Lecture 20 - Large Open Economy

Question 1

Basic concept of a large open economy like US

Answer 1

The economy can now influence global financial markets (INTEREST RATE)

Question 2

3 equations (output, money supply, and NX)

2. How can we find the IS curve for a large economy

Answer 2

Y= a+b(Y-T) + I(r) +G+NX(ε) (Same as small but r not r* and ε not e)

M/P=L(r,Y)

NX(ε) = CF(r)

2. Sub NX equation into Y equation.
   Y= a+G-bT/(1-b) + I(r)+CF(r)/(1-b)

Then as prices are fixed in SR we can use nominal exchange rate e rather than ε for the diagram Y axis.

Question 3

3 models used to show SR large open economy

Answer 3

ISLM
NCO
FEM

Question 4

how these 3 diagrams are connected

Answer 4

ISLM determines output and interest rate (Y and R)

NCO model - The given level of r from ISLM creates a certain CF level

FEM model CF=NX in the FEM model to find exchange rate

Question 5

Scenario 1
Effect of :
Fiscal expansion in a large open economy

Answer 5

ISLM model - IS increase. Increased Y and r.

NCO model - Increased r means a fall in CF (capital inflows>capital outflows as foreign investors invest domestically)

NCO model - A fall in CF means an appreciation in currency since demand for domestic currency increases

Question 6

Scenario 2
Effect of :
Increase in domestic money supply in large open economy

Answer 6

ISLM - Increased LM. Increased Y fall in r.

NCO - fall in R means increase in CFs (capital outflows since domestic investment less attractive - sell domestic assets to buy foreign)

FEM - increase in CF causes depreciation, NX increases (exporrts cheap)

NOTE: this ignores the idea that small economies copy the interest rate.. pto

Question 7

Is this always the case? pg 7

Answer 7

No, this last scenario omits the response of the rest of the world. Remember, small economies match the rate offered in large open economy.

So in this instance, a fall in interest rates will also lower rates in the small economy.

So NCO impact will not be as big as all countries become less attractive together (they won’t sell domestic to buy foreign as foreign has matched rate) so we assume no change in capital outflows. A shift down in CF but no change in actual CFs.

In the FEM model NX still increased since the monetary policy in the large economy may have increased incomes in small economies (since they lower interest rates too) and so spend more on goods of the large economy, thus increasing large economies NX.

Question 8

Impact of uncertainty in the large economy

Answer 8

ISLM - fall in IS and LM.
IS falls as consumption/investment falls
LM falls as demand for money rises (safer to hold in cash) so a fall in real money supply LM>LM2.

For simplicity the shifts occur and only Y falls, r remains.

NCO - Fall in CF, investors move inflows from small economies to large (safe haven)

NX could shift inwards because uncertainty also carries over to small economies, the small economies reduce their import demand, and so NX in the large economy falls. Fall in NX means an appredciation.

Second possible outcome - NX could increase if the large economy reduces the amount it imports significantly. ]