Question

Consider a large open domestic economy with a financial account surplus.

i. Draw a diagram showing this situation (Your answer should include two graphs, one for the domestic economy and one for the foreign economy). 

Note: Draw the two graphs side by side and clearly indicate the world interest rate as a single line going through both graphs.

ii. What are the effects, in equilibrium, on the world real interest rate, domestic national saving, domestic investment, the domestic current account balance, foreign national saving, foreign investment, and the foreign current account balance if wealth rises in the foreign country?

Show a diagram to illustrate your results.

Answer 1

In an open economy, the equilibrium condition in the goods market is that Production (Y), is equal to the demand for goods, which is the sum of consumption, investment, Public Spending and Net Exports. This relationship determines IS. If we define consumption (C) as C = C(Y-T) where T corresponds to taxed, the equilibrium would be given by:

Y = C (Y- T) + I + G + NX

We consider that investment is not constant, and we see that it depends mainly on two factors: the level of sales and interest rates. It is a positive relation with sales i.e. If firm’s sale increase, it will need to invest in new production plants to raise production and similarly with interest rates the relationship is negative which means the higher they are, the more expensive investments become. In addition to net exports, we also must consider is the exchange rates, which directly affect net exports. Exchange rata can be defined as the number of units of our own currency that can be given up to receive 1 unit of the foreign currency. Thus, the relationship established is as follows (where i is the interest rate):

Y = C (Y- T) + I (Y, i) + G + NX(E)

The IS curve represents the value of equilibrium for any interest rate existing in the good market. The curve has a negative slope which explains that an increasing interest rate will cause a reduction in production through its effect on investment.

An increase in “E” i.e. exchange rate causes net exports to increase making the IS curve to shift right and a decrease in “E” causes net export to decrease making the IS curve to shift left.

LM curve: The money Market

The LM curve represents the relationship between liquidity and money. In an open economy, the interest rate is determined by the equilibrium of Supply and Demand for money: M/P=L(i,Y) where

‘M’ is the amount of money offered,

Y is real income

‘I’ is the real interest rate, and

L the demand for money, a function of ‘I’ and ‘Y’.

The equilibrium of the money market implies that, given the amount of money, the interest rate is an increasing function of the output level. When output increases, the demand for money raises, but the money supply is already determined. Therefore, the interest rate should rise until the opposite effects acting on the demand for money are cancelled, people will demand more money because of higher income and less due to rising interest rates.

The slope of the curve is positive, contrary to what happened in the IS curve. This is because the slope reflects the positive relationship between output and interest rates.

BP curve: the balance of payments

The BP curve shows the combinations of production and interest rates that guarantee that the balance of payments is viably financed, which means that the volume of net exports that affect total production must be consistent with the volume of net capital flows. It will usually slope up since the higher the production, the higher the imports, which will disturb the equilibrium of the balance of payments, unless interest rates rise.

The IS-LM-BP model describing Flexible exchange rate and Imperfect Capital Mobility

An expansionary monetary policy will shift the LM curve to LM’, which makes the equilibrium go from point E₀ to E₁. However, since now exchange rates are flexible, the balance of payments deficit will depreciate the domestic currency. This will increase net exports, shifting the IS curve to IS’. Also, since domestic assets are less expensive, the BP curve will shift to the right (to either BP’+ or BP’-). Therefore, with high capital mobility, final equilibrium will be at point E₂.

An expansionary fiscal policy will shift the IS curve to IS’, moving the equilibrium form point E₀ to point E₁. Now, depending on capital mobility, we’ll either have a balance of payments surplus i.e. high capital mobility which is BP+ curve or a balance of payments deficit i.e. small capital mobility, which is BP- curve. In the case of a balance of payments surplus, and considering flexible exchange rates, there will be an appreciation of the domestic currency. This will decrease net exports, which will shift the IS’ curve to the left. Also, when the domestic assets are more expensive, the BP+ curve will shift to the left. The final equilibrium will therefore be at point E₂. If there is a balance of payments deficit the case for the BP- curve, the result will be the same one as in the monetary policy case i.e. point E₂* representing the final equilibrium.

Derivation of IS-LM slopes are shown in the below figure:

b)

Answer : In small open economy, goods market equiliburm assumes that it is small enough as compare to other partners. Its policy is that they are price takers. When there is a permanent increased in the proportional tax rates

EFFECTS ON VARIOUS ITEMS AS FOLLOWS:

• OUTPUT : Increasing proportional tax rates is a fiscal policy of the government. So output production has been reduced. Output has been decreased where as Y is also less.
• BALANCE OF PAYMENT INCLUDES CURRENT ACCOUNT AND CAPITAL ACCOUNT : As output fall lead to fall in investment that is sharper than any change in private and national savings. Thus, the current account will improve where as capital account is in deficit.
• NATIONAL SAVINGS : National savings remains the same .
• EXCHANGE RATES : Appreciation of real exchange rate.

c)

PLease post B , so that mathematical aspect and change ,can be shown.

Theoritically , if there is only perfect inward mobility , there can only be inflows and no outflows.

Case 1

if i

case 2

if i >i*

Capital inflows ( as interest rate in home is more attractive) , will create a pressure on exchange rate , and currency would appreciate ( imports rise , export falls) , just as to match the inflows corrected by negative current account balance.