lecture 11 oct 26 open economy i

7/25/2019 Lecture 11 Oct 26 Open Economy I

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MINUTES NEEDED

TO MAKE ONE KG OF

AMOUNT PRODUCED

(KG) IN 8 HOURS

MEAT POTATOES MEAT POTATOES

RUSSIA

BRAZIL

60 MIN./KG 15 MIN./KG 8 32

20 MIN./KG 10 MIN./KG 24 48

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CONSIDER THE NUMERICAL EXAMPLE

RUSSIA BRAZIL

MEAT POTATOES MEAT POTAOES

WITHOUT TRADE

Production & Consumption 4 16 12 24

WITH TRADE

Production 0 32 18 12

Trade Gets 5 Gives 15 Gives 5 Gets 15

Consumption 5 17 13 27

Gains from Trade +1 +1 +1 +39



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Potatoes Kg

4

16

8

32

A

0

Meat Kg

’

If there is no trade,

Russia chooses

this production and

consumption.

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U%&c!(

Potatoes Kg

12

24

B

0

Meat Kg

’

48

24

If there is no trade,

Brazil chooses

this production and

consumption.

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Potatoes Kg

4

16

5

17

8

32

A

A*

0

Meat Kg

’

Russia’s

production and

consumption

without trade

Russia’s

consumption

with trade

Russia’s

production

with trade

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Potatoes Kg

12

24

13

27

B

0

Meat Kg ’

48

24

12

18

B*

Brazil’s consumption

with trade

Brazil’s

production

with trade

Brazil’s

production and

consumption

without trade

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Y = C + I + G + NX

or, NX = Y – (C + I + G )

net exports

domestic

spending

output

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NX = EX – IM = Y – (C + I + G )

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r

S, I

NATIONAL SAVING

DOES NOT

DEPEND ON THE

INTEREST RATE

( )S Y C Y T G = ! ! !

S

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Investment is still a downward-sloping function of the interest

rate

r *

but the exogenousworld interest

rate… …determines

the country’slevel of

investment. I (r* )

r

S, I

I (r )

27

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& +('*$, '"$

r

S, I

I (r )

S

r

THE INTEREST

RATE WOULD

ADJUST TO

EQUATEINVESTMENT

AND SAVING:

I(r) = S28



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r

S, I

I (r )

S

r

r*

I

The exogenous

world interestrate determines

investment…

difference

between savingand investment

determines net

capital outflow

and net exports

NX

WHAT IS‘SMALL’?

29



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r

S, I

I (r )

1S

I

An increase in G

or decrease in T

reduces saving.1

*r

NX 1

2S

NX 2

Results:

0I ! =

0NX S ! = ! <

31



W!*+&( .'(!+0 &U%'&,

r

S, I

I (r )

1S Expansionary

fiscal policy

abroad raises

the world

interest rate. 1

*

r

NX 1

NX 2

Results:

0I ! <

0NX I ! = "! >

2

*r

1( )*I r

2( )*I r

32



&" !"+%$&*$ !" !"b$*#/$"# ,$/&",

r

S, I

I (r )1

EXERCISE:

Use the model to

determine the impact

of an increase in

investment demandon NX, S, I, and

net capital outflow.

NX 1

*r

I 1

S

33



r

S, I

I (r )1

ANSWERS:

I > 0,

S = 0,

net capital

outflow and

NX fall by the

amount I

NX 2

NX 1

*r

I 1I 2

S

I (r )2

34



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38

lecture 11 oct 26 open economy i

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