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Open-economy Macroeconomics National output { { We start with the Keynesian model Recall a simple Keynesian model implies prices are fixed. National income and foreign trade ----in a flexible exchange rate regime Open economy macroeconomics { Our previous discussion assmes z z z z { Prices are fixed Exchange rate is fixed Interest rate is fixed No capital mobility { { { { Domestic absorption defined as { Aggregate Expenditure z z A=C+I+G AE = A + X - J Now we first relax the fixed exchange rate assumption Determinants of Current and Capital Accounts { Open economy macroeconomics Net Exports NX = X – J Exchange rate and export An increase in exchange rate, a depreciation of dollar, causes export to increase X (e): z e↑ ⇒ X ↑ z Xe > 0 Determinants of Current and Capital Accounts { { { Imports are affected by the exchange rate and domestic absorption An exchange rate increase, or dollar depreciation, cause imports to go down J (e, A): z z e↑ ⇒ J ↓ Je < 0 1 Determinants of Current and Capital Accounts { { Increase in domestic absorption causes imports to increase J (e, A): z z z A↑ ⇒ J ↑ External Balance { z { { JA > 0 JA < 1 { { External Balance { External Balance NX = X(e) – J (e, A) = 0 External balance means that the trade is balanced. If e goes up, NX goes up. To maintain the external balance, A should also go up, to increase imports and reduce NX. de/dA > 0 External balance Totally differentiate external Balance NX = X(e) – J (e, A) = 0 e External balance (EB) X-J=0 X e de − J e de − J A dA = 0 ( X e − J e ) de = J A dA de JA (+ ) = = >0 dA X e − J e (+ ) − (−) 0 External balance Internal Balance { e External balance (EB) X-J=0 CA surplus { { CA deficit { 0 A A { Internal Balance is reached when the aggregate expenditure equals potential GDP That is, in the state of full employment Yp=potential GDP = AE Yp = A + X(e) – J(e,A) Note, Yp is exogeneous. 2 Internal Balance { Totally differentiate internal Balance z Yp = A + X(e) – J (e, A) Internal balance A+X-J=AE=Yp Internal balance (IB) e 0 = dA + X e de − J e de − J A dA = ( X e − J e )de + (1 − J A )dA de − X e + J e −(+) + (−) = = <0 1− J A (+ ) dA Internal Balance { { { Insight: If domestic absorption A is too small hence the AE is less than potential GDP, it results in recession. Then it needs e to go up, to stimulate the net export, in order to reach the full employment (internal balance). Equilibrium { Equilibrium is the state where the economy reaches both the internal and external equilibrium. A 0 Internal balance A+X-J=AE=Yp Internal balance (IB) e Inflation recession A 0 Equilibrium e IB Inflation EB CA surplus Recession Inflation CA surplus CA deficit Recession CA deficit 0 A 3 Internal and external balance { To reach both internal and external equilibriums, we need adjust both policy instruments z z { Adjusting domestic absorption A Adjusting exchange rate e Cannot relying on only one instrument. 4