Chapter 4- Aggregate Demand in the Open Economy PDF

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CHAPTER 4 AGGREGATE DEMAND IN THE OPEN ECONOMY Even if you never leave your hometown, you are an active participant in the global economy. Because our economy is integrated with many others around the world, consumers have more goods and services from which to choose, and savers have more opportunities to invest their wealth.

4.1. The International Flows of Capital and Goods 

Key macroeconomic difference between open & closed economies- in an open economy, a country’s spending in any given year need not equal its output of goods and services. 

A country can spend more than it produces by borrowing from abroad, or 

It can spend less than it produces and lend the difference to foreigners.

 The Role of Net Export 

In a closed economy, all output is sold domestically, and expenditure is divided into three components: consumption, investment, and government purchases.



In an open economy, some output is sold domestically and some is exported to be sold abroad. Y = Cd + Id + Gd + X Where, Cd + Id + G d is domestic spending on domestic goods and services and X, is foreign spending on domestic goods and services.



Domestic spending on all goods and services equals domestic spending on domestic goods and services plus domestic spending on foreign goods and services. C = Cd + Cf I = Id + If G = Gd + Gf We substitute these three equations into the identity above: Y = (C – Cf) + (I – If) + (G – Gf) + X We can rearrange to obtain Y = C + I + G + X – (Cf + If + Gf)

The sum of domestic spending on foreign goods and services (C f + If + Gf) is expenditure on imports (IM). Y = C + I + G + X – IM Defining net exports to be exports minus imports (NX = X − IM), the identity becomes Y = C + I + G + NX 

The national income accounts identity shows how domestic output, domestic spending, and net exports are related. In particular, NX = Y – (C + I + G) Net Export = Output – Domestic Spending



This equation shows that in an open economy, domestic spending need not equal the output of goods and services. 

If output exceeds domestic spending, we export the difference: net exports are positive. If output falls short of domestic spending, we import the difference: net exports are negative.

 International Capital Flows and the Trade Balance 

Financial markets and goods markets are closely related. To see the relationship, we must rewrite the national income accounts identity in terms of saving and investment. Begin with the identity Y = C + I + G + NX Subtract C and G from both sides to obtain Y – C – G = I + NX Where, Y − C − G is national saving S, which equals the sum of private saving, Y− T− C, and public saving, T – G. S = I + NX S – I = NX



An economy’s net exports must always equal the difference between its saving and its investment. 

Another name for net exports, NX, is trade balance 

The difference between domestic saving and domestic investment, S − I, is called net capital outflow (or net foreign investment).



Net capital outflow reflects the international flow of funds to finance capital accumulation.





Positive net capital outflow - lending the excess to foreigners. 

Negative net capital outflow - financing extra investment by borrowing from abroad.

The national income accounts identity shows that net capital outflow always equals the trade balance. Net Capital Outflow = Trade Balance S − I = NX 

S − I and NX are positive- Trade Surplus



S − I and NX are negative- Trade Deficit 



S − I and NX are exactly zero- Balanced Trade

The national income accounts identity shows that the international flow of funds to finance capital accumulation and the international flow of goods and services are two sides of the same coin.



Note that the international flow of capital can take many forms 

Foreigners make loans to us when we run a trade deficit. 

Foreigners can also buy domestic assets Whether foreigners buy domestically issued debt or domestically owned assets, they obtain a claim to the future returns to domestic capital.

4.2. Saving and Investment in a Small Open Economy  Capital Mobility and the World Interest Rate 

In open economy, we do not assume that the real interest rate equilibrates saving and investment 

We allow the economy to run a trade deficit and borrow from other countries or to run a trade surplus and lend to other countries.



If the real interest rate does not adjust to equilibrate saving and investment in this model, what does determine the real interest rate? We answer this question here by considering the simple case of a small open economy with perfect capital mobility. 

Small open economy- an economy is a small part of the world market and thus, by itself, can have only a negligible effect on the world interest rate. 

Perfect capital mobility- residents of the country have full access to world financial markets. The government does not impede international borrowing or lending.



Because of this assumption of perfect capital mobility, the interest rate in our small open economy, r, must equal the world interest rate r*, the real interest rate prevailing in world financial markets: r = r*



The world interest rate determines the interest rate in our small open economy. Residents of the small open economy 

Never borrow at any rate above r* because they can always get a loan at r* from



abroad. Never lend at any rate below r* because they can always earn r* by lending abroad.

 The Model 

To build the model of the small open economy, we take three assumptions 

The economy’s output Y is fixed by the factors of production and the production function. We write this as Y == F(,) 

Consumption C is positively related to disposable income Y − T. We write the consumption function as C = C(Y − T)



Investment I is negatively related to the real interest rate r. We write the investment function as I = I(r) 

We can now return to the accounting identity and write it as NX = (Y − C − G) − I NX = S − I 

With the assumption that the interest rate equals the world interest rate, we obtain NX = [– C(– T) – G] – I(r*) NX =



– I(r*)

This equation shows that the NX depends on those variables that determine S and I. 

Because saving depends on fiscal policy (lower government purchases G or higher taxes T raise national saving) and investment depends on the world real interest rate r* (a higher interest rate makes some investment projects unprofitable).

 How Policies Influence the Trade Balance 

Fiscal Policy at Home- starting from balanced trade, a change in fiscal policy that reduces national saving leads to a trade deficit.



Fiscal Policy Abroad- starting from balanced trade, an increase in the world interest rate due to a fiscal expansion abroad leads to a trade surplus.

 Shifts in Investment Demand- starting from balanced trade, an outward shift in the investment schedule causes a trade deficit. 

For example, if the government changed the tax laws to encourage investment by 

providing tax incentives, at a given world interest rate, investment is now higher. Because saving is unchanged, some investment must now be financed by borrowing from abroad.

4.3. Exchange Rate The exchange rate between two countries is the price at which residents of those countries trade with each other. Economists distinguish between two exchange rates: the nominal exchange rate and the real exchange rate.  Nominal Exchange Rate 

Nominal exchange rate is the rate at which a person can trade the currency of one country for the currency of another. It is the relative price of the currencies of two countries.





Expressed in two ways: 

In units of foreign currency per one domestic currency (0.0333USD/1Birr) 

In units of domestic currency per one foreign currency (30Birr/1USD)

Appreciation refers to an increase in the value of a currency as measured by the amount of foreign currency it can buy.



Depreciation refers to a decrease in the value of a currency as measured by the amount of foreign currency it can buy.

 Real Exchange Rate 

Real exchange rate is the rate at which a person can trade the goods and services of one country for the goods and services of another. It is the relative price of the goods of two countries. 



Compares the prices of domestic goods and foreign goods in the domestic economy.

The real exchange rate between two countries is computed from the nominal exchange rate and the price levels in the two countries. Real Exchange Rate = Nominal Exchange Rate X Ratio of Price Levels E

=

e

X

P/P*

Where, P is domestic price and P* is foreign price of similar product. E.g. Real Exchange rate = (1/30 USD/Birr) × (15 Birr/Cup of ET Coffee) (1 USD/Cup of US Coffee) = ½ Cup of US Coffee Cup of ET Coffee

or

2 Cup of ET Coffee Cup of US Coffee

 If the real exchange rate is high, foreign goods are relatively cheap, and domestic goods are relatively expensive. If the real exchange rate is low, foreign goods are relatively expensive, and domestic goods are relatively cheap.

4.4. The Mundell-Fleming Model The Mundell–Fleming model is a close relative of the IS–LM model. 

Both models stress the interaction between the goods market and the money market.



Both models assume that the price level is fixed and then show what causes short-run fluctuations in aggregate income (or, equivalently, shifts in the aggregate demand curve).

The key differences 

IS–LM model assumes a closed economy.



Mundell–Fleming model assumes an open economy.

 The Key Assumption: Small Open Economy With Perfect Capital Mobility 

Mundell–Fleming model assumes a small open economy with perfect capital mobility. 

The economy can borrow or lend as much as it wants in world financial markets and,



As a result, the economy’s interest rate is determined by the world interest rate. r = r*



The r = r* equation represents the assumption that the international flow of capital is rapid enough to keep the domestic interest rate equal to the world interest rate.

 The Goods Market and the IS* Curve 

The Mundell–Fleming model describes the market for goods and services much as the ISLM model does, but it adds a new term for net exports. Y = C(Y – T) + I(r) + G + NX(e) This equation states that 

Aggregate income Y is the sum of consumption C, investment I, government purchases G, and net exports NX. 

Consumption depends positively on disposable income Y − T.  



Investment depends negatively on the interest rate r. Net exports depend negatively on the exchange rate e.

Net export is more related to the real exchange rate rather than nominal exchange rate. 

However, Mundell–Fleming model assumes that the price levels at home and abroad are fixed, so the real exchange rate is proportional to the nominal exchange rate.



The goods-market equilibrium condition above has two financial variables affecting expenditure on goods and services (the interest rate and the exchange rate), but the situation can be simplified using the assumption of perfect capital mobility, so r = r*. We obtain Y = C(Y – T) + I(r*) + G + NX(e)



Let’s call this the IS* equation. (The asterisk reminds us that the equation holds the interest rate constant at the world interest rate r*.)



The IS* curve summarizes the relationship between the exchange rate e and income Y. 

The IS* curve slopes downward because a higher exchange rate reduces net exports, which in turn lowers aggregate income.

 The Money Market and the LM* Curve 

The Mundell–Fleming model represents the money market with an equation that should be familiar from the IS–LM model: M/P = L(r, Y) 

This equation states that The supply of real money balances M/P equals the demand L(r, Y).



The demand for real balances depends negatively on the interest rate and positively on income Y.



The money supply M is an exogenous variable controlled by the central bank, and 

Because the Mundell–Fleming model is designed to analyze short-run fluctuations, the price level P is also assumed to be exogenously fixed.



Once again, we add the assumption that the domestic interest rate equals the world interest rate, so r = r*: M/P = L(r*, Y)



Let’s call this the LM* equation. The LM* curve is vertical because the exchange rate does not enter into the LM* equation. Given the world interest rate, the LM* equation determines aggregate income, regardless of the exchange rate.

 Putting the Pieces Together 

According to the Mundell–Fleming model, a small open economy with perfect capital mobility can be described by two equations: Y = C(Y – T) + I(r*) + G + NX(e)

IS*

M/P = L(r*, Y)

LM*



The first equation describes equilibrium in the goods market; the second describes equilibrium in the money market. 

Exogenous variables- fiscal policy G and T, monetary policy M, the price level P, and the world interest rate r*.





Endogenous variables- income Y and the exchange rate e.

The equilibrium for the economy is found where the IS* curve and the LM* curve intersect. 

This intersection shows the exchange rate and the level of income at which the goods market and the money market are both in equilibrium.



With this diagram, we can use the Mundell–Fleming model to show how aggregate income Y and the exchange rate e respond to changes in policy.

4.5. The Small Open Economy Under Floating Exchange Rates Floating exchange rate- the exchange rate is set by market forces and is allowed to fluctuate in response to changing economic conditions.



The exchange rate e adjusts to achieve simultaneous equilibrium in the goods market and the money market.

Let’s now consider three policies that can change the equilibrium: fiscal policy, monetary policy, and trade policy using Mundell-Fleming model.  Fiscal Policy 

An expansionary fiscal policy (an increase in government purchases or cut in taxes) increases planned expenditure, it shifts the IS* curve to the right. As a result, the exchange rate appreciates, whereas the level of income remains the same.



In the closed-economy IS–LM model, a fiscal expansion raises income, whereas in a small open economy with a floating exchange rate, a fiscal expansion leaves income at the same level. 

The difference arises because the LM* curve is vertical, while the LM curve we used to study a closed economy is upward sloping.



What are the economic forces that lie behind the different outcomes? To answer this question, we must think through what is happening to the international flow of capital and the implications of these capital flows for the domestic economy.



The interest rate and the exchange rate are the key variables in the story. When income rises in a closed economy, the interest rate rises, because higher income increases the demand for money. That is not possible in a small open economy because, as soon as the

interest rate starts to rise above the world interest rate r*, capital quickly flows in from abroad to take advantage of the higher return. As this capital inflow pushes the interest rate back to r*, it also has another effect: because foreign investors need to buy the domestic currency to invest in the domestic economy, the capital inflow increases the demand for the domestic currency in the market for foreign-currency exchange, bidding up the value of the domestic currency. The appreciation of the domestic currency makes domestic goods expensive relative to foreign goods, reducing net exports. The fall in net exports exactly offsets the effects of the expansionary fiscal policy on income. 

Why is the fall in net exports so great that it renders fiscal policy powerless to influence income? To answer this question, consider the equation that describes the money market: M/P = L(r, Y)



In both closed and open economies, the quantity of real money balances supplied M/P is fixed by the central bank (which sets M) and the assumption of sticky prices (which fixes P). The quantity demanded (determined by r and Y) must equal this fixed supply. In a closed economy, a fiscal expansion causes the equilibrium interest rate to rise. This increase in the interest rate (which reduces the quantity of money demanded) implies an increase in equilibrium income (which raises the quantity of money demanded); these two effects together maintain equilibrium in the money market. By contrast, in a small open economy, r is fixed at r*, so there is only one level of income that can satisfy this equation, and this level of income does not change when fiscal policy changes. Thus, when the government increases spending or cuts taxes, the appreciation of the currency and the fall in net exports must be large enough to offset fully the expansionary effect of the policy on income.

 Monetary Policy 

An increase in the money supply, price level is assumed to be fixed, increases real money balances, and this shifts the LM* curve to the right.





Hence, an increase in the money supply raises income and lowers the exchange rate.

Although monetary policy influences income in an open economy, as it does in a closed economy, the monetary transmission mechanism is different. Recall that in a closed economy an increase in the money supply increases spending because it lowers the interest rate and stimulates investment. In a small open economy, this channel of monetary transmission is not available because the interest rate is fixed by the world interest rate. So how does monetary policy influence spending? To answer this question, we once again need to think about the international flow of capital and its implications for the domestic economy.



The interest rate and the exchange rate are again the key variables. As soon as an increase in the money supply starts putting downward pressure on the domestic interest rate, capital flows out of the economy, as investors seek a higher return elsewhere. This capital outflow prevents the domestic interest rate from falling below the world interest rate r*. It also has another effect: because investing abroad requires converting domestic currency into foreign currency, the capital outflow increases the supply of the domestic currency in the market for foreign currency exchange, causing the domestic currency to depreciate in value. This depreciation makes domestic goods inexpensive relative to foreign goods, ...