Open-Economy Macroeconomics Chapter 17 Open-Economy Macroeconomics

Topics to be Covered National Income Accounting Modeling the Macroeconomy Internal and External Balance International Policy Coordination

National Income Accounting The fundamental identity of national income accounting: total production = total income = total expenditure Three alternative approaches give the same measurements Production approach: the amount of output produced Income approach: the incomes generated by production Expenditure approach: the amount of spending by purchasers Why are the three approaches equivalent? Any output produced (product approach) is purchased by someone (expenditure approach) and results in income to someone (income approach)

National Income Accounting: The Measurement of Production, Income, and Expenditure Total Production (Components of GDP) Value added in services production (app. 70%) Value added in goods production (app. 20%) Value added by gov’t (app. 10%) Total Income National income = compensation of employees (including benefits) + proprietors’ income + rental income of persons + corporate profits + net interest + taxes on production and imports + and others Wage: 60%, proprietors’ income : 10%, Interest: 5%, Taxes: 10%, Corporate profits: 10% Total income will be used for 3 categories: purchase goods and services (C)+saving(S)+pay taxes(TX)

National Income Accounting: The Measurement of Production, Income, and Expenditure Total Expenditure: Four main categories of spending (i.e., aggregate demand) Consumption (C: 75%) Investment (I: 15%) Government purchases of goods and services (G: 15%) Net exports (export-import: app. -5%)

Open Economy Goals: Internal and External Balance Internal Balance A situation where the economy is producing at its potential and has low inflation and unemployment rates. External Balance A situation where the country’s current account balance is zero.

Modeling the Macroeconomy Assumptions to construct the model of the macroeconomy Small open economy. Presence of unemployed labor and capital. Domestic price level is fixed. Domestic interest rate is fixed.

Closed Economy and Open Economy Closed economy’s output (Y) equals consumption (C) plus investment (I) plus government spending (G): (17.1) In an open economy with international trade, the output identity becomes: (17.2) where EX is exports and IM is imports.

Income Approach to GDP By definition, output Y equals to all uses of incomes received by factors of production: (17.3) Setting Equations (17.2) and (17.3) equal: (17.4) or, (17.5) Thus, in equilibrium, LHS (investment + gov’t spending + export) equals RHS (saving + imports + taxes).

Circular Flow of Income In macroeconomic equilibrium, all leakages equal all injections Leakages: part of household’s income that does not return directly to firms (saving plus taxes plus imports) Injections: firms revenue not originating from the household (investment plus government spending plus exports). Examples of Injections Some firms buy goods from other firms: I Gov’t purchase goods financed by taxes: G Foreign consumers buy home products: EX

Additional Model Assumptions Behavioral assumptions are expressed as: S = sY, 0<s (=ΔS/∆Y) <1 I = I0 G = G0 TX = TX0 IM = IM0 + mY, 0<m (=ΔIM/∆Y) <1 EX = EX0 where s and m are marginal propensities to save and to import, respectively.

Model (cont.)  

FIGURE 17.1 The Determination of Equilibrium Output

Macroeconomic Equilibrium Refer to Figure 17.1 At output levels below Ye, injections into the economy exceed leakages. At output levels above Ye , injections are less than leakages. The size of the current account balance is the vertical distance between IM and EX at the equilibrium Y. Figure 17.1 shows that this country has a current account deficit

Shocks to the System Suppose there is an economic shock such as a fall in investment. The impact on Y can be calculated as: (17.7) The resulting change in Y is a product of the initial fall in investment and the open economy multiplier (1/s+m). s: marginal propensity to save m: marginal propensity to spend on imports

Figure 17.2 Impact of a Fall in Investment Spending on Output

Figure 17.3 Impact of a Rise in Exports on Output

Open Economy Multiplier A multiplier term that equals one divided by the sum of the marginal propensity to save (s) and the marginal propensity to import (m): Open Economy Multiplier = 1/(s+m) Since s and m are fractions less than 1, then the OEM is expected to be greater than 1. Thus, an increase in I, G, or EX would cause the equilibrium income level to rise by more than the initial change in spending.

Effect on Current Account Balance The change in CAB is the sum of changes in exports and imports: (17.9) The change in imports depends on the change in Y: (17.10) Setting ∆EX =0 (exogenous variable) and combining Eq’n 17.7, 17.9, and 17.10, we get: (17.11)

Effect of an Increase in Exports The impact of an increase in exports on output is given as: If exports increase, then the incomes of factors for the export industry will rise. These resource-owners (e.g., workers) will increase their spending on goods and services, thereby stimulating production, and further increases in income and spending (the multiplier effect).

Effect of Export Rise on CAB The effect of the rise in exports on the current account balance is given as: An increase in exports does not translate one for one with an increase in CAB. This is because the economy has also expanded and that induces a rise in imports.

Impact of an Expansionary Fiscal Policy Refer to Figure 17.4 Twin Deficits Phenomenon – a situation where a current account deficit and a government budget deficit occur at the same time.

Figure 17.4 Impact of an Increase in Government Spending on Output

Multiplier Effect of Increase in G The change in output resulting from an increase in government spending equals: The expansionary fiscal effect on CAB is: As a result of G increasing, the CAB falls since the increase in income induces a rise in imports (while exports stay constant).

Tinbergen Rule States that a country must have at least as many independent policy tools as the number of economic targets or goals it wants to achieve. Fiscal policy and exchange rate policy are two tools available to achieve internal and external balance.

Swan Diagram of Internal and External Balance Refer to Figure 17.5 The Swan diagram has government spending, G, on the horizontal axis and the exchange rate, E, on the vertical axis. The upward-sloping curve, EB, shows combinations of G and E that yield external balance (i.e., zero CAB). The downward-sloping curve, IB, represents G and E combinations for internal balance.

FIGURE 17.5 Swan Diagram of Internal and External Balance

Why Does the EB Curve Slope Upward? Refer to Figure 17.5 Starting at a point (say, A) on the EB curve, then the country’s CAB equals zero. If the country increases its government spending, then output and imports will rise, leading to a CAB deficit. To eliminate this deficit, the country’s currency must lose value, i.e., E must rise. Thus points to the right (left) of EB indicate CAB deficits (surpluses).

Why Does the IB Curve Slope Downward? Consider point B where the country is in internal balance. (i.e., low inflation and low unemployment rate) Suppose E falls, then It leads to a rise in the price of the country’s exports and a fall in its import price → less exports and more imports The resulting recession will cause gov’t to raise gov’t spending to return to internal balance Thus, the IB curve slopes downward. Points below (above) the IB curve represent recessions (inflationary booms).

Swan Diagram (cont.) The intersection of the IB and EB curves show the equilibrium combination of government spending and exchange rate which achieves both internal and external balances. See Figure 17.5

Four Zones of the Swan Diagram See Figure 17.5 Zone I – shows situations of internal recession and CAB surplus. Zone II – shows situations of inflationary boom and CAB surplus. Zone III – inflationary boom and CAB deficit Zone IV – recession and CAB deficit Gov’t needs to adopt the policy mix to achieve internal–external balance Exchange rate policy: need to take a currency depreciation policy (more exports and less imports) Fiscal policy: appropriate fiscal policy (expansionary or contractionary) depends on the significance of the recession

Difficulties Faced by Policymakers Economic data take time to be gathered and analyzed. Economic models cannot determine the exact size of the appropriate policy change. Policies conducted by large economies can affect other countries.

<Sample Question> Exercise Question Ignore the Example 1 on pp. 354-355 in your textbook. <Sample Question> Let us characterize an economy as follows: s = 0.15, m = 0 .05, Io = 400, Go=TXo=IMo= 0, EXo = 600 Find the value of the open economy multiplier: 1/(0.15+0.05) = 1/0.2 = 5 What is the equilibrium level of GDP for this economy? Equilibrium GDP = 5,000 Suppose that exports were to rise by 200, what is the new equilibrium level of GDP? New GDP = 5,000+1,000 = 6,000 Suppose that investment increases by 500. What would be the effect on GDP? What will happen to the CAB from the initial equilibrium point? Change in GDP = 2,500. Thus, the new GDP = 7,500. CAB decreases 125 ⇒∆CAB=∆EX-∆IM ← ∆IM=m∆Y ← ∆Y=[1/(s+m)]∆I.