🗊Презентация The Small Open Economy

The Small Open Economy How the real exchange rate keeps the goods market in equilibrium. Y = C + I + G + NX(ε)

Model Background This model is open in the sense that there are exports (X) and imports (M) in the model. Note that net exports (NX) equals (X–M). The model still includes government tax and expenditure. The real exchange rate (not the interest rate) is the equilibrating force in this model. In other words if the model is out of equilibrium it is the changing real exchange rate that returns the model to equilibrium.

Building the Goods Market Model: supply side This is a long run model so output Y is determined by factor inputs (i.e. K and L) only.

Building the Goods Market Model: supply side

Building the Goods Market Model: supply side Factor demand is the marginal product of that factor. labour demand, for example, is defined as the MPL.

Building the Goods Market Model: demand side We begin with consumption, investment, government expenditure, and net exports. This gives us the following national income accounting identity. Y = C + I(r*) + G + NX(ε) …We know Y=F(K,L) Now, given a savings rate “s” we say c = (1–s) is the marginal propensity to consume. This gives us a consumption function C = c(Y–T). “r” is the real interest rate. Investment and the real interest rate have a negative relationship so I(r) is negatively sloped. As “r” increases “I” decreases. In this case however it is the world interest rate (r*) that dominates the small open economy. Much like a perfect competitor is a price taker the small open economy is an interest rate taker. Domestic investors always have access to the world interest rates and their economy is so small it can not affect the world interest rate. “T” is the amount of tax collected. NX = (X–M) is the trade balance and is dependent on the real exchange rate “ε” From this we get… Y = c(Y–T) + I(r*) + G + NX(ε) …rearranging we get, Y – c(Y–T) – G = I(r*) + NX(ε) …or, Sn = I(r*) + NX(ε) …or Sn – I(r*) = NX(ε) …so national savings – investment = net exports we call (S–I) net capital outflow because when savings is positive it is lent abroad.

Goods Market Equilibrium: The Loanable Funds Market We said the small open economy model long run equilibrium occurs at the point where Y = c(Y – T) + I(r*) + G + NX(ε) and that if the system is out of equilibrium then “ε” must change to equilibrate the system.

The Markets in Transition There are various effects which can enter the model and change either S – I or NX leading to a change in the real exchange rate.

Conclusion The small open economy model is a simple static model that allows us to see how the real exchange rate adjusts to keep equilibrium in the loanable funds market which implies equilibrium in the goods market. We also see how various exogenous shocks can affect either (S–I) or NX and therefore lead to a different real exchange rate that equilibrates the goods market.