Download JOHANNES KEPLER UNIVERSITÄT DEPARTMENT OF

JOHANNES KEPLER UNIVERSITÄT
DEPARTMENT OF ECONOMICS
IK: Einkommen Inflation and Arbeitslosigkeit WS08/09
Worksheet 7: The open economy
1 December 2008
Question 1
Explain the following concepts:
a. The two main determinants of imports Real exchange rate (ε) and domestic
output (Y)
b. The two main determinants of exports Real exchange rate (ε) and foreign output
(Y*)
c. Marshall-Lerner condition For a depreciation to improve the balance of
payments, the sum of the (absolute values of the) import and export elasticities
with respect to the exchange rate has to be greater than one
d. The J-curve A depreciation of the currency in response to a deficit on the
current account first causes the current account to worsen (since prices change,
but quantities do not change), but after some time the current account improves
(when quantities change)
e. Interest parity (1 + it) = (1 + it*) [Et/Et+1e]; what it means is that the exchange
rate is expected to change by the difference in the two countries exchange rate,
with the result that the returns (expressed in a common currency) would be
equalised.
f. The implication of pegging the exchange rate on monetary policy This question
is better answered with knowledge of the Mundell-Fleming model
Question 2 (taken from Blanchard)
Consider the following open economy. The real exchange rate is fixed and equal to one.
The domestic expenditure components are as follows:
C = 10 + 0.8(Y – T), with T = 10
I = 10
G = 10
Imports and exports are as follows:
IM = 0.3Y
X = 0.3 Y*, where Y* denotes foreign output
a. Solve for equilibrium output in the domestic economy, given Y*. What is the
multiplier in this economy? If we were to close the economy – so exports and
imports were both equal to zero – what would the multiplier be? Why would the
multiplier be different in a closed economy?
Y = C + I + G + X – IM/ε → Y
= 10 + 0.8(Y – 10) + 10 + 10 + 0.3Y* -0.3Y → Y = 44 + 0.6Y*; multiplier in
open economy = 2; multiplier in closed economy = 5; the multiplier in an open
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economy is smaller than the multiplier in a closed economy because an increase
in output implies an increase in imports, which means that some of the additional
income flows out of the country; this can be illustrated graphically by the flatter
slope of the ZZ curve, compared to the DD curve in a closed economy.
b. Assume that the foreign economy has the same equations as the domestic
economy (with asterisks reversed). Use the two sets of equations to solve for the
equilibrium output of each country. (Hint: Use the equations for the foreign
economy to solve for Y* as a function of Y, and substitute this solution for Y* in
part (a)). What is the multiplier for each country now? Why is it different from the
open economy multiplier in (a)? One can easily derive that Y* = 44 + 0.6Y,
thus Y = 44 + 0.6 (44 + 0.6Y) → Y = 70.4 + 0.36Y → Y = 110. For Y*,
we simply substitute Y* = 44 + 0.6 (110) = 110, which is the same as Y, which is
what we would expect. The multiplier is now 3.125 [1/(1-0.8+0.3-0.18)]. To
calculate this you solve for Y* in terms of Y for the foreign economy (Y* =
44+0.6Y) and then substitute this into the Y = C + I + G +( X - IM) equation for
the domestic economy. Then solve for Y and you will get the multiplier as above.
You cannot just use the equation Y=44+0.6Y* for the domestic economy because
you will not get the correct multiplier since this already incorporates a multiplier.
You will notice that the multiplier is greater than 2 (as calculated in part a)
because of feedbacks back into the domestic country. Greater X* means that Y*
increases, which in turn means that M* increases. Since the foreign country can
get its imports only from “our” country, it means that local X (and thus Y)
increases.
c. Assume the domestic government has a target level of output of 125. Assuming
that the foreign government does not change the G*, what is the increase in G
necessary to achieve the target output in the domestic economy? Solve for net
exports and the budget deficit in each country. Using the multiplier of 3.125, to
increase Y to 125 (from 110 which was the value of Y from b) requires additional
government spending of 4.8. Y*=119 which can be worked out using the equation
for Y* in terms of Y from part b. Thus domestic Nx = 0.3*119 - 0.3*125= -1.8
(i.e. a deficit of 1.8). Foreign Nx=1.8 (i.e. a surplus of 1.8). Domestic T-G = 1014.8=-4.8 (i.e. a budget deficit of 4.8). Foreign T-G = 10-10 = 0 (i.e. a balanced
budget). So the story here is that the additional spending in the domestic
economy has increased output for both countries, but at the expense of a trade
deficit and budget deficit - the foreign economy scores 9 additional output and a
trade surplus.
d. Suppose each government has a target level of output of 125, and that each
government increases government spending by the same amount. What is the
common increase in G and G* necessary to achieve the target output in both
countries? Solve for net exports and the budget deficit in each country.
For
this question you can use the equation from a and substitute Y=125 and Y*=125
and G=10+x. Simplify and solve for x. The result is x=3. Thus both countries
are increasing their government spending by 3 (so we have G = G* = 13),
creating budget deficits -3 in both countries. Both also have a trade balance as in
the beginning.
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e. Why is fiscal coordination, such as the common increase in G and G* in (d),
difficult to achieve in practice? See Blanchard, pages 403-405; the argument is
basically as follows: the foreign country benefits (increased Y* and improved
NX*) from the domestic country’s fiscal expansion, without carrying any cost. If
they co-ordinate fiscal policy, the foreign country also carries a part of the cost
(burden) in the form of a fiscal deficit. It may not want to carry that cost.
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Question 3
Assuming the Marshall-Lerner condition holds and using a simple open economy
Keynesian Cross (known as Aggregate demand or ZZ/Y) diagram and the net exports
diagram, illustrate graphically and explain what effect a real depreciation will have on
output, exports, imports and net exports. Clearly label all curves and clearly label the
initial and final equilibriums.
Y=Z
DD1
Demand
(Z)
ZZ2
B
Z2
NX
ZZ1
Z1
A
Y1
Net
Exports
(NX)
Y2
NX
Income
(Y)
Income
(Y)
NX2
NX1
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Consider the economy illustrated by the above graph. Initially the economy is in
equilibrium at A, with zero net exports (NX), output (Y) at Y1 and demand (Z) at Z1. Now
consider the effect on the equilibrium of a real depreciation of the domestic currency
assuming that the Marshall-Lerner condition holds.
A real depreciation is a decline in the price of domestic goods in terms of foreign goods.
The result of this is that domestic goods become cheaper, relative to their own goods for
foreign consumers (the first effect). Similarly, foreign goods become more expensive for
local consumers, relative to the price of domestic goods (the second effect).
The result of the first effect is that the demand for exports rises at every level of domestic
output. This translates into an increase in the demand for domestic goods. The result of
the second effect is that the demand for imports falls at every level of domestic output,
assuming that the Marshall-Lerner condition holds. Domestic consumers thus choose to
consume more domestic goods and less foreign goods.
Both of the two effects (above) lead to an increase in the demand for net exports at every
level of domestic income and thus the net exports curve shift upwards to NX2. An
increase in the demand for net exports translates into an increase in the demand for
domestic goods, causing the ZZ curve to shift upwards to ZZ2. The increase in the
demand for domestic goods results in producers stockpiles falling and hence their
decision to increase production. Output thus rises from Y1 to Y2.
The economy reaches its new equilibrium at B where once again domestic output is equal
to the demand for domestic goods. Domestic output is at a higher level and the trade
balance has improved, and is in net surplus. Net exports are illustrated on both graphs;
the difference between demand for domestic goods (ZZ) and domestic demand for
domestic goods (DD).
Question 4
Consider a world with only two economies, Kazakhstan and Uzbekistan. Assume that
both economies are currently in recession. Explain, using an open economy Keynesian
Cross and a net exports diagram, how the use of coordinated fiscal or monetary policy
could help both countries out of recession. Also explain why this may be unlikely to
happen. (Hint: why is there an incentive not to coordinate policy?)
See pages 403-404 in the textbook. If Kazakhstan and Uzbekistan coordinate their fiscal
and monetary policies it is possible for both to increase domestic output without any
associated deterioration of the trade balance. If both countries agree to employ an
expansionary fiscal policy, for example, both countries will experience an increase in
output, with an indeterminate change in the trade balance (depends on the relative size of
the two policies). The problem is that there is a high incentive for one country to cheat
on such an agreement.
The result of an expansionary fiscal policy in the foreign country is an increase in output
and an improvement in the trade balance for the domestic country. If the domestic
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country chooses to follow the agreement, it can increase income further, but at the cost of
losing its gains on the trade balance.
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