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Macroeconomics ECO 403
VU
LESSON 15
OPEN ECONOMY
Three experiments
1.
Fiscal policy at home
2.
Fiscal policy abroad
3.
An increase in investment demand
1. Fiscal policy at home
r
S2
S1
An increase in G or
decrease in T reduces
NX2
saving.
r1*
NX1
Results:
ΔI = 0
I (r)
ΔNX = ΔS < 0
S, I
I1
NX and the Govt. Budget Deficit
10
9
Budget Deficit
8
7
6
5
4
3
Net Export Deficit
2
1
0
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Macroeconomics ECO 403
VU
2. Fiscal policy abroad
r
S1
Expansionary fiscal
NX2
policy abroad raises
the world interest rate.
r2*
NX1
r1*
Results:
ΔI < 0
I (r )
ΔNX = -ΔI > 0
S, I
I (r2*)
I (r1*)
3. An increase in investment demand
ΔI > 0,
r
ΔS = 0,
S
net capital
outflows and net
NX2
exports
r *
fall by the amount
ΔI
NX1
I (r )2
I (r )1
S, I
I2
I1
The nominal exchange rate
e = nominal exchange rate, the relative price of domestic currency in terms of foreign currency
(e.g. Yen per Dollar)
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Macroeconomics ECO 403
VU
Exchange rates as of February 26, 2005
Country
Currency
exchange rate
Europe
Euro(€)
Rs. 78.53
Japan
Yen(¥)
Rs. 0.5642
U.K.
Pound(£)
Rs. 113.99
United States
Dollar($)
Rs. 59.32
UAE
Dirham
Rs. 16.15
The real exchange rate
ε = real exchange rate, the relative price of domestic goods in terms of foreign goods (e.g.
Japanese Big Macs per U.S. Big Mac)
Understanding the units of ε
e ×P
ε
=
P*
(Yen per $) × ($ per unit U.S. goods)
=
Yen per unit Japanese goods
Yen per unit U.S. goods
=
Yen per unit Japanese goods
Units of Japanese goods
=
per unit of U.S. goods
~ Example ~
· One good: Burger
· Price in Japan: P* = 200 Yen
· Price in USA: P = $2.50
· Nominal exchange rate, e = 120 Yen/$
e ×P
ε
=
P *
1 2 0 × $ 2 .5 0
=
= 1 .5
200 Yen
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Macroeconomics ECO 403
VU
To buy a U.S. burger, someone from Japan would have to pay an amount that could buy 1.5
Japanese Burgers.
ε in the real world & our model
·
In the real world:
We can think of ε as the relative price of a basket of domestic goods in terms of a
basket of foreign goods
·
In our macro model:
There's just one good, "output." So ε is the relative price of one country's output in
terms of the other country's output
How NX depends on ε
↑ε ⇒ US goods become more expensive relative to foreign goods
⇒
↓EX, ↑IM
⇒
↓NX
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