Chapter 5: The Open Economy

1 Savings and Investment in a Small Open Economy

1.1 Denitions
N X = X M = Y (C + I + G)

Trade surplus: X > M (output > spending) Trade decit: X < M (output < spending) Net capital outow: S I (net outow of loanable funds)
S>I S<I
country is a net lender country is a net borrower

World interest rate: r

1.2 Assumptions
1. Production function:

= F (K, L ) Y =Y T) C = C (Y

2. Consumption function: 3. Investment function:

I = I (r ) G=G
and

4. Exogenous scal policy:

T =T

5. Domestic and foreign bonds are perfect substitutes: same risk, maturity, etc. 6. Perfect capital mobility: no restrictions on international trade in assets 7. Economy is small relative to the rest of the world:

exogenous

1.3 Equilibrium
The exogenous world interest rate determines savings and investment; the dierence between savings and investment determines net capital outow, which equals net exports.

C G S = Y I = I (r )
1 Econ
302, Week 7, 10/16/2009; UW-Madison. TAs Lihan Liu and Scott Swisher.

(1) (2)

1.4 Policy
G
or

shifts savings curve to the left

capital outow

N X N X
capital outow

Expansionary scal policy abroad raises Domestic investment demand

capital outow

investment curve shifts right

N X

Exchange Rates
the relative price of the currencies of two countries. Let's dene it as the units

2.1 Denitions/Assumptions
Nominal exchange rate (e): Real exchange rate (
price level and of foreign currency per US Dollar (

$U S , for example). P = eP , where P f

is the domestic

): the relative price of the goods of the two countries.

Pf

is the price level abroad. downward-sloping in the real exchange rate. When is relatively low,

Net exports function (N X = N X ( )):

US goods are inexpensive abroad, so US net exports will be high.

2.2 Equilibrium
Real exchange rate adjusts in equilibrium so that net capital outows (the supply of $US to be invested abroad) equal net exports (the demand for $US due to foreigners buying US goods).

C G I (r ) N X ( ) = S I = Y

(3)

2.3 Policy
G
national savings shifts left

and

NX
national savings shifts right

Expansionary scal policy abroad raises

r I

and

NX

Exercise: Small Open Economy

1 3;

Y = AK L1 ; = I = 325 15.5r

A = 0.3; K = 1000; L = 8000 r = 5)

C = 23 + 0.72(Y T )
(real interest rate = 5%

Y = C + I + G + N X ; G = 220; T = 155
a) b) c) d) e) f) g) h) What is aggregate output, Y? What is the level of consumption, C? What is the level of investment, I, if

r = 7%?

Taking your results in parts (a) - (c) as given, nd NX. Is this country a net borrower or net lender? Trade decit/surplus? Explain. Repeat parts (a) - (d) with G = 245 (increase in government spending of 25 units). Do you observe complete crowding out in part (f )? Why or why not? What happens to the domestic real exchange rate after the increase in government spending,

ceteris paribus ?

Are foreign goods more or less attractive to domestic consumers? Explain.