MOD001072MOD001072MANAGING THE ECONOMYMANAGING THE ECONOMY

Weeks 7-8Weeks 7-8

Classical model- small open Classical model- small open economyeconomy

Weeks 7-12 Weeks 7-12 The three topicsThe three topics

WKS 7-8CLASSICAL MODEL

•‘Long run’ –flexible prices•Open economy

WKS 9-10IS-LM [‘Keynesian’] MODEL•‘Short run’ – fixed prices

•Open economy

WKS 11-12INFLATIONARY EXPECTATIONS

•Adaptive expectations•Rational expectations

HOLIDAY BREAK

WEEKS 7-8 SUMMARY WEEKS 7-8 SUMMARY CLASSICAL MODELCLASSICAL MODEL

• 0. Classical models –basic features, closed vs open0. Classical models –basic features, closed vs open

• 1. International flows of goods and money 1. International flows of goods and money (finance) - definitions(finance) - definitions

• 2. Savings and Investment in an SOE (Small Open 2. Savings and Investment in an SOE (Small Open Economy) - analysisEconomy) - analysis

• 3. How Changes in Savings and Investment affect 3. How Changes in Savings and Investment affect the Trade Balance – role of exchange ratethe Trade Balance – role of exchange rate

COVERED IN LECTURE

AND CLASS WEEK 7

COVERED IN LECTURE AND CLASS WEEK 8

0. CLASSICAL models0. CLASSICAL modelsBasic featuresBasic features

Assume Assume supply side supply side of economy drives the economyof economy drives the economy• Spending power (aggregate demand) created by supply side forcesSpending power (aggregate demand) created by supply side forces

• Assumes always ENOUGH spending power to buy all the output suppliedAssumes always ENOUGH spending power to buy all the output supplied Government DOESN’T NEED TO REGULATE ‘aggregate demand’Government DOESN’T NEED TO REGULATE ‘aggregate demand’ So ‘So ‘output’ assumed to be fixed by supply sideoutput’ assumed to be fixed by supply side

Focus a lot on Focus a lot on price adjustment price adjustment to ensure equilibriumto ensure equilibrium• Role of Role of interest rates interest rates ensures equilibrium in closed economy model ensures equilibrium in closed economy model

• Role of Role of exchange rates exchange rates ensures equilibrium in open economy model ensures equilibrium in open economy model

Government MACRO policy role: Government MACRO policy role:

Ensure price stability + maintain healthy supply sideEnsure price stability + maintain healthy supply side

0. CLASSICAL models: ‘closed’ vs 0. CLASSICAL models: ‘closed’ vs ‘open’‘open’So far...CLOSED ECONOMYSo far...CLOSED ECONOMY Now... Focus on a [SMALL] OPEN Now... Focus on a [SMALL] OPEN

ECONOMYECONOMY

Real interest

rate ‘r’S

I(r)

National economy decides its own real interest rate ‘r1’

r1

Trade with rest of world: NET EXPORTS

Lend to/borrow from overseas

Supply = demand in national economy determined by real

interest rate ‘r1’ balancing its own S and I

No trade with rest of worldNo lending to/borrowing from

overseas

World economy (NOT the national economy) decides the real interest

rate

Supply = demand in national economy determined by both

[1] World real interest rate[2] Real exchange rate

National economy’s S and I may no longer be equalCan lend capital abroad

Can borrow capital from abroad

Loanable funds

Supply side Govt policy

Source: Mankiw CH 5Source: Mankiw CH 5

Evidence: degrees of ‘openness’Evidence: degrees of ‘openness’Trade-GDP ratio, selected countries, Trade-GDP ratio, selected countries, 20042004

(Imports + Exports) as a percentage of GDP (Imports + Exports) as a percentage of GDP

Luxembourg 275.5%

Ireland 150.9

Czech Republic 143.0

Hungary 134.5

Austria 97.1

Switzerland 85.1

Sweden 83.8

Korea, Republic of 83.7

Poland 80.0

Canada 73.1

Germany 71.1%

Turkey 63.6

Mexico 61.2

Spain 55.6

United Kingdom 53.8

France 51.7

Italy 50.0

Australia 39.6

United States 25.4

Japan 24.4

WEEKS 7-8 SUMMARY WEEKS 7-8 SUMMARY CLASSICAL MODELCLASSICAL MODEL

• 0. Classical models –basic features, closed vs open0. Classical models –basic features, closed vs open

• 1. International flows of goods and money 1. International flows of goods and money (finance) - definitions(finance) - definitions

• 2. Savings and Investment in an SOE (Small Open 2. Savings and Investment in an SOE (Small Open Economy) - analysisEconomy) - analysis

• 3. How Changes in Savings and Investment affect 3. How Changes in Savings and Investment affect the Trade Balance – role of exchange ratethe Trade Balance – role of exchange rate

1. International flows of goods and 1. International flows of goods and money - definitionsmoney - definitions

Two aspects hereTwo aspects here

• International flow of goods International flow of goods net exports or ‘NX’ net exports or ‘NX’

• International flows of finance (saving, investment)International flows of finance (saving, investment)

The idea of ‘The idea of ‘net exportsnet exports’ or NX’ or NX

Total demand or spending in Total demand or spending in closedclosed economy was: economy was:

Y = C + I + GY = C + I + G

All this spent ‘domestically’ (on home economy All this spent ‘domestically’ (on home economy output)output)

In In openopen economy it is economy it is

Y = C + I + G + NXY = C + I + G + NX

International International capitalcapital flows and net flows and net exportsexports

We now know total demand is Y = C + I + G + NXWe now know total demand is Y = C + I + G + NX

Subtracting C and G from both sidesSubtracting C and G from both sides

Y Y – C – G – C – G = C = C – C– C + I + G + I + G - G- G + NX + NX

givesgives

Y – C - G = I + NXY – C - G = I + NX

OrOr

S = I + NXS = I + NX

oror

S- I = NXS- I = NX

REMINDER : Why Y – C – G is ‘saving’ (S)REMINDER : Why Y – C – G is ‘saving’ (S)

PRIVATE SAVING

TotalSavings S

PUBLIC SAVINGY - T - C

T - GSO TOTAL SAVING IS

Y – T – C + (T – G)

OR....Y – C - G

YY-T

T

C

S-I = NXS-I = NXThis is the Open Economy Classical This is the Open Economy Classical

equilibrium conditionequilibrium condition

S – I

We have, in equilibrium:

NX=

NET CAPITAL OUTFLOW

S-I>0NET Lending

capital to foreigners

S-I<0NET

Borrowing from

foreigners

TRADE BALANCE

NX > 0Export more than import

NX <0Import

more than export

WEEKS 7-8 SUMMARY WEEKS 7-8 SUMMARY CLASSICAL MODELCLASSICAL MODEL

• 0. Classical models –basic features, closed vs open0. Classical models –basic features, closed vs open

• 1. International flows of goods and money 1. International flows of goods and money (finance) - definitions(finance) - definitions

• 2. Savings and Investment in an SOE (Small Open 2. Savings and Investment in an SOE (Small Open Economy) - analysisEconomy) - analysis

• 3. How Changes in Savings and Investment affect 3. How Changes in Savings and Investment affect the Trade Balance – role of exchange ratethe Trade Balance – role of exchange rate

2. Saving and Investment in a 2. Saving and Investment in a SOE (Small Open Economy)SOE (Small Open Economy)

2.1. Two ideas: Capital mobility and world 2.1. Two ideas: Capital mobility and world interest rateinterest rate

2.2. The Classical Model of S and I in a SOE2.2. The Classical Model of S and I in a SOE

2.3. How Govt Policy affects Savings, 2.3. How Govt Policy affects Savings, Investment and NX Investment and NX

2.1. Two ideas: Capital mobility and 2.1. Two ideas: Capital mobility and the ‘world’ interest ratethe ‘world’ interest rate

So far...CLOSED ECONOMYSo far...CLOSED ECONOMYNow... Focus on SMALL OPEN Now... Focus on SMALL OPEN ECONOMY [SOE]ECONOMY [SOE]

Real interest

rate ‘r’

S

I(r)

National economy decides its own real interest rate

r1

r1

rS

I(r)

World S

World I

r*

r

Small open economy HAS TO ACCEPT WORLD real interest rate

r*

[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

If both [a] + [b] are true:

Loanable fundsglobally

Loanable fundsin country Loanable funds

in a country

2.2. The Classical Model of S and I in a 2.2. The Classical Model of S and I in a SOESOE

We know:We know:

• Total supply of output given at Y =Yn.Total supply of output given at Y =Yn.

• Government spending fixed at G = GnGovernment spending fixed at G = Gn

• Government taxation fixed at T = TnGovernment taxation fixed at T = Tn

• Consumption demand [=consumption function] is C = C(Y-T)Consumption demand [=consumption function] is C = C(Y-T)

• Investment demand [ = investment function] is I = I(r)Investment demand [ = investment function] is I = I(r)

• SOE must accept world interest rate level r*SOE must accept world interest rate level r*

We know We know Net exports NX = S - I or [Y – C(Y-T) – G)] – I (r) Net exports NX = S - I or [Y – C(Y-T) – G)] – I (r)

Plug in values for Yn, Tn, Gn and r*Plug in values for Yn, Tn, Gn and r*

We get NX = [Yn – C(Yn-Tn) – Gn] – I(r*)We get NX = [Yn – C(Yn-Tn) – Gn] – I(r*)

Or NX = S(Yn,Tn,Gn) – I(r*)Or NX = S(Yn,Tn,Gn) – I(r*)

NX = net exports = S(Yn,Tn,Gn) – I(r*)NX = net exports = S(Yn,Tn,Gn) – I(r*)

The level of ‘S’ is determined byThe level of ‘S’ is determined by

• Given supply of output Yn (which determines total income)Given supply of output Yn (which determines total income)

• Nature of consumption function (which explains how Y affects C)Nature of consumption function (which explains how Y affects C)

• Government policy (which fixes G at Gn and T at Tn)Government policy (which fixes G at Gn and T at Tn)

The level of ‘I’ is determined byThe level of ‘I’ is determined by

• World interest rate r* (because economy is a SOE)World interest rate r* (because economy is a SOE)

• Available investment opportunities globallyAvailable investment opportunities globally

• Government policy (e.g. Tax incentives to invest)Government policy (e.g. Tax incentives to invest)

REMINDER of the savings-investment REMINDER of the savings-investment diagram diagram (same as closed economy case last (same as closed economy case last week)week)

Loanable fundsDn a country

S(Yn,Tn,Gn)

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.I(r)

This line is vertical since S level doesn’t depend on

r

So any change in G or T or Y will cause a SHIFT

left or right in the S line.

This line shows that as r falls, more investment

projects become worthwhile, so I rises

Real interest Rate (r)

3 possible situations for Small Open 3 possible situations for Small Open Economy depending on level of world Economy depending on level of world

interest rateinterest rate

Here:S>I at world interest rateSITUATION 1

SS S

I(r) I(r)I(r)

Here:S = I at world interest rate SITUATION 2

Here:S< I at world interest rate SITUATION 3

White horizontal line = world interest rate, set by interaction of world S and world I

SITUATION 1: capital outflow and trade surplus at SITUATION 1: capital outflow and trade surplus at world interest rate r**world interest rate r**

r

I,S

S(Yn,Tn,Gn) Here:Total S at r** is SnTotal I at r** is I**

I(r)

r**

So at r**S > I

If S> I, then NX >0At r= r**:Economy ‘exports’ capital (S>I) and has a trade surplus (NX >

0)

SnI**

SITUATION 2: no capital flow and trade balance at SITUATION 2: no capital flow and trade balance at world interest rate r*world interest rate r*

r

I,S

S(Yn,Tn,Gn) Here:Total S at r* is SnTotal I at r* is I*

I(r)

r*

So at r*S = I

If S= I, then NX =0At r= r* [ like closed econ case]Economy has no external capital

flows and has trade balance (NX = 0)

I*=Sn

SITUATION 3: capital inflow and trade deficit at SITUATION 3: capital inflow and trade deficit at world interest rate r***world interest rate r***

r

I,S

S(Yn,Tn,Gn)

Here:Total S at r*** is Sn

Total I at r*** is I***

I(r)r***

So at r***S < I

If S< I, then NX <0At r= r***:Economy ‘imports’ capital (S<I) and

has a trade deficit (NX < 0)

Sn I***

2.3. How Govt policy affects S and I 2.3. How Govt policy affects S and I and therefore the Trade Balance (i.e. and therefore the Trade Balance (i.e. NX)NX)

Mankiw looks at:Mankiw looks at:

• Effects of SOE’s own Fiscal policyEffects of SOE’s own Fiscal policy

• Effects of Fiscal Policy in rest of world Effects of Fiscal Policy in rest of world on SOEon SOE

• Effects of shifts in investmentEffects of shifts in investment

Effects of Changes on Capital flows and Trade Effects of Changes on Capital flows and Trade Balance: THE INITIAL EQUILIBRIUM POSITIONBalance: THE INITIAL EQUILIBRIUM POSITION

r

I,S

S(Yn,Tn,Gn)

Assume SOE always starts

whereWorld int rate = r*Total S at r* is SnTotal I at r* is I*

I(r)

r*

So at r*S = I

If S= I, then NX =0 in the initial

position

I*=Sn

Effects of Fiscal Policy Changes Effects of Fiscal Policy Changes by SOEby SOE

r

I,S

S(Yn,Tn,Gn)

Assume GOVERNMENT SPENDING INCREASED

from Gn to Gn’

I(r)

r*

[2]Private saving (Y – T - C) unchanged

[1]No change in I (because I doesn’t

depend on G)

I*=Sn

[3]Public saving falls (because T-G gets

lower)

[4] SO S() SHIFTS LEFT

TO S’()

[5] Now at r*Sn’< I*

capital INFLOWtrade DEFICIT

Sn’

S’(Yn, Tn, Gn’)

Effects on SOE of Fiscal Policy Changes Effects on SOE of Fiscal Policy Changes in Rest of in Rest of WorldWorld

r

I,S

S(Yn,Tn,Gn)

Assume GOVERNMENT SPENDING INCREASED IN

BIG OVERSEAS ECONOMY

I(r)

r*

[2] WORLD real interest rate will RISE

to r**

[1] WORLD savings will fall

I*=Sn[3] At new r**, I is lower in SOE (now

I**)[4] So in SOE, At r**, S > I

[5] Now in SOE at r**:

Sn > I** capital OUTFLOW

trade SURPLUS (i.e. NX >0)

I**

r**

Effects on SOE of shifts in Investment demandEffects on SOE of shifts in Investment demand

r

I,S

S(Yn,Tn,Gn)

Assume SOE GOVERNMENT changed

tax regulations to encourage investment

I(r)

r*

[2] SOE investment line I(r) SHIFTS RIGHT

to I’(r)

[1] SOE investment would increase even though world real interest rate unchanged

at r*

I*=Sn

[3] At r*, I is higher in SOE (now I***)[4] So in SOE,

at r*, S < I

[5] Now in SOE at r*:Sn< I***

capital INFLOWtrade DEFICIT (i.e.

NX < 0)

I***

I’(r)

WEEKS 7-8 SUMMARY WEEKS 7-8 SUMMARY CLASSICAL MODELCLASSICAL MODEL

• 0. Classical models –basic features, closed vs open0. Classical models –basic features, closed vs open

• 1. International flows of goods and money 1. International flows of goods and money (finance) - definitions(finance) - definitions

• 2. Savings and Investment in an SOE (Small Open 2. Savings and Investment in an SOE (Small Open Economy) - analysisEconomy) - analysis

• 3. How Changes in Savings and Investment affect 3. How Changes in Savings and Investment affect the Trade Balance – role of exchange ratethe Trade Balance – role of exchange rate

3. How Changes in Savings and 3. How Changes in Savings and Investment affect the Trade Balance – Investment affect the Trade Balance – role of exchange raterole of exchange rate

3.1. The basic idea – where the exchange rate fits...3.1. The basic idea – where the exchange rate fits...

3.2. Nominal and real exchange rate3.2. Nominal and real exchange rate

3.3. Linking Real exchange rate and Trade Balance 3.3. Linking Real exchange rate and Trade Balance (NX)(NX)

3.4.The equilibrium real exchange rate3.4.The equilibrium real exchange rate

3.5. Policy effects on real exchange rate3.5. Policy effects on real exchange rate

3.1. The basic idea – where the exchange 3.1. The basic idea – where the exchange rate fitsrate fits

S – INET CAPITAL

OUTFLOW

NX NET EXPORTS

Financial flows

S-I>0NET Lending

capital to foreigners

S-I<0NET

Borrowing from

foreigners

‘Real’ flows of goods/services

NX > 0Export more than import

NX <0Import more than export

(Real) Exchang

e rate

3.2. Nominal vs real exchange rates3.2. Nominal vs real exchange rates

NOMINAL EXCHANGE RATENOMINAL EXCHANGE RATE

= relative price of CURRENCIES of 2 countries= relative price of CURRENCIES of 2 countries

e.g. e.g.

1 GBP = 120Yen1 GBP = 120Yen

1 Yen = 0.0083GBP1 Yen = 0.0083GBP

We assume: We assume:

price of currency = number of units of FOREIGN currency price of currency = number of units of FOREIGN currency that ONE unit of it can buythat ONE unit of it can buy

• APPRECIATION APPRECIATION GBP buys more GBP buys more

• DEPRECIATION DEPRECIATION GBP buys less GBP buys less

3.2. Nominal vs real exchange rates3.2. Nominal vs real exchange rates

REAL EXCHANGE RATEREAL EXCHANGE RATE= relative price of GOODS of 2 countries = relative price of GOODS of 2 countries ‘TERMS OF TRADE’‘TERMS OF TRADE’

e.g.e.g.

UK car costs 10000GBPUK car costs 10000GBP

Japanese car costs 2,400,000YenJapanese car costs 2,400,000Yen

If 1GBP = 120 YenIf 1GBP = 120 Yen

Then UK car costs 10000 x 120Then UK car costs 10000 x 120 UK car costs 1,200,000YenUK car costs 1,200,000Yen UK car costs 0.5 of Japanese carUK car costs 0.5 of Japanese car

Can exchange 2 UK cars for one Japanese carCan exchange 2 UK cars for one Japanese car

Definition of real exchange rate ‘E’Definition of real exchange rate ‘E’

Real exchange rate ‘E’ =

Nominal exchange rate

‘e’X

Price level of

domestic goods (Pd)

Price level of foreign goods (Pf)

This is what is quoted on currency exchanges

This matters more for classicaltheory

‘E’ will be HIGH

when domestic goods price level is relatively HIGH

3.3. Link between real exchange rate 3.3. Link between real exchange rate and Trade Balance (NX)and Trade Balance (NX)

Because E = e . [ Pd/Pf]Because E = e . [ Pd/Pf]

If E ‘higher’ then Pd/Pf is ‘higher’If E ‘higher’ then Pd/Pf is ‘higher’ If Pd/Pf is higher then If Pd/Pf is higher then

• Exports will be lowerExports will be lower

• Imports will be higherImports will be higher NX will be lowerNX will be lower

So: NX depends negatively on E So: NX depends negatively on E

write as NX = NX(E)write as NX = NX(E)

E

0 NX

+-

NX(E)E3

E2

E1

NX1NX2NX3

3.4. The equilibrium real exchange 3.4. The equilibrium real exchange rate E*rate E*

For equilibrium we know:For equilibrium we know:

SS-I must equal NX-I must equal NX

OrOr

Y – C(Y-T) – GY – C(Y-T) – G – I(r) = NX(E) – I(r) = NX(E)

Plug in Plug in givengiven values for Yn, Tn, Gn, r*: values for Yn, Tn, Gn, r*:

Yn – C(Yn – Tn) – Gn Yn – C(Yn – Tn) – Gn – I(r*) = NX(E)– I(r*) = NX(E)

OrOr

S(Yn,Tn,Gn)S(Yn,Tn,Gn) – I(r*) – I(r*) = NX(E)= NX(E)One value of E makes this possible: One value of E makes this possible:

E*.E*.

E

NX

+-

NX(E)

E*

NX*

S(Yn,Tn,Gn) - I(r*)

Checking understanding of diagram Checking understanding of diagram

S(Yn,Tn,Gn)S(Yn,Tn,Gn) – I(r*) – I(r*) = NX(E)= NX(E) E

NX

+-

NX(E)

E*

NX1

S(Yn,Tn,Gn)-I(r*)

This line is VERTICAL because both S and I don’t depend on 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

Checking understanding of diagram Checking understanding of diagram Three possible equilibrium positionsThree possible equilibrium positions

E

NX

NX(E)

E***

0

S(Yn,Tn,Gn)-I(r*) EE

NXNX

NX(E)NX(E)

0 0NX1

Here S> I So NX = NX1>0

E*

NX2=

E**

Here S = Iand NX = NX2 = 0

POSSIBILITY 1Net capital outflow

Trade surplus

POSSIBILITY 2No capital inflow/outflow

Trade balance

NX3

Here S < ISo NX = NX3 <0

POSSIBILITY 3Net capital inflow

Trade deficit

S(Yn,Tn,Gn) – I(r*)S(Yn,Tn,Gn) – I(r*)

Doing an exampleDoing an exampleFINDING EQUILIBRIUM SITUATIONFINDING EQUILIBRIUM SITUATION

Assume Yn = 5000Assume Yn = 5000

Assume Gn = 1000, Tn = 1000Assume Gn = 1000, Tn = 1000

C = 250 + 0.75(Y-T)C = 250 + 0.75(Y-T)

I = 1000 – 50rI = 1000 – 50r

NX = 500 – 500E and r = r* = 5NX = 500 – 500E and r = r* = 5

FIND INVESTMENT ‘I’ AND SAVINGS ‘S’FIND INVESTMENT ‘I’ AND SAVINGS ‘S’ I = 1000-50(5) = I = 1000-50(5) = 750750 S = Y – C – G S = Y – C – G S= 5000-250-0.75(4000) -1000 = S= 5000-250-0.75(4000) -1000 = 750750 S-I = 750-750 = 0 S-I = 750-750 = 0

FIND NET EXPORTS NXFIND NET EXPORTS NX

since in equilib: S-I = NX, then since in equilib: S-I = NX, then NX(E) also=0NX(E) also=0

FIND EQUILIB ‘E’ FIND EQUILIB ‘E’

SET S-I = 0 = NX =500-500ESET S-I = 0 = NX =500-500E

0= 500-500E 0= 500-500E 500E = 500 500E = 500 E* = 1 E* = 1

E

NX

NX(E) = 500-500E

E*= 1

0

S-I

DRAW?S-I is vertical at NX = 0NX(E) is 0 = 500-500EWhen E = 0, NX = 500When E = E* = 1, NX = 0

500

3.5.Policy impact on equilibrium real exchange rate E*

SOE FISCAL POLICY – impact on ESOE FISCAL POLICY – impact on E

Saving (S) FALLS + I(r*) unchangedSaving (S) FALLS + I(r*) unchanged S-I gets lowerS-I gets lower S-I line SHIFTS LEFTS-I line SHIFTS LEFT Reduced supply of currency [as less Reduced supply of currency [as less

capital outflow]capital outflow] Currency Currency rises in value from E* to E**rises in value from E* to E** So [by E definition] Pd must rise So [by E definition] Pd must rise

relative to Pfrelative to Pf So exports fall, imports riseSo exports fall, imports rise So NX So NX FALL TO NX1’ <0FALL TO NX1’ <0

E

NX

+-

NX(E)

E*

NX1=0

Assume NX(E) = 0 AS INITIAL POSITION

[POSSIBILITY2]

S(Yn,Tn,Gn)-I(r*)

Assume Government of SOE increases G (above Gn) to Gn’

E**

NX1’<0

S(Yn,Tn Gn’)-I(r*)

FISCAL POLICY – impact on EFISCAL POLICY – impact on EDoing an exampleDoing an example

Assume same model, assume original Assume same model, assume original equilibrium.equilibrium.

Assume G rises by 250 to 1250Assume G rises by 250 to 1250

IMPACT ON ‘I’: NO CHANGEIMPACT ON ‘I’: NO CHANGE

IMPACT ON ‘S’?IMPACT ON ‘S’?

S = Y –C – G = 5000-250-0.75(4000)-1250S = Y –C – G = 5000-250-0.75(4000)-1250

S = 500 [it was 750]S = 500 [it was 750]

S-I = 500-750 S-I = 500-750 = -250 <0 CAP INFLOW= -250 <0 CAP INFLOW

IIMPACT ON NET EXPORTS?MPACT ON NET EXPORTS?

In new equilibrium, S-I = NX In new equilibrium, S-I = NX NX = -250<0NX = -250<0 NX have fallenNX have fallen

IMPACT ON EQUILIBRIUM EXCHANGE RATE?IMPACT ON EQUILIBRIUM EXCHANGE RATE?

S-I = - 250 = NX = 500-500E S-I = - 250 = NX = 500-500E 500E = 750 500E = 750

New E** = 1.5 New E** = 1.5 E has risenE has risen

E

NX

+-

NX(E) = 500-500E

E* = 1

0

S-INewS-I

-250

E** = 1.5

BIG OVERSEAS GOVERNMENTBIG OVERSEAS GOVERNMENTFISCAL POLICY – impact on EFISCAL POLICY – impact on E

World saving FALLSWorld saving FALLS

World interest rate World interest rate RISES to r**RISES to r** SOE Saving (S) unchanged but SOE Saving (S) unchanged but

I(r**) in SOE FALLSI(r**) in SOE FALLS S-I gets largerS-I gets larger S-I line SHIFTS RIGHTS-I line SHIFTS RIGHT Increased supply of currency [as Increased supply of currency [as

more capital outflow]more capital outflow] Currency Currency FALLS in value to E***FALLS in value to E***

NX NX RISES to NX1’’>0RISES to NX1’’>0

E

NX

+-

NX(E)

E*

NX1=0

Assume NX(E) = 0 AS INITIAL POSITION

[POSSIBILITY2]

S(Yn,Tn,Gn)-I(r*)Assume LARGE OVERSEAS GOVT increases government spending

E***

NX1’’>0

S(Yn,Tn Gn’)-I(r**)