Open Economy II Flashcards
What 2 assumptions do we make about the Theory of Open Economy?
- GDP is taken as Given
- Price Level taken as Given- Model of SR
What 2 Markets are involved in Open Market Theory?
- S + D for Loanable Funds
- S + D for Foreign Currency
What does S + D for Loanable Funds Coordinate?
Savings, Investments + NCO in Open Economy
What does S + D for Foreign Currency Coordinate?
People who want to Exchange Domestic currency for Foreign currency
What are Savings equal to in an Open Economy?
S = I + NCO
- S = Domestic Investment + Net Capital Outflow
What can Savings be used to Finance?
Domestic or Foreign Capital Accumulation
What is the Supply of Loanable Funds?
Domestic Saving - Public + Private
What is the Demand for Loanable Funds
D = I + NCO
- Investments at Home or Abroad
What does the Real Interest Rate (r) equilibrate?
S + D for Loanable Funds
What does S(r) of Loanable Funds look like + why?
Increasing
Increased r –> Encourage Saving –> Increased S(r)
What does D(r) for Loanable Funds look like + why?
Decreasing
Increased r –> Discourages I + Foreign Assets less Attractive –> Decreased D(r)
How does NCO depend on r?
Increased Domestic r –> Domestic Assets more attractive –> Decreased NCO
What does Negative NCO mean?
Economy has Net Inflow of Capital
In the FX Market- what is the Demand for £s?
D for £s = NX
- Since NX is paid in £s
In the FX Market- what is the Supply of £s?
Supply of £s = NCO
- Since people Buying Foreign Assets must Sell £s at FX market to buy the assets
What does the Real Exchange Rate (E) equilibrate?
S + D for £s in FX Market
Why is S in FX Market fixed?
Vertical Supply Curve
- S = NCO
- NCO determined by Market for Loanable Funds
What does D for £s in FX look like + why?
Decreasing in E
- D = NX
- Increased E –> Decreased X + Increased M –> Decreased NX –> Decreased D for £s
How is E determined in FX market, through Market for Loanable Funds?
Market for Loanable Funds –> Determines r
- r –> Determines NCO
- NCO = S –> Determines E with NX
What do E + r adjust to?
E + r adjust to equilibrate Market for Loanable Funds + FX market
What is Trade Policy?
Gov. Policy that directly Influences Q. of G+S a country Exports + Imports
- e.g. Tariffs, Quotas, Voluntary export restrictions…
What does an Import Quota do?
Directly restricts M –> decreased M –> Increased NX
Why is the Effect of an Import Quota on NX offset?
Increased NX –> Increased D for £s –> Increased E –> Decreased NX
Do Import Quotas affect Trade Balance + why
NO- does NOT affect Trade Balance
- NX = NCO => S = I
- Trade Policies do NOT alter S or I –> E adjusts to keep Trade Balance the same, regardless of Trade Policy
What are the Micro Effects of Trade Policy?
Can affect Specific Firms / Industries
- e.g. Import Quota- benefits Domestic Firms– BUT Increased E- hurts Exporters –> Decreased X
What can Political or Economic Instability lead to?
Capital Flight
What is Capital Flight?
large Sudden Decrease in D for Assets located in a country
How does Capital Flight affect r + E?
Capital Flight –> Increased NCO –> Increased NX –> Increased D for Loanable Funds –> Increased r
– Increased NCO –> Increased S of currency –> Decreased E- Depreciation
What are the main effects of Increased r from Capital Flight?
- Decreased I
- Slows Capital Accumulation
- Slows Economic Growth
What are the main effects of Decreased E from Capital Flight?
- Depreciation
- Increased NX –> Improves Trade Balance
What is the relationship of Open Economy with PPP?
PPP assumes International trade responds instantly to changes in P ÷ P*
- i.e. Changes in Relative Prices
What does the relationship of Open Economy with PPP mean?
FX Demand is Horizontal at E = 1
What does Decreasing D for £s allow?
Allows E to differ from what PPP would have- Consistent with facts
What is the Gov. Budget Deficit?
Gov. Spending > Gov. Revenue
What does a Gov. Budget Deficit cause?
Decreased National Savings –> Decreased S of Loanable Funds
How does an Increased Budget Deficit affect r + E?
Increased Budget Deficit –> Decreased S of Loanable Funds –> Increased r
–> Decreased NCO –> Decreased S of £s on FX –> Increased E- Appreciation
