Chapter 6 - The open economy

Question 1

What is the key difference between an open and a closed economy?

Answer 1

In an open economy, a country’s spending in any given year need not equal its output of goods and services

In a closed economy, national savings equal investment
In an open economy, national savings need not equal investment, S - I = NX

Question 2

Expenditure in an open economy can be divided into four components. What are they?

Answer 2

C^d - consumption of domestic goods and services

I^d - investment in domestic goods and services

G^d - government purchases of domestic goods and services

EX - exports of domestic goods and services

GDP = expenditure on domestically produced goods & services

Y=C^d+I^d+G^d+EX

Question 3

What is the national income identity in anopen economy?

Answer 3

Y=(C-C^f )+(I-I^f )+(G-G^f )+EX

The sum of domestic spending on foreign goods and services is C^f+I^f+G^f=IM

Y=C+I+G+EX+IM

Y=C+I+G+NX

Where C + I + G is domestic spending

Question 4

How does Y=C+I+G+NX show that domestic spending need not equal output of goods and services in an open economy?

Answer 4

This equation shows that in an open economy, domestic spending need not equal the output of goods and services (if output exceeds domestic spending, we export the difference: net exports are positive) and vice versa

Question 5

What must an open economy’s net exports equal?

Answer 5

The difference between its saving and its investment, in other words, net capital outflow

Question 6

What is net capital outflow?

Answer 6

S - I - difference between domestic saving and domestic investment - net capital outflow (net foreign investment)

Net capital outflow - net outflow of loanable funds (the amount domestic residents are lending abroad minus the amount that foreigners are lending to us) = net purchases of foreign assets (the country’s purchases of foreign assets minus foreign purchases of domestic assets)

When S > I, country is a net lender and vice versa

Net capital outflow = trade balance

Question 7

What is GNP`?

Answer 7

Gross national product

GNP = GDP + factor payments from abroad - factor payments to abroad

Question 8

What are the assumptions for our saving and investment in a small open economy model?

Answer 8

(a) Small - negligible effect on world interest rate
(b) Perfect capital mobility - residents have full access to world financial markets
(c) Domestic & foreign bonds are perfect substitutes

a & b imply r=r* and c implies r* is exogenous

Y is fixed by factors of production and production function Y=Y ̅=F(K ̅,L ̅ )

Consumption is positively related to disposable income C=C(Y-T)

Investment is negatively related to the real interest rate I=I(r)

Supply of loanable funds = S ̅=Y ̅-C(Y ̅-T ̅ )-G ̅- assume national savings do not depend on interest rate

Exogenous policy variables G=G ̅ and T=T ̅

Question 9

How is the world interest rate determined?

Answer 9

In closed economy, interest rate determined by equilibrium of domestic saving and investment

The equilibrium of world saving, and world investment determines the world interest rate

The exogenous world interest rate determines investment

Question 10

What is the trade balance?

Answer 10

• The trade balance is determined by the difference between saving and investment at the world interest rate

Question 11

How does fiscal policy at home influence the trade balance?

Answer 11

If the economy beings in a position of balanced trade

Increase in G or decrease in T reduces national as S=Y - C - G

As world interest rate is unchanged, investment remains the same

Savings falls below investment - some investment must be financed by borrowing from abroad

As NX = S - I, there is a fall in NX - now trade deficit

Same happens if there is a decrease in taxes

Question 12

How does fiscal policy abroad influence the trade balance?

Answer 12

If the economy beings in a position of balanced trade

If a foreign country with large influence on world economy starts increasing government purchases - decrease in world saving causes world interest rate to increase

As cost of borrowing is higher - investment reduced in our small open economy

S exceeds I, and some of S starts flowing abroad

Increase in NX - trade surplus

Question 13

What happens to the small open economy if there is an outward shift in investment demand (i.e. increase)?

Answer 13

At given world interest rate, investment is now higher

Saving is unchanged - hence, we must borrow from abroad

Capital flows into the economy - net capital outflow is negative

Result - trade deficit (NX = S - I )

Question 14

What is the nominal exchange rate and what does it mean if the domestic currency appreciates or depreciates?

Answer 14

Nominal exchange rate - the relative price of the currency of two countries

When the domestic currency appreciates, it buys more of the foreign currency, when it depreciates, it buys less

Appreciation - strengthening, depreciation - weakening

Question 15

What is the real exchange rate? What does it mean if the real exchange rate is high?

Answer 15

Real exchange rate - the relative price of the goods of two countries

Sometimes called terms of trade

real exchange rate=nominal exchange rate·ratio of price levels ε=e·(P/P*)

If real exchange rate is high - foreign goods are relatively cheap and domestic relatively expensive

Question 16

How does NX depend on the real exchange rate?

Answer 16

Relative price of domestic and foreign goods affect demand

If real exchange rate low - domestic goods cheap, lower demand for imports and higher demand for exports - and vice versa

NX=NX(ε)

Hence, if ε increases, EX falls, IM rises, NX falls

Question 17

What are the determinants of the real exchange rate?

Answer 17

Trade balance must = net capital outflow = S - I

Saving is fixed by consumption function and fiscal policy - investment is fixed by investment function and world interest rate

ε must adjust to ensure NX(ε)=S ̅-I(r*)

At the equilibrium real exchange rate, the supply of domestic currency available from the net capital outflow balances the demand for domestic currency by foreigners buying our net exports

Question 18

How do changes in fiscal policy at home affect the real exchange rate?

Answer 18

If government reduces national saving (i.e. increases purchases or cuts taxes) - the supply of domestic currency is reduced

This raises the real exchange rate, which causes net exports to fall

Question 19

How do changes in fiscal policy abroad affect the real exchange rate?

Answer 19

Expansionary fiscal policy abroad - reduces world savings and thus increases world interest rate

This in turn increases the supply of domestic currency, which makes real exchange rate fall and thus raises net exports

Question 20

How does an increase in investment demand affect the real exchange rate?

Answer 20

At given world interest rate, higher investment means lower savings, i.e. lower supply of domestic currency

Result: raises the real exchange rate and reduces net exports

Question 21

What are trade policies?

Answer 21

Trade policies - policies designed to influence directly the amount of goods and services exported or imported

Tariff - tax on foreign imports

Quota - restricting the amounts of import

Question 22

What is the effect of a protectionist trade policy on the trade balance?

Answer 22

Do not alter trade balance

Demand for net exports increases and the real exchange rate increases, which leaves net exports unchanged

The appreciation of the real exchange rate offsets the increase in net exports as the increase in the price of domestic goods relative to foreign lower net exports by stimulating imports and depressing exports

As we export less but net exports are unchanged, we must also import less

Hence, fall in total amount of trade

Protectionist policies diminish gains from trade - society is on average worse off even though the policies might benefit certain producers

Question 23

What are the determinants of the nominal exchange rate?

Answer 23

e depends on the real exchange rate and the price levels at home and abroad

% change in e=% change in ε+(π*-π)

If a foreign country has a high rate of inflation relative to the domestic country, the domestic currency will buy an increasing amount of the foreign currency over time and vice versa

Monetary policy thus affects the nominal exchange rate