Macroeconomics & The global economy
Ace Institute of Management Session 6: The open economy
Instructor Rijan Dhakal
[email protected] 9851069004
Open Economy: Open to foreigners Contrary to Closed Economy: Export and Import some of its goods and services to other countries including capital mobility (depends on savings and investments in the economy)
An Important Macroeconomic Model Relating to Saving and Investment and Trade Balance
Y = Cd + Id + Gd + EX
Consumption of Domestic Goods and Services Investment in Domestic Goods and Services Govt. Purchase of Domestic Goods and Services Export of Domestic Goods and Services
Domestic Spending on Domestic Goods and Services
Foreign Spending on Domestic Goods and Services
We know that, Domestic Spending on all Goods and Services = Domestic Spending on Domestic Goods and Services + Domestic Spending on Foreign Goods and Services
C = Cd +Cf or, Cd = C - Cf I = Id +If or, Id = I - If
C = Total Consumption Cd = Consumption of Domestic goods & services Cf = Consumption of Foreign goods & services I = Total Investment Id = Investment in Domestic goods & services If = Investment in Foreign goods & services
G = Gd +Gf or, Gd = G - Gf
G = Total Govt. Purchase Gd = Govt. Purchse. of Domestic goods & services Gf = Govt. Purchse. of Foreign goods & services
Y = (C - Cf) + (I - If) + (G - Gf) + EX
Y = C + I + G + EX(Cf+If+Gf)
Y = C + I + G + EXIM
Expenditure on Imports Net Exports or Trade Balance Domestic spending need not equal the Output
Y = C + I + G + NX
NX= Y (C + I + G)
Net Exports = Output Domestic Spending
If Output > Domestic Spending : NX Positive: Export more If Output < Domestic Spending : NX Negative: Import more
Y = C + I + G + NX YC G= I+ NX S = I+ NX
S I = NX
Net Capital Outflow or Net Foreign Investment
Net Exports or Trade Balance
If, Domestic S > Domestic I, NCO is +ve ; Excess S will be loaned out to foreigners and economy experiences Capital Outflow. If, Domestic S < Domestic I, NCO is ve ; Deficit financing is done by borrowing from abroad and economy experiences Capital Inflow. Net Capital Outflow = Amount that Domestic residents are lending abroad Amount that foreigners are lending to us
Net Capital Outflow = Trade Balance
In Equilibrium,
In Equilibrium,
S I = NX
Net Capital Outflow = Trade Balance
Condition of Trade Surplus: If S I is positive, NX is positive, implies Trade Surplus Net Lender in International Financial Market Condition of Trade Deficit If S I is negative, NX is negative, implies Trade Deficit Net Borrower from International Financial Market Condition of Balance Trade If S I exactly equals to NX
The national income account identity shows that the international flow of funds to finance capital accumulation and the flow of goods and services are two sides of the same coin.
Assumptions:
Small Economy: Economy that is a small part of the world economy and can not affect the world interest rates. Perfect Capital Mobility: Country has full access to world financial markets. Domestic Interest rate (r) = World Interest Rate (r*) due to perfect capital mobility
Determination of Interest Rates: Domestic : Intersection of Domestic Savings and Investment World: Intersection of World Savings and Investment
More Assumptions:
production function
Y Y F (K , L )
consumption function
investment function
C C ( Y T )
I I (r )
G G , T T
exogenous policy variables
More Assumptions:
S Y C ( Y T ) G
National saving: The supply of loanable funds
S, I
More Assumptions:
Investment: The demand for loanable funds but the exogenous world interest rate
determines the
r*
I (r )
I (r* )
countrys level of investment.
S, I
Explanations:
If the economy were closed
r
S
the interest rate would adjust to equate investment and saving:
rc I (r )
I (rc ) S
S, I
Explanations:
the exogenous world interest rate determines investment
and the difference between saving and investment determines net capital outflow and net exports
But in a small open economy r
S
NX
r* rc I (r ) I1
S, I
Case of Trade Surplus (S >I)
Explanations:
Or, Case of Trade Deficit
S
Trade Deficit (S < I)
rc r* I1 I (r )
S, I
How do government policies affect Trade Balance?
Three Cases:
Case 1: Starting from Trade Balance, What happens if the Home Government uses expansionary fiscal polices such as increase in G or reduce T? (Fiscal policy at home)
Case 2: Starting from Trade Balance, What happens if the Foreign Government uses expansionary fiscal polices such as increase in G?(Fiscal policy abroad) Case 3: Starting from Trade Balance, What happens if the Investment increases in the home country?(An increase in investment demand)
How Policies Influence the Trade Balance?
Case 1: Starting from Trade Balance, What happens if the Home Government uses expansionary fiscal polices such as increase in G or reduce T? As we know, i) S = Y C G; When G increases, S decreases. i) As T decreases due to tax cut, disposable income Y T increase; Stimulate consumption and C increases Which lowers S
Fiscal policy at home
r
An increase in G or decrease in T reduces saving.
S 2 S1
- NX
S<I Country runs trade deficit
* 1
I (r ) I1
S, I
Starting from Trade Balance, a change in fiscal policy that reduces national savings causes Trade Deficit
How Policies Influence the Trade Balance?
Case 2: Starting from Trade Balance, What happens if the Foreign Government uses expansionary fiscal polices such as increase in G? Considering the foreign economy is large enough i) Increase in G by foreign government reduces world S and world interest rate r* rises. ii) Rise in r* increases costs of borrowing and reduces domestic I. iii) Since domestic S has not change, S>I and some of the savings flow abroad as capital outflow. iv) Again, as NX = S I; NX increases as I decreases that leads to Trade Surplus.
Fiscal policy abroad
Expansionary fiscal policy abroad raises the world interest rate.
r
NX2
S1
r 2* r1*
I (r )
I (r2* ) I (r1* )
S>I Country runs trade surplus
S, I
Starting from Trade Balance, an increase in the world interest rate due to fiscal expansion abroad causes Trade Surplus
How Policies Influence the Trade Balance?
Case 3: Starting from Trade Balance, What happens if the Investment increases in the home country in existing r? i) Increase in I but no change in r* ii) Since S has not changed, S<I and some of the investment has to be financed by borrowing from abroad as capital inflow. iii) Again, as NX = S I; NX decreases as I increases that leads to Trade Deficit.
An increase in investment demand
r
S
S<I Country runs trade deficit
r*
- NX
I (r )2 I (r )1 I1 I 2 S, I
Starting from Trade Balance, an outward shift in the investment schedule causes Trade Deficit
Thank You
