Chapter 6 - Open Economies In Long Run Flashcards
What are small open economies and assumptions?
Suppose there are only two countries in the world, Domestic and the rest of the world, say, Foreign.
Small Open Economy:
This country cannot affect the world variables, especially world interest rate, i.e., it can borrow or lend any amount without affecting the world interest rate.
Assume that Domestic is a small open economy, while the Foreign country is a large economy.
In our macro model, we have only two goods (Domestic and Foreign Real GDPs, Y and Y), two types of currencies, and two price levels (Domestic and Foreign GDP deflators, P and P).
In a small open economy in the long run, what does the equation NX = S−I represent, and how does it relate to national saving and net exports?
In an open economy, the domestic expenditure may not be equal to output (income).
➔ National Saving may not be equal to investment.
Equations:
Y=C+I+G+NX
Where:
NX = Net Export
Y = Output (Income)
C + I + G = Domestic Expenditure
Rearranging:
NX=Y−(C+I+G)
NX=(Y−C−G)−I
NX = S−I
Where:
S = National Saving
I = Investment
Net Export = Net Capital Outflow
Explain what happens in terms of trade balance when a country has a trade surplus versus a trade deficit. Use the formula NX=X−IM to describe each case.
Trade Surplus:
When NX>0, exports are greater than imports (IM), meaning X>IM. This implies that output (income) is greater than domestic expenditure.
Trade Deficit:
When NX<0, imports (IM) are greater than exports (X), meaning X<IM. This implies that output (income) is less than domestic expenditure.
Explain the relationship between National Saving (S), Investment (I), and Net Exports (NX) in terms of capital outflows and inflows. What does it mean when S>I or S<I?
Answer:
When S>I:
The country is a net buyer of foreign assets.
Net Capital Outflow > 0
The country is a net LENDER.
Net foreign investment > 0
When S<I:
The country is a net seller of assets to foreigners.
Net Capital Outflow < 0 (Inflow)
The country is a net BORROWER.
Net foreign investment < 0
What is the relationship between Trade and Net Capital Outflow (NX), and how does it relate to net foreign investment?
NX = X−IM = S−I
X = Exports
IM = Imports
S - I = Net Capital Outflow
Net Capital Outflow:
Represents the net flow of loanable funds.
Equals the net purchase of foreign assets. (Net foreign investment)
The country’s purchase of foreign assets minus foreigners’ purchases of domestic assets.
The country’s lending to foreigners minus the country’s borrowing from foreigners.
What are the assumptions and key concepts of loanable funds in a small open economy?
Assumptions:
Domestic and foreign bonds (assets) are perfect substitutes (same risk, maturity, etc.).
Perfect capital mobility: No restrictions on international trade in assets and on capital inflow and outflow.
Small open economy: The country cannot affect world variables, especially the world interest rate (i.e., it can borrow or lend any amount without affecting the world interest rate).
Key Concept:
The domestic interest rate r equals the world interest rate r* (foreign real interest rate).
Equation for Demand and Supply of Loanable Funds:
Demand for loanable funds: I(r)
Supply of loanable funds: S=Y‾−C(Y‾−T‾)−G‾
In equilibrium: I(r∗)=Y‾−C(Y‾−T‾)−G‾
What determines investment in a small open economy in the long run, and what is the relationship between savings, investment, and net exports? Draw a Graph
World interest rate r* (exogenous) determines the level of investment in a small open economy.
Investment in an open economy: Iopen=I(r∗)
The difference between savings and investment determines net capital outflow and net exports.
When Savings (S) > Investment (I):
This results in a trade surplus and positive net capital outflow.
What are the impacts of an expansionary fiscal policy (e.g., increase in G) in a small open economy’s LOANABLE FUND Market and GOOD MARKET in the long run? GRAPH
Loanable Funds Market:
Public savings fall
National savings fall
Supply of loanable funds falls
With a fixed real interest rate r*:
Investment remains fixed
Demand for loanable funds is fixed
Net capital outflow falls due to the decrease in S−I represented by:
Δ(S−I)=−ΔG<0
Good Market:
Consumption and investment are fixed, but domestic demand for goods rises due to increased government expenditure.
Supply of goods (output) in the long run is fixed at Y‾
Net exports (NX) must fall, meaning ΔNX=−ΔG<0
Additional Note: The loanable market and goods market must always match.
What are the impacts of higher demand for investment at any level of interest rate in the LOANABLE FUNDS MARKET AND GOODS MARKET in a small open economy in the long run?
Loanable Funds Market:
Investment rises.
Demand for loanable funds rises.
Supply of loanable funds is fixed.
Net capital outflow falls.
Net exports (NX) decrease, with Δ(S−I)<0
Key Equation:
ΔNX= −ΔI <0
Goods Market:
Consumption and government expenditure are fixed, but domestic demand for goods rises due to the increase in investment.
Supply of goods (output) in the long run is fixed at Yˉˉ.
Net exports (NX) must fall.
Key Equation:
ΔNX=−ΔI<0
What are the impacts of a higher foreign interest rate (r↑) in a small open economy ON LOANABLE FUNDS MARKET AND GOODS MARKET in the long run?*
Loanable Funds Market Effects:
Investment falls.
Demand for loanable funds falls.
Supply of loanable funds is fixed.
Net capital outflow rises.
Equation Impact:
Change in (S - I) = -ΔI > 0
Goods Market Effects:
Consumption and government expenditure are fixed.
Domestic demand for goods falls due to decreased investment.
Supply of goods (output) in the long run is fixed at Yˉ.
Net exports must rise, NX↑
Equation Impact:
Change in ΔNX=−ΔI>0
What should always match?
The equation shows that the flow of goods (Net Exports, NX) and the flow of loanable funds (Savings S minus Investment I) always match.
