13.

1 Open Economy Fiscal Policy Expansion Below Full Employment

 Y=1000, I=150, S=150, X=0, M=0, MPCD=0.6, MPS=0.25,
and MPM=0.15.
 If the government decides to increase government
expenditures by 100, the AE curve shifts upward leading to a
shortage of goods (AE>Y). In addition, the increase in
government expenditures leads to a decrease in savings by
100.
 G (100A-B)S (100A-B)AEAE>Y & I>S.
 The increase in G leads to a shortage of loanable funds (I>S) and excess demand for goods
(AE>Y). We know from our previous analysis, that this will
lead to either an increase production or an increase in interest
rates. Assuming that we start below full employment, then
firms will increase outputY. Using the open economy
multiplier, we know the
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∆Y = ∗∆ G= ∗100=2.5∗100=250 . In
MPS + MPM .25+.15
addition, we can also calculate the change in C, S, and M.
 ∆C=∆Y*MPCD=0.6*250=150
 ∆M=∆Y*MPM250*0.15=37.50
 ∆S=∆Y*MPS=250*.25=62.50.
 YC (150), S(62.50), & M(37.50)
 Total Change in AE is 250: ∆G=100 and ∆C=150 (AE Model: A-
C). Total change in output is 250
 In our closed economy analysis, we saw that the initial decrease
in savings that came as the government borrowed funds to
increase expenditures was completely replaced by increased
savings through the multiplier.
 However, in a open economy, this is not the case. As
shown above, the change in savings was 62.50 and not the
100 needed to replenish savings.
 The inclusion of the MPM in our multiplier causes the
resulting increase in savings from the change in income to
be less than the original decrease in savings. Therefore,
unlike a closed economy where savings was replenished,
in the open economy there is still a shortage of domestic
savings after the income increase leading to upward pressure on interest rates has firms seek
funds not available within the economy.
 Therefore, savings does shift back, but not far enough. The shortage of savings equals the
amount of income spent on imports.
 ∆M=∆Y*MPM250*0.15=37.50
 Therefore, when imports are positive and exports are zero, Savings
will be less than Investment. We can show this in our S&I with
income graph as well. The initial increase in G resulted in a decrease

1
 in S by 100 (A-B). Through the multiplier, S increased (B-C) by 62.50 to a total savings of
112.50Point C. However, investment is still at 150point C’.
 Therefore, because of the imports, we now have leakages greater than injections. The shortage
of savings is 37.50. If nothing else happens, the interest rate would increase due to I>S and
investment decrease 18.75 and savings would increase by 18.75. This would then cause a total
reduction in output by 37.50 times the multiplier of 93.75 (93.75=2.5*37.50).
 However, in open economy, firms can also borrow from foreign countries. Therefore, the
leakages due to imports will be compensated for by capital inflows as firms borrow from
international markets. As such, the distance between C and C’ (37.50) will equal capital
inflows.
 This allows investment to remain at its current level. We can
show this in the injections-leakages model with S+M=I+X.
Investment is still at 150 and exports at zero. However, we now
add the 37.50 in imports to the savings of 112.50 to get
S+M=I+X.
 Finally, we can show this in the S-I=NX graph. The initial
decrease in savings to fund increased G is shown from A-B.
Then as income grows from the multiplier, savings increases
form B-C. At the same time. The increase in imports from higher
income is shown from A-C. We have a new equilibrium at C where NX is -37.50 and NCO is
-37.50 (Inflows>outflows).
 In the above example we assumed that exports were zero. However, anytime imports are
greater than exports, we will see the shortage of savings and as a result, firms will borrow
from foreign countries to prevent interest rates from increasing and investment and
consumption from falling. It is true that exports could also increase bringing NX back to zero
and S=I.
 We can see in this analysis that the cause of the capital inflow was imports leaking out of the
domestic economy. Let’s assume that capital flows were not allowed due to government
restrictions. Under this assumption the interest adjustment would be triggered, and the
shortage of domestic savings would lead firms to bid up the interest rate. This would then lead
to lower investment and higher savings (these would be movements up the curve). Since the
higher savings were caused by an increase in interest rates, we know the higher savings would
be financed through lower consumption. Therefore, in the absence of capital flows, imports
would be financed through a reduction in domestic investment and a reduction in domestic
consumption. If consumers continue to import in future periods, there will be a continual
shrinkage of the economy.