Mankiw chapter 5 Classical model of an open economy.

End of chapter questions:

Questions for review: all should be looked over; they are straightforward review questions for the chapter. Problems and applications: Note: A small open economy is assumed in all cases. Problem 1: What happens if: a. Fall in consumer confidence induces consumers to spend less and save more. In the classical model, income remains constant; and since there has been no change in investment or government spending or taxes specified, the only change in the only other adjustment possible is through net exports (NC below means NO CHANGE): Y = C + I + G + NX NC drops NC NC must rise The excess savings are lent abroad since there is nowhere to place them at home; this increases the demand for foreign currency (to buy foreign bonds) and hence leads to exchange rate depreciation. For a graphical picture, see graph 5.9, only with an increase in the S I line rather than the decrease shown.
Note that in a large open economy, the excess savings would drive down the interest rate and increase investment, so the excess savings would be most likely be divided between the increase in investment at home and a rise in the trade balance. (It is possible, but not likely, that NX could remain unchanged or actually fall).

BASE MODEL: For a numerical example, try (assuming no government): Y = 10,000 C = 0.8 Y I = 4000 200 r with world interest rate at r* = 10 percent; so I = 2000 NX = 1000 250 REX G=T=0 Put this together and you will have Y = C + I + NX 10,000 = .8 (10,000) + 2000 + NX = 8000 + 2000 + NX NX = 0 hence REX = 4. Change the consumption function to C = 0.75 Y and we will have 10,000 = 0.75 (10,000) + 2000 + NX = 7500 + 2000 + NX hence NX = 500 and REX = 2 Part b: Shift in consumer tastes toward imported goods: on the S-I, REX graph, shift the net export schedule to the LEFT (the opposite of the shift shown on figure 5-12, p. 138). Note that under classical assumptions the actual volume of NX will remain unchanged. For a numerical example, change the NX function in the BASE MODEL from NX = 1000 250 REX to NX = 750 250 REX Y = C + I + NX 10,000 = 0.8 (10,000) + 2000 + NX so NX must still equal zero. NX = 750 250 REX = 0, so REX must equal 3. Depreciation, caused by the increase in our demand for foreign currency (the yen needed to buy the Toyotas in the Mankiw example) will restore the trade balance to zero.

Problem 1, Part c: Impact of change in money demand on prices not covered in class, so not relevant for exam. However, the reduction in the demand for money with no change in supply will lead to people trying to get rid of their holdings of money by spending it faster, so to an increase in prices. This in turn leads to real exchange rate appreciation: REX = e (Yen / dollar) * P (in dollars) / P(in yen) Problem 2: Numerical example: Y = C + I + G + NX Y = 5000 C = 250 + 0.75 (Y T) = 250 + .75 (5000 1000) = 3,250 I = 1000 50 r and since r = 5, I = 750 G = T = 1000 NX = 500 500 REX a. Put the given information together to get: Y = C + I + G + NX 5000 = 3250 + 750 + 1000 + 500 500 REX 5000 = 5000 + 500 500 REX hence REX = 1 and NX = 0 b. If G goes up to 1250, under the classical model for a small open economy, the only flexibility is in the NX function. Y = C + I + G + NX 5000 = 3250 + 750 + 1250 + 500 500 REX NX must move to negative 250, and the exchange rate will move to 1.5. The home currency country appreciates: with the increase in government borrowing, in a closed economy the interest rate in the home country would rise but with perfect capital mobility, foreigners will want to start buying the newly issued government bonds, and the resulting purchases will lead to currency appreciation.

Part c. The world interest rate rises to 10 percent, so investment falls: I = 1000 50 r = 500 Y = C + I + G + NX 5000 = 3250 + 500 + 1000 + 500 500 REX 5000 = 5250 500 REX; hence REX falls to 0.5. The real exchange rate depreciates. With the fall in investment, the excess savings must go abroad (and initially savers will be anxious to take advantage of the higher interest rates in the rest of the world, leading to currency depreciation for us as they buy foreign currency in order to buy foreign bonds)

Problem 6. Case study: Why doesn't capital flow to poor countries? p. 130-131 The capital/labor ratio is low in the developing world, so the marginal productivity and return should be high. Why doesn't capital follow ? Aside from restrictions on capital flows, the reason is probably less secure property rights and perhaps more corrupt court systems than in the developed world. Problem 6 asks what would happen given more secure property rights: a. Investment demand would increase in poor countries as local entrepreneurs felt more secure that they would reap the fruits of their investment: In the BASE MODEL, imagine that I = 1200 50 r I = 1200 50 (5) = 950 rather than 750. b.The demand for loanable funds would increase on world markets, since initial domestic income would not change, and savings would be insufficient to meet the higher investment demand. c.The world interest rate might rise if the new investment demand is coming from China and India rather than Botswana and Sri Lanka. d.Reduced investment in the developed world would mean developed world savings would seek investment outlets in the developing world. Note that the capital flows would be to the developing world; since the capital account and the current account are mirror images of each other, the net exports of the developed world would increase. Problem 7. Tariffs and the exchange rate. In the classical model, the NX curve would shift outward. But there would be no change in income (Y) or savings (S) or investment, so S-I does not shift and the trade balance remains the same. If we were to succeed in getting a trade surplus with the rest of the world, foreign demand for our currency would exceed supply unless the exchange rate appreciates, and the exchange rate appreciation would return the trade balance to its initial level. See figure 5-12 and the discussion on p. 138-139. Problem 8. Investment subsidies or investment tax credits by LARGE countries. Investment demand increases, so the world interest rate will rise; our (the small economy) investment drops, so our trade balance will improve. Note that the rise in the world interest rate will increase our demand for foreign currency so that we can buy foreign bonds; our increased demand for foreign currency will lead to depreciation of our currency, which in turn will make our goods more attractive to the rest of the world. Problem 9. Nominal and real exchange rates. The friend is right about the NOMINAL exchange rate: the dollar has appreciated against the peso, and the peso has depreciated. But the REAL exchange rate of the dollar is REX = Pesos per dollar X Price in dollars / Price in Pesos Initially, REX = 10 X 100 / 100 = 10 After the peso depreciation and differing price levels (25 percent in US and 100 percent in Mexico): REX = 15 * 125 / 200 = 7.5 Your dollar buys more pesos, but fewer tortillas, thanks to Mexican inflation.