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CHAPTER 10
An Open Economy Framework
CHAPTER OVERVIEW
Chapter 10 begins with an overview of GDP accounting, and addresses nominal versus real values, various
price deflators and the circular flow of income and expenditure. The chapter’s discussion of how the circular
flow diagram can be represented in terms of both the income identity, which indicates that real income must
equal the sum of real consumption, real savings, real not taxes and real imports, and in terms of the product
identity, which indicates that real product must equal the sum of real consumption, real realized investment
spending, real government spending and real exports. The chapter then describes the behavioral determinants
for the savings function, the import function, the consumption function, and desired investment spending, and
also discusses three important marginal propensities: (1) the marginal propensity to consume, (2) the marginal
propensity to save and (3) the marginal propensity to import, each in response to changes in disposable income.
Government spending and net taxes are taken to be autonomous, and exports are assumed to be exogenous with
respect to changes in domestic income.
Using these relationships, the chapter then derives the open economy Keynesian-Cross diagram in the incomeexpenditure plane for a given interest rate. Chapter 10 also introduces the Keynesian IS-LM-BP model, which
will be employed in the next several chapters on open economy macroeconomics and policy analysis. The IS
schedule is derived by allowing nominal interest rates to vary while maintaining equilibrium between income
and expenditure. This produces the familiar downward sloping IS curve in the nominal interest rate-real income
plane. The “multiplier effect” is described in terms of a shift of the IS curve in response to changes in net
autonomous expenditures.
Next the chapter derives the LM schedule. It does so by first introducing a demand for real money balances as a
consequence of the transactions and precautionary motives and a portfolio motive. These are used to motivate
the downward sloping money demand curve in the nominal interest rate-real balances plane. The supply of real
balances are assumed to be autonomously determined by the central bank, which is reflected in a vertical money
supply curve in this same diagram. Using this diagram for money market equilibrium, the LM schedule is
derived by allowing real income to vary while maintaining equilibrium between the supply and demand for real
money balances. This produces the familiar upward sloping LM curve in the nominal interest rate-real income
plane. The curve is shown to shift in response to changes in either the stock of nominal money or the price
level.
In the final section, the balance of payments, BP, schedule is derived as a situation in which the current account
balance and the capital account balance sum to zero, so that the official settlements balance must be zero along
the BP curve. The upward slope of the BP curve in the nominal interest rate-real income plane is motivated by
the fact that the current account is related negatively too real income by virtue of the import spending effect,
and the capital account is related negatively to nominal interest rates. The BP curve is then combined with the
IS and LM curves into a single diagram. A balance of payments deficit occurs when the IS and LM curves
intersect to the left of the BP curve, while a balance of payments deficit occurs when the IS and LM curves
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intersect to the right of the BP curve. The text is also careful to point out that for the time being an implicit
assumption has been made that the exchange rate remains unchanged in this analysis.
OUTLINE
I.
Measuring Economy’s Performance
A. Gross Domestic Product
B. Nominal vs. Real and GDP Price Deflator
C. Fixed- and Flexible-Weight Price Measures
II. The IS Schedule
A. Circular Flow
1. Income Identity
2. Product Identity
B. Private and Public Expenditures
1. Saving Function
2. Importing Function
3. Consumption Function
4. Investment Spending
5. Government Spending
6. Export Spending
C. Income-Expenditure Model
D. IS Schedule
1. Derivation of IS Schedule
2. Position of IS Curve
3. Multiplier Effects
III. LM Schedule
A. Demand for Money
1. Transaction Motive
2. Precautionary Motive
3. Portfolio Motive
B. LM Schedule
1. Derivation
2. Position
IV. Balance of Payments Schedule
A. Real Income and Balance of Payments
B. Nominal Interest Rate and Balance of Payments
V. Combine to Use IS-LM-BP
VI. Summary
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95
FUNDAMENTAL ISSUES
1.
How do economists measure a nation’s flow of income and expenditures and overall level of prices of
goods and services?
2.
How is equilibrium real income determined in an open economy?
3.
What is the IS schedule, and what factors determine its position?
4.
What is the LM schedule, and what factors determine its position?
5.
What is the IS-LM equilibrium?
6.
What is the BP schedule, and how can we use the IS-LM-BP model to determine a nation’s balance-ofpayments status?
CHAPTER FEATURES
1.
Policy Notebook: “What Will Digital Cash Replace?”
This notebook considers the increasing role of digital money in the economy. It compares and contrasts the role
of cash, traditional checks and digital cash in transactions. It is noted that digital cash can be used anonymously
and have the low transactions cost of cash. Speculation suggests that digital cash may “crowd out” government
provided currency.
For Critical Analysis: Firms that require cash payments are likely to be hurt by digital cash. In so far as
governments lose seigniorage, they lose as well. Banks and customers can gain, however, from lower
transactions costs.
ANSWERS TO END OF CHAPTER QUESTIONS
1.
GDP = c + i + g + x
= $4,000 + $1,300 + 1,500 – $200
= $6,600
2.
Leakages = s + t + im
Injections = i + g + x
In equilibrium, injections will equal leakages; i.e., s + t + im = i + g + x
3.
One can interpret the intercepts of these functions as the amount of each activity that takes place when
disposable income is equal to zero. One could also consider the intercepts more broadly as the amount of
each activity that takes place independent of disposable income. The latter is a better interpretation for an
upper division class. The marginal propensities to save, consume, and import must sum to equal one
because these are the only activities in which one engages after paying taxes.
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4.
The difference between desired and realized investment comes from unintended changes in inventories.
Firms experience unintended changes in inventories when the economy deviates from equilibrium
production. When the economy is in equilibrium, planned expenditures are equal to aggregate production,
and there are no unintended changes in inventories.
5.
By definition, MPC + MPS + MPIM = 1, so that MPIM = 1 – MPS – MPC = 1 – 0.20 – 0.45 = 0.35.
A ¥10 billion increase in disposable income would cause Japanese consumption to rise by 0.45 times
¥10 billion, or ¥4.5 billion. Saving would rise by 0.20 times ¥10 billion = ¥ 2.0 billion, and imports would
increase by 0.35 times ¥10 billion = ¥3.5 billion. The total rise in consumption, saving, and imports would
equal ¥10 billion, which is the amount of the rise in Japanese disposable income.
6.
The autonomous spending multiplier is 1 / (MPS + MPIM) =1 / (0.15 + MPIM) = 4. Dividing this equation
by 4 and multiplying through by (0.15 + MPIM) then yields 1/4 = 0.25 = 0.15 + MPIM. Hence, MPIM
must equal 0.10.
7.
The equation for the LM schedule (units in $ trillion) is 1.8 = (0.9 * R), or 100 * R = (0.9 * y) – 1.8.
Dividing by 100, we have R = (0.009 * y) – 0.018. If y = 8, then R= (0.009 * 8) – 0.018 = 0.072 – 0.018 =
0.054. Hence, the equilibrium interest rate at an income level of $8 trillion is 5.4 percent.
8.
Setting y = c + i + g + x yields (in $trillions) y =3 + 7.4 – (100 * R) + 2 + 1, or y = 13.4 – (100 * R), or
100 * R = 13.4 – y, or R = 0.134 – (0.01 * y). If R = 0.054, then this equation implies that 0.054 =
13.4 – (0.01 * y), so that – 0.08 = –0.01 * y. Thus, y = 8, so that equilibrium real income is $8 trillion.
9.
The equation for the LM schedule is R = (0.009 * y) – 0.018, and the equation for the IS schedule is
R = 0.134 – (0.01 * y). At a point of IS-LM equilibrium, both must yield the same interest rate, so that
(0.009 * y) – 0.018 = 0.134 – (0.01 * y). Adding (0.01 * y) and 0.018 to both sides of the equation yields
0.019 * y = 0.152. This yields y = 0.152 / 0.019 = 8, so that equilibrium real income equals $8 trillion. As
already calculated in number 7, this yields 0.054 as the equilibrium nominal interest rate.
10. In this situation, the IS-LM equilibrium would lie below and to the right of the BP schedule, so that the
$8 trillion equilibrium income level would be sufficiently high to induce a relatively large volume of
imports, while the 5.4 percent nominal interest rate would be sufficiently low to encourage a relatively
small inflow of funds from abroad. On net, therefore, there is a balance-of-payments deficit at this real
income-nominal interest rate combination.
MULTIPLE CHOICE EXAM QUESTIONS
1.
Gross domestic product is the total value of
A.
B.
C.
D.
all domestic assets within a nation’s borders during a given period of time.
all market transactions within a nation’s borders during a given period of time.
all final goods and services produced within a nation’s borders during a given period of time.
currency that is circulating within a nation’s borders at one point in time.
Answer: C
Chapter Ten
2.
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Which of the following aggregates is not used in the product approach to tabulating GDP?
A.
B.
C.
D.
consumption
net exports
investment
depreciation
Answer: D
3.
Suppose the measure of real GDP in a given year is $8 billion. If we know that consumption spending was
$5.5 billion, government spending was $1.5 billion, exports were $1 billion and imports were $1.2 billion,
what was the value of investment spending in this year?
A. –$0.2 billion
B. $0.8 billion
C. $1.2 billion
D. $2.4 billion
Answer: C
4.
Which of the expenditure components of U.S. gross domestic product is the largest?
A.
B.
C.
D.
consumption spending
investment spending
government spending
net exports
Answer: A
5.
Which of the following transactions would be included in the value of measured GDP?
A.
B.
C.
D.
a sale of a used houseboat that had been manufactured in a previous year
an illegal drug transaction
an agreement by two individuals to exchange two goods without any monetary transaction
payment of a monthly cable television bill
Answer: D
6.
Real GDP differs from nominal GDP in that it
A.
B.
C.
D.
includes the wages of those working abroad.
is adjusted to control for movements in the aggregate price level.
includes the value of household production.
does not include services in its measure of output.
Answer: B
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7.
The GDP price deflator can be calculated by
A.
B.
C.
D.
subtracting the producer price index from the consumer price index.
dividing real GDP by the consumer price index.
subtracting real GDP from nominal GDP.
dividing nominal GDP by real GDP.
Answer: D
8.
Suppose that the value of the GDP deflator is 2, real GDP is $100 billion, and Consumption spending is
$60 billion. What is the value of nominal GDP?
A.
B.
C.
D.
$200 billion
$160 billion
$50 billion
$40 billion
Answer: A
9.
As a measure of the overall, economy-wide price level, economists generally prefer to use the
A.
B.
C.
D.
producer price index.
consumer price index.
GDP deflator.
Dow Jones index.
Answer: C
10. If the GDP deflator is 1.5, we know that
A.
B.
C.
D.
prices have risen by 5% since the base year.
real GDP has risen by 5% since the base year.
prices have risen by 50% since the base year.
real GDP has risen by 50% since the base year.
Answer: C
11. If nominal GDP is $10 trillion and real GDP is $8 trillion dollars, what would be the value of the GDP
deflator in the base year?
A.
B.
C.
D.
0.8
1.00
1.25
It is impossible to know without further information.
Answer: B
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12. The consumer price index (CPI) measures the
A.
B.
C.
D.
value of consumption in nominal GDP.
cost of a basket of goods and services purchased by a typical consumer.
value of total output adjusted for inflation.
cost of a typical collection of inputs into production.
Answer: B
13. The producer price index (PPI) is
A.
B.
C.
D.
a weighted average of the prices of goods and services used as inputs into production.
a weighted average of the prices charged by producers of final goods.
always less than the value of the consumer price index, regardless of the choice of base year.
always more than the value of the consumer price index, regardless of the choice of base year.
Answer: A
14. Which of the following statements about the consumer price index (CPI) is incorrect?
A.
B.
C.
D.
The CPI is a fixed-weight price index.
The CPI is calculated by the Bureau of Labor Statistics.
The CPI is a comprehensive index that tracks the prices of all the goods in the economy.
The CPI includes typical consumer expenditures such as housing and food.
Answer: C
15. The income identity specifies four categories into which households allocate their income. Which of these
is not one of those categories?
A.
B.
C.
D.
real savings
real net taxes
real transfer payments
real imports
Answer: C
16. The product identity relates the four categories of expenditure to national income. Which of these is not one
of the expenditure categories in the product identity?
A.
B.
C.
D.
real realized investment
real exports
real government spending
real net taxes
Answer: D
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100
17. Which of these relationships is not a result of the circular flow of income and expenditure?
A.
B.
C.
D.
Real net taxes must equal real government expenditure.
The real value of income equals the real value of output.
Real income equals the sum of real consumption, real net taxes, real imports, and real saving.
Real output equals the sum of real consumption, real exports, real government spending and real
realized investment.
Answer: A
18. The marginal propensity to consume represents
A.
B.
C.
D.
total real consumption divided by total real income.
total real consumption divided by total real output.
the additional consumption that occurs as a result of an increase in real income.
the additional consumption that occurs as a result of a decrease in real net taxes.
Answer: C
19. Suppose that the marginal propensity to import in the U.S. is equal to 0.10. This means that
A.
B.
C.
D.
the marginal propensity to consume is 0.90.
ten cents out of every dollar of U.S. income is spent on imports.
U.S. imports exceed U.S. exports by 10 percent.
given a one-dollar increase in national income, 10 additional cents will be spent on imports.
Answer: D
20. Autonomous dissaving is the amount by which
A. household’s implicit debt obligations rise as a result of net government borrowing.
B. households draw upon their current wealth to purchase domestic consumption, irrespective of their
after tax income.
C. households reduce their savings as household income decreases.
D. households reduce their savings when they experience a change in their expectations about the future
state of the economy.
Answer: B
21. An increase in the real interest rat induces
A.
B.
C.
D.
a leftward shift in the desired investment schedule.
a rightward shift in the desired investment schedule.
a leftward movement along the desired investment schedule.
an increase in the expected inflation rate.
Answer: C
Chapter Ten
22. In equilibrium, total real income is exactly equal to
A.
B.
C.
D.
aggregate desired expenditures on domestically produce goods.
real exports.
total output less net taxes.
real consumption plus real savings.
Answer: A
23. The aggregate real expenditures schedule
A.
B.
C.
D.
relates real consumption to real income.
relates nominal and real GDP in equilibrium.
is a positive function of total income.
shifts upward as the real exchange rate appreciates.
Answer: C
24. The level of aggregate net autonomous expenditures is
A.
B.
C.
D.
positively related to income.
negatively related to income.
assumed to be positive.
a 45-degree line through the origin.
Answer: C
25. Equilibrium national income occurs at the points where
A.
B.
C.
D.
the aggregate real expenditure schedule intersects with the real interest rate.
the aggregate real expenditure schedule intersects with the real consumption schedule.
the real aggregate expenditure equals the real value of domestically produced output.
real net exports are exactly equal to zero.
Answer: C
26. The IS schedule shows the relationship between which two variables?
A.
B.
C.
D.
real investment and inflation
real government spending and real net taxes
the nominal interest rate and real money balances
the nominal interest rate and real income
Answer: D
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Instructor’s Manual — International Monetary and Financial Economics
102
27. A decrease in the nominal interest rate induces a
A.
B.
C.
D.
rightward movement along the IS schedule.
leftward movement along the IS schedule.
rightward shift in the IS schedule.
leftward shift in the IS schedule.
Answer: A
28. The autonomous expenditure multiplier is equal to
A.
B.
C.
D.
1/ (1 – MPS).
1/ (1–MPC).
1/ (1 – g).
1/ (1 – MPIM).
Answer: B
29. Suppose MPC = 0.6, MPS = 0.3 and MPIM = 0.1. A $1 billion increase in autonomous expenditure would
lead to a $ ________ billion increase in equilibrium real income.
A.
B.
C.
D.
10
3.33
2.5
1
Answer: C
30. Which of the following events will shift the IS curve to the right?
A.
B.
C.
D.
a decrease in the nominal interest rate
a rise in autonomous saving
a fall in autonomous investment spending
a decrease in real net taxes
Answer: D
31. Keynes proposed three motivations for demanding positive real money balances. Which of these was not
one of the motives proposed by Keynes?
A.
B.
C.
D.
portfolio motive
real interest rate motive
transactions motive
precautionary motive
Answer: B
Chapter Ten
32. One of Keynes’ proposed motivations for holding real money balances described the desire to hold a
variety of financial assets. Which of these terms describes this behavior?
A.
B.
C.
D.
portfolio motive
real interest rate motive
transactions motive
precautionary motive
Answer: A
33. The quantity of real money balances supplied is determined by
A.
B.
C.
D.
the nominal interest rate.
the demand for real money balances.
real aggregate expenditures.
the nation’s Central Bank.
Answer: D
34. An increase in national income leads to an increase in
A.
B.
C.
D.
both the supply and demand for real money balances.
the demand for real money balances.
the supply of real money balances.
the equilibrium level of real money balances.
Answer: B
35. The LM schedule shows the relationship between which two variables?
A.
B.
C.
D.
the price level and the nominal money stock
the nominal interest rate and real investment spending
the nominal interest rate and aggregate real income
aggregate real income and the price level
Answer: C
36. An increase in the nominal money stock will shift the
A.
B.
C.
D.
LM schedule to the left.
LM schedule to the right.
IS schedule to the left.
IS schedule to the right.
Answer: B
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104
37. The BP schedule defines combinations of ________ that are consistent with a balance-of-payments
equilibrium.
A.
B.
C.
D.
aggregate real income and real aggregate expenditures
real investment and the nominal interest rate.
real income and the nominal interest rate.
real net exports and the nominal interest rate.
Answer: D
38. The intersection of the IS and LM schedules determines the equilibrium levels of
A.
B.
C.
D.
the nominal interest rate and aggregate real income.
real investment spending and the real interest rate.
real money balances and the price level.
real net exports and the nominal interest rate.
Answer: A
39. A balance of payments equilibrium is defined as a situation in which
A.
B.
C.
D.
net exports are equal to zero.
net foreign borrowing is equal to zero.
real money balances equals aggregate real consumption.
the sum of the capital and current accounts are equal to zero.
Answer: D
40. An IS-LM equilibrium that lies below the BP schedule represents a
A.
B.
C.
D.
balance of payments deficit.
balance of payments equilibrium.
balance of payments surplus.
It is impossible to say without further information.
Answer: A
41. An exogenous increase in the price level causes a
A.
B.
C.
D.
rightward shift in the LM schedule.
leftward shift in the LM schedule.
rightward shift in the IS schedule.
leftward shift in the IS schedule.
Answer: B
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42. Suppose that a nation is experiencing a balance of payments deficit. Which of the following changes will
return the economy to a balance of payments equilibrium?
A.
B.
C.
D.
an increase in the supply of real money balances
a real appreciation of the exchange rate
an increase in the nominal interest rate
an increase in autonomous import spending
Answer: C
43. An increase in the price level will cause the LM
A.
B.
C.
D.
curve to shift up.
curve to shift down.
schedule to become less elastic.
curve to become more elastic.
Answer: A
44. A reduction in taxes will cause the
A.
B.
C.
D.
IS curve shift left.
IS curve to shift right.
LM curve to shift left.
LM curve to shift right.
Answer: B