Terms in this set (39)
Two differences between small open and closed economy
- spending does not need to equal output
-saving does not need to equal investment
GDP equation with domestic and foreign goods
Y= (C-C^f) + (I - I^f) + (G-G^f) + EX
output > spending
exports > imports
size of the trade surplus NX
spending > output
imports > exports
size of trade deficit is -NX
Net Capital outflow equation
CF = S- I
Net capital outflow definition
= savings- investment
=net purchases of foreign assets
Country is a net lender when
S > I
Country is a net borrower when
S < I
Trade and capital flows
NX = (Y-C-G)- I
NX= S - I
A country with a trade deficit is a
A country with a trade surplus is a
Production function equation of a small open economy
Y=Y bar=F(K bar,L bar)
Consumption function in small open economy
Investment function in small open economy
what are the 2 exogenous policy variables in a small open economy
G and T
Equation of supply of loanable funds in a small open economy
S bar=Y bar-C(Y bar-T bar) -G bar
3 assumptions about capital flows
1. Domestic & foreign bonds are perfect substitutes
2. Perfect capital mobility
3. Economy is small
What is investment in a small open economy?
the demand of loanable funds
What determines net capital outflow and net exports?
the difference between savings and investment
3 experiments about capital flows
1. fiscal policy at home= an increase in G or a decrease in T then reduce savings
2. fiscal policy abroad= expansionary fiscal policy abroad will raise world interest rate
3. increase in investment demand =∆I >0, ∆S=0 then net capital outflow and NX will fall by ∆I
What is the variable and definition of nominal exchange rate?
e; the relative price of domestic currency in terms of foreign currency
What is the variable and definition of real exchange rate?
ε; the relative price of domestic goods in terms of foreign goods
what is equation of real exchange rate and nominal exchange rate?
ε= (e x P) / (P*)
Real exchange rate in the real world vs in the model
ε in the real world = relative price of a basket of domestic goods in terms of a basket of foreign goods
ε in the model = relative price of one country's output in terms of the other country's output
How NX depends on ε
if ε rises;
- U.S. goods become more expensive relative to foreign goods
- Exports fall, imports rise
-net exports fall
if ε falls;
-U.S. goods are relatively inexpensive
-NX will rise
What is the accounting identity of net exports?
how is S-I determined?
- S depends on domestic factors
- I is determined by world interest rate (r*)
- neither depends on ε
Fiscal Policy at home; what will fiscal expansion do?
Fiscal expansion reduces nation savings, net capital outflow, and the supply of dollars in the foreign exchange market CAUSING ε to rise and NX to fall
Fiscal Policy abroad; what would changing r* cause?
An increase in r* reduces investment, increasing net capital outflow, and the supply of the dollar in the foreign exchange market CAUSING ε to fall and NX to rise
Increase in investment demand would cause?
an increase in investment reduces net capital outflow, and the supply of dollars in the foreign exchange market CAUSING ε to rise and NX to fall
Trade policy to restrict imports would cause?
At any given ε, an import quota reduces imports, increases NX, and increases demand for dollars CAUSING no effect on S or I
the growth rate of e; for any given value of ε
growth rate of e = foreign - domestic inflation rate
Purchasing Power Parity (PPP) two definitions
1. A doctrine that states that goods much sell at the same price in all countries
2. The nominal exchange rate adjusts to equalize the cost of a basket goods across countries
PPP equation and explanation of variables
PPP: e x P =P*
- e x P→ cost of basket of domestic goods in foreign currency
- P→ cost of a basket of domestic goods in domestic currency
- P*→ cost of basket of foreign goods in foreign currency
Does PPP hold in the real world?
NO for 2 reasons
1. International arbitrage is not possible
- non-traded goods
- transportation costs
2. Different countries' goods are not perfect substitutes
r in a closed, large open, and small open economy
Large open→ Rises, but not as much as in closed
Small open→ no change
I in a closed, large open, and small open economy
Large open→ falls, but not as much as in closed
Small open→ no change
NX in a closed, large open, and small open economy
Closed→ no change
Large open→ Falls, but not as much as in small
What is net exports?
NX is the difference between:
Exports and imports
a countries output (Y) and its spending (C+I+G)