Long-run Model For Small/Large Open Economy (Mankiw Pg189) Flashcards
- What do we assume for r in a small open economy
- We can see how this works by letting r<r*. What would happen?
- r=r* (small economy r is fixed at global r)
- We let r=B/Pb where Pb is price of bond and B is interest paid on bond.
If r>r. International investors will sell domestic bonds and buy foreign bonds. So supply of domestic bonds increases, Pb falls until r=r.
Scenario 1:
Implications of global financial integration for a small open economy.
Assume global r* is above r.
LFM model - We can see a trade surplus since S>I(r*)
FEM model - Starting at balanced trade ε₀ (NX=0), since r* is higher than domestic, we supply domestic bonds to buy foreign bonds which depreciates to ε₁.
Price of bonds will fall until r=r* (as required for our assumption)
Scenario 2: Increase in foreign government spending on a small open economy
LFM model : Foreign governments increased spending increases the global r*, due to crowding out!
Since r=r*, r domestically increases too (movement along I(r) curve) . This makes investment less attractive, investment falls, causing a trade surplus (since S>I now)
FEM model : National saving surplus increases and we fund investment abroad (increase in CF). Causes a depreciation and increase in NX and
Scenario 3:
A rise in domestic firms confidence
LFM: Investment increases, creating a trade and Sn deficit.
I>S, so we have to borrow from abroad to fund investment.
FEM: appreciation of currency as foreign investors demand our currency to invest and a fall in NX (since SPICED)
Large open economy - key implication
Large open economy influences the global interest rate, which influences CF.
What does the saving/investment relation become and why?
S=I+CF
Because national saving (S) is used for domestic fixed capital investment (I) , and foreign fixed capital investment
Large open economy diagram NCF diagram
High interest rate>NCO falls as domestic investments more attractive.
(Dotted vertical line through middle)
LFM demand curve for large open economy explained
Demand curve becomes I(r) + CF(r) which represents the 2 options to invest domestically I(r) or abroad CF(r)
FEM for a large open economy
Supply curve is CF and CF=Sn - I
Level of CF determines the real exchange rate such that CF=NX at equilibrium.
Scenario 2:
Impact of fiscal expansion financed by selling gov bonds. (Small open economy)
LFM - Fiscal expansion means G increases, and so national saving falls. This causes a trade deficit (I>S).
FEM - Government selling bonds to foreigns, and thus demand for domestic currency increases, causing an appreciation.
Scenario 1 for a large open economy:
A fall in national savings.
Reminder : for large economy, need to show 3 diagrams.
LFM - Shift in Sn, raising the interest rate. (E.g crowding out pushing r up)
NCO - an increase in r means domestic investments are attractive so capital inflows, so CF falls.
FEM - Since CF is the supply curve, we see the fall in CF, people demand the currency to buy domestic assets causing an appreciation and a fall in NX.
Scenario 2 for large open economy:
Increase in US firm investment
LFM - increase in investment demand. Pushes r up.
NCO - increase in R causes a fall in CF since domestic assets attractive (CI>CO) (same as previous scenario of fall in Sn)
FEM - CF shifts left. Foreigners demand domestic currency causing appreciation and fall in NX.
Scenario 3 for a large open economy:
Greater global uncertainty.
When there is global uncertainty, investors invest in US since it is a safe haven.
So in this case we consider NCO diagram first
NCO - fall in CF since invest more domestically.
LFM - since demand curve is (I + CF), shift down causing a fall in r.
FEM - fall in CF appreciates currency as foreigners demand domestic currency.
(All 3 large open economy scenarios cause an appreciation)
Small open economies have perfect capital mobility, what does this mean
They have full access to global financial markets
