Lent - Lecture 11 - Classical Open Economy

Question 1

Define NX, net exports

Answer 1

real exports of domestic goods and services subtract the real value of imports of foreign goods and services

Question 2

Are imports a part of C, I and G?

Answer 2

yes

Question 3

What are the three main components of the current account? What’s the equation for the current account?

Answer 3

• net exports (NX)
• net income from overseas assets (NIA)
• net transfers (NT)
• CA = NX + NIA + NT

Question 4

What is the counterpart to the current account?

Answer 4

net capital flows (NCF)

Question 5

Define net capital flows, give an equation for net capital flows

Answer 5

• net capital flows are the changes in net wealth stock of domestic citizens/government, due to current account deficit/surplus
• = ∆ foreign ownership of domestic assets - ∆ domestic ownership of foreign assets

Question 6

What is the international accounting identity which involves the current account and net capital flows?

Answer 6

CA + NCF = 0

Question 7

What is the international accounting identity which involves the current accounts of all countries?

Answer 7

the current accounts of all countries sum to zero

Question 8

Show that NX = S - I. What’s the easiest way to understand this?

Answer 8

• Y = C + I + G + NX
• (Y - C - G) - I = NX
• S - I = NX
• to understand:
• NX ≈ CA = -NCF

Question 9

What is the major assumption for the classical open economy?

Answer 9

perfect capital mobility

Question 10

Explain why, for a small open classical economy, r = r* , when r* is an exogenous world real interest rate

Answer 10

• domestic r below r* would lead to unmanageable capital outflows (NCF → −∞)
• domestic r above r* would lead to unmanageable capital inflows (NCF → ∞)
• will only have stable NCF if r = r*

Question 11

State the value of NX for r* < r(autonomous) and for r* > r(autonomous)

Answer 11

• r* < r(autonomous) ⇒ NX < 0
• r* > r(autonomous) ⇒ NX > 0

Question 12

Would be expect capital importers or capital exporters to have r* < r(autonomous)? Briefly show why

Answer 12

• capital importers
• r* < r(autonomous) ⇒ NX < 0
• NX < 0 ⇒ CA < 0
• CA < 0 ⇒ NCF > 0
• hence, capital importers

Question 13

In a Classical (Solow) model, r(autonomous) = MPK. Suppose a Cobb-Douglas function, and a constant A in all countries, we would expect capital to flow from where L/K is highest. This means we expect the CA to be positive in rich counties (high K/L) and negative in poor countries (low K/L). What are the three explanations that Lucas gives for why this isn’t really seen in reality?

Answer 13

• human capital differences:
• rich country workers embody more ‘labour units’ than poor country workers; K/L is not so different between countries when L is measured this way
• technology differences:
• A varies from country to country
• capital market imperfections
• political risk, monopoly power ⇒ foreign investment curtailed

Question 14

Explain what happens to NX as a result of an increase in G in this model

Answer 14

• higher G implies lower S by the amount ∆G
• investment remains constant, as r = r* (world real interest rate)
• instead, NX fall by ∆G
• (implies budget deficits go together with CA deficits) (twin deficits hypothesis)