Week 16 - The open economy Flashcards
What conditions no longer hold when an economy is open?
- Saving doesn’t have to equal investment
- Expenditure doesn’t have to equal output
What is NX?
Net exports (EX - IM). If this is positive, the country is said to have a trade surplus. If negative, the country has a trade deficit.
What is the national income identity in an open economy?
Y = C + I + G + NX OR NX = Y - (C + I + G)
What is another important identity in the open economy model?
NX = S - I (trade balance = net capital flows)
What are net capital outflows?
Simply S - I. This is also equal to the “net outflow of loanable funds, or the net purchases of foreign assets minus foreign purchases of domestic assets.
How does the loanable funds model change when considering open economies?
Supply of LFs is vertical (national saving doesn’t depend on interest rate). Demand is downward sloping still (as r falls investment increases). However, KEY DIFFERENCE: Actual level of investment is set by world interest rate, not domestic rate. This is why investment doesn’t have to equal savings.
How does fiscal policy at home affect NX?
- Shifts supply of loanable funds to the left (savings reduces)
- Investment is unchanged as r* doesn’t change.
- Net effect: NX reduces by the reduction in savings.
How does fiscal policy abroad affect NX?
- Expansionary fiscal policy abroad raises the world interest rate.
- Savings is unaffected (doesn’t depend on r*).
- Investment falls
- Net effect: NX increases by the magnitude of the fall in I
How does an increase in investment demand affect NX?
- Shifts demand for loanable funds to the right.
- S is left unchanged.
- Net effect: NX reduces by the change in investment.
What is a nominal exchange rate?
The relative price of domestic currency, in terms of foreign currency.
What is a real exchange rate?
The relative price of domestic GOODS, in terms of foreign goods.
Formula: {Epsilon} = (e * P) / P*
How does NX respond to the real exchange rate?
- Fall in real exchange rate means domestic goods are relatively cheaper than foreign goods. Therefore, NX increases (exports rise, imports fall). The converse is true
- Thus, there is an inverse relationship between epsilon and NX.
How is the real exchange rate determined?
- NX (E) = S - I
- S - I is a vertical line (doesn’t depend on E)
- NX (E) is downward sloping (explain why?)
- Thus, the intersection of these two curves determines the real exchange rate
How does fiscal policy at home affect the real exchange rate?
- S falls, so the (S - I) curve shifts to the left (the supply of pounds has fallen).
- Demand for pounds remains unchanged
- Net effect: The real exchange rate to rises, whilst NX falls.
How does fiscal policy abroad affect the real exchange rate?
- r* rises, which reduces investment, increasing net capital outflows and hence shifting the supply of pound to the right.
- Net effect: NX increases, and the real exchange rate falls,
How does an increase in investment demand affect the real exchange rate?
- Increase in inv. demand reduces net capital flows and shifts supply of pounds to the left.
- Net effect: real exchange rate rises, and NX falls.
How does trade policy to restrict imports affect the real exchange rate?
- At any given E, imports is now lower, and exports higher - demand for pounds shifts to the right.
- Net effect: real exchange rate rises, NX remains constant.
How is the nominal exchange rate determined?
- If the real exchange rate is constant, then the change in e is equal to the difference between foreign and domestic inflation rates.
What is purchasing power parity (PPP)?
Two defs:
- Doctrine that states all goods must sell at the same (currency adjusted price) in all countries.
- Nominal exchange rate adjusts to equalise the cost of a basket of goods across all countries.
WHY?! Due to arbitrage, or the “law of one price”.
FORMULA = PPP: e * P = P*
How does PPP effect our determination of the real exchange rate?
Under PPP, the real exchange rate is simply 1 (this is what PPP means). Therefore, the NX curve is horizontal.
This means that changes in S or I will have no effect of the real exchange rate.
Does PPP hold in the real world?
No, because arbitrage is not always possible:
- There are transportation costs
- Some goods aren’t traded
- Goods are not always perfect substitutes
HOWEVER: Still a useful tool as simple and intuitive, and empirical evidence suggests exchange rates converge on PPP values in the long run.
