K )

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. borrowing
NX>0  a country’s production exceeds its
spending, i.e. lending
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.
S (domestic+foreign)
r
I
Fiscal Policy in a small open economy
Monetary 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
Actual Expenditures
Planned
expend
Planned Expenditures
equilibrium
Ap
Real Income (Y)
Note: MPC is the slope of the Ep function
multiplier
Variable
The multiplier
Change in Y
G
---
DG * Multiplier
T
---
- mpc * multiplier * (DT)
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
E(r2)
r1>r2
E(r1)
Y
r
r1
r2
Y
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
Ms/P
Md/P
Real money balance
Liquidity and Money
• Combinations of Y and r for which the money market is in
equilibrium
r
r
Ms/P
L(Y1)
LM
L(Y2)
Y2>Y1
RMB
Y1
Y2
Y
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 AD
r
LM1(P1)
LM2(P2)
As P decreases the real Money supply
increases, thus the LM curve shifts
outwards, leading to a higher equilibrium
level of Y
IS
Y
P
P1
P2
AD
Y
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 I
supply 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 I
demand 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 dk
• Capital evolution (formation) equation:
The Solow Growth Model – Part I
demand 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 dk
• Capital evolution (formation) equation:
Dk = i - dk
The Solow Growth Model – Part I
steady state
• Capital stock remains the same over time
 Dk = 0  sf(k) = dk
- Convergence to the steady state
- The Golden Rule of Capital Stock
- Maximization of consumption
- c=y–i
in Steady State i = dk
c = f(k) – dk
MPk = d