ECON 282: The Open Economy Flashcards
In an open economy,
-Spending need not equal output
-Saving need not equal investment
Trade surplus
output > spending
exports (NX) > imports (IM)
Size of the trade surplus = NX
Trade Deficit
spending > output
imports > exports
Size of the trade deficit = -NX
Net Capital Outflow
= S-I
= net outflow of ‘loanable funds’
= net purchase of foreign assets
-the country’s purchases of foreign assets minus foreign purchases of domestic assets
When S > I
the country is a net lender
When S < I
the country is a net borrower
Assumptions about capital flows:
-Domestic and foreign bonds are perfect substitutes (same risk, maturity, etc)
-Perfect capital mobility: no restrictions on international trade in assets
-Economy is small: cannot affect the world interest rate, denoted r*
a and b imply r=r*
c implies r* is exogenous
Investment: demand for loanable funds
-Investment is still a downward-sloping function of the interest rate, but the exogenous world interest rate determines the country’s level of investment
If the economy were closed…
-The interest rate would adjust to equate investment and saving
But in a small open economy…
-the exogenous world interest rate determines investment
-and the difference between saving and investment determines net capital outflow and net exports
Fiscal Policy at home
An increase in G or decrease in T reduces saving
Fiscal Policy Abroad
-Expansionary fiscal policy abroad raises the world interest rate.
Nominal exchange rate
the relative price of domestic currency in terms of foreign currency
(example: yen per dollar)
The real exchange rate
the relative price of domestic goods in terms of foreign foods
(example: Japanese Big Macs per Canadian Big Mac)
e in the real world and our model
-In the real world: we can think of e as the relative price of a basket of domestic goods in terms of a basket of foreign goods
-In our macro model: there is just one good “output”, so e is the relative price of one country’s output in terms of the other country’s output
How NX depends on e
If e rises:
- Canadian goods become more expensive relative to foreign goods
-exports fall, imports rise
-net exports fall
The next exports function
The net exports function reflects this inverse relationship between NX and e:
NX = NX(e)
(real exchange rate)
How is e determined
Neither S nor I depends on e, so the net capital outflow curve is vertical
Supply and Demand in the foreign exchange market
-Demand: foreigners need dollars to buy Canadian net exports
Supply: net capital outflow (S-I) is the supply of dollars to be invested abroad
Fiscal Policy at home.
Fiscal expansion causes net capital outflow, national saving, and the supply of dollars in the foreign exchange market to go down.
National saving: increased government spending or tax cuts means people save less and spend more
NCO: less money available for investment, less capital flowing from the country to foreign markets
Dollars: with lower NCO, less dollars in market
Real exchange rate: decrease I the dollars in the foreign exchange market raises the interest rate, when fewer dollars available, value of dollars rises
NX: Higher exchange rate means domestic goods are more expensive, this reduces NX.
Fiscal Policy Abroad
-An increase in world interest rate, reduces investment, increasing net capital outflow and the supply of dollars in the foreign exchange market
NCO: higher interest rate attracts foreign investors seeking better returns. More domestic funds flow to foreign assets
-causing real exchange rate to fall and NX to fall and NX rise
Trade Policy to restrict imports
At any given world real exchange rate, an import quota reduces IM, increases NX, and increases demand for dollars
-Trade policy doesn’t affect S or I, so capital flows and the supply of dollars remain fixed
Results:
change in real exchange rate > 0
change in NX = 0
change in IM < 0
change in EX < 0
The determinants of the nominal exchange rate
expression for real exchange rate
real exchange rate = (e x P)/P*
Solve for e
e = real exchange rate x (P*/P)
-e depends on the real exchange rate and the price levels at home and abroad
Purchasing Power Parity
Two definitions: a doctrine that states that goods must sell at the same (currency-adjusted) price in all countries
-the normal exchange rate adjusts to equalise the cost of a basket of goods across countries
Reasons: arbitrage, the law of one price
- PPP implies that the nominal exchange rate between two countries equals the ratio of the countries’ price levels
