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1. Personal Web Site (information, materials, advices): https://beatricevitali-unibo.weebly.com/ Email: beatrice.vitali8@unibo.it Dott.ssa Vitali Beatrice

2. MacroeconomicsExercise5(Ch. 6 and 13) • The Open Economy (Ch. 6) • The Open Economy Revisited (Ch. 13)

3. Chapter 6: The Open Economy Key- concepts • Trade balance and current accounts (saving vs. investments) • Exchange rates (nominal vs. real, determinants of the exchange rates, effects on trade balance) • Trade policy

4. The trade balance GDP in the open economy: Y = Cd + Id + Gd + NX If national income is larger (smaller) than internal expenditure (= Cd + Id + Gd), net exports will be positive (negative) NX=Y – (C + I + G) Net exports (NX) correspond to trade balance • if NX > 0: the country incurrs a trade surplus • if NX < 0: the country incurrs a trade deficit

5. Saving and investment NX=Y – (C + I + G) The above equation can be re-written as: I + NX =Y – C – G ⇒ S= I + NX ⇒ S – I = NX • If S > I, then NX > 0 (the country is an international lender) • If S < I, then NX < 0 (the country is an international borrower)

6. Exercise 1 Consider a country in which consumption is C=50, investment is I=20 and public spending is G=15. A) Suppose that private saving is Spr=25, while taxation is T=20. Compute the level of net exports as well as the resulting national income. B) What will the answer to the previous question be, in caseSpr=15, while T=10?

7. Ex. 1 – (a) Net exports, namely NX, correspond to S – I National saving (S) is the sum of private saving (Spr=25) and public saving (Spub = T- G) Since T=20 and G= 15 ⇒ Spub = T – G = 20 – 15 = 5 ⇒ S = Spr+ Spub= 25 + 5 = 30 Given I = 20, net exports will be: NX = S - I = 30 - 20 = 10 (> 0) The country of interest is a net exporter National income is: Y = C+ I + G + NX = 50 + 20 +15 + 10 = 95

8. Ex. 2 – (b) Net exports, namely NX, correspond to S – I National saving (S) is the sum of private saving (Spr=25) and public saving (Spub = T- G) Since T=10 and G= 15 ⇒ Spub = T – G = 10 – 15 = -5 ⇒ S = Spr+ Spub= 15 + (-5) = 10 Given I = 20, net exports will be: NX = S - I = 10 - 20 = -10 (< 0) The country of interest is a net importer National income is: Y= C+ I + G + NX = 50 + 20 +15 +(- 10) = 75

9. Interest rates and trade balance (I) Remember the loanable funds market… In a closed economy, the equilibrium interest rate is pinned down by the intersection between the investment demand curve (which is downward sloping, as I falls when r) and the vertical line which stands for the (exogenous) national saving supply r S I = I(r) re I NX = S - I

10. Interest rates and trade balance (II) S In a small, open economy with no restrictions on capital flows, the interest rate is equal to the international interest rate: r=r* If r* corresponds to the autarky equilibrium interest rate, namely re, then trade is balanced: NX=0 r NX=0 I = I(r) r* = re I

11. Interest rate and trade balance (III) If r* is higher than the former autarky equilibrium interest rate re, then the country will be a lender in the international market (S>I) and therefore a net exporter (i.e. NX>0) At the opposite, if r* is lower than re, then the country will borrow from the international market (S<I) and therefore will be a net importer (i.e. NX<0) r S NX>0 r* I = I(r) re r* I NX<0

12. Exercise 2 Consider a country in which trade is initially balanced (NX=0) A) By using the model of the loanable funds market (with saving assumed to be exogenously given), show the effects on the trade balance of a reduction in the demand for investment B) Show the change in trade balance induced by a restrictive fiscal policy (i.e. public spending cuts or increased taxation) C) Show the change in trade balance induced by an increase in the foreign amount of saving, which lowers the international interest rate r*

13. Ex. 2 – (a) Given the reduction in the domestic demand for investment, at the international interest rate r*, national saving now exceeds the domestic level of investment The country will turn into an international lender, i.e. will «finance» foreing consumption by means of positive net exports r S NX=0 r* I = I(r) NX’>0 I = I’(r) I

14. Ex. 2 – (b) A restrictive fiscal policy increases public saving and lowers private saving but less than proportionally ⇒ the overall national saving rises Now S > I: the existing surplus of saving can be lent in the international funds market, and implies positive net exports r S S’ NX’>0 NX=0 r* I = I(r) I

15. Ex. 2 – (c) In the rest-of-the-world saving rises: the increased supply of loanable funds will imply a decrease in the international interest rate r* In the country of interest, at the new rate r*’ (with r*’<r*), national saving is lower than the domestic demand for investment: S < I The country is a net borrower from the international funds market, and therefore a net importer (NX <0) r S NX=0 NX’<0 r* r*’ I = I(r) I

16. Exchange rates The nominal exchange rate (namely e) is the relative price of the currencies of two different countries Example: e(euro-to-dollar) = 1,2 ⇒ 1€ = 1,2 $ • If e rises, the euro appreciates against the dollar • If e falls, the euro depreciates against the dollar The real exchange rate (ε) is the relative price of goods in two different countries, i.e. the ratio between the price (in foreign currency) of national goods and the price of foreign goods ⇒

17. Exercise 3 Suppose that the euro-to-pound nominal exchange rate is e=0.8 (that is, 1€ = 0.8 £) and the same sweater is sold for €20 in Italy and £ 19 in UK. A) A british turist has a budget of £ 100 for shopping in Italy. How many euros will she get in exchange for her £ 100 ? What if she were converting £ 150, instead of £ 100? B) How much does it cost to the british turist the purchase of the sweater in Italy, in terms of pounds? C) What is the real exchange rate betwen Italy and UK?

18. Ex. 3 - (a) If e=0.8, then the following proportion applies: €1 : £0.8 = € X : £100 , where X in the amount of euros that will be obtained in exchange for £100 ⇒ X = (£100 · €1 ) / £0.8 = €125 If the amount of pounds to be converted is £150, then the proportion becomes: €1 : £0.8 = € X : £150 ⇒ X = (£150 · €1 ) / £0.8 = €187.5

19. Ex. 3 – (b) and (c) If e=0.8, then the proportion that applies is: €1 : £0.8 = €20 : Y where Y is the amount of pounds that must be spent in order to obtain €20, i.e. the amount of euros needed for purchasing the sweater in Italy ⇒ X = (€20 · £0.8) / € 1 = £16 • The price in foreign currency (pounds) of the sweater in Italy is £ 16 (= e · P) • The price of the same sweater in UK is £ 19 (=P*) ⇒ the real exchange rate (i.e. the relative price of the sweaters in the two countries) is: 𝜺 = (𝒆 · 𝑷 )/𝑷∗ = £ 16 / £ 19 = 0.8421

20. Exchange rates and trade balance (I) The real exchange rate εaffects the trade balance  εnational goods become relatively moreexpensive then foreign goods Exports tend to fall, whereas imports tend to rise NX NX can therefore be expressed as a negative function of ε e NX(e)

21. Exchange rates and trade balance (II) S = I e If εis high national goods are relatively expensive and net exports tend to be negative (NX<0) If εis low national goods are relatively cheap and net exports tend to be positive (NX>0) NX<0 e1 NX>0 e0 e2 NX(e) 0 NX

22. Exercise 4 Consider a country in which, at the current level of the real exchange rate, trade is balanced: NX = 0 Since NX(ε) = S – I: A) Assess the impact on trade balance of an expansionary fiscal policy (such as a rise in G or a reduction in T). B) Assess the impact on the trade balance of an increase in foreing saving, which lowers the international interest rate.

23. Ex. 4 – (a) An expansionary fiscal policy reduces total national saving. Ate,S is now lower than I (which is unaffected): the country turns into an international borrower and this causes an inward capital flow. More foreign currency is exchanged into national currency: ε appreciates and net exports fall e NX’=0 e’ NX=0 e NX(e) 0 NX

24. Ex. 4 – (b) A decrease in the international interest rate implies a higher demand for investment in the country of interest, whereas national saving is unaffected. Ate,Iis now larger than S: the country borrows funds from the international market (an inward capital flow occurs) More foreign currency is converted into national currency, and the exchange rate rises: εappreciates and net exports fall e NX’=0 e’ NX=0 e NX(e) 0 NX

25. Trade policy The government can alter the price of imported goods (or exported goods) in such a way to make national goods more convenient and/or foreign goods more expensive to be purchased To accomplish this task, the government can use different tools: tariffs, quotas, export subsidies, etc.. In all these cases, net exports are expected to increase for any possible level of the real exchange rate, which means that the curve NX(ε) shifts upwards

26. Multiple choice quiz 1. A depreciation of the euro will have the following effects: • European imports rise, while exports fall. • Both European imports and exports rise. • European exports rise, while imports fall. • Both European imports and exports fall. 2. Suppose that the euro-to-dollar nominal exchange rate appreciates by 10%; if the inflation rate in the Eurozone is 2% while in the US is 5%, what is the change of the euro-to-dollar real exchange rate? • It appreciates by 15%. • It appreciates by 10%. • It appreciates by 7%. • It depreciates by 3%.

27. Recap of the most important equations we have seen so far • GDP – closed economy • Aggregate production function Y = f(K,L) • Aggregate demand C+I+G • Real GDP Y = C+I+G • Nominal GDP PY • Money and inflation MV=PY • Unemployment U/L = s/(s+f) • Growth • Steady State condition k*/f(k) = s/δ • Golden rule PMK = δ • Real GDP – open economy Y = C+I +G+NX

28. Ch. 13: il modello Mundell-Fleming Key- concepts • The Mundell-Fleming model (which is the IS-LM model in the open economy version): • changes in the IS curve (NX and aggregate income) • changes in the LM curve (perfect capital mobility) • Effects of monetary, fiscal and trade policy under floating exchange rates • Effects of monetary, fiscal and trade policy under fixedexchange rates

29. The Mundell-Fleming model Assumptions: • Small open economy • Perfect capital mobility • National and foreign financial assets are identical, but for the interest rate and the currency in which they are denominated These assumptionsimplythatr=r* (otherwise, arbitrage!) The IS-LM model in the open economy • Exogenous variables: P, G, T, M, r(=r*) • Endogenous variables: Y, e, C, I, NX

30. The IS curve in open economy e GDP in the open economy: Y = C + I + G + NX, where: • C is a function which depends (positively) on Y and (negatively) on T • I is an inverse function of r • NX is an inverse function of e A fall in the exchange rate (↓ e) makes national goods relatively cheaper than foreign goods IS* Y Exports rise while imports lower: NX increases and this leads to an increase in aggregate demand and therefore in production

31. The LM curve in open economy e LM* The equilibrium in the market of real money holdings is achieved when demand equals supply. The money supply (in real terms) is given by M/P and is exogenously given: it depends on the quantity of money supplied by the Central Bank, and on the level of prices, assumed as given. The demand for money only depends on Y, since the interest rate is forced to be r = r*, due to the perfect capital mobility Y The LM curve is therefore represented as a perfectly vertical line: in the money market, the equilibrium does not depend on e

32. Floating Exchange rates Floating Exchange Rate Regime: the exchange rate can freely (and endogenously) adjust depending on trade and financial inflows and outflows. The exchange rate is the relative price of the currencies, which varies based on: • the demand for national currency (against foreign currency) • the supply of national currency (against foreign currency) Why might one want to supply or demand foreign currency? • purchase foreign finanancial assets (financial flows) • purchase foreign goods (trade flows)

33. Fluctuation of the exchange rate If the demand for the national currency exceeds its supply, then the price of the national curency rises: the exchange rate increases and the national currency appreciates (↑e) A reduction in money supply is equivalent to an increase in the demand for national currency (i.e. ↑e ) If the demand for the national currency is lower than its supply, then the price of the national curency declines: the exchange rate decreases and the national currency depreciates (↓e) An increase in money supply is equivalent to a reduction in the demand for national currency (i.e. ↓e)

34. Fixed Exchange Rates In a fixed exchange rate regime, the Central Bank commits itself to keep the exchange rate fixed and constant over time. To achieve this goal, the Central Bank has to continuously adjust the money supply, in such a way to neutralize any excess demand or excess supply of national currency (against foreign currency): • If the demand for the national currency exceeds its supply, then the Central Bank has to increase the money supply • If the demand for the national currency is lower than its supply, then the Central Bank has to decrease the money supply

35. Exercise 6 A) Show the effect on the open economy equilibrium of a restrictive fiscal policy (e.g. a cut in public spending G), depending on the exchange rate regime which is in place. B) Show the effect on the open economy equilibrium of an expansionary monetary policy (e.g. an increase in money supply M), depending on the exchange rate regime. C) Show the effect on the open economy equilibrium of a protectionist trade policy (e.g. an increase in import tariffs), depending on the exchange rate regime.

36. Ex. 6 – (a)↓G under floating rates e A reduction in G lowers aggregate demand: the IS* curve moves to the left ⇒ r tends to decline and this gives rise to capital outflows: foreignassetsyield a higher return (= r*) This outflow prevents rfrom falling, but the demand for the national currencyfalls: ↓e NX rises, stimulating aggregate demand and therefore Y, which comes back to its original level (fiscal policy is ineffective!) LM* e0 IS*0 e1 IS*1 Y Y1

37. Ex. 6 – (a)↓G under fixed rates e LM1* LM0* Exactly as before: ↓G ⇒ ↓AD and the IS* curve moves to the left This createsdownward pressure on r and hence capital outflow, which reduces the demand for the national currency. To avoid the depreciation (i.e. the fall in e) the Central Bank reduces money supply (↓M): e does not change, but M/Pfalls and Y decreases e0 IS*0 IS*1 Y1 Y0 Y

38. Ex. 6 – (b)↑M under floating rates e A rise in M shifts the LM* curve towards the right ⇒ r tends to decline, and this triggers capital outflow: investorswant to buy foreignassets, thatyield a higher return (=r*) This outflow prevents r from falling, butitreduces the demand for the national currency: ↓e NX rise (as domestic goods are now relatively cheaper than foreign goods), stimulating AD and raising Y in a permanent way LM0* LM1* e0 e1 IS* Y Y0 Y1

39. Ex. 6 - (b)↑M under fixed rates Exactly as before: ↑M shifts the LM* curve towards right and createsdownward pressure on r, whichcauses capital outflow: the demand for nationalcurrencyfalls To prevent depreciation (i.e. ↓e), the Central Bank decreases the money supply (↓M), doing exactly the opposite of whatithas done before! The LM* curves comes back to itsoriginal position: by fixing e, the Central Bank gives up the possibility to use monetary policy e LM0* LM1* e0 IS* Y Y0

40. Ex. 6 – (c)Tariffs under floating rates e Tariffs lower imports (and raise NX) for any level of e: the IS* curve shifts towards the right… Upward pressure on rcauses capital inflow ⇒ because of increased demand for national currency, the exchange rate rises: ↑e ↓NX (national goods are now relatively more expensive than foreign goods): ADfalls and Y (which has increased due to the rise in net exports) comes back to its original level. LM* e1 IS1* e0 IS0* Y0 Y

41. Ex. 6 – (c)Tariffs under fixed rates e LM1* Exactly as before: tariffs reduce imports for any level of e: ↑NX and the IS* moves to the right… The upward pressure on r gives rise to increased capital inflow, which boosts the demand for the national currency. To avoid appreciation (i.e. ↑e) the Central Bank increases the money supply, shifting the LM* curve towards the right ↑M/P stimulates production, which now exceeds its original level LM0* e0 IS1* IS0* Y1 Y0 Y

42. Multiple choice 5. According to the Mundell-Fleming model, under a fixed exchange rate regime a revaluation of the national currency has the same effectas… • an expansionary monetary policy under floatingexchange rates • a restrictive monetary policy under floatingexchange rates • a restrictive fiscal policy under floatingexchange rates • an expansionary fiscal policy under floatingexchange rates 6. Under floating exchange rates, when hit by any shock, the economy tends to adjusts mainly by means of a change: • in aggregate demand • in the interest rate • in the exchange rate • in the money supply