ECON 205 2nd Edition Lecture 19 Outline of Last Lecture I Open Economy Macroeconomics II Net foreign investment and imports III Government annual budget IV Fiscal policy and the fiscal clif V Deficit and Debt J B Say s Law Outline of Current Lecture I Savings Investment Relation and Net Exports in an Open Economy II The European Monetary Union III Inflation Current Lecture I Savings Investment Relation and Net Exports in an Open Economy The savings investment relation in an open economy is It I X S T G where total national investment It consists of investment in domestic capital I plus net exports X This must equal total private saving S plus total public saving T G Net exports are determined by the diference between national saving and national investment which is determined by domestic factors and the world interest rate Moreover changes in exchange rates are the mechanism by which savings and investment adjust How net exports adjust to provide necessary investment during budget deficit if the government suddenly runs a budget deficit this will lead to an imbalance in the savingsinvestment market which would push up domestic interest rates relative to world rates This rise will attract international funds and appreciate the foreign exchange rate causing a decrease in net exports This will continue until the savings investment gap is closed An increase in private saving or lower government spending will increase national savings rate depreciating exchange rates An increase in domestic investment will lead to an appreciation of the exchange rate until net exports decline to balance An increase in world interest rates will reduce levels of investment depreciating foreign exchange rates and increasing net exports Promoting economic growth in an open economy includes having high rates of saving and investment in productive ventures by ensuring businesses use best practice techniques These include stable macroeconomic climate property rights for both tangible investments and intellectual property providing a convertible exchange rate and maintaining political and economic stability II The European Monetary Union In 1999 eleven European nations linked their currencies and joined the European Monetary Union EMU They created one currency the Euro as their unit of account and medium of exchange The European Central Bank ECB conducts the European monetary policy and defines its main goal as price stability inflation rates of below 2 percent per year Some economists are more pessimistic about the Euro believing that Europe is not an optimal currency area a region with high labor mobility and common aggregate supply and demand shocks The post war period however has seen the highest economic growth in recorded history an emergent monetary system and resurgence of free markets III Inflation Inflation occurs when the general level of prices is rising We calculate it using prices indexes most commonly the consumer price index CPI The GDP deflator is the price of all of the diferent components of the GDP The rate of inflation is the percentage change in price level Rate of inflation in year t 100 x Pt Pt 1 Pt 1