1. KYIV SCHOOL OF ECONOMICS MACROECONOMICS I September-October 2013 Instructor: Maksym Obrizan Lecture notes IV # 2. CHAPTER 5 The open economy So far we only considered a simplified closed economy # 3. Consider the expenditure on goods and services # 4. We can now substitute these equations in the identity above: The national income accounts identity is then

2. # 5. After we define net exports NX = EX-IM Quote from Mankiw: “If output exceeds domestic spending, we export the difference: net exports are positive. If output falls short of domestic spending, we import the difference: net exports are negative.” # 6. Another name for net exports is the trade balance Re-arrange the identity to obtain # 7. If S − I and NX are positive, we have a trade surplus # 8. Quote from Mankiw: “The national income accounts identity shows that the international flow of funds to finance capital accumulation and the international flow of goods and services are two sides of the same coin.”

3. # 9. CAPITAL MOBILITY AND THE WORLD INTEREST RATE Consider a small open economy with perfect capital mobility. # 10. Question: What must be true about the interest rate in a small open economy? Question: would domestic investors pay interest rate higher than r*? # 11. How the world interest rate is determined?# 12. For your notes

4. # 13. The Model# 14. Recall the accounting identity which can be modified to include assumptions from the model: # 15. Key insight from Mankiw: “The trade balance is determined by the difference between saving and investment at the world interest rate.” # 16.

5. # 17. Fiscal policies at home# 18. Fig 5-3 # 19. Fiscal policies abroad Assume instead that a large foreign economy such as EU increases government purchases # 20.

6. # 21. Consider a scenario when investment demand increases # 22. # 23. Is trade deficit a problem?# 24. South Korea In other cases, trade deficit might indicate high foreign investment This in turn may be a sign of economic development One example is South Korea that had large trade deficits through 1970s but is a good example of successful economic growth

7. # 25. EXCHANGE RATES Economists define two exchange rates: nominal and real The exchange rate you see in the currency kiosk is nominal exchange rate # 26. Example of real exchange rate computation # 27. We can also define the exchange rate for a basket of goods Quote from Mankiw: “If the real exchange rate is high, foreign goods are relatively cheap, and domestic goods are relatively expensive.” # 28. Net exports NX can depend on the real exchange rate For example, when real exchange rate is high domestic residents will buy more foreign goods and foreigners will buy fewer our goods

8. # 29. Fig 5-8# 30. How real exchange rate is determined? Recall that trade balance must equal the net capital outflow # 31. Fiscal policy at home and the real exchange rate Suppose government stimulates the economy by increasing G # 32. Fig 5-9

9. # 33. Fiscal policy abroad and the real exchange rate Suppose that a large foreign country such as EU reduces taxes # 34. Fig 5-10 # 35. Determinants of nominal exchange rate We can write the nominal exchange rate as It is also convenient to consider the changes in the nominal exchange rate over time # 36. The effects of monetary policy on the nominal exchange rate

10. # 37.# 38. Purchasing power parity The law of one price states that an identical good cannot sell at a different price in 2 different locations at the same time # 39. Purchasing power parity is law of one price applied at the international market # 40. The Big Mac Index According to the purchasing power parity the price of Big Mac should be closely related to the nominal exchange rate