dr Bartłomiej Rokicki Chair of Macroeconomics and International Trade Theory Faculty of Economic Sciences, University of Warsaw

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1 Chair of Macroeconomics and International Trade Theory Faculty of Economic Sciences, University of Warsaw

2 The small open economy The small open economy is an economy that is small enough compared to the world markets in which it participates. As a result that its policies do not alter world prices, incomes or interest rates. The country is thus a price taker in world markets. The term is normally applied to a country as a whole, although it is sometimes used in the context of only a single product. The term price taker applies both to the goods market and the money market. Hence, the small open economy takes a world s interest rate as given.

3 Closed versus open economy In an open economy, we repeal one of the key assumptions for a closed economy: the expenditure must not be equal to the value of production. Economy may spend more than it produces, if it borrows from the non-residents or may spend less than the produce, lending a surplus abroad. In an open economy, spending on final goods and services produced in the country can be divided into four components: C d + I d + G d + EX (with EX being foreign consumption, investment and government spending on domestic goods and services).

4 Flows of capital and net exports balance Basic SNA identity: S I = NX(CA) The difference between saving and investment can be interpreted as a net outflow of capital (domestic investments abroad on a net basis). Positive net capital outflow means that a country lends to nonresidents national surplus of savings over investment. With NX <0 (trade deficit), country is a net borrower at international financial market.

5 Investment, savings and the current account

6 The Feldstein-Horioka paradox In an open economy with perfect capital mobility between countries, the relationship between national savings and investment should be relatively small. Feldstein and Horioka studied empirically the above relationship. The estimated equation: Yet, the estimated parameter = 0.89 and is not close to zero! Further attempts to estimate did not change the results significantly. Both savings and investment are procyclical, thus move together with the economic cycle. FH interpret the results as evidence of low mobility capital. It is quite controversial proposal (hence arose the concept of "Feldstein- Horioka puzzle"), as empirical evidence indicate the exact opposite.

7 The classical model basic assumptions The main assumptions of the model are exactly the same as in classical model of a closed economy. The only difference is that real interest rate do not necessary balance national savings and investment since our country has an access to international capital markets and we are a small economy (that means that we cannot influence interest rate of other countries) our real interest rate equals world s interest rate. Production level is determined at a level given by the technology, production factors resources and the production function: Y = AF ( K, L)

8 The classical model basic assumptions (2) Consumption depends positively on disposable income: C = C (Y T) Investment depends, in turn, negatively on the real interest rate r: I = I(r) We also know that Y = C + G + I + NX(CA). Solving for NX(CA) we have: NX ( CA ) = [ Y C G ] I ( r*) = S I ( r*) where Y C G are the national savings and r* is the world s real interest rate.

9 Determinants of trade balance We have that: NX ( CA ) = [ Y C G ] I ( r*) = S I ( r*) The above equation shows what determines savings and investment, and thus trade balance in equilibrium. Savings depend on fiscal policy the lower the G or the higher taxes T ceteris paribus, the higher domestic saving. Investment depends on the real interest rate the higher the world interest rate r *, the lower investment. So the balance of trade in equilibrium is determined by the difference between saving and investment at the world interest rate why developing countries often run trade deficit?

10 Savings and investment in a small open economy The diagram shows the relations between real interest rate, investment, savings and current account balance. In a closed economy the level of interest rate would be determined by the intersection of investment curve and savings curve (r clo ). In case of small open economy, when world s interest rate is higher than for closed economy (r 1 *) we will face a current account surplus. On the other hand, lower interest rate (r 2 *) means the existence of current account deficit. r S NX r 1 * r clo r 2 * NX I(r) I, S

11 The impact of national fiscal policy on balance of payments The amount of national savings depends on national fiscal policy. Since there is: S = Y C G It is clear that an increase in G leads to a decrease in S. The same impact will have a decrease in taxes that causes an increase of consumption (consumption depends on disposable income). If interest rate remains unchanged than the investment remains unchanged. As a result a decrease in savings has to lead to a decrease in net export, since: S I = NX

12 Expantionary national fiscal policy In case when we start with balance trade (NX = 0), expansive fiscal policy (that leads to an increase in government spending or in consumption) will cause the emergence of current account deficit and capital account surplus. It appears that the theoretical previsions are valid in the real economy. Hence, budget deficit is usually accompanied by current account deficit.

13 Twin deficits revisited

14 The impact of foreign fiscal policy on balance of payments If foreign countries are a small part of the global economy, their fiscal policy may be neglected, since it does not affect the world interest rate. Yet, in case of a big country, we suppose that its policy may influence world s interest rate. Hence, an expansionary fiscal policy will cause a decrease in world s savings and an increase in world s interest rate. As a result, small open economy will face capital account deficit and current account surplus.

15 The impact of change in investment on balance of payments Once national investment demand increases (e.g. due to some government incentives), a current account deficit has to appear. Investment will be partly financed by foreign lending capital account has to increase.

16 The nominal exchange rate The nominal exchange rate is a relative price of two different currencies. Therefore, the exchange rate that we find in an exchange office is a nominal exchange rate. It can be defined as: e = P cur /P cur * where e is a nominal exchange rate, P cur i P cur * are currency prices The above implies that the nominal exchange rate is defined as a price of foreign currency in national currency (e.g. 1.3 $ for 1 euro).

17 The real exchange rate The balance of payments depends though on real and not nominal exchange rate. Real exchange rate is the ratio of prices of foreign goods expressed in national currency to the price of domestic goods: q = ep*/p An increase in q means that foreign goods became more expensive or domestic goods become cheaper. Such a change affects the demand for domestic and foreign goods: the higher the real exchange rate, the higher the demand for domestic goods and lower demand for foreign goods growth of domestic competitiveness.

18 The impact of real exchange rate on net exports The real exchange rate influences the competitiveness of goods produced home and abroad. The definition of real exchange rate shows that its decrease will hamper the competitiveness of national products (because their prices are rising or foreign goods prices are falling). On the other hand once real exchange rate increases our competitiveness increases as well. In other words, the net exports are a function of the real exchange rate: NX = NX(q)

19 The determinants of real exchange rate Since the real exchange rate depends on the prices of goods produced home and abroad it is related to the current account level. In equilibrium current account and capital account must be balanced so real exchange rate will be determined by the two accounts. As can be seen aside, the real exchange rate is determined by intersection of current account curve (NX) and capital account curve (S-I).

20 The impact of national fiscal policy on the real exchange rate Expansionary fiscal policy leads to a decrease of national savings. As a result S I curve shifts to the left. This causes decline in demand for foreign currencies (declining domestic investment abroad). With foreign currency depreciation and with real appreciation of domestic currency, domestic goods become more expensive and less competitive. So, exports fall and we face current account deficit.

21 The impact of foreign fiscal policy on real exchange rate Expansionary fiscal policy run by a big open economy will cause an increase in world s interest rate. Hence, national investment will fall and the curve S I will shift to the right. As a result both real exchange rate and net exports will increase.

22 The impact of change in investment on real exchange rate The impact of increase in investment demand is exactly the same as an impact of decrease in national savings (e.g. as e result of expansionary fiscal policy). This causes decline in demand for foreign currencies (declining domestic investment abroad). So there will be a fall in both the real exchange rate and the net exports.

23 The impact of protectionist trade policy on the real exchange rate Decline in imports at a current level of real exchange causes a fall in demand for foreign currency. Hence, there will be an appreciation of national currency. National currency real appreciation makes the domestic exports attractiveness decreased. In the new equilibrium the trade balance remains unchanged. However, since the volume of trade is reduced, this type of policy leads to a pure welfare loss, both for country and for the rest of the world.

24 Question 1. Show graphically the model of small open economy using both the graph with interest rate and the level of savings and investment and the graph with real exchange rate and NX. For what level of interest rate there will be a current account deficit? For what level of interest rate there will be a current account surplus? Question 2. People sometimes talk about twin deficits" where the twins are the current account and the government budget deficit. Explain how these tow deficits are related economically so that changes in one are reflected in changes in the other. Question 3. Imagine that the government of a small open economy receives an important transfer from abroad. How would it influence S, I, q and CA if the government spent it entirely on public consumption?

25 Question 4. Consider a small open economy that initially has its budget and current account balanced. What would happen with the income, national savings, investment, trade balance, real interest rate and the real exchange rate once there is an improvement in production technology in the home country? Would we face a twin deficits in this case? Please, answer the question using algebra and drawing the necessary diagrams. Question 5. Lets suppose that the government of small open economy has decided to decrease its spending. At the same time they decided to lower lump taxes the way that the budget deficit would remain constant. How would it affect the trade balance, investment and the real interest rate?

26 Question 6. The US recession has forced Barrack Obama administration to apply fiscal expansion on an unprecedented scale. At the same the capital is outflowing from the East Europe region, including Poland, due to fears concerning the possibility of public finance insolvency. Using the classical model of an open economy, please show how this happenings will influence the structure of aggregate demand in Poland (e.g. C, I, G, NX) and the real exchange rate. Let s suppose that the consumption is not related to the interest rate and that there is a current account deficit. Is there any policy that can be applied by Polish government in order to keep current account balance unchanged? Question 7. Imagine that the government of a big open economy increases pensions. How would it influence savings, investment, current account balance and the real exchange rate of the small open economy?

27 Question 8. Production function of a small open economy takes a form of: Y = AK where A=1,25 K=L=8000 C=100+0,8(Y-T) T=1500 I= r G=1100 NX=500-50q r*=10. Please, calculate: 1/ 3 L 2 / 3 the level of C, I, NX, q in equilibrium; the change of C, I, NX, q after a decrease of c by 0,2; the change of C, I, NX, q after an increase of G by 500; the change of C, I, NX, q after a decrease of r* by 3 percentage points; the change of C, I, NX, q after an increase of output by 20% (caused by technological progress); the change of C, I, NX, q after a decrease of autonomous investment by 1000.

28 Question 9. Imagine that the production function of a small open 1/ 2 1/ 2 economy is given by: where A=1,25 K=L=3600 C=200+0,75Y d T=900 I= r G=1200 CA= q r*=5. Please, calculate: Y = AK The level of C, I, S, FA, CA and q in equilibrium if we are a closed economy; The level of C, I, S, FA, CA and q in equilibrium if we open our economy; Draw the necessary diagrams showing the difference between the closed and the open economy in this particular case; How should change the government spending in order to assure the CA equilibrium? What would happen to the real exchange rate? L

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