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Economic Modelling
Lecture 17
Small Open Economy
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Determinants of Output in an Open Economy
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Aggregate demand depends on consumption, investment,
government spending and net exports.
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Consumption depends on disposable income.
Investment on the real interest rate.
Tax revenues on national income.
Exports on foreign income and the real exchange rates.
Imports on domestic income and the real exchange rate.
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The real exchange rate is determined by domestic and foreign
price levels and the nominal exchange rates.
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Nominal interest rate is determined in the money market.
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Capital inflow/outflow depends on the difference in the
domestic and foreign real interest rates.
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Aggregate supply depends on capital stock and labour force.
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Mundell-Fleming Small Open Economy Model
National income
*
f
eP
e
Y  C(Y T )  I (Y , i  )  G  NX (Y ,Y ,
)
P
Money market:
M
 Li, Y 
P
 r   (3)
eP *
 
P

*
NX

KF
r

r
Balance of payment:
e


Y

Y


P

P
Aggregate supply:

(2)
e
Real and nominal interest rates: i
Real exchange rate:
(1)
Natural rate of output: Y  F K , L


(4)
(5)
(6)
(7)
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Notations in the Above Open Economy Model
Y= Actual output Y =natural rate of output
i = nominal interest rate r = real interest rate
r* foreign interest rate
ε = real exchange rate
e
P
=
T
p
=
t
K
e
P
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, i, r, ε
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:
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Exogenous variables (10):
T, G, M,  , P*, r*, P , K , L and
e
e
Y
f
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An Example of an Open Economy Model

Y  C Y  T   I i     G  NX Y , Y f , 
National Income
Consumption
Investment
Tax and Spending
C  200  0.8Y  T 
I  50  200i   
T =100 G = 100
NX  10  0.3Y f  0.1Y  20
Net exports
Real exchange rate
Financial integration
Demand for Money
Parameters

Y  500
f
EP *

P
i  i *  5%
M
 200  50i  0.5Y
P
  0.02
P 2 P2
*
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A Solution of the Model
Y  1280
C  1144
I  44
Private Saving:
NX  8
S = Y-T-C = 1280 - 100-1144= 36
Equilibrium Condition:

Y  C Y  T   I i     G  NX Y , Y f , 

=1144 + 44 +100-8=1280
Model Closure:
T  G  S  I   NX 100  100  36  44  8
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Three GAPs: Investment-Saving, Budget and Trade Gaps
SI
S(Y)
Trade Surplus
S  I   T  G   X  M
NX  0  NX  Cap Flow
K-outflow
i
T G  0
i
Private saving +public saving
= net export
SI
I(r)
Trade deficit
K-inflow NX  0
0
Saving and Investment
Re call : Y  C  S  T  M  C  I  G  X  rK  wL  Tr
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Keynesian Open Economy Model
How an Expansion in Income causes Trade Deficit?
AD
*
eP
f
e
Y  C (Y  T )  I (Y , i   )  G  NX (Y , Y , )
P
0
Y
M=M(Y)
X=X0
+
Trade
balance
Surplus
0
-
Deficit
Y
8
NX=X-M
Derivation of Net Exports and Investment Saving in an Open Economy
Note:
AD
(a) Shows reduction in AD
following an increase in ER
(b) Shows investment saving
balance in an open economy
(c) Shows net export as
a function of the exchange
rate
(c)
AD
(a)
ΔNX
Y1
(b)
e2
e2
Y2 Y
e1
e1
IS*(e)
NX (e)
y1
NX2
NX1
Y2
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IS-LM Model in an Open Economy: Mundell-Fleming Model
Exchange
Rate
LM (y, i)
Assumption:
Money supply does not
depend on exchange rate
e*
IS*
o
y
Output
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Impact of Fiscal Policy under Fixed and Flexible Exchange Rate Systems
Flexible Exchange Rate System
Fixed Exchange Rate System
LM
LM1
LM2
e2
IS*’
e
IS*’
e1
IS*
IS*
Y
No Impact of Fiscal Policy
Y1
Y2
Full Impact of Fiscal Policy
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Impact of Monetary Policy under Fixed and Flexible Exchange Rate Syste
Flexible Exchange Rate System
Fixed Exchange Rate System
LM
LM1
LM2
e2
IS*’
e
e1
IS*
IS*
Y1
Y2
Full Impact of Monetary Policy
Y1
Y2
No Impact of Monetary Policy
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Open Economy Fixed Exchange Rate
Effectiveness of Fiscal Policy and Ineffectiveness of Monetary Policy
LM0
LM1
2
i1
i=i*
3
1
BOP=X-M=0
IS1
IS0
0
y1
y2
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IS-LM and Uncovered Interest Parity Model
LM
2
1
i
i
IS
0
Y0
Y1
0
E0
E1
Appreciation
Exchange rate
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J-Curve Hypothesis: Impact of Devaluation on Net Exports
Export creation and
Import substitution or
demand switching takes time
Net
Exports
o
Time
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Determinants of Net Export
Net export function
NX  X  eM




NX  X Y *,e  eM Y ,e
NX = net exports
X = exports
e = nominal exchange rate
M = imports
Y* = income level in the foreign country
Y = income level at home
Three sources of changes in net exports:
1. Exports 2. Imports and 3. Exchange rate
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Marshall-Lerner condition
Devaluation is effective if
ex  em  1
Devaluation is ineffective if
ex  em  1
Devaluation has no effect in trade balance
ex  em  1
ex
em
is elasticity of export
is the elasticity of imports
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Numerical Example of the Marshall-Lerner Condition
Change in net exports is zero if the sum of exchange
rate elasticity of exports and imports equals 1.
Net export increases if this sum is greater than one.
Net export decreases if this sum is less than one.
Example: There is a devaluation
Export elasticity is 0.9
import elasticity if –0.8
Net export rises because 0.9-(-0.8) =1.7%.
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References
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Blanchard (18) Mankiw (2) M&S (20)
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Bhattarai (2002) Welfare Gains to the UK from a Global Free Trade, European
Research Studies, vol. IV, Issue 3-4, 2001, pp55-72. pp. 1161-1176.
Fleming J. Marcus (1962) Domestic financial policies under fixed and under floating
exchange rates, IMF staff paper 9, November , 369-379.
Krugman Paul (1979) A Model of Balance of Payment Crisis, Journal of Money
Credit and Banking, 11, Aug.
Krugman P. and L. Taylor (1978) “Contractionary Effects of Devaluation” Journal of
International Economics, 445-56.
Miller, Marcus; Salmon, Mark When Does Coordination Pay? Journal of Economic
Dynamics and Control, July-Oct. 1990, v. 14, iss. 3-4, pp. 553-69
Mundell R. A (1962) Capital mobility and stabilisation policy under fixed and flexible
exchange rates, Canadian Journal of Economic and Political Science, 29, 475-85.
Sebastian E (1986) Are Devaluations Contractionary? Review of Economics and
Statistics, vol. 68, 3, 501-508.
Taylor Mark (1995) The Economics of Exchange Rates, Journal of Economic
Literature, March, vol 33, No. 1, pp. 13-47.
Whalley (1985) Trade Liberalisation among Major World Trading Areas , MIT Press
for developments on trade arrangement among various trading regions.
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