Review of the previous lectureNominal interest rateequals real interest rate + inflation rate. Fisher effect: nominal interest rate moves one-for-one w/ expected inflation. is the opp. cost of holding money

Money demanddepends on income in the Quantity Theorymore generally, it also depends on the nominal interest rate; if so, then changes in expected inflation affect the current price level.

Review of the previous lectureCosts of inflationExpected inflation shoeleather costs, menu costs, tax & relative price distortions, inconvenience of correcting figures for inflation

Unexpected inflation all of the above plus arbitrary redistributions of wealth between debtors and creditors

Review of the previous lectureHyperinflationcaused by rapid money supply growth when money printed to finance govt budget deficitsstopping it requires fiscal reforms to eliminate govts need for printing money

Lecture 21

Open economy - IInstructor: Prof.Dr.Qaisar AbbasCourse code: ECO 400

Lecture Outline

Open economy

Saving and investment

Three experiment

Open economyspending need not equal output

saving need not equal investment

Preliminaries

EX = exports = foreign spending on domestic goods

IM = imports = C f + I f + G f = spending on foreign goods

NX = net exports (a.k.a. the trade balance) = EX IM

superscripts:d =spending on domestic goodsf =spending on foreign goods

Open economyGDP = expenditure on domestically produced g & s

Open economyThe national income identity in an open economy

Y = C + I + G + NXor, NX = Y (C + I + G )

Open economyTrade surpluses and deficits

trade surplus output > spending and exports > imports

Size of the trade surplus = NX

trade deficit spending > output and imports > exports Size of the trade deficit = NX

NX = EX IM = Y (C + I + G )

Open economyInternational capital flows Net capital outflows=S I

=net outflow of loanable funds

=net purchases of foreign assets the countrys purchases of foreign assets minus foreign purchases of domestic assets

When S > I, country is a net lender

When S < I, country is a net borrower

Link between trade & cap. flowsThe link between trade & cap. flows

NX = Y (C + I + G )implies

NX = (Y C G ) I

= S Itrade balance = net capital outflows

Thus, a country with a trade deficit (NX < 0) is a net borrower (S < I ).

Saving and Investment in a Small Open EconomyAn open-economy version of the loanable funds model includes

Saving and InvestmentNational Saving: The Supply of Loanable Funds

Saving and InvestmentAssumptions re: capital flowsdomestic & foreign bonds are perfect substitutes (same risk, maturity, etc.)

b. perfect capital mobility: no restrictions on international trade in assets

c. economy is small: cannot affect the world interest rate, denoted r*

a & b imply r = r*c implies r* is exogenous

Saving and InvestmentInvestment: The Demand for Loanable Funds

Investment is still a downward-sloping function of the interest rate,but the exogenous world interest ratedetermines the countrys level of investment.

Saving and InvestmentIf the economy were closed

the interest rate would adjust to equate investment and saving:

Saving and InvestmentBut in a small open economy

the exogenous world interest rate determines investmentand the difference between saving and investment determines net capital outflows and net exports

Three experimentsThree experiments Fiscal policy at homeFiscal policy abroadAn increase in investment demand

1. Fiscal policy at home

An increase in G or decrease in T reduces saving.

Three experiments2. Fiscal policy abroad

Expansionary fiscal policy abroad raises the world interest rate.Results:

Three experiments3. An increase in investment demand

EXERCISE:Use the model to determine the impact of an increase in investment demand on NX, S, I, and net capital outflow.

Three experimentsAn increase in investment demand

ANSWERS: I > 0, S = 0,net capital outflows and net exports fall by the amount I

SummaryNet exports--the difference between exports and importsa countrys output (Y ) and its spending (C + I + G)

Net capital outflow equalspurchases of foreign assets minus foreign purchases of the countrys assetsthe difference between saving and investment