ECON 282: The Open Economy

Question 1

In an open economy,

Answer 1

-Spending need not equal output
-Saving need not equal investment

Question 2

Trade surplus

Answer 2

output > spending
exports (NX) > imports (IM)
Size of the trade surplus = NX

Question 3

Trade Deficit

Answer 3

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

Question 4

Net Capital Outflow

Answer 4

= S-I
= net outflow of ‘loanable funds’
= net purchase of foreign assets
-the country’s purchases of foreign assets minus foreign purchases of domestic assets

Question 5

When S > I

Answer 5

the country is a net lender

Question 6

When S < I

Answer 6

the country is a net borrower

Question 7

Assumptions about capital flows:

Answer 7

-Domestic and foreign bonds are perfect substitutes (same risk, maturity, etc)
-Perfect capital mobility: no restrictions on international trade in assets
-Economy is small: cannot affect the world interest rate, denoted r*

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

Question 8

Investment: demand for loanable funds

Answer 8

-Investment is still a downward-sloping function of the interest rate, but the exogenous world interest rate determines the country’s level of investment

Question 9

If the economy were closed…

Answer 9

-The interest rate would adjust to equate investment and saving

Question 10

But in a small open economy…

Answer 10

-the exogenous world interest rate determines investment
-and the difference between saving and investment determines net capital outflow and net exports

Question 11

Fiscal Policy at home

Answer 11

An increase in G or decrease in T reduces saving

Question 12

Fiscal Policy Abroad

Answer 12

-Expansionary fiscal policy abroad raises the world interest rate.

Question 13

Nominal exchange rate

Answer 13

the relative price of domestic currency in terms of foreign currency

(example: yen per dollar)

Question 14

The real exchange rate

Answer 14

the relative price of domestic goods in terms of foreign foods

(example: Japanese Big Macs per Canadian Big Mac)

Question 15

e in the real world and our model

Answer 15

-In the real world: we can think of e as the relative price of a basket of domestic goods in terms of a basket of foreign goods
-In our macro model: there is just one good “output”, so e is the relative price of one country’s output in terms of the other country’s output

Question 16

How NX depends on e

Answer 16

If e rises:
- Canadian goods become more expensive relative to foreign goods
-exports fall, imports rise
-net exports fall

Question 17

The next exports function

Answer 17

The net exports function reflects this inverse relationship between NX and e:
NX = NX(e)
(real exchange rate)

Question 18

How is e determined

Answer 18

Neither S nor I depends on e, so the net capital outflow curve is vertical

Question 19

Supply and Demand in the foreign exchange market

Answer 19

-Demand: foreigners need dollars to buy Canadian net exports
Supply: net capital outflow (S-I) is the supply of dollars to be invested abroad

Question 20

Fiscal Policy at home.

Answer 20

Fiscal expansion causes net capital outflow, national saving, and the supply of dollars in the foreign exchange market to go down.
National saving: increased government spending or tax cuts means people save less and spend more
NCO: less money available for investment, less capital flowing from the country to foreign markets
Dollars: with lower NCO, less dollars in market
Real exchange rate: decrease I the dollars in the foreign exchange market raises the interest rate, when fewer dollars available, value of dollars rises
NX: Higher exchange rate means domestic goods are more expensive, this reduces NX.

Question 21

Fiscal Policy Abroad

Answer 21

-An increase in world interest rate, reduces investment, increasing net capital outflow and the supply of dollars in the foreign exchange market
NCO: higher interest rate attracts foreign investors seeking better returns. More domestic funds flow to foreign assets
-causing real exchange rate to fall and NX to fall and NX rise

Question 21

Trade Policy to restrict imports

Answer 21

At any given world real exchange rate, an import quota reduces IM, increases NX, and increases demand for dollars
-Trade policy doesn’t affect S or I, so capital flows and the supply of dollars remain fixed
Results:
change in real exchange rate > 0
change in NX = 0
change in IM < 0
change in EX < 0

Question 22

The determinants of the nominal exchange rate

Answer 22

expression for real exchange rate
real exchange rate = (e x P)/P*
Solve for e
e = real exchange rate x (P*/P)
-e depends on the real exchange rate and the price levels at home and abroad

Question 23

Purchasing Power Parity

Answer 23

Two definitions: a doctrine that states that goods must sell at the same (currency-adjusted) price in all countries
-the normal exchange rate adjusts to equalise the cost of a basket of goods across countries
Reasons: arbitrage, the law of one price
- PPP implies that the nominal exchange rate between two countries equals the ratio of the countries’ price levels

Question 25

Does PPP hold in the real world?

Answer 25

No,
1. International arbitrage is not possible
-non traded goods
-transportation costs
2. Different countries goods are not perfect substitutes