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Macro Session 4

Macro Session 4

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macro session 4
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Macroeconomics & The global economy

Ace Institute of Management Session 4: The open economy
Instructor Sandeep Basnyat Sandeep_basnyat@yahoo.com 9841 892281

Open Economy: • Open to foreigners • Contrary to Closed Economy: Export and Import some of its goods and services to other countries including capital mobility

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 G = Gd +Gf or, Gd = G - Gf

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 = 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 + EX–IM 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 .

Deficit financing is done by borrowing from abroad and economy experiences Capital Inflow. NCO is ve . Domestic S > Domestic I. • Net Capital Outflow = Amount that Domestic residents are lending abroad – Amount that foreigners are lending to us Net Capital Outflow = Trade Balance In Equilibrium. • If.Y = C + I + G + NX Y–C – 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. .

implies Trade Surplus • Net Lender in International Financial Market • Condition of Trade Deficit • If S – I is negative.In Equilibrium. . implies Trade Deficit • Net Borrower from International Financial Market • Condition of Balance Trade • If S – I is 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. S – I = NX Net Capital Outflow = Trade Balance • Condition of Trade Surplus: • If S – I is positive. NX is positive. NX is negative.

An Important Macroeconomic Model Relating to Saving and Investment and Trade Balance .

• 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 . • Perfect Capital Mobility: Country has full access to world financial markets.Assumptions: • Small Economy: Economy that is a small part of the world economy and can not affect the world interest rates.

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: r S Y  C ( Y T )  G National saving: The supply of loanable funds S S. I .

S. I .More Assumptions: r Investment: The demand for loanable funds but the exogenous world interest rate… …determines the r* I (r ) I (r* ) country’s level of investment.

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) .

Case of Trade Deficit S r Trade Deficit (S < I) rc r* I1 I (r ) S. I .Explanations: Or.

How do government policies affect Trade Balance? Three Cases: Case 1: Starting from Trade Balance. What happens if the Investment increases in the home country?(An increase in investment demand) . 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 Home Government uses expansionary fiscal polices such as increase in ‘G’ or reduce ‘T’? (Fiscal policy at home) Case 2: Starting from Trade Balance.

When ‘G’ increases. i) S = Y – C – G. What happens if the Home Government uses expansionary fiscal polices such as increase in ‘G’ or reduce ‘T’? As we know. • Stimulate consumption and ‘C’ increases • Which lowers ‘S’ .How Policies Influence the Trade Balance? Case 1: Starting from Trade Balance. i) As ‘T’ decreases due to tax cut. disposable income Y – T increase. ‘S’ decreases.

NX S<I Country runs trade deficit r * 1 I (r ) I1 S. a change in fiscal policy that reduces national savings causes Trade Deficit . I Starting from Trade Balance.Fiscal policy at home r An increase in G or decrease in T reduces saving. S 2 S1 .

S>I and some of the savings flow abroad as capital outflow. 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. NX increases as “I” decreases that leads to Trade Surplus. ii) Rise in ‘r*’ increases costs of borrowing and reduces domestic “I”. iii) Since domestic “S” has not change. iv) Again.How Policies Influence the Trade Balance? Case 2: Starting from Trade Balance. as NX = S – I. .

an increase in the world interest rate due to fiscal expansion abroad causes Trade Surplus . r NX2 S1 r 2* r1* I (r ) I (r2* ) I (r1* ) S>I Country runs trade surplus S. I Starting from Trade Balance.Fiscal policy abroad Expansionary fiscal policy abroad raises the world interest rate.

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 change. S<I and some of the investment has to be financed by borrowing from abroad as capital inflow. as NX = S – I. . iii) Again. NX decreases as “I” increases that leads to Trade Deficit.How Policies Influence the Trade Balance? Case 3: Starting from Trade Balance.

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. an outward shift in the investment schedule causes Trade Deficit . I Starting from Trade Balance.

• Nominal and Real 23 .The exchange rate between two countries is the price at which residents of those countries trade with each other.

The nominal exchange rate e = nominal exchange rate.g. 73 per US Dollar) . Nepali Rs. the relative price of domestic currency in terms of foreign currency (e.

• Demand and Supply for the currency determines the exchange rate. • Important factor: trade and Investment requirements e S$ e0 A D$ $ Dollar Value of Transactions .

Suppose there is an increase in the demand for U. would be a depreciation of the dollar. Dollars in Nepal (for importing goods and services or going abroad). and thus decrease e.S. This is known as appreciation of the dollar. Events which decrease the demand for the dollar. D$  D$ $ Dollar Value of Transactions . How will this affect the nominal exchange rate for US dollar in Nepal? e e1 e0 A S$ B D$ shifts rightward and increases the nominal exchange rate. e.

000 Japanese Yen. • The car model he likes in Japan costs 2400.Understanding Real Interest Rate • A Japanese businessman thinks that Japanese cars made in the US are far better than those made in Japan. . The existing spot (nominal) exchange rate is 120 Yen/dollar.

000 and Travels to US to buy the same car.Understanding Real Interest Rate • So. the same car in US costs only $10.000 Japanese Yen for $20. he exchanges 2400. • What are his impressions about the US and Japanese currencies? . • For his surprise.000.

The Japanese Yen is overvalued 2.Understanding Real Interest Rate Impression: 1. Overvaluation of Japanese currency: He can buy more cars (2 cars) in US than Japan with same amount of money. Real exchange rate is different from nominal exchange rate: 1 American car = 0.5 Japanese Car (as US car costs half the price of the car in Japan). .

How many Nepali KFC baskets can you buy with the amount you pay for 1 U. KFC basket?) . the relative price of domestic goods the lowercase Greek letter in terms of foreign goods epsilon (e.g.The real exchange rate ε = real exchange rate.S.

Goods Exchange = Price of Foreign Goods Rate Nominal Relative Real Exchange = Exchange X Price of Rate Goods Rate P = Price of Domestic Goods P* = Price of Foreign Goods e = e X (P / P*) .Relationship between ‘e’ and ‘e ’ Real Nominal Exchange Rate at Home x Price of Domes.

1) What is the real exchange rate? 2) Is Nepalese currency overvalued or undervalued compared to US currency? .The real exchange rate with KFC Costs of KFC basket in Nepal = Rs. 73/dollar. 900 Costs of same KFC basket in US = $10 If the nominal exchange rate is Rs.

Overvalued . 900 Costs of same KFC basket in US = $10 If the nominal exchange rate is Rs.The real exchange rate with KFC Costs of KFC basket in Nepal = Rs.23 2) Is Nepalese currency overvalued or undervalued compared to US currency? . 73/dollar. 1) What is the real exchange rate? – 1.

IM  NX .Relationship between NX and ε ? ε  Nepalese goods become more expensive relative to US goods  EX.

net exports and the real exchange rate.U.S. 1973-2006 3% 2% 1% 0% 100 80 60 Trade-weighted real exchange rate index 140 120 -1% -2% -3% -4% -5% Net exports (left scale) 40 20 0 -6% -7% 1973 1977 1981 1985 1989 1993 1997 2001 2005 Index (March 1973 = 100) NX (% of GDP) .

• The net exports function reflects this inverse relationship between NX and ε : The net exports function NX = NX(ε ) ε1 NX NX(ε ) .

fiscal policy variables. NX (ε )  S  I (r *) .How ε is determined • The accounting identity says NX = S – I • We saw earlier how S – I is determined: – S depends on domestic factors (output. etc) – I is determined by the world interest rate r * • So.

ε1 NX(ε ) NX 1 NX . ε S 1  I (r *) ε adjusts to equate NX with net capital outflow.How ε is determined Neither S nor I depend on ε. so the net capital outflow curve is vertical. S  I.

Next. Expansionary Fiscal policy at home 2. Domestic increase in investment demand 4. four applications: Impact on Real Exchange Rate due to: 1. Expansionary Fiscal policy abroad 3. Trade policy to restrict imports .

ε S 2  I (r *) S 1  I (r *) ε2 ε1 NX(ε ) NX 2 NX 1 NX . Fiscal policy at home A fiscal expansion reduces national saving.1. and the supply of NPR against dollars in the foreign exchange market… …causing the real exchange rate to rise and NX to fall. net capital outflow.

reduces investment in Nepal. .2. Fiscal policy abroad Expansionary Fiscal Policy abroad increases world interest rate r*. increasing net capital outflow (S>I) and the supply of NPR against dollars in the foreign exchange market… ε S 1  I (r1 *) S 1  I (r2 *) ε1 ε2 NX(ε ) NX 1 NX 2 NX …causing the real exchange rate to fall and NX to rise.

Increase in investment demand at home An increase in investment in Nepal reduces net capital outflow (S<I) and the supply of NPR against dollars in the foreign exchange market… ε S1  I 2 S1  I 1 ε2 ε1 NX(ε ) NX 2 NX 1 NX …causing the real exchange rate to rise and NX to fall. .3.

4. Trade policy to restrict imports At any given value of ε. so capital flows and the supply of NPR against US Dollar remain fixed. NX (ε )2 NX (ε )1 NX1 NX . ε an import quota  IM  NX (Note: Net Export = ε2 Export – Import) S I ε1 Trade policy doesn’t affect S or I .

the law of one price . – The nominal exchange rate adjusts to equalize the cost of a basket of goods across countries. Reasoning: – arbitrage.Purchasing Power Parity (PPP) Law of One Price: – A doctrine that states that goods must sell at the same (currency-adjusted) price in all countries.

 Solve for e : e = P*/ P  PPP implies that the nominal exchange rate between two countries equals the ratio of the countries’ price levels. in foreign currency. Cost of a basket of domestic goods. Cost of a basket of domestic goods. . in foreign currency.Purchasing Power Parity (PPP) • PPP: e P = P* Cost of a basket of foreign goods. in domestic currency.

PPP is a useful theory: – It’s simple & intuitive – In the real world. International arbitrage not possible. . for two reasons: 1. Different countries’ goods not perfect substitutes. • nontraded goods • transportation costs 2. nominal exchange rates tend toward their PPP values over the long run. • Nonetheless.Does PPP hold in the real world? • No.

Thank You .

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