Review of the previous lecture

• Nominal interest rate equals real interest rate + inflation rate. Fisher effect: nominal interest rate moves one-for-one w/ expected

inflation. is the opp. cost of holding money

• Money demand depends on income in the Quantity Theory more generally, it also depends on the nominal interest rate; if so, then changes in expected inflation

affect the current price level.

Review of the previous lecture

• Costs of inflation Expected inflation

shoeleather costs, menu costs, tax & relative price distortions, inconvenience of correcting figures for inflation

Unexpected inflationall of the above plus arbitrary redistributions of wealth between debtors and creditors

Review of the previous lecture

• Hyperinflation caused by rapid money supply growth when money printed to finance

govt budget deficits stopping it requires fiscal reforms to eliminate govt’s need for printing

money

Lecture 21

Open economy - IInstructor: Prof.Dr.Qaisar Abbas

Course code: ECO 400

Lecture Outline

1. Open economy

2. Saving and investment

3. Three experiment

Open economy•spending need not equal output

•saving need not equal investment

Preliminaries

•EX = exports = foreign spending on domestic goods

•IM = imports = C f + I f + G f = spending on foreign goods

•NX = net exports (a.k.a. the “trade balance”) = EX – IM

d fC C C d fI I I

d fG G G

superscripts:d =spending on

domestic goods

f = spending on foreign goods

Open economyGDP = expenditure on domestically produced g & s

d d dY C I G EX

( ) ( ) ( )ff fC C I I G G EX

( )ff fC I G EX C I G

C I G EX IM

C I G NX

Open economyThe national income identity in an open economy

YY = = CC + + II + + GG + + NXNX

or, NX = Y – (C + I + G )

net exports

output

domestic spending

Open economyTrade surpluses and deficits

trade surplus

•output > spending and exports > imports

•Size of the trade surplus = NX

trade deficit

•spending > output and imports > exports

•Size of the trade deficit = –NX

NX = EX – IM = Y – (C + I + G )

Open economy

International capital flows •Net capital outflows

=S – I

=net outflow of “loanable funds”

=net purchases of foreign assets the country’s purchases of foreign assets

minus foreign purchases of domestic assets

•When S > I, country is a net lender

•When S < I, country is a net borrower

Link between trade & cap. flows

The link between trade & cap. flows

NX = Y – (C + I + G )

implies

NX = (Y – C – G ) – I

= S – Itrade balance = net capital outflows

Thus, Thus,

a country with a trade deficit (a country with a trade deficit (NXNX < < 00) )

is a net borrower (is a net borrower (SS < < I I ).).

Thus, Thus, a country with a trade deficit (a country with a trade deficit (NXNX < <

00) )

is a net borrower (is a net borrower (SS < < I I ).).

Saving and Investment in a Small Open EconomySaving and Investment in a Small Open Economy

An open-economy version of the loanable funds model includes

production function: ( , )Y Y F K L

consumption function: ( )C C Y T

investment function: ( )I I r

exogenous policy variables: ,G G T T

Saving and InvestmentSaving and InvestmentNational Saving: National Saving:

The Supply of Loanable FundsThe Supply of Loanable Funds

Saving and InvestmentSaving and InvestmentAssumptions re: capital flowsa. domestic & foreign bonds are perfect substitutes (same risk, maturity, etc.)

b. perfect capital mobility:no restrictions on international trade in assets

c. economy is small:cannot affect the world interest rate, denoted r*

aa & & bb imply imply rr = = r*r*

cc implies implies r*r* is exogenousis exogenous

aa & & bb imply imply rr = = r*r*

cc implies implies r*r* is exogenousis exogenous

Saving and InvestmentSaving and InvestmentInvestment:

The Demand for Loanable Funds

Investment is still a downward-sloping function of the interest rate,but the exogenous

world interest rate……determines the country’s level of investment.

Saving and InvestmentSaving and InvestmentIf the economy were closed…

…the interest rate would adjust to equate investment and saving:

Saving and InvestmentSaving and InvestmentBut in a small open economy…

the exogenous world interest rate determines investment…

…and the difference between saving and investment determines net capital outflows and net exports

Three experimentsThree experiments

• Fiscal policy at home•Fiscal policy abroad•An increase in investment demand

1. Fiscal policy at home

An increase in G or decrease in T reduces saving.

Results:

0I

0NX S

Three experiments2. Fiscal policy abroad

Expansionary fiscal policy abroad raises the world interest rate.

Results: 0I

0NX I

Three experiments3. An increase in investment demand

EXERCISE:Use the model to determine the impact of an increase in investment demand on NX, S, I, and net capital outflow.

Three experiments

An increase in investment demand

ANSWERS:I > 0,

S = 0,

net capital outflows and net exports fall by the amount I

Summary

• Net exports--the difference between exports and imports a country’s output (Y )

and its spending (C + I + G)

• Net capital outflow equals purchases of foreign assets

minus foreign purchases of the country’s assets the difference between saving and investment