1. MOD001072 MANAGING THE ECONOMY Weeks 7-8 Classical model- small open economy

2. Weeks 7-12 The three topics WKS 7-8 CLASSICAL MODEL ‘Long run’ –flexible prices Open economy WKS 9-10 IS-LM [‘Keynesian’] MODEL ‘Short run’ – fixed prices Open economy WKS 11-12 INFLATIONARY EXPECTATIONS Adaptive expectations Rational expectations HOLIDAY BREAK

3. WEEKS 7-8 SUMMARY CLASSICAL MODEL 0. Classical models –basic features, closed vs open 0. Classical models –basic features, closed vs open 1. International flows of goods and money (finance) - definitions 1. International flows of goods and money (finance) - definitions 2. Savings and Investment in an SOE (Small Open Economy) - analysis 2. Savings and Investment in an SOE (Small Open Economy) - analysis 3. How Changes in Savings and Investment affect the Trade Balance – role of exchange rate 3. How Changes in Savings and Investment affect the Trade Balance – role of exchange rate COVERED IN LECTURE AND CLASS WEEK 7 COVERED IN LECTURE AND CLASS WEEK 8

4. 0. CLASSICAL models Basic features Assume supply side of economy drives the economy Spending power (aggregate demand) created by supply side forces Spending power (aggregate demand) created by supply side forces Assumes always ENOUGH spending power to buy all the output supplied Assumes always ENOUGH spending power to buy all the output supplied  Government DOESN’T NEED TO REGULATE ‘aggregate demand’  So ‘output’ assumed to be fixed by supply side Focus a lot on price adjustment to ensure equilibrium Role of interest rates  ensures equilibrium in closed economy model Role of interest rates  ensures equilibrium in closed economy model Role of exchange rates  ensures equilibrium in open economy model Role of exchange rates  ensures equilibrium in open economy model Government MACRO policy role:  Ensure price stability + maintain healthy supply side

5. 0. CLASSICAL models: ‘closed’ vs ‘open’ So far...CLOSED ECONOMY Now... Focus on a [SMALL] OPEN ECONOMY Real interest rate ‘r ’ S I(r) National economy decides its own real interest rate ‘r1’ r1 Trade with rest of world: NET EXPORTS Lend to/borrow from overseas Supply = demand in national economy determined by real interest rate ‘r1’ balancing its own S and I No trade with rest of world No lending to/borrowing from overseas World economy (NOT the national economy) decides the real interest rate Supply = demand in national economy determined by both [1] World real interest rate [2] Real exchange rate National economy’s S and I may no longer be equal  Can lend capital abroad  Can borrow capital from abroad Loanable funds Supply side Govt policy

6. Source: Mankiw CH 5 Evidence: degrees of ‘openness’ Trade-GDP ratio, selected countries, 2004 (Imports + Exports) as a percentage of GDP Luxembourg275.5% Ireland150.9 Czech Republic143.0 Hungary134.5 Austria97.1 Switzerland85.1 Sweden83.8 Korea, Republic of83.7 Poland80.0 Canada73.1 Germany71.1% Turkey63.6 Mexico61.2 Spain55.6 United Kingdom53.8 France51.7 Italy50.0 Australia39.6 United States25.4 Japan24.4

7. WEEKS 7-8 SUMMARY CLASSICAL MODEL 0. Classical models –basic features, closed vs open 0. Classical models –basic features, closed vs open 1. International flows of goods and money (finance) - definitions 1. International flows of goods and money (finance) - definitions 2. Savings and Investment in an SOE (Small Open Economy) - analysis 2. Savings and Investment in an SOE (Small Open Economy) - analysis 3. How Changes in Savings and Investment affect the Trade Balance – role of exchange rate 3. How Changes in Savings and Investment affect the Trade Balance – role of exchange rate

8. 1. International flows of goods and money - definitions Two aspects here International flow of goods  net exports or ‘NX’ International flow of goods  net exports or ‘NX’ International flows of finance (saving, investment) International flows of finance (saving, investment)

9. The idea of ‘net exports’ or NX Total demand or spending in closed economy was: Y = C + I + G Y = C + I + G  All this spent ‘domestically’ (on home economy output) In open economy it is Y = C + I + G + NX

10. International capital flows and net exports We now know total demand is Y = C + I + G + NX Subtracting C and G from both sides Y – C – G = C – C + I + G - G + NX gives Y – C - G = I + NX Or S = I + NX or S- I = NX

11. REMINDER : Why Y – C – G is ‘saving’ (S) PRIVATE SAVING Total Savings S PUBLIC SAVING Y - T - C T - G SO TOTAL SAVING IS Y – T – C + (T – G) OR....Y – C - G Y Y-T T C

12. So we had Y – C – G = I + NX Which is S = I + NX Or S – I = NX

13. S-I = NX This is the Open Economy Classical equilibrium condition S – I We have, in equilibrium: NX = NET CAPITAL OUTFLOW S-I>0 NET Lending capital to foreigners S-I<0 NET Borrowing from foreigners TRADE BALANCE NX > 0 Export more than import NX <0 Import more than export

14. WEEKS 7-8 SUMMARY CLASSICAL MODEL 0. Classical models –basic features, closed vs open 0. Classical models –basic features, closed vs open 1. International flows of goods and money (finance) - definitions 1. International flows of goods and money (finance) - definitions 2. Savings and Investment in an SOE (Small Open Economy) - analysis 2. Savings and Investment in an SOE (Small Open Economy) - analysis 3. How Changes in Savings and Investment affect the Trade Balance – role of exchange rate 3. How Changes in Savings and Investment affect the Trade Balance – role of exchange rate

15. 2. Saving and Investment in a SOE (Small Open Economy) 2.1. Two ideas: Capital mobility and world interest rate 2.2. The Classical Model of S and I in a SOE 2.3. How Govt Policy affects Savings, Investment and NX

16. 2.1. Two ideas: Capital mobility and the ‘world’ interest rate So far...CLOSED ECONOMY Now... Focus on SMALL OPEN ECONOMY [SOE] Real interest rate ‘r ’ S I(r) National economy decides its own real interest rate r1 r S I(r) World S World I r* r Small open economy HAS TO ACCEPT WORLD real interest rate r* [a]SOE’s own S and I too small to affect world S, I [b] SOE allows residents full access to global financial (i.e. Loanable funds) markets If both [a] + [b] are true: Loanable funds globally Loanable funds in country Loanable funds in a country

17. 2.2. The Classical Model of S and I in a SOE We know: Total supply of output given at Y =Yn. Total supply of output given at Y =Yn. Government spending fixed at G = Gn Government spending fixed at G = Gn Government taxation fixed at T = Tn Government taxation fixed at T = Tn Consumption demand [=consumption function] is C = C(Y-T) Consumption demand [=consumption function] is C = C(Y-T) Investment demand [ = investment function] is I = I(r) Investment demand [ = investment function] is I = I(r) SOE must accept world interest rate level r* SOE must accept world interest rate level r* We know Net exports NX = S - I or [Y – C(Y-T) – G)] – I (r) Plug in values for Yn, Tn, Gn and r* We get NX = [Yn – C(Yn-Tn) – Gn] – I(r*) Or NX = S(Yn,Tn,Gn) – I(r*)

18. NX = net exports = S(Yn,Tn,Gn) – I(r*) The level of ‘S’ is determined by Given supply of output Yn (which determines total income) Given supply of output Yn (which determines total income) Nature of consumption function (which explains how Y affects C) Nature of consumption function (which explains how Y affects C) Government policy (which fixes G at Gn and T at Tn) Government policy (which fixes G at Gn and T at Tn) The level of ‘I’ is determined by World interest rate r* (because economy is a SOE) World interest rate r* (because economy is a SOE) Available investment opportunities globally Available investment opportunities globally Government policy (e.g. Tax incentives to invest) Government policy (e.g. Tax incentives to invest)

19. REMINDER of the savings-investment diagram (same as closed economy case last week) Loanable funds Dn a country S(Yn,Tn,Gn) Writing S as S(Yn,Tn,Gn) just says that the position of the vertical line (for Savings) depends on Y,T,G, which are fixed at levels Yn, Tn, Gn. I(r) This line is vertical since S level doesn’t depend on r So any change in G or T or Y will cause a SHIFT left or right in the S line. This line shows that as r falls, more investment projects become worthwhile, so I rises Real interest Rate (r)

20. 3 possible situations for Small Open Economy depending on level of world interest rate Here: S>I at world interest rate SITUATION 1 S S S I(r) Here: S = I at world interest rate SITUATION 2 Here: S< I at world interest rate SITUATION 3 White horizontal line = world interest rate, set by interaction of world S and world I

21. SITUATION 1: capital outflow and trade surplus at world interest rate r** r I,S S(Yn,Tn,Gn) Here: Total S at r** is Sn Total I at r** is I** I(r) r** So at r** S > I If S> I, then NX >0 At r= r**: Economy ‘exports’ capital (S>I) and has a trade surplus (NX > 0) SnI**

22. SITUATION 2: no capital flow and trade balance at world interest rate r* r I,S S(Yn,Tn,Gn) Here: Total S at r* is Sn Total I at r* is I* I(r) r* So at r* S = I If S= I, then NX =0 At r= r* [ like closed econ case] Economy has no external capital flows and has trade balance (NX = 0) I*=Sn

23. SITUATION 3: capital inflow and trade deficit at world interest rate r*** r I,S S(Yn,Tn,Gn) Here: Total S at r*** is Sn Total I at r*** is I*** I(r) r*** So at r*** S < I If S< I, then NX <0 At r= r***: Economy ‘imports’ capital (S<I) and has a trade deficit (NX < 0) SnI***

24. 2.3. How Govt policy affects S and I and therefore the Trade Balance (i.e. NX) Mankiw looks at: Effects of SOE’s own Fiscal policy Effects of SOE’s own Fiscal policy Effects of Fiscal Policy in rest of world on SOE Effects of Fiscal Policy in rest of world on SOE Effects of shifts in investment Effects of shifts in investment

25. Effects of Changes on Capital flows and Trade Balance: THE INITIAL EQUILIBRIUM POSITION r I,S S(Yn,Tn,Gn) Assume SOE always starts where World int rate = r* Total S at r* is Sn Total I at r* is I* I(r) r* So at r* S = I If S= I, then NX =0 in the initial position I*=Sn

26. Effects of Fiscal Policy Changes by SOE r I,S S(Yn,Tn,Gn) Assume GOVERNMENT SPENDING INCREASED from Gn to Gn’ I(r) r* [2]Private saving (Y – T - C) unchanged [1]No change in I (because I doesn’t depend on G) I*=Sn [3]Public saving falls (because T-G gets lower) [4] SO S() SHIFTS LEFT TO S’() [5] Now at r* Sn’< I*  capital INFLOW  trade DEFICIT Sn’ S’(Yn, Tn, Gn’)

27. Effects on SOE of Fiscal Policy Changes in Rest of World r I,S S(Yn,Tn,Gn) Assume GOVERNMENT SPENDING INCREASED IN BIG OVERSEAS ECONOMY I(r) r* [2] WORLD real interest rate will RISE to r** [1] WORLD savings will fall I*=Sn [3] At new r**, I is lower in SOE (now I**) [4] So in SOE, At r**, S > I [5] Now in SOE at r**: Sn > I**  capital OUTFLOW  trade SURPLUS (i.e. NX >0) I** r**

28. Effects on SOE of shifts in Investment demand r I,S S(Yn,Tn,Gn) Assume SOE GOVERNMENT changed tax regulations to encourage investment I(r) r* [2] SOE investment line I(r) SHIFTS RIGHT to I’(r) [1] SOE investment would increase even though world real interest rate unchanged at r* I*=Sn [3] At r*, I is higher in SOE (now I***) [4] So in SOE, at r*, S < I [5] Now in SOE at r*: Sn< I***  capital INFLOW  trade DEFICIT (i.e. NX < 0) I*** I’(r)

29. WEEKS 7-8 SUMMARY CLASSICAL MODEL 0. Classical models –basic features, closed vs open 0. Classical models –basic features, closed vs open 1. International flows of goods and money (finance) - definitions 1. International flows of goods and money (finance) - definitions 2. Savings and Investment in an SOE (Small Open Economy) - analysis 2. Savings and Investment in an SOE (Small Open Economy) - analysis 3. How Changes in Savings and Investment affect the Trade Balance – role of exchange rate 3. How Changes in Savings and Investment affect the Trade Balance – role of exchange rate

30. 3. How Changes in Savings and Investment affect the Trade Balance – role of exchange rate 3.1. The basic idea – where the exchange rate fits... 3.2. Nominal and real exchange rate 3.3. Linking Real exchange rate and Trade Balance (NX) 3.4.The equilibrium real exchange rate 3.5. Policy effects on real exchange rate

31. 3.1. The basic idea – where the exchange rate fits S – I NET CAPITAL OUTFLOW NX NET EXPORTS Financial flows S-I>0 NET Lending capital to foreigners S-I<0 NET Borrowing from foreigners ‘Real’ flows of goods/services NX > 0 Export more than import NX <0 Import more than export (Real) Exchange rate

32. 3.2. Nominal vs real exchange rates NOMINAL EXCHANGE RATE = relative price of CURRENCIES of 2 countries e.g. 1 GBP = 120Yen 1 Yen = 0.0083GBP We assume: price of currency = number of units of FOREIGN currency that ONE unit of it can buy APPRECIATION  GBP buys more APPRECIATION  GBP buys more DEPRECIATION  GBP buys less DEPRECIATION  GBP buys less

33. 3.2. Nominal vs real exchange rates REAL EXCHANGE RATE = relative price of GOODS of 2 countries  ‘TERMS OF TRADE’ e.g. UK car costs 10000GBP Japanese car costs 2,400,000Yen If 1GBP = 120 Yen Then UK car costs 10000 x 120  UK car costs 1,200,000Yen  UK car costs 0.5 of Japanese car  Can exchange 2 UK cars for one Japanese car

34. Definition of real exchange rate ‘E’ Real exchange rate ‘E’ = Nominal exchange rate ‘e’ X Price level of domestic goods (Pd) Price level of foreign goods (Pf) This is what is quoted on currency exchanges This matters more for classical theory ‘E’ will be HIGH when domestic goods price level is relatively HIGH

35. 3.3. Link between real exchange rate and Trade Balance (NX) Because E = e. [ Pd/Pf]  If E ‘higher’ then Pd/Pf is ‘higher’  If Pd/Pf is higher then Exports will be lower Exports will be lower Imports will be higher Imports will be higher  NX will be lower So: NX depends negatively on E  write as NX = NX(E) E 0NX +- NX(E) E3 E2 E1 NX1NX2NX3

36. 3.4. The equilibrium real exchange rate E* For equilibrium we know: S-I must equal NX Or Y – C(Y-T) – G – I(r) = NX(E) Plug in given values for Yn, Tn, Gn, r*: Yn – C(Yn – Tn) – Gn – I(r*) = NX(E) Or S(Yn,Tn,Gn) – I(r*) = NX(E) One value of E makes this possible: E*. E NX +- NX(E) E* NX* S(Yn,Tn,Gn) - I(r*)

37. Checking understanding of diagram S(Yn,Tn,Gn) – I(r*) = NX(E) E NX +- NX(E) E* NX1 S(Yn,Tn,Gn)-I(r*) This line is VERTICAL because both S and I don’t depend on E This line shifts left/right if any changes in Yn, Tn, Gn or r*. This line SLOPES DOWN because a rise in E leads to a fall in NX

38. Checking understanding of diagram Three possible equilibrium positions E NX NX(E) E*** 0 S(Yn,Tn,Gn)-I(r*) E E NX NX(E) 00 NX1 Here S> I So NX = NX1>0 E* NX2= E** Here S = I and NX = NX2 = 0 POSSIBILITY 1 Net capital outflow Trade surplus POSSIBILITY 2 No capital inflow/outflow Trade balance NX3 Here S < I So NX = NX3 <0 POSSIBILITY 3 Net capital inflow Trade deficit S(Yn,Tn,Gn) – I(r*)

39. Doing an example FINDING EQUILIBRIUM SITUATION Assume Yn = 5000 Assume Gn = 1000, Tn = 1000 C = 250 + 0.75(Y-T) I = 1000 – 50r NX = 500 – 500E and r = r* = 5 FIND INVESTMENT ‘I’ AND SAVINGS ‘S’  I = 1000-50(5) = 750  S = Y – C – G  S= 5000-250-0.75(4000) -1000 = 750  S-I = 750-750 = 0 FIND NET EXPORTS NX  since in equilib: S-I = NX, then NX(E) also=0 FIND EQUILIB ‘E’  SET S-I = 0 = NX =500-500E  0= 500-500E  500E = 500  E* = 1 E NX NX(E) = 500-500E E*= 1 0 S-I DRAW? S-I is vertical at NX = 0 NX(E) is 0 = 500-500E  When E = 0, NX = 500  When E = E* = 1, NX = 0 500

40. 3.5.Policy impact on equilibrium real exchange rate E*

41. SOE FISCAL POLICY – impact on E  Saving (S) FALLS + I(r*) unchanged  S-I gets lower  S-I line SHIFTS LEFT  Reduced supply of currency [as less capital outflow]  Currency rises in value from E* to E**  So [by E definition] Pd must rise relative to Pf  So exports fall, imports rise  So NX FALL TO NX1’ <0 E NX +- NX(E) E* NX1=0 Assume NX(E) = 0 AS INITIAL POSITION [POSSIBILITY2] S(Yn,Tn,Gn)-I(r*) Assume Government of SOE increases G (above Gn) to Gn’ E** NX1’<0 S(Yn,Tn Gn’)-I(r*)

42. FISCAL POLICY – impact on E Doing an example Assume same model, assume original equilibrium. Assume G rises by 250 to 1250 IMPACT ON ‘I’: NO CHANGE IMPACT ON ‘S’? S = Y –C – G = 5000-250-0.75(4000)-1250 S = 500 [it was 750]  S-I = 500-750 = -250 <0 CAP INFLOW I MPACT ON NET EXPORTS? In new equilibrium, S-I = NX  NX = -250<0  NX have fallen IMPACT ON EQUILIBRIUM EXCHANGE RATE? S-I = - 250 = NX = 500-500E  500E = 750  New E** = 1.5  E has risen E NX +- NX(E) = 500-500E E* = 1 0 S-I New S-I -250 E** = 1.5

43. BIG OVERSEAS GOVERNMENT FISCAL POLICY – impact on E  World saving FALLS  World interest rate RISES to r**  SOE Saving (S) unchanged but I(r**) in SOE FALLS  S-I gets larger  S-I line SHIFTS RIGHT  Increased supply of currency [as more capital outflow]  Currency FALLS in value to E***  NX RISES to NX1’’>0 E NX +- NX(E) E* NX1=0 Assume NX(E) = 0 AS INITIAL POSITION [POSSIBILITY2] S(Yn,Tn,Gn)-I(r*) Assume LARGE OVERSEAS GOVT increases government spending E*** NX1’’>0 S(Yn,Tn Gn’)-I(r**)