macro 3020

Introduction

• Discussion is centered around the concept of trade and its relation to sports and the economy.
• Reference to popular culture (Bad Bunny, ESPN) is used to engage students.
• Transition to the topic of a small open economy and trade.

Small Open Economy Model

Loanable Bonds Market

• Focus on the loanable bonds market while analyzing the small open economy.
• Assumptions on Savings:
  • National savings are determined by GDP minus consumption ($Y - C$).
  • National savings are assumed to not depend on the interest rate.
  • National savings represented as natural savings.

Investment Function

• The investment function exhibits a negative slope:
  • Explanation: Higher borrowing costs lead to a lower quantity of demanded funds for investment, and vice versa.

Fiscal Policy Effects

Fiscal Policy at Home

• If the government increases spending beyond revenue, a budget deficit occurs.
• Impact on National Savings:
  • Increasing the government deficit decreases national savings, moving from $S<em>1$ to $S</em>2$.
• The investment level is determined by the world interest rate ($R^*$) in a small open economy; domestic actions cannot influence world prices.

Impacts on Net Exports and Capital Outflows

• When national savings drop, the gap between savings and investment narrows leading to:
  • A reduction in net exports (NX).
  • A decrease in net capital outflows (NCO).
  • Important to note that government budget deficits affect investment but not the investment level itself in the model.

Fiscal Policy Abroad

• Understanding impacts of foreign government budget deficits:
  • When other countries expand their budget deficits (increase G or decrease T), world savings decline,
  • Resulting in an increase in the world interest rate ($R^*$).
  • This also influences the US investment demand curve shifting along the existing demand curve but without changing savings.

Adjustments in US Economy

• As world interest rates go up, the quantity of demanded loanable funds in the US decreases, leading to:
  • An increase in net capital outflows (NCO).
• Importance of understanding that no changes occur domestically in savings from foreign fiscal policies directly.

Real and Nominal Exchange Rates

Definitions

• Nominal Exchange Rate ($E$): Price of domestic currency in terms of foreign currency:
  • Examples:
  • yen per dollar,
  • pesos per dollar.
• Caution in definitions: sometimes expressed as dollar per foreign currency which changes interpretations of appreciation vs depreciation.

Notation Differences

• Understand the appreciation vs. depreciation of the domestic currency based on exchange rate movements:
• Appreciation: when the nominal exchange rate increases, indicating the domestic currency's increased value in terms of foreign currency.
• Depreciation: opposite conditions apply when the nominal exchange rate decreases.

Real Exchange Rate ($rac{E imes P}{P^*}$)

• Real exchange rate measures the price of domestic goods in terms of foreign goods:
  • Formula: $ext{Epsilon} ( ext{ε}) = \frac{ ext{Nominal Exchange Rate} (E) imes ext{Domestic Price Level} (P)}{ ext{Foreign Price Level} (P^*)}$
• Implications of Real Exchange Rate:
  • Higher ε indicates that US goods are more expensive in real terms, likely reducing exports and increasing imports.

Exchange Rate Magnitudes and Economic Outcomes

Impact of ε on Trade

• Increase in ε leads to:
  • Decrease in exports: Goods become more expensive for foreign consumers.
  • Increase in imports: Foreign goods become relatively cheaper for domestic consumers.
• Graphical representation of the relationship between ε and net exports.

Net Exports Function

Graphical Representation

• The graph of the net exports function reveals a negative slope:
  • High relative price (real exchange rate) results in lower net exports.
  • Conversely, low prices increase net exports.
• Importance of horizontal and vertical axes:
  • Horizontal represents quantity of net exports.
  • Vertical depicts the real exchange rate.

Identifying Trade Balance

• Accounting Identity:
  • Net Exports (NX) = Savings (S) - Investment (I)
  • Maintaining equilibrium between NX and NCO through adjustments in ε.

Policy Analysis: Effects of Fiscal Expansions

Domestic Fiscal Policy Changes

• Fiscal expansions decrease national savings.
• Result: higher real exchange rate due to a shrinking supply of domestic dollars in international markets.
• Increases relative prices of US goods leading to reduced net exports.

Foreign Fiscal Policy Changes

• Understanding the external effects of global budget expansions:
  • Higher world interest rates lead to decreased domestic investment.
  • Increased net capital outflows due to less domestic investment borrowing.

Closing Thoughts

• The analysis emphasizes the importance of understanding both nominal and real exchange rates, the dynamics of savings and investments, and the interconnectedness of domestic and foreign fiscal policies.
• Discussion on upcoming trade policies and tariffs indicates the relevance of exchange rate dynamics to modern economic concerns.