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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]