Economics

CHAPTER FOUR
Aggregate Demand in the Open Economy

International flows of Capital Goods
The key macroeconomic difference between open and
closed economies is that
in an open economy, a country’s spending in any given
year need not equal its output of goods and services.
 A country can spend more than it produces by
borrowing from abroad, or it can spend less than it
produces by lending to foreigners.
 In a closed economy, all output is sold domestically,
and expenditure is divided into three components:
consumption, investment, and government purchases.
In an open economy, some output is sold domestically
and some is exported to be sold abroad.
Cont..
 We can divide expenditure on an open economy’s
output Y into four components:
• Consumption of domestic g&s………………(Cd)
• Investment spending on domestic g&s……(Id)
• Government purchase of domestic g&s ….(Gd)
• Export of domestic g&s …………………………..Ex
 division of expenditure into these components is
expressed in the identity as
 the first components stand for domestic spending on

domestic g&s and
 the second component (EX) indicates foreign
spending on domestic g&s.
NEX – is foreign spending on domestic g&s minus domestic
spending on foreign g&s.
NEX=Y-(C+I+G) ,Y>(C+I+G), EX >IM
 International Capital Flows and the Trade Balance

 Recall the national income accounts identity can
be written in terms of saving and investment
relationships: Y=C+I+G+NEX
• Y-C-G=I+NEX
But, Y-C-G is national savings(S), (the sum of private
saving(Y-T-C), and public saving , T-G
Therefore ,S=I+NEX and NEX=S-I
Cont…
 NEX (trade balance )=S-I ( net Capital Outflow )
 the difference between domestic saving and domestic
investment, S − I, which we call net capital outflow.
 (It’s sometimes called net foreign investment.)
 If net capital outflow is positive, our saving exceeds our
investment, and we are lending the excess to foreigners.
 If the net capital outflow is negative, our investment exceeds
our saving, and we are financing this extra investment by
borrowing from abroad.
 Thus, net capital outflow equals the amount that domestic
residents are lending abroad minus the amount that
foreigners are lending to us.
 It reflects the international flow of funds to finance capital
accumulation.
Cont..
 The national income accounts identity shows that net capital

outflow always equals the trade balance.
 That is, Net Capital Outflow = Trade Balance
 S-I = NEX
 If S − I and NX are positive, we have a trade surplus.
 In this case, we are net lenders in world financial markets,
and we are exporting more goods than we are importing.
 If S − I and NX are negative, we have a trade deficit.
 In this case, we are net borrowers in world financial markets,
and we are importing more goods than we are exporting.
 If S − I and NX are exactly zero, we are said to have balanced
trade because the value of imports equals the value of
exports.
Saving and Investment in the Small Open Economy
• Since the trade balance equals the net capital
outflow,
• which in turn equals saving minus investment(S-I)
• , our model focuses on saving and investment.
• To develop this model, we do not assume that the
real interest rate equilibrates saving and
investment.
• Instead, we allow the economy to run a trade
deficit and borrow from other countries,
• to run a trade surplus and lend to other countries.
Cont..
 We are assuming a small open economy with
perfect capital mobility.
 By “small’’ we mean that this economy is a
small part of the world market and thus, by
itself, can have only a negligible effect on the
world interest rate.
 By “perfect capital mobility’’ we mean that
residents of the country have full access to
world financial markets.
 In particular, the government does not impede
international borrowing or lending
Cont..
• Because of this assumption of perfect capital

mobility, the interest rate in our small open
economy, r, must equal the world interest rate
r*, the real interest rate prevailing in world
financial markets:
• r = r*(the world interest rate determines the
interest rate in our small open economy) and
• the small open economy takes the world
interest rate as exogenously given.
Cont..
Effects of policies on trade balance
• Suppose that the economy begins in a position
of balanced trade
• That is, at the world interest rate, investment I
equal saving S, and net exports NX equal zero.
Let’s use our model to predict the effects of
government policies at home and abroad.
A .Fiscal Policy at Home
B.Fiscal Policy Abroad
Shift in investment demand
Exchange rates
• Exchange rates
• The exchange rate between two countries is the price at
which exchange between them takes place.
• B.The nominal exchange rate
• It is the relative price of the currency of two countries
• For example, if the exchange rate between the U.S.
dollar and the Ethiopian birr is 20 birr per dollar, then
you can exchange one dollar for 20 birr in world
markets for foreign currency.
• B. Real exchange rate:
Cont..
• If the real exchange rate is high, foreign goods
are relatively cheap, and domestic goods are
relatively expensive
• If the real exchange rate is low, foreign goods
are relatively expensive, and domestic goods are
relatively cheap.
The Mundell-Fleming model
 Mundell–Fleming model is an open-economy version of the IS–
LM model.
 Both models stress the interaction between the goods market and
the money market.
 Both models assume that the price level is fixed and then show
what causes short-run fluctuations in aggregate income
 The key difference is that the IS–LM model assumes a closed
economy,
 whereas the Mundell–Fleming model assumes an open economy.
 The Mundell–Fleming model is assumes that the Economy being
studied is a small open economy with perfect capital mobility .
 That is, the economy can borrow or lend in world financial markets
and,
 as a result, the Economy’s interest rate is determined by the world
interest rate. r = r*
Cont..
• The r = r* equation represents international flow of

capital is rapid enough to keep the domestic
interest rate equal to the world interest rate.
• capital inflow
• capital would outflow
The Goods Market and the IS* Curve
 The Mundell–Fleming model describes the market for goods and
services
 This equation states that aggregate income Y is the sum

of consumption C, investment I, government purchases
G, and net exports NX.
 Consumption depends positively on disposable income
Y-T.
 Investment depends negatively on the interest rate,
which equals the world interest rate r*.
 Net exports depend negatively on the exchange rate e.
The Money Market and the LM* Curve
 The Mundell–Fleming model represents the
money market the only difference from IS LM is
that MFM is at world interest rate
 M/P = L(r*, Y).
• The demand for real balances depends
negatively on the interest rate, which is now set
equal to the world interest rate r*, and positively
on income Y.
• generally G ,T,M, r* and P are exogenous
• But Y and e are endogenous variable
Cont..
The LM* Curve Panel (a) shows the standard LM curve

[which graphs the equation M/P=L(r,Y) together with a
horizontal line representing the world interest rate r*.
 The intersection of these two curves determines the
level of income, excregardless of the exchange rate.
Therefore, as panel (b) shows, a given world interest
rate the LM* equation determine aggregate income
regardless of exchange rate
Cont…
• Generally, according to the Mundell–Fleming

model, a small open economy with perfect
capital mobility can be described by two
equations:
• The first equation describes equilibrium in the

goods market, and the second equation
describes equilibrium in the money market.
Cont..
The intersection of these two curves shows the level of
income and the exchange rate that satisfy equilibrium
both in the goods market and in the money market.
Fiscal and monetary policies in an open economy with perfect capital mobility
Floating exchange rate
fiscal policy
Cont..
 expansionary fiscal policy increases planned
expenditure, then it shifts the IS* curve to the right,
• the exchange rate appreciates,
• whereas the level of income remains the same.
• the reduction in national saving
• NEX or net foreign investment to fall
reduces NEX that offsets the expansion in domestic
demand of g&s( fully the normal expansionary effect of
the policy on income.)
Monetary policy
Suppose an increase in money supply, price is fixed

real money balances increase
raises income and lowers the exchange rate.
monetary policy influences income in an open economy, as it does
in a closed economy,
In a closed economy M increases , increase spending because it
lowers the interest rate and stimulates investment
Monetary and fiscal policy under fixed exchange rate
• A fixed exchange rate dedicates a country’s

monetary policy to the single goal of keeping the
exchange rate at the announced level.
• The central bank is committed to allow the money
supply to adjust to whatever level to ensure that
the equilibrium exchange rate equals the
announced exchange rate.

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CHAPTER FOUR

Aggregate Demand in the Open Economy

 the first components stand for domestic spending on

 International Capital Flows and the Trade Balance

 The national income accounts identity shows that net capital

• Because of this assumption of perfect capital

• The r = r* equation represents international flow of

 This equation states that aggregate income Y is the sum

The LM* Curve Panel (a) shows the standard LM curve

• Generally, according to the Mundell–Fleming

• The first equation describes equilibrium in the

Suppose an increase in money supply, price is fixed

• A fixed exchange rate dedicates a country’s

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