Classical Open Economies

Question 1

What is changed about the expenditure definition of GDP when moving to an open economy model?

Answer 1

Y = C + I + G + NX with NX being the real exports of domestic goods and services less the real value of imports of foreign goods and services
Imports are a part of all three other components so factors affecting one can affect the other in the same or opposite direction

Question 2

What is the current account?

Answer 2

CA = net income flows from abroad received by domestic citizens and government over a given period = NX + NIA (net income from overseas assets) + NT (net transfers) ≈ NX

Question 3

What are net capital (in)flows?

Answer 3

The counterpart to the CA, measuring the changes in net wealth stock of domestic citizens/government due to current deficit/surplus = Δforeign ownership of domestic assets - Δdomestic ownership of foreign assets
International investment flows are comprised of foreign direct investment, portfolio investment, and official sector (CB) flows

Question 4

What are the international accounting identities?

Answer 4

CA + NCF = 0
ΣCA = 0 across countries

Question 5

How can NX be expressed in terms of S and I?

Answer 5

NX = (Y - C - G) - I = S - I
Can interpret this as NX ≈ CA = -NCF
If domestic savings exceed domestic use of funds for investment, some funds must go abroad

Question 6

How can changes to savings be used to explain the US’ persistent trade deficit?

Answer 6

By international accounting identities NX_US + NX_rest = 0 => (S_rest - I_rest) = -NX_US so if savings are higher in the rest of the world the US will have a higher trade and current account deficit
Global savings could be higher because of demographics, crisis insurance, CB interventions, and SWFs
However it is hard to assign causality, could equally say US has low savings

Question 7

What features characterise a classical open economy?

Answer 7

A fixed level of output is determined by technology and FoPs, prices are perfectly flexible, classical dichotomy holds, each country is small relative to the rest of the world

Question 8

What is the implication of assuming relatively small countries?

Answer 8

Combined with the assumption of perfect capital mobility, they imply that there must be an exogenous global real interest rate r*
r < r* => NCF –> -∞
r > r* => NCF –> +∞
This rate will determine CA

Question 9

How would NX be represented graphically?

Answer 9

On an r against S, I plot of savings and investment, NX is the difference between S and I at r*
r* > r_aut => NX > 0
Would expect capital importers to have an autarkic rate above the global rate (Solow model has r_aut = MPK so can write MPK in terms of K to get this relationship)

Question 10

What are the explanations for the lack of capital flows into developing countries that would be expected by the differences in K/L?

Answer 10

Human capital differences which would change K/L, technology differences (different TFP = A), and capital market imperfections

Question 11

Is there crowding out in a classical open economy?

Answer 11

Higher G implies lower S by ΔG but investment is determined the (global) interest rate so it is NX that falls by ΔG
Twin deficits hypothesis: budget and CA deficits go together

Question 12

What is the real exchange rate ε?

Answer 12

price of home goods in home currency x nominal exchange rate / price of foreign goods in foreign currency = eP/P*
The nominal exchange rate is units of foreign currency per unit of home currency
This definition has higher ε <=> higher relative price of domestic goods: real appreciation but this is not a universal convention so use terms appreciation and depreciation

Question 13

What is the relationship between NX and ε?

Answer 13

NX decreases in ε as long as the Marshall-Lerner condition holds because the effect of real appreciation in decreasing quantity of exports and increasing quantity of imports outweighs the effect of real appreciation lowering the value of imports and increasing the value of exports (quantity effects > price effects)

Question 14

How is the Marshall-Lerner condition derived?

Answer 14

Break NX into baskets exported and the real cost of imports times baskets imported
NX = X - 1/ε M with X decreasing and M increasing in ε
M-L condition gives where dNX/dε < 0
Differentiate NX, multiply through by ε²/M, then use the approximation X ≈ M/ε which holds when close to trade balance to get that the sum of the elasticities of imports and exports wrt to ε must be greater than one
η_X = -ε/X dX/dε > 0
η_M = -ε/M dM/dε > 0

Question 15

What determines ε?

Answer 15

The negative relationship between NX and ε gives a price-sensitive component of AD like closed economy I(r), so ε adjusts to ensure aggregate demand equals Ỹ
The unique S - I set by r* fixes ε
Graphically, a vertical NX* = S - I intersects the downward sloping NX(ε) at ε* on an (NX, ε) plot (y axis should be in the middle of x axis because NX can be less than 0)

Question 16

What does the relationship between ε and NX imply about the effect of government stimulus?

Answer 16

Graphically, an increase in G increases domestic borrowing requirements so savings on an r against S, I plot shifts to the left so NX = (S - I) shifts left on an ε against NX plot, leading to a higher intersection point so a higher eqm ε at a contracted NX
Gov stimulus puts pressure on the market for loanable funds, foreign lenders are attracted to invest => capital inflows needed to maintain r = r* => e appreciates => ε appreciates until eqm is restored (equivalently can say higher domestic AD drives up P which raises ε)

Question 17

What is the law of one price?

Answer 17

The idea that the real price of a homogenous tradable good with negligible transport (maybe like basic commodities) should not vary between countries
p_i = p_i*/e
Guaranteed by arbitrage

Question 18

What is the Purchasing Power Parity hypothesis?

Answer 18

PPP is the extension of the law of one price to a basket of goods
P = P*/e so ε = 1 (horizontal line on ε against S, I plot
PPP implies no volatility in ε which is unlikely (trade costs, tariffs, and taxes limit scope for arbitrage, some goods aren’t tradeable)
ε between developed countries often around 1 but with developing countries often very far from 1

Question 19

What could explain the more appreciated exchange rate of richer countries?

Answer 19

If proportion t of goods are tradeable then agg price level P = tp_t + (1 - t)p_nt
Reasonable assumption that growth reduces cost more quickly in tradeable sectors implies developed countries have higher p_nt/p_t due to higher relative cost of production
Assuming the law of one price holds only for tradeables, can use 1 = ep_t/p_t* in the formula for ε and divide through by p_t* to get ε = (t + (1-t)p_nt/p_t) / (t + (1-t)p_nt/p_t)
This is the Balassa-Samuelson effect, resulting from more efficiency in manufactures raising real wages which crosses over to services without the same efficiency improvement so relative cost of non-tradeables rises so relative cost of full basket rises

Question 20

How does the Balassa-Samuelson effect hold up empirically?

Answer 20

There is some evidence for the implication that fast-growing countries will see ε rise towards 1 for some post-WW2 economies (e.g. yen:dollar)