Lecture Business economics - Lecture 21: Open economy - I. In this chapter, students will be able to understand: Open economy, saving and investment, three experiment, exchange rate, four experiments, purchasing power parity.
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 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 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 Lecture 21 Open economy - I Instructor: Prof.Dr.Qaisar Abbas Course code: ECO 400 Lecture Outline Open economy Saving and investment Three experiment Open economy •spending need not equal output •saving need not equal investment Preliminaries C =Cd +Cf I =I d +I f G =Gd +Gf superscripts: d = spending on domestic goods f = spending on foreign goods •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 Open economy GDP = expenditure on domestically produced g & s Y =Cd + I d + G d + EX = ( C − C f ) + ( I − I f ) + ( G − G f ) + EX = C + I + G + EX − ( C f + I f + G f ) = C + I + G + EX − I M = C + I + G + NX Open economy The national income identity in an open economy Y = C + I + G + NX or, NX = Y – (C + I + G ) domestic spending net exports output Open economy Trade surpluses and deficits NX = EX – IM = Y – (C + I + G ) 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 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 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, Thus, a country with a trade deficit ( a country with a trade deficit (NX NX