Econ 322 1st Edition Exam 2 Study Guide Chapter 6 13 14 18 Chapter 6 February 24 The Open Economy Open 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 Goods o In an open economy a country s spending in any given year does not need to equal its output of goods and services o Open Economy Expenditure Y C I G NX C consumption I investment G government purchases NX net exports of goods and services NX exports imports NX Y C I G o Output Domestic Spending National Income Accounts Identity S I NX NX net export of goods and services Trade Balance S I difference between domestic saving and domestic investment Net Capital Outflow NCO o Trade Surplus Exports Imports Y C I G Saving Investment NCO 0 o Trade Deficit Exports Imports Y C I G Saving Investment NCO 0 o Balanced Trade Y C I G Saving Investment NCO 0 Saving and Investment in a Small Open Economy o Capital 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 o Exchange Rate Nominal 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 1 o Dollar appreciates e increases o Dollar depreciates becomes less valuable e decreases o One currency s appreciation another currency s depreciation Real Exchange Rate The rate at which two countries goods and services trade against each other Measure of actual goods and services Adjust for price changes across countries eP P o P price of domestic goods o eP price of foreign goods If E increases our goods and services become more expensive foreign goods and services become less expensive Net exports decrease If E decreases our goods and services become less expensive foreign goods become more expensive Net exports increase In equilibrium S I NX NCO Net exports Net Capital Outflow NX almost like demand for US dollars S I almost like supply of US dollars Demand of US dollars Supply of US dollars value of US increases Demand of US dollars Supply of US dollars value US decreases o Purchasing Power Parity PPP Over time real exchange rates converge to one P P Goods will sell for the same price in different markets over time E 1 e Chapter 13 February 26 March 3 The Open Economy Mundell Fleming Model and Exchange Rate Mundell Fleming Model close relative to the IS LM model o Stresses the interaction between the goods market and money market o Short run model assumes prices are sticky o Small open economy with perfect capital mobility r 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 where is the risk premium o Goods Market equation small open economy with perfect capital mobility IS Curve Y C Y T I r G NX e C Consumption Y T Disposable income I r Investment G Government purchases NX e Net exports exchange rate Investment depends negatively on the interest rate Net exports depend negatively on exchange rate IS curve slops downward because a higher exchange rate reduces net exports which lowers aggregate income As e increases GDP Y decreases As e decreases GDP Y increases o Money Market equation LM Curve M L r Y P M Equation states that the supply of real money balances equals P 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 M Supply of real money balances P L r Y Demand for real money balances M and Y are proportionate As M increases Y increases As M decreases Y decreases LM curve is vertical because the exchange rate does not enter into the LM equation o Exogenous variables given variables G T M P r o Endogenous variables variables we must solve for to find equilibrium e Y axis variables e vertical axis Y horizontal axis Exchange Rate Effects o Two Exchange Rates Floating 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 o High demand high value of currency high nominal value o Low demand low value of currency low nominal value Fixed 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 rate The 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 Policies o Three Major Policies Fiscal 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 o Exampleso Expansionary Fiscal Policy with a Floating Exchange Rate Assume an increase in government purchases or tax reduction 1 IS Curve shifts right by x G 1 C LM curve does not move Exchange rate e increases Y stays the same Increase in e perfect crowding out o Reduction in investment that results when expansionary fiscal policy raises the interest rate o Decrease in net exports Increase in G decrease in NX o Spending more money overseas more imports In conclusion does not work well to stimulate the domestic economy o Monetary Policy with a Floating Exchange Rate To stimulate the economy increase Money Supply M M LM shifts right L r Y P M has a positive correlation with Y M has a negative correlation with r Increase M Increase Y Exchange rate falls Y increases More dollars floating around value decreases o Higher exports decrease in the exchange rate In conclusion monetary policy