Macroeconomic Theory of the Open Economy - Exam Notes

Recap of Chapter 13: Market for Loanable Funds

• Supply: National Saving S = Y - C - G
• Demand: Investment in a closed economy.
• Fiscal Policy:
  • Expansionary: Increase in government spending (G), decrease in taxes (T). People reduce consumption (C).
  • Contractionary: Decrease in government spending (G), increase in taxes (T). Slows down overheating or curbs inflation.
• Government provides tax incentives to firms:
  • Stimulates economic growth to encourage investment (I). Demand for borrowing increases.

Chapter 18: Open Economy

• Formula: Y = C + I + G + NX where NX is net exports.
• Rearranging: Y - C - G = I + NX which means S = I + NX in an open economy.
• Since NX = NCO (Net Capital Outflow), S = I + NCO
• S and I depend on the real interest rate (i).
• Net Capital Outflow (NCO):
  • Domestic residents buy foreign financial assets minus foreign residents buying domestic financial assets.
• Real interest rate:
  • The real return on domestic assets.
  • High interest rate: Domestic assets become more attractive.
  • Decrease in real interest rate:
    • People in the US buy less foreign financial assets.
    • People abroad buy more US financial assets, increasing NCO.

Active Learning: Budget Deficit Effects

• Scenario: Government runs a budget deficit.
• Question: Determine the effects on the real interest rate and NCO.
• Budget Deficit: Increase in (G).
• Impact on Loanable Funds (LF) Market:
  • Decrease in supply of loanable funds: S = Y - C - G
    downarrow
  • Increase in real interest rate (i).
  • Decrease in NCO.

Keep in mind:

• LF market determines the real interest rates (i).
• The value of (i) determines the NCO.

The Market for Foreign-Currency Exchange

• Price: Real Exchange Rate (R).
• Formula: R = \frac{P * P{US}}{P{Foreign}}
• Key determinant of NX: Real exchange rate (R).
• Demand for $ is decided by NX.
• Supply of $ is decided by NCO.
• US invests in Japan: Increase in Supply of $
• Foreigners invest in the US: Increase in NCO, increase in Demand for $

Open Economy & Changes in Loanable Funds

• S = I + NCO
• Change in S: open economy?
• Change in I: open economy?

Active Learning: Budget Deficit & Trade Balance

• Scenario: Analyzing the impact of a budget deficit on the real interest rate and trade balance.
• Budget Deficit:
  • Decrease in Supply of loanable funds
  • Increase in interest rates
  • Decrease in NCO
• Consequences in Foreign Exchange Market:
  • Decrease in NCO leads to decrease in Supply of $ in the foreign exchange market.
  • Real Exchange Rate appreciates.
  • Net Exports decrease.
• Trade Balance Impact:
  • Budget deficit causes a trade deficit (NX < 0) because trade used to be balanced.

Active Learning 2: Investment Incentives

• Scenario: Government provides new tax incentives to encourage investment.
• Impact:
  • Increase in Demand for loanable funds.
  • Real interest rate increases.
  • NCO decreases.
• Comparison:
  • Budget Deficit & Incentives on I: Both increase the real interest rates and R appreciates, leading to decrease in net exports.
• Important Difference:
  • Investment Incentives: I increases leading to increase in K (capital) and productivity, thus living standards go up.
  • Budget Deficit: G increases, productivity decreases, so living standards go down.

Changes in the Currency Market

• Trade Policy: Government policy that directly influences the quantity of g&s that a country exports or imports.
  • Tariff: A tax on imported g&s.
  • Quota: A limit on the quantity of imports.

Analysis of Quota on Cars from Japan

• Impact: Quota does NOT affect S or I. It does NOT change NCO or the real interest rate.
  • Net Exports = Exports - Imports; Imports go down.

Surprising Implications of Quotas

• Quota leads to the $ appreciating.
• US NX (Net Exports) on cars increases.
• US NX on aircraft decreases.
• Overall trade balance stays the same because Trade policies do not affect the trade balance since they do not affect S & I.
• Impact on Industries:
  • Quota on cars: US car Demand increases, US car hires go up
  • Reduces workers in the aircraft industry; Destroys jobs in the US EX (export) industry in general.