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MOD001072
MANAGING THE ECONOMY
Weeks 7-8
Classical model- small open
economy
Weeks 7-12
The three topics
•
WKS 7-8
CLASSICAL MODEL
‘Long run’ –flexible prices
•Open economy
WKS 9-10
IS-LM [‘Keynesian’] MODEL
•‘Short run’ – fixed prices
•Open economy
HOLIDAY BREAK
WKS 11-12
INFLATIONARY EXPECTATIONS
•Adaptive expectations
•Rational expectations
WEEKS 7-8 SUMMARY
CLASSICAL MODEL
COVERED IN
LECTURE AND
CLASS WEEK 7
• 0. Classical models –basic features, closed vs open
• 1. International flows of goods and money (finance) definitions
• 2. Savings and Investment in an SOE (Small Open
Economy) - analysis
• 3. How Changes in Savings and Investment affect the
Trade Balance – role of exchange rate
COVERED IN
LECTURE AND
CLASS WEEK 8
0. CLASSICAL models
Basic features
Assume supply side of economy drives the economy
• Spending power (aggregate demand) created by supply side forces
• Assumes always ENOUGH spending power to buy all the output supplied
 Government DOESN’T NEED TO REGULATE ‘aggregate demand’
 So ‘output’ assumed to be fixed by supply side
Focus a lot on price adjustment to ensure equilibrium
• Role of interest rates  ensures equilibrium in closed economy model
• Role of exchange rates  ensures equilibrium in open economy model
Government MACRO policy role:
 Ensure price stability + maintain healthy supply side
0. CLASSICAL models: ‘closed’ vs ‘open’
So far...CLOSED ECONOMY
Supply side
Real
interest
rate ‘r’
Govt policy
Now... Focus on a [SMALL]
OPEN ECONOMY
Trade with rest of world: NET EXPORTS
Lend to/borrow from overseas
S
r1
I(r)
Loanable funds
No trade with rest of world
No lending to/borrowing from
overseas
National economy decides its
own real interest rate ‘r1’
Supply = demand in national
economy determined by real interest
rate ‘r1’ balancing its own S and I
World economy (NOT the national
economy) decides the real interest rate
National economy’s S and I may no
longer be equal
Can lend capital abroad
Can borrow capital from abroad
Supply = demand in national economy
determined by both
[1] World real interest rate
[2] Real exchange rate
Evidence: degrees of ‘openness’
Trade-GDP ratio, selected countries, 2004
(Imports + Exports) as a percentage of GDP
Luxembourg
275.5%
Germany
71.1%
Ireland
150.9
Turkey
63.6
Czech Republic
143.0
Mexico
61.2
Hungary
134.5
Spain
55.6
Austria
97.1
United Kingdom
53.8
Switzerland
85.1
France
51.7
Sweden
83.8
Italy
50.0
Korea, Republic of
83.7
Australia
39.6
Poland
80.0
United States
25.4
Canada
73.1
Japan
24.4
Source: Mankiw CH 5
WEEKS 7-8 SUMMARY
CLASSICAL MODEL
• 0. Classical models –basic features, closed vs open
• 1. International flows of goods and money (finance) definitions
• 2. Savings and Investment in an SOE (Small Open
Economy) - analysis
• 3. How Changes in Savings and Investment affect the
Trade Balance – role of exchange rate
1. International flows of goods and money definitions
Two aspects here
• International flow of goods  net exports or ‘NX’
• International flows of finance (saving, investment)
The idea of ‘net exports’ or NX
Total demand or spending in closed economy was:
Y=C+I+G
 All this spent ‘domestically’ (on home economy output)
In open economy it is
Y = C + I + G + NX
International capital flows and net exports
We now know total demand is Y = C + I + G + NX
Subtracting C and G from both sides
Y – C – G = C – C + I + G - G + NX
gives
Y – C - G = I + NX
Or
S = I + NX
or
S- I = NX
REMINDER : Why Y – C – G is ‘saving’ (S)
T
Y
Y-T
C
Total
Savings S
PRIVATE SAVING
PUBLIC SAVING
Y-T-C
SO TOTAL SAVING IS
Y – T – C + (T – G)
OR....Y – C - G
T-G
S-I = NX
This is the Open Economy Classical equilibrium
condition
We have, in equilibrium:
S–I
NET CAPITAL
OUTFLOW
S-I>0
NET Lending
capital to
foreigners
S-I<0
NET Borrowing
from foreigners
=
NX
TRADE BALANCE
NX > 0
Export more
than import
NX <0
Import more
than export
WEEKS 7-8 SUMMARY
CLASSICAL MODEL
• 0. Classical models –basic features, closed vs open
• 1. International flows of goods and money (finance) definitions
• 2. Savings and Investment in an SOE (Small Open
Economy) - analysis
• 3. How Changes in Savings and Investment affect the
Trade Balance – role of exchange rate
2. Saving and Investment in a SOE
(Small Open Economy)
2.1. Two ideas: Capital mobility and world interest
rate
2.2. The Classical Model of S and I in a SOE
2.3. How Govt Policy affects Savings, Investment
and NX
2.1. Two ideas: Capital mobility and the
‘world’ interest rate
Now... Focus on SMALL
So far...CLOSED ECONOMY OPEN ECONOMY [SOE]
Real
interest
rate ‘r’
r1
S
r
World S
r
S
r*
I(r)
Loanable funds
in country
World I
I(r)
Loanable funds
globally
Loanable funds
in a country
Small open economy HAS TO ACCEPT
WORLD real interest rate r*
National economy decides its
own real interest rate
r1
If both [a] + [b] are
true:
[a]SOE’s own S and
I too small to
affect world S, I
[b] SOE allows residents
full access to global
financial (i.e. Loanable
funds) markets
2.2. The Classical Model of S and I in a SOE
We know:
• Total supply of output given at Y =Yn.
• Government spending fixed at G = Gn
• Government taxation fixed at T = Tn
• Consumption demand [=consumption function] is C = C(Y-T)
• Investment demand [ = investment function] is I = I(r)
• SOE must accept world interest rate level r*
We know Net exports NX = S - I or [Y – C(Y-T) – G)] – I (r)
Plug in values for Yn, Tn, Gn and r*
We get NX = [Yn – C(Yn-Tn) – Gn] – I(r*)
Or NX = S(Yn,Tn,Gn) – I(r*)
NX = net exports = S(Yn,Tn,Gn) – I(r*)
The level of ‘S’ is determined by
• Given supply of output Yn (which determines total income)
• Nature of consumption function (which explains how Y affects C)
• Government policy (which fixes G at Gn and T at Tn)
The level of ‘I’ is determined by
• World interest rate r* (because economy is a SOE)
• Available investment opportunities globally
• Government policy (e.g. Tax incentives to invest)
REMINDER of the savings-investment
diagram (same as closed economy case last week)
This line is vertical since S
level doesn’t depend on r
S(Yn,Tn,Gn)
Real
interest
Rate (r)
I(r)
Loanable funds
Dn a country
This line shows that as r falls,
more investment projects
become worthwhile, so I rises
Writing S as S(Yn,Tn,Gn) just
says that the position of
the vertical line (for
Savings) depends on Y,T,G,
which are fixed at levels Yn,
Tn, Gn.
So any change in G or T or Y
will cause a SHIFT left or
right in the S line.
3 possible situations for Small Open Economy
depending on level of world interest rate
White horizontal line = world interest rate,
set by interaction of world S and world I
S
S
I(r)
Here:
S>I at world
interest rate
SITUATION 1
S
I(r)
Here:
S = I at world
interest rate
SITUATION 2
I(r)
Here:
S< I at world
interest rate
SITUATION 3
SITUATION 1: capital outflow and trade surplus at world
interest rate r**
r
S(Yn,Tn,Gn)
r**
I(r)
I** Sn
At r= r**:
Economy ‘exports’ capital (S>I) and
has a trade surplus (NX > 0)
I,S
Here:
Total S at r** is Sn
Total I at r** is I**
So at r**
S>I
If S> I, then NX >0
SITUATION 2: no capital flow and trade balance at world
interest rate r*
r
S(Yn,Tn,Gn)
Here:
Total S at r* is Sn
Total I at r* is I*
r*
I(r)
I*=Sn
So at r*
S=I
I,S
At r= r* [ like closed econ case]
Economy has no external capital flows
and has trade balance (NX = 0)
If S= I, then NX =0
SITUATION 3: capital inflow and trade deficit at world
interest rate r***
r
S(Yn,Tn,Gn)
Here:
Total S at r*** is Sn
Total I at r*** is I***
So at r***
S<I
r***
I(r)
Sn
I***
I,S
At r= r***:
Economy ‘imports’ capital (S<I) and has a
trade deficit (NX < 0)
If S< I, then NX <0
2.3. How Govt policy affects S and I and
therefore the Trade Balance (i.e. NX)
Mankiw looks at:
• Effects of SOE’s own Fiscal policy
• Effects of Fiscal Policy in rest of world on
SOE
• Effects of shifts in investment
Effects of Changes on Capital flows and Trade Balance:
THE INITIAL EQUILIBRIUM POSITION
r
S(Yn,Tn,Gn)
Assume SOE always
starts where
World int rate = r*
Total S at r* is Sn
Total I at r* is I*
r*
I(r)
I*=Sn
I,S
So at r*
S=I
If S= I, then NX =0 in
the initial position
Effects of Fiscal Policy Changes by SOE
r
Assume GOVERNMENT
SPENDING INCREASED from
Gn to Gn’
S’(Yn, Tn, Gn’)
S(Yn,Tn,Gn)
[1]No change in I
(because I doesn’t
depend on G)
r*
I(r)
Sn’
[5] Now at r*
Sn’< I*
 capital INFLOW
trade DEFICIT
I*=Sn
I,S
[4] SO S()
SHIFTS LEFT TO
S’()
[2]Private saving (Y – T C) unchanged
[3]Public saving falls
(because T-G gets
lower)
Effects on SOE of Fiscal Policy Changes in Rest of World
Assume GOVERNMENT
SPENDING INCREASED IN
BIG OVERSEAS ECONOMY
r
S(Yn,Tn,Gn)
r**
[1] WORLD savings
will fall
r*
I(r)
I**
[5] Now in SOE at r**:
Sn > I**
 capital OUTFLOW
trade SURPLUS (i.e.
NX >0)
I*=Sn
I,S
[4] So in SOE,
At r**, S > I
[2] WORLD real interest
rate will RISE to r**
[3] At new r**, I is
lower in SOE (now I**)
Effects on SOE of shifts in Investment demand
Assume SOE GOVERNMENT
changed tax regulations to
encourage investment
r
S(Yn,Tn,Gn)
[1] SOE investment would
increase even though world real
interest rate unchanged at r*
r*
I’(r)
I(r)
I*=Sn I*** I,S
[5] Now in SOE at r*:
Sn< I***
capital INFLOW
trade DEFICIT (i.e.
NX < 0)
[4] So in SOE,
at r*, S < I
[2] SOE investment line
I(r) SHIFTS RIGHT to I’(r)
[3] At r*, I is higher in
SOE (now I***)
WEEKS 7-8 SUMMARY
CLASSICAL MODEL
• 0. Classical models –basic features, closed vs open
• 1. International flows of goods and money (finance) definitions
• 2. Savings and Investment in an SOE (Small Open
Economy) - analysis
• 3. How Changes in Savings and Investment affect the
Trade Balance – role of exchange rate
3. How Changes in Savings and Investment
affect the Trade Balance – role of exchange
rate
3.1. The basic idea – where the exchange rate fits...
3.2. Nominal and real exchange rate
3.3. Linking Real exchange rate and Trade Balance (NX)
3.4.The equilibrium real exchange rate
3.5. Policy effects on real exchange rate
3.1. The basic idea – where the exchange rate fits
S–I
NET CAPITAL
OUTFLOW
NX
NET EXPORTS
Financial flows
‘Real’ flows of
goods/services
S-I>0
NET Lending
capital to
foreigners
NX > 0
Export more
than import
S-I<0
NET Borrowing
from foreigners
(Real)
Exchange
rate
NX <0
Import more
than export
3.2. Nominal vs real exchange rates
NOMINAL EXCHANGE RATE
= relative price of CURRENCIES of 2 countries
e.g.
1 GBP = 120Yen
1 Yen = 0.0083GBP
We assume:
price of currency = number of units of FOREIGN currency that ONE
unit of it can buy
• APPRECIATION  GBP buys more
• DEPRECIATION  GBP buys less
3.2. Nominal vs real exchange rates
REAL EXCHANGE RATE
= relative price of GOODS of 2 countries ‘TERMS OF TRADE’
e.g.
UK car costs 10000GBP
Japanese car costs 2,400,000Yen
If 1GBP = 120 Yen
Then UK car costs 10000 x 120
 UK car costs 1,200,000Yen
 UK car costs 0.5 of Japanese car
 Can exchange 2 UK cars for one Japanese car
Definition of real exchange rate ‘E’
This matters
more for classical
theory
This is what is quoted
on currency exchanges
Real exchange rate ‘E’
=
Nominal
exchange rate ‘e’
Price level
of domestic
goods (Pd)
X
Price level of
foreign
goods (Pf)
‘E’ will be
HIGH
when domestic goods price level is
relatively HIGH
3.3. Link between real exchange rate and
Trade Balance (NX)
Because E = e . [ Pd/Pf]
 If E ‘higher’ then Pd/Pf is ‘higher’
 If Pd/Pf is higher then
• Exports will be lower
• Imports will be higher
 NX will be lower
So: NX depends negatively on E

write as NX = NX(E)
E
NX(E)
E3
E2
E1
NX3
-
NX2
0
NX1
+
NX
3.4. The equilibrium real exchange rate E*
For equilibrium we know:
S-I must equal NX
Or
Y – C(Y-T) – G – I(r) = NX(E)
S(Yn,Tn,Gn) - I(r*)
E
NX(E)
E*
Plug in given values for Yn, Tn, Gn, r*:
Yn – C(Yn – Tn) – Gn – I(r*) = NX(E)
Or
S(Yn,Tn,Gn) – I(r*) = NX(E)
One value of E makes this possible: E*.
NX*
-
NX
+
Checking understanding of diagram
S(Yn,Tn,Gn) – I(r*) = NX(E)
S(Yn,Tn,Gn)-I(r*)
E
NX(E)
This line is VERTICAL
because both S and I
don’t depend on E
E*
This line shifts left/right
if any changes in Yn,
Tn, Gn or r*.
This line SLOPES DOWN
because a rise in E leads to a fall
in NX
NX1
-
NX
+
Checking understanding of diagram
Three possible equilibrium positions
Here S> I
So NX = NX1>0
E
Here S = I
and NX = NX2 = 0
S(Yn,Tn,Gn)-I(r*) E
Here S < I
So NX = NX3 <0
S(Yn,Tn,Gn) – I(r*)
NX(E)
0
NX1
POSSIBILITY 1
Net capital outflow
Trade surplus
NX
S(Yn,Tn,Gn) – I(r*)
E***
E**
E*
E
NX(E)
NX(E)
NX2=
0
POSSIBILITY 2
NX
No capital inflow/outflow
Trade balance
NX3
0
POSSIBILITY 3
Net capital inflow
Trade deficit
NX
Doing an example
FINDING EQUILIBRIUM SITUATION
Assume Yn = 5000
Assume Gn = 1000, Tn = 1000
C = 250 + 0.75(Y-T)
I = 1000 – 50r
NX = 500 – 500E and r = r* = 5
FIND INVESTMENT ‘I’ AND SAVINGS ‘S’
 I = 1000-50(5) = 750
 S=Y–C–G
 S= 5000-250-0.75(4000) -1000 = 750
 S-I = 750-750 = 0
FIND NET EXPORTS NX
since in equilib: S-I = NX, then NX(E) also=0
FIND EQUILIB ‘E’
 SET S-I = 0 = NX =500-500E
 0= 500-500E  500E = 500  E* = 1
E
NX(E) = 500-500E
S-I
E*= 1
0
500
DRAW?
S-I is vertical at NX = 0
NX(E) is 0 = 500-500E
When E = 0, NX = 500
When E = E* = 1, NX = 0
NX
3.5.Policy impact on equilibrium
real exchange rate E*
SOE FISCAL POLICY – impact on E
Assume Government of SOE
increases G (above Gn) to Gn’
 Saving (S) FALLS + I(r*) unchanged
 S-I gets lower
 S-I line SHIFTS LEFT
 Reduced supply of currency [as less
capital outflow]
 Currency rises in value from E* to E**
 So [by E definition] Pd must rise
relative to Pf
 So exports fall, imports rise
 So NX FALL TO NX1’ <0
S(Yn,Tn Gn’)-I(r*)
E
S(Yn,Tn,Gn)-I(r*)
NX(E)
E**
E*
NX1’<0
NX1=0
NX
+
Assume NX(E) = 0 AS
INITIAL POSITION
[POSSIBILITY2]
FISCAL POLICY – impact on E
Doing an example
Assume same model, assume original equilibrium.
E
Assume G rises by 250 to 1250
IMPACT ON ‘I’: NO CHANGE
IMPACT ON ‘S’?
S = Y –C – G = 5000-250-0.75(4000)-1250
E** = 1.5
S = 500 [it was 750]
E* = 1
 S-I = 500-750 = -250 <0 CAP INFLOW
New
S-I
NX(E) = 500-500E
S-I
IMPACT ON NET EXPORTS?
In new equilibrium, S-I = NX
 NX = -250<0
 NX have fallen
IMPACT ON EQUILIBRIUM EXCHANGE RATE?
S-I = - 250 = NX = 500-500E  500E = 750
 New E** = 1.5  E has risen
-250
-
0
NX
+
BIG OVERSEAS GOVERNMENT
FISCAL POLICY – impact on E
Assume LARGE OVERSEAS GOVT
increases government spending
 World saving FALLS
 World interest rate RISES to r**
 SOE Saving (S) unchanged but I(r**)
in SOE FALLS
 S-I gets larger
 S-I line SHIFTS RIGHT
 Increased supply of currency [as more
capital outflow]
 Currency FALLS in value to E***
 NX RISES to NX1’’>0
S(Yn,Tn Gn’)-I(r**)
E
S(Yn,Tn,Gn)-I(r*)
NX(E)
E*
E***
NX1=0 NX1’’>0
NX
+
Assume NX(E) = 0 AS
INITIAL POSITION
[POSSIBILITY2]