Open Economy (Chapter 6 Mankiw)

Question 1

1. AD formula in an open economy.
2. NX formula

Answer 1

1. Y=C+I+G+NX

Where c= cd+cf, i=id+if, g=gd+gf
(d represents domestic goods, f foreign goods)

2. NX = X-(Cf+Gf+If) (since it is exports-imports)

Question 2

Savings investment balance equation - how is it composed? (NX)

Answer 2

Y=C+I+G+NX
Y=C+S+T (household budget constraint)

Put equal to each other.
NX= (S-I)+(T-G)

Which also means = to Sn (national saving) - I.
Therefore NX is determined by different between national saving and investment. (Sn - i)

Question 3

What are NCO

Answer 3

Net capital outflows - amount of excess national saving which can be invested abroad (outflows).

So national saving - I=CF=NX
E.G positive CFO, S>I, too much saving so goes abroad to global financial markets. Trade surplus.

Question 4

Real exchange rate (RER) ε formula and definition

Answer 4

ε = EP/pF

P is price of domestic goods
P is price of foreign goods
E is nominal exchange rate

The amount of foreign good needed to purchase one domestic good.

Question 5

Why is NX downward sloping

Answer 5

As when RER high, exports are dear so export revenue falls. NX reduced.

Question 6

Why national saving - investment (S-I) vertical

Answer 6

Not influenced by RER so vertical line

Question 7

What does the Purchasing power parity argue and why?

Answer 7

Argues P*=EP for domestic goods to be competitive.
(Price of foreign goods=foreign price of domestic goods)

Basically equalising the purchasing power by accounting for differences in inflation and cost of living across countries) e.g if burger $5 and £3, make $5 and £3 equal in purchasing power

Why? Demand for goods are highly price elastic so demand is responsive to changes in exchange rate

Question 8

Why is PPP unlikely to hold in long run (3)

Answer 8

Transaction costs
Similar goods from diff countries are not perfect subs
Non-traded goods that countries may make.

Question 9

What does the PPP look like on the exchange rate diagram

Answer 9

NX is very flat since elastic demand. So changes in national saving - investment (S-I), will change the RER very little.

Question 10

Relative PPP - maths equation

Answer 10

% change in E (nominal) = % change in ε (real) - (% change in P - % change in Pf)

Question 11

How is the circular flow edited in the open economy? (2)

Answer 11

In markets for G&S where households consume, and firms produce, we include exports and imports.

In financial markets, we consider foreign financial markets (NCO’s)