USC ECON 205 - Savings and Investment in the Open Economy

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ECON 205 2nd Edition Lecture 19 Outline of Last Lecture I. Open-Economy MacroeconomicsII. Net foreign investment and importsIII. Government annual budgetIV. Fiscal policy and the fiscal clifV. Deficit and DebtJ.B. Say’s LawOutline of Current LectureI. Savings-Investment Relation and Net Exports in an Open EconomyII. The European Monetary UnionIII. InflationCurrent LectureI. Savings-Investment Relation and Net Exports in an Open EconomyThe 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 savings-investment 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 decreasein 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. InflationInflation 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 –

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USC ECON 205 - Savings and Investment in the Open Economy

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