LectureNote7 GRIPS PDF
LectureNote7 GRIPS PDF
LectureNote7 GRIPS PDF
Junichi Fujimoto
December 22, 2014
Y = C + I + G + EX IM.
(1)
Cd
Y = C d + I d + Gd + EX.
Then, letting
C f , I f , Gf
(2)
(C C f ) + (I I f ) + (G Gf ) + EX
= C + I + G + EX (C f + I f + Gf )
= C + I + G + EX IM.
1
(3)
N X = EX IM ,
N X = S I.
This equation shows that net exports
NX
(4)
S=I
S I.
Note the
holds.
In this lecture, we focus on the long run analysis of a small open economy - the short run analysis will be explored
in the next lecture.
2.1 Overview
A small open economy model with perfect capital mobility is a model often used to analyze an open economy.
Small here means the economy is so small relative to the world market that it has a negligible impact on the world
economy. Perfect capital mobility implies that the domestic real interest rate
r .
To be more precise on this point, the world interest rate is determined such that in the world economy, which is
a closed economy, saving equals investment. In contrast, a small open economy, which is negligible in the world
market, takes the world interest rate as given.
Y T , and
noting r = r ,
investment
NX
equals
between
Consumption
is an increasing function of
[Y C(Y T ) G] I(r )
S I(r ).
Y .
r.
(5)
I . In a small open economy, the real interest rate equals the world
S and I equals net exports N X . In Figure 2, there is trade surplus.
interest rate
r ,
rc ,
at which
X
r
rc
I (r )
S, I
N X = 0).
2
in Figure 3, there will be a trade decit. The same result follows when the domestic government decreases taxes
S2
T.
S1
I (r )
X
S, I
X
r2
r1
I (r )
S, I
S I,
r*
I 2 (r )
I1 ( r )
S, I
NX
Exchange Rates
In other words, at current prices, we can exchange 2 American cars for 1 Japanese car.
Mathematically,
0.5
Japanese Car
American Car
P, P
is given by
=e
P
.
P
(6)
Note that the nominal exchange rate here is expressed in units of foreign currency per domestic currency. The
real exchange rate tells us how much a unit of domestic good costs in terms of units of foreign goods. Thus, the
greater the
e(),
the more expensive is the domestic currency (good), and the less expensive is the foreign currency
(good).
),
domestic goods are expensive relative to foreign goods, so exports fall and imports rise, hence
net exports fall. Conversely, if the real exchange rate is low, domestic goods are relatively inexpensive, so exports
rise and imports fall, hence net exports rise.
Therefore,
N X = N X()
NX
S I.
NX ( )
SI
NX
Figure 6: The Determinants of the Real Exchange Rate
In Figure 6,
function of
SI
; N X
Figure 6 can also be interpreted as depicting the foreign demand for domestic currency,
outow, or the supply of domestic currency,
S I.
3.4 Eects of Policies on Trade Balances and the Real Exchange Rate
(a) Fiscal Policy at Home
When the domestic government increases government purchases
G,
SI
falls. As shown
in Figure 7, this raises the real exchange rate (= appreciation of the domestic currency), and reduces net exports.
The same result follows when the domestic government decreases taxes
T.
S2 I
S1 I
NX ( )
NX 2
NX , S I
NX 1
investment and increases net foreign investment. So, as shown in Figure 8, the real exchange rate falls, and net
exports increase.
S I (r1* ) S I (r2* )
NX ( )
NX1
NX , S I
NX 2
S I,
so as shown in Figure 9, the real exchange rate rises, and net exports decrease.
S I2
S I1
NX ( )
NX 2
NX , S I
NX 1
foreign cars. Such a policy reduces imports, so it increases net exports; thus it shifts the
NX
in Figure 10. In equilibrium, however, net exports do not change. This is because the rise in the real exchange rate
makes domestic goods relatively expensive, and reduces imports by the same amount as the decrease in exports.
Thus, both exports and imports are lower in the new equilibrium, which implies lower social welfare.
S I
NX 2 ( )
NX 1 ( )
NX , S I
Figure 10: Protectionist Trade Policies
e=
P
.
P
(7)
Thus, the nominal exchange rate is determined by the real exchange rate as well as the domestic and the foreign
price levels. For example, if the domestic price level
exchange rate
falls.
Taking log of both sides of (7), and dierentiating with respect to time, we obtain
= + .
e
(8)
This equation implies that the nominal exchange rate of a country with relatively high ination rates falls (=
depreciation of the currency), and that of a country with relatively low ination rates rises (= appreciation of the
currency). This is consistent with the empirical ndings (see Figure 5-13 in textbook p145). Therefore, an increase
in the money supply causes ination, and lowers the nominal exchange rate.
1. On
=
0
in 8).
If PPP holds approximately, it implies that international arbitrageurs react very fast to international price
in any country; to be precise, this is called absolute PPP, and if it holds, the real exchange rate must equal
the other hand, relative PPP states that the real exchange rate is constant, such that
dierences, and so net exports are very sensitive to small changes in the real exchange rate.
Accordingly,
NX
becomes close to horizontal at the real exchange rate that achieves PPP. (See Figure 11). Then, changes in saving
or investment have little eect on the real or nominal exchange rate.
almost constant, almost all changes in the nominal exchange rate result from changes in price levels.
SI
NX ( )
NX
Figure 11: Purchasing Power Parity
While PPP is an important concept, it does not apply perfectly in the real economy. This is due to, for example,
the presence of nontradable goods (e.g., haircut), imperfect substitution between domestic and foreign goods, and
transportation costs.