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MacroeconomicsECO 403
VU
LESSON 14
MONEY AND INFLATION (Continued...)
TheClassical Dichotomy
Realvariables are measured in physical units: quantitiesand relative prices,e.g.
·  Quantity of output produced
·  Realwage: output earned perhour of work
·  Realinterest rate: output earned in the future
by lending one unit of outputtoday
Nominalvariables: measured in money units, e.g.
·
Nominalwage: dollars per hour of work
·
Nominalinterest rate: dollarsearned in future
by lending one dollartoday
·
Theprice level: the amount of dollars needed
to buy a representative basket of goods
·
ClassicalDichotomy:
"Thetheoretical separation of realand nominal variables in theclassical model, whichimplies
nominalvariables do not affect realvariables. "
·
Neutrality of Money:
Changes in the money supply do notaffect real variables. In the real world, money is
approximatelyneutral in the longrun.
TheOpen Economy
·
Accountingidentities for the openeconomy
·
Smallopen economy model
·
Whatmakes it "small"
·
Howthe trade balance andexchange rate aredetermined
·
Howpolicies affect tradebalance & exchangerate
Importsand Exports as a percentage of output
40
Percentage
of GDP  35
30
25
20
15
10
5
0
U.K.
Canada  France Germany
Italy
Japan
U.S.
Pakistan
Imports
Exports
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MacroeconomicsECO 403
VU
In an open economy:
·
Spendingneed not equaloutput
·
Savingneed not equalinvestment
Preliminaries
C =C d +C f
I =Id +If
G =G  d +G  f
Superscripts:
d = spending on domesticgoods
f = spending on foreigngoods
EX = exports = foreign spending on domestic goods
IM = imports = C f + I f + G f = spending on foreign goods
NX = net exports (the "tradebalance")
= EX ­ IM
·
If NX > 0, country has a tradesurplus equal to NX
·
If NX < 0, countryhas a trade deficit equal to ­ NX
GDP = expenditure on domestically producedgoods &services
Y = C d + I d + G  d + EX
= (C - C f ) + (I - I f ) + (G - G  f ) + EX
= C + I + G + EX - (C f + I f + G  f )
= C + I + G + EX - IM
= C + I + G + NX
Thenational income identity in an open economy
Y = C + I + G + NX
Or,
NX = Y ­ ( C + I + G )
Where,
NX => Net Export
Y   => Output
C + I + G => Domestic Spending
NetForeign Investment and TradeBalance
·
We have
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MacroeconomicsECO 403
VU
Y = C + I + G + NX
Re-arranging;
Y ­ C ­ G = I + NX
·
Recall, Y ­ C ­ G is national savings S,
thesum of private savings (Y ­ T ­ C) and public savings (T ­ G).
Hence;
S = I + NX
or
S ­ I = NX
·
S ­ I is the difference betweendomestic saving and domesticinvestment, referred to as Net
ForeignInvestment
·
While NX is the TradeBalance
·
So
NetForeign Investment = TradeBalance
S ­ I = NX
Internationalcapital flows
·
Netcapital outflows
=S ­ I
=netoutflow of "loanablefunds"
=netpurchases of foreignassets
·Net capitaloutflows
thecountry's purchases of foreignassets minus foreignpurchases of domesticassets
·
When S > I, country is a netlender
·
When S < I, country is a netborrower
·
An open-economy version of theloanable funds modelincludes many of thesame
elements:
Savingand Investment in a SmallOpen Economy
Y = Y = F (K , L )
productionfunction:
C = C ( -T )
Y
consumptionfunction:
I = I (r )
investmentfunction:
exogenouspolicy variables: G = G , T = T
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MacroeconomicsECO 403
VU
NationalSaving: The Supply of Loanable Funds
r
S = Y ­ C(Y ­ T) - G
Nationalsaving does not
depend on the interest rate
S, I
S
Assumptions:capital flows
·
Domestic & foreign bonds areperfect substitutes
·
Perfectcapital mobility:
no restrictions on international trade in assets
·
Economy is small:
cannotaffect the world interestrate, denoted r*
Investment:Demand for LoanableFunds
r
Investment is still a downward-sloping
function of the interest rate, butthe
exogenousworld interest ratedetermines
thecountry's level of investment.
r*
I (r )
S, I
I (r* )
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MacroeconomicsECO 403
VU
ClosedEconomy
r
S
rc
I (r )
S
I ( r)c
=
S
...the interest rate would adjust to equate investment andsaving:
A Small OpenEconomy
r
S
Theexogenous world interestrate
determinesinvestment and thedifference
betweensaving and investment
determinesnet capital outflows andnet
NX
exports
r*
rc
I (r )
S, I
I1
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