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Economic Modelling

Lecture 17

Small Open Economy

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Determinants of Output in an Open Economy

• Aggregate demand depends on consumption, investment, government spending and net exports.

• Consumption depends on disposable income.• Investment on the real interest rate. • Tax revenues on national income.• Exports on foreign income and the real exchange rates. • Imports on domestic income and the real exchange rate.

• The real exchange rate is determined by domestic and foreign price levels and the nominal exchange rates.

• Nominal interest rate is determined in the money market.

• Capital inflow/outflow depends on the difference in the domestic and foreign real interest rates.

• Aggregate supply depends on capital stock and labour force.

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National income

)*

,,(),()(PePfYYNXGeiYITYCY (1)

Money market: YiLP

M, (2)

Real and nominal interest rates:eri (3)

Real exchange rate: P

eP * (4)

Balance of payment: *rrKFNX (5)

Aggregate supply: ePPYY (6)

Natural rate of output: LKFY , (7)

Mundell-Fleming Small Open Economy Model

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Y= Actual output Y =natural rate of output i = nominal interest rate r = real interest rate r* foreign interest rate ε = real exchange rate e = nominal exchange rate. P = price level, P* = foreign price level T = tax rate G =government expenditure M = imports,

K = capital stock, L = labour force, and fY = foreign income

eP = expected domestic price level e = expected inflation.

Endogenous variables (7): Y, Y , i, r, ε, P, e. Exogenous variables (10):

T, G, M, e , P*, r*, eP ,K , L and fY

Notations in the Above Open Economy Model

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TYC 8.0200 iI 20050

201.03.010 YYNX f

P

EP*

%5* ii

T =100 G = 100

,, fYYNXGiITYCY

YiP

M5.050200

National Income

Consumption

Investment

Tax and Spending

Net exports

Real exchange rate

Financial integration

Demand for Money

An Example of an Open Economy Model

500fY 02.0 2* P 2PParameters

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A Solution of the Model

1280Y 1144C44I 8NX

S = Y-T-C = 1280 - 100-1144= 36

,, fYYNXGiITYCY =1144 + 44 +100-8=1280

NXISGT 84436100100

Equilibrium Condition:

Model Closure:

Private Saving:

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Three GAPs: Investment-Saving, Budget and Trade Gaps

i

Saving and Investment

I(r)

S(Y)

TrwLrKXGICMTSCYcall :Re

FlowCapNX

MXGTIS

IS

Private saving +public saving = net export

IS

0NXTrade Surplus

Trade deficit0NX

0

i

0 GTK-outflow

K-inflow

8

0

+

-

Y

Y0

AD

Tradebalance

Keynesian Open Economy ModelHow an Expansion in Income causes Trade Deficit?

)

*

,,(),()(P

ePfYYNXG

eiYITYCY

X=X0

Surplus

Deficit

M=M(Y)

NX=X-M

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Derivation of Net Exports and Investment Saving in an Open Economy

ΔNX

AD

Y

e2

Y1 Y2

e2

e1 IS*(e)

y1 Y2

AD

NX (e)

NX2 NX1

(a)

(b)(c)

Note:(a) Shows reduction in ADfollowing an increase in ER(b) Shows investment savingbalance in an open economy(c) Shows net export as a function of the exchange rate

e1

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IS-LM Model in an Open Economy: Mundell-Fleming Model

IS*

e*

LM (y, i)

Output

Exc

hang

e R

ate

o y

Assumption:Money supply does not depend on exchange rate

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Impact of Fiscal Policy under Fixed and Flexible Exchange Rate Systems

IS*

IS*’

e1

e2

YNo Impact of Fiscal Policy

LM LM1LM2

Fixed Exchange Rate System

Y1 Y2

e

IS*IS*’

Flexible Exchange Rate System

Full Impact of Fiscal Policy

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Impact of Monetary Policy under Fixed and Flexible Exchange Rate Systems

IS*

IS*’

e1

e2

Full Impact of Monetary Policy

LM LM1LM2

Fixed Exchange Rate System

Y1 Y2

e

IS*

Y1 Y2

Flexible Exchange Rate System

No Impact of Monetary Policy

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Open Economy Fixed Exchange RateEffectiveness of Fiscal Policy and Ineffectiveness of Monetary Policy

i=i*

LM0

IS0IS1

LM1

1

2

3BOP=X-M=0

i1

0 y1 y2

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Exchange rate

i

LM

IS

Y00 0

i

IS-LM and Uncovered Interest Parity Model

Y1 E0 E1

1

2

Appreciation

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Time

J-Curve Hypothesis: Impact of Devaluation on Net Exports

Net Exports

o

Export creation and Import substitution or demand switching takes time

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Determinants of Net ExportNet export function

eMXNX

eYeMeYXNX ,,*

NX = net exports X = exports e = nominal exchange rate M = imports Y* = income level in the foreign country Y = income level at home

Three sources of changes in net exports: 1. Exports 2. Imports and 3. Exchange rate

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Marshall-Lerner condition Devaluation is effective if

1 mx ee

Devaluation is ineffective if

1 mx ee

Devaluation has no effect in trade balance

1 mx ee

xe is elasticity of export

me is the elasticity of imports

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Change in net exports is zero if the sum of exchange rate elasticity of exports and imports equals 1. Net export increases if this sum is greater than one.

Net export decreases if this sum is less than one. Example: There is a devaluation

Export elasticity is 0.9 import elasticity if –0.8 Net export rises because 0.9-(-0.8) =1.7%.

Numerical Example of the Marshall-Lerner Condition

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References• Blanchard (18) Mankiw (2) M&S (20)

• Bhattarai (2002) Welfare Gains to the UK from a Global Free Trade, European Research Studies, vol. IV, Issue 3-4, 2001, pp55-72. pp. 1161-1176.

• Fleming J. Marcus (1962) Domestic financial policies under fixed and under floating exchange rates, IMF staff paper 9, November , 369-379.• Krugman Paul (1979) A Model of Balance of Payment Crisis, Journal of Money

Credit and Banking, 11, Aug.• Krugman P. and L. Taylor (1978) “Contractionary Effects of Devaluation” Journal of

International Economics, 445-56.• Miller, Marcus; Salmon, Mark When Does Coordination Pay? Journal of Economic

Dynamics and Control, July-Oct. 1990, v. 14, iss. 3-4, pp. 553-69• Mundell R. A (1962) Capital mobility and stabilisation policy under fixed and flexible

exchange rates, Canadian Journal of Economic and Political Science, 29, 475-85.• Sebastian E (1986) Are Devaluations Contractionary? Review of Economics and

Statistics, vol. 68, 3, 501-508.• Taylor Mark (1995) The Economics of Exchange Rates, Journal of Economic

Literature, March, vol 33, No. 1, pp. 13-47. • Whalley (1985) Trade Liberalisation among Major World Trading Areas , MIT Press

for developments on trade arrangement among various trading regions.