KYIV SCHOOL OF ECONOMICS APPLIED MACROECONOMICS II Instructor: Maksym Obrizan Lecture notes III

1. KYIV SCHOOL OF ECONOMICS APPLIED MACROECONOMICS II Instructor: Maksym Obrizan Lecture notes III # 2. CHAPTER 5 The Open Economy In this lecture we discuss macroeconomic implications of exchange rates and international trade # 3. Expenditure on an open economy’s output Y can be divided into four components: # 4. Now we can substitute these identities: which allows to obtain

2. # 5. We can re-write the last equation as: Net Exports = Output − Domestic Spending Quote from Mankiw: “If output exceeds domestic spending, we export the difference: net exports are positive.” (and vice versa) # 6. The national income accounts identity can be re-written as S – I = NX It follows that net capital outflow on the left-hand side equals trade balance on the RHS # 7-8. International flows of goods and capital: summary

3. # 9. 5.2 Saving and Investment in a Small Open Economy We will consider a small open economy with perfect capital mobility Small open economy can make only negligible effect on the world interest rates Question: how is the world interest rate determined? # 10. Assumptions of the model Output Y is fixed by the factors of production and the production function: Consumption C increases in disposable income (Y−T): # 11. Equation for trade balance Quote from Mankiw: “The trade balance is determined by the difference between saving and investment at the world interest rate.” # 12. Figure 5-2

4. # 13. Effects of fiscal policy at home Suppose that government increases G Quote from Mankiw: “Hence, starting from balanced trade, a change in fiscal policy that reduces national saving leads to a trade deficit.” # 14. Fiscal policy in a large foreign country In this case increase in G leads to a higher world interest rate Then at home S exceeds I because of lower investment # 15. Changes in investment demand at home Suppose that domestic investment increases (because of better economic policies, for example) A rightward shift in the investment curve causes a trade deficit # 16. Is trade deficit a problem? To summarize, policies increasing investment (or decreasing saving) tend to cause a trade deficit

5. # 17. Exchange rates The nominal exchange rate is the relative price of the currency of two trading countries # 18. Quote from Mankiw: “If the real exchange rate is high, foreign goods are relatively cheap, and domestic goods are relatively expensive.” # 19. # 20. What determines the real exchange rate? Consider, once again the case of increase in domestic G

6. # 21. Fiscal expansion abroad If a large foreign country cuts taxes (or increases G) the world interest rate will increase and domestic investment will be lower # 22. Figure 5-10 # 23. The effects of trade policies Trade policies seek to protect domestic producers from foreign competition (most often by means of a tariff or quota) # 24.

7. # 25. Nominal exchange rate and inflation We can re-arrange our exchange rate equation and take % changes # 26. # 27. The law of one price The same good cannot sell for 2 different prices in different locations at the same time # 28. When would PPP fail? Many goods (such as services) are non-tradable