1. Review of the previous lecture Nominal interest rate equals real interest rate + inflation rate. Fisher effect: nominal interest rate moves one-for-one w/ expected inflation. is the opp. cost of holding money Money demand depends on income in the Quantity Theory more generally, it also depends on the nominal interest rate; if so, then changes in expected inflation affect the current price level.

2. Review of the previous lecture Costs of inflation Expected inflation shoeleather costs, menu costs, tax & relative price distortions, inconvenience of correcting figures for inflation Unexpected inflation all of the above plus arbitrary redistributions of wealth between debtors and creditors

3. Review of the previous lecture Hyperinflation caused by rapid money supply growth when money printed to finance govt budget deficits stopping it requires fiscal reforms to eliminate govt’s need for printing money

4. Lecture 21 Open economy - I Instructor: Prof.Dr.Qaisar Abbas Course code: ECO 400

5. Lecture Outline 1.Open economy 2.Saving and investment 3.Three experiment

6. Open economy spending need not equal output saving need not equal investment Preliminaries EX = exports = foreign spending on domestic goods IM = imports = C f + I f + G f = spending on foreign goods NX = net exports (a.k.a. the “trade balance”) = EX – IM superscripts: d =spending on domestic goods f =spending on foreign goods

7. Open economy GDP = expenditure on domestically produced g & s

8. Open economy The national income identity in an open economy Y = C + I + G + NX or, NX = Y – (C + I + G ) net exports output domestic spending

9. Open economy Trade surpluses and deficits trade surplus output > spending and exports > imports Size of the trade surplus = NX trade deficit spending > output and imports > exports Size of the trade deficit = –NX NX = EX – IM = Y – (C + I + G )

10. Open economy International capital flows Net capital outflows =S – I =net outflow of “loanable funds” =net purchases of foreign assets the country’s purchases of foreign assets minus foreign purchases of domestic assets When S > I, country is a net lender When S < I, country is a net borrower

11. Link between trade & cap. flows The link between trade & cap. flows NX = Y – (C + I + G ) implies NX = (Y – C – G ) – I = S – I trade balance = net capital outflows Thus, a country with a trade deficit (NX < 0) is a net borrower (S < I ).

12. Saving and Investment in a Small Open Economy An open-economy version of the loanable funds model includes

13. Saving and Investment National Saving: The Supply of Loanable Funds

14. Saving and Investment Assumptions re: capital flows a.domestic & foreign bonds are perfect substitutes (same risk, maturity, etc.) b. perfect capital mobility: no restrictions on international trade in assets c. economy is small: cannot affect the world interest rate, denoted r* a & b imply r = r* c implies r* is exogenous a & b imply r = r* c implies r* is exogenous

15. Saving and Investment Investment: The Demand for Loanable Funds Investment is still a downward-sloping function of the interest rate, but the exogenous world interest rate… …determines the country’s level of investment.

16. Saving and Investment If the economy were closed… …the interest rate would adjust to equate investment and saving:

17. Saving and Investment But in a small open economy… the exogenous world interest rate determines investment… …and the difference between saving and investment determines net capital outflows and net exports

18. Three experiments Fiscal policy at home Fiscal policy abroad An increase in investment demand 1. Fiscal policy at home An increase in G or decrease in T reduces saving. Results:

19. Three experiments 2. Fiscal policy abroad Expansionary fiscal policy abroad raises the world interest rate. Results:

20. Three experiments 3. An increase in investment demand EXERCISE: Use the model to determine the impact of an increase in investment demand on NX, S, I, and net capital outflow.

21. Three experiments An increase in investment demand ANSWERS:   I > 0,  S = 0, net capital outflows and net exports fall by the amount  I

22. Summary Net exports--the difference between exports and imports a country’s output (Y ) and its spending (C + I + G) Net capital outflow equals purchases of foreign assets minus foreign purchases of the country’s assets the difference between saving and investment