Exam #2 Study Guide (Chapter 6,13-14,18)Chapter 6 (February 24)The Open EconomyOpen economy – Goods and services are exported abroad and goods and services are imported from abroad. Economies borrow and lend in world financial markets.International Flows of Capital and GoodsIn an open economy, a country’s spending in any given year does not need to equal its output of goods and services.Open Economy Expenditure: Y = C + I + G + NXC = consumptionI = investmentG = government purchasesNX = net exports of goods and servicesNX = exports – importsNX = Y – (C + I + G)Output – Domestic SpendingNational Income Accounts Identity: S – I = NXNX – net export of goods and services; Trade BalanceS – I – difference between domestic saving and domestic investment; Net Capital Outflow (NCO)Trade Surplus – Exports > ImportsY > C + I + GSaving > InvestmentNCO > 0Trade Deficit – Exports < ImportsY < C + I + GSaving < InvestmentNCO < 0Balanced TradeY = C + I + GSaving = InvestmentNCO = 0Saving and Investment in a Small Open EconomyCapital Mobility – Residents in a certain economy have full access to world financial markets and their government does not effect international borrowing or lending.Small economy’s interest rate r must equal theworld interest rate r*r = r*The equilibrium of world saving and world investment determines the world interest rate.Small open economy has a negligible effect on the world interest rate.Exchange RateNominal Exchange Rate – The rate at which two countries’ currencies trade against each other.(e) = # of units of foreign currency that can be bought with one unit of domestic currency.Ex. Pesos (p); e = 10; 10 p for $1Dollar ($) appreciates – e increasesDollar ($) depreciates – becomes less valuable  e decreasesOne currency’s appreciation = another currency’s depreciationReal Exchange Rate – The rate at which two countries goods and services trade against each other.Measure of actual goods and servicesAdjust for price changes across countriesΕ =P – price of domestic goodseP* - price of foreign goodsIf E increases – our goods and services become more expensive; foreign goods and services become less expensiveNet exports decreaseIf E decreases – our goods and services become less expensive, foreign goods become more expensiveNet exports increaseIn equilibrium: S – I = NX = NCONet exports = Net Capital OutflowNX almost like demand for US dollarsS – I almost like supply of US dollarsDemand of US dollars > Supply of US dollars – value of $US increasesDemand of US dollars <Supply of US dollars – value $US decreasesPurchasing Power Parity (PPP)Over time, real exchange rates converge to one.E = 1; e =Goods will sell for the same price in different markets over time.Chapter 13 (February 26 – March 3)The Open Economy: Mundell-Fleming Model and Exchange RateMundell-Fleming Model – close relative to the IS-LM modelStresses the interaction between the goods market and money marketShort-run model  assumes prices are stickySmall open economy with perfect capital mobilityr = r*The world interest rate is said to be exogenously fixed because the economy is small relative to the world economy.The small economy can borrow or lend as much as it wants in the world financial market without affecting the world interest rate.r = r* +θ (whereθis the risk premium)Goods Market equation – small open economy with perfect capital mobility:IS* CurveY = C(Y - T) + I(r*) + G + NX(e)C – Consumption(Y – T) – Disposable incomeI(r*) – InvestmentG – Government purchasesNX(e) – Net exports (exchange rate)Investment depends negatively on the interest rateNet exports depend negatively on exchange rateIS* curve slops downward because a higher exchange rate reduces net exports, which lowers aggregate income.As e increases, GDP (Y) decreasesAs e decreases, GDP (Y) increasesMoney Market equationLM* Curve= L(r*, Y)Equation states that the supply of real money balances ( ) equals the demand for real money balances L(r*, Y)The demand for real money balances depends negatively on the interest rate and positively on income (Y).Money supply(M) is an exogenous variable controlled by the central bank.Price level (P) is assumed to be exogenously fixed– Supply of real money balancesL(r*, Y) – Demand for real money balancesM and Y are proportionateAs M increases, Y increasesAs M decreases, Y decreasesLM* curve is vertical because the exchange rate does not enter into the LM* equation.Exogenous variables – given variablesG, T, M, P, r*Endogenous variables – variables we must solve for to find equilibriume, Y (axis variables)e – vertical axisY – horizontal axisExchange Rate EffectsTwo Exchange RatesFloating – The exchange rate is set by market forces and is allowed to fluctuate in respond to changing economic conditions.Exchange rate (e) adjusts to achieve simultaneous equilibrium in goods market and money market.Set by market conditions; supply and demand of currency on world markets.High demand – high value of currency; high nominal valueLow demand – low value of currency; low nominal valueFixed – The exchange rate is set by the Central Bank and the exchange rate (e) is kept “pegged” to a chosen country.Central Bank stands ready to buy and sell foreign currency at exchange rate e*This exchange rate fixes the nominal exchange rateThe fixation of the real exchange rate depends on the time horizon, as the real exchange rate can change even if the nominal exchange rate is fixed.LM* curve automatically adjusts to keep e = e*Equilibrium Changing PoliciesThree Major PoliciesFiscal Policy – Altering government spending or taxation.Monetary Policy – Increasing or decreasing money supply.Trade Policy –Changes in demand for imported goods by either an import restriction or tariff.Examples-Expansionary Fiscal Policy with a Floating Exchange RateAssume an increase in government purchases or tax reduction.IS* Curve shifts right by x Δ GLM* curve does not moveExchange rate (e) increases, Y stays the sameIncrease in (e)  “perfect crowding out”Reduction in investment that results when expansionary fiscal policy raises the interest rateDecrease in net exportsIncrease in G  decrease in NXSpending more money overseas = more importsIn conclusion, does not work well to stimulate the domestic economy.Monetary Policy with a Floating Exchange RateTo stimulate the economy, increase Money Supply (M)LM* shifts right = L(r, Y)M has a