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Open Economy: Open to foreigners Contrary to Closed Economy: Export and Import some of its goods and services to other countries including capital mobility
Y = Cd + Id + Gd + EX
Consumption of Domestic Goods and Services Investment in Domestic Goods and Services Govt. Purchase of Domestic Goods and Services Export of Domestic Goods and Services
We know that, Domestic Spending on all Goods and Services = Domestic Spending on Domestic Goods and Services + Domestic Spending on Foreign Goods and Services
C = Total Consumption Cd = Consumption of Domestic goods & services Cf = Consumption of Foreign goods & services I = Total Investment Id = Investment in Domestic goods & services If = Investment in Foreign goods & services G = Total Govt. Purchase Gd = Govt. Purchse. of Domestic goods & services Gf = Govt. Purchse. of Foreign goods & services
Y = C + I + G + EX(Cf+If+Gf)
Y = C + I + G + EXIM
Expenditure on Imports Net Exports or Trade Balance Domestic spending need not equal the Output
Y = C + I + G + NX
NX= Y (C + I + G)
If Output > Domestic Spending : NX Positive: Export more If Output < Domestic Spending : NX Negative: Import more
Y = C + I + G + NX
YC G= I+ NX S = I+ NX
S I = NX
Net Capital Outflow or Net Foreign Investment Net Exports or Trade Balance
If, Domestic S > Domestic I, NCO is +ve ; Excess S will be loaned out to foreigners and economy experiences Capital Outflow. If, Domestic S < Domestic I, NCO is ve ; Deficit financing is done by borrowing from abroad and economy experiences Capital Inflow. Net Capital Outflow = Amount that Domestic residents are lending abroad Amount that foreigners are lending to us
Net Capital Outflow = Trade Balance
In Equilibrium,
In Equilibrium,
S I = NX
Condition of Trade Surplus: If S I is positive, NX is positive, implies Trade Surplus Net Lender in International Financial Market Condition of Trade Deficit If S I is negative, NX is negative, implies Trade Deficit Net Borrower from International Financial Market Condition of Balance Trade If S I is exactly equals to NX
The national income account identity shows that the international flow of funds to finance capital accumulation and the flow of goods and services are two sides of the same coin.
An Important Macroeconomic Model Relating to Saving and Investment and Trade Balance
Assumptions:
Small Economy: Economy that is a small part of the world economy and can not affect the world interest rates. Perfect Capital Mobility: Country has full access to world financial markets. Domestic Interest rate (r) = World Interest Rate (r*) due to perfect capital mobility
Determination of Interest Rates: Domestic : Intersection of Domestic Savings and Investment World: Intersection of World Savings and Investment
Y Y F (K , L )
consumption function
investment function
C C ( Y T )
I I (r )
G G , T T
More Assumptions:
S Y C ( Y T ) G
S, I
More Assumptions:
Investment: The demand for loanable funds but the exogenous world interest rate
determines the
r*
I (r )
I (r* )
S, I
Explanations:
rc I (r )
I (rc ) S
S, I
Explanations:
the exogenous world interest rate determines investment
and the difference between saving and investment determines net capital outflow and net exports
r* rc I (r ) I1
S, I
Explanations:
S, I
Case 1: Starting from Trade Balance, What happens if the Home Government uses expansionary fiscal polices such as increase in G or reduce T? (Fiscal policy at home)
Case 2: Starting from Trade Balance, What happens if the Foreign Government uses expansionary fiscal polices such as increase in G?(Fiscal policy abroad) Case 3: Starting from Trade Balance, What happens if the Investment increases in the home country?(An increase in investment demand)
S 2 S1
- NX
S<I
Country runs trade deficit
* 1
I (r ) I1
S, I
Starting from Trade Balance, a change in fiscal policy that reduces national savings causes Trade Deficit
r
NX2
S1
r 2* r1*
I (r )
I (r2* ) I (r1* )
S, I
Starting from Trade Balance, an increase in the world interest rate due to fiscal expansion abroad causes Trade Surplus
S<I
Country runs trade deficit
r*
- NX
I (r )2 I (r )1 I1 I 2 S, I
Starting from Trade Balance, an outward shift in the investment schedule causes Trade Deficit
The exchange rate between two countries is the price at which residents of those countries trade with each other.
Nominal and Real
23
Demand and Supply for the currency determines the exchange rate. Important factor: trade and Investment requirements
e
S$
e0
D$
$
Suppose there is an increase in the demand for U.S. Dollars in Nepal (for importing goods and services or going abroad). How will this affect the nominal exchange rate for US dollar in Nepal?
e e1 e0
A S$
D$ shifts rightward and increases the nominal exchange rate, e. This is known as appreciation of the dollar. Events which decrease the demand for the dollar, and thus decrease e, would be a depreciation of the dollar.
D$
D$
$
(P / P*)
NX
140 120
-1% -2%
-3%
-4% -5%
40 20 0
-6%
-7% 1973 1977 1981 1985 1989 1993 1997 2001 2005
NX (% of GDP)
The net exports function reflects this inverse relationship between NX and :
NX = NX( )
1
NX
NX( )
How is determined
The accounting identity says NX = S I We saw earlier how S I is determined: S depends on domestic factors (output, fiscal
policy variables, etc) I is determined by the world interest rate r *
So,
NX ( ) S I (r *)
How is determined
Neither S nor I depend on , so the net capital outflow curve is vertical.
S 1 I (r *)
adjusts to
equate NX with net capital outflow, S I.
1 NX( ) NX 1
NX
S 2 I (r *)
S 1 I (r *)
2 1 NX( ) NX 2 NX 1
NX
S 1 I (r1 *)
S 1 I (r2 *)
1 2
NX( )
NX 1 NX 2
NX
S1 I 2
S1 I 1
2 1 NX( ) NX 2 NX 1
NX
S I
1
Trade policy doesnt affect S or I , so capital flows and the supply of NPR against US Dollar remain fixed.
NX ( )2
NX ( )1
NX1
NX
Reasoning:
arbitrage, the law of one price
PPP:
e P = P*
Solve for e : e = P*/ P PPP implies that the nominal exchange rate
between two countries equals the ratio of the countries price levels.
Nonetheless, PPP is a useful theory: Its simple & intuitive In the real world, nominal exchange rates tend toward their PPP values over the long run.
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