CLASS WEEKS 7-8 The classical model (open economy)

1. Module/Unit title:Managing the Economy Module Code: MOD001072 Academic Year: 2012/3 Module Leader: Dr Chris Fuller Campus/ Building/ Room: Cambridge, LAB316 Email: chris.fuller@anglia.ac.uk CLASS WEEKS 7-8 The classical model (open economy)

2. An open economy Exercises • NOTE 1: • NX can be called • Net exports • OR •  Trade balance Y = Y= 1,200 Y = C + I + G C = 125 + 0.75(Y – T) I = I(r) = 200 – 10r G = G = 150 T = T = 100 NX = 200 - 100 ε NOTE 2: This symbol [epsilon].... ...I write as ‘E’ a) If the world interest rate is 10%, then r = 10, solve for I and S, and thus NX. But it will be like epsilon in the exam (if if comes up) Assume that there are two factors of production, K and L, and that they are both fully employed. Furthermore, assume that the economy is described by the following set of equations:

3. Answer to [a] Find NX [a] Use the I equation: I = i(r) = 200—10r* = 200- 10(10) = 100 = I To find S, note that S = Y – C – G, so: S = Y – C – G = 1200 –[125+0.75(1100)] – 150  S = 1200 – 125-825 -150 = 100 = S • S-I = 100-100 = 0 You know that in equilibrium, S-I must = NX, so S-I = 0 = NX E S-I 0 NX

4. An open economy Exercises Y = Y = 1,200 Y = C + I + G C = 125 + 0.75(Y – T) I = I(r) = 200 – 10r G = G = 150 T = T = 100 NX = 200 - 100 ε b) Determine the real exchange rate ε. Draw the net export and the net capital outflow and identify equilibrium (label as point A). Assume that there are two factors of production, K and L, and that they are both fully employed. Furthermore, assume that the economy is described by the following set of equations:

5. ANSWER TO [b] Find E [b] Find [equilibrium] real exchange rate E We know (from question [a]) that S-I = 0. In equilibrium, must have NX = S-I NX = 200-100E = 0 in equilibrium. • 100E = 200, so E* = 2 To draw NX line, note: • When E= 2, NX = 0 • When E=0, NX = 200 • So S-I crosses NX where E = E* = 2 E S-I A E* =2 NX(E) 200 0 NX

6. An open economy Exercises Y = Y = F (K, L) = 1,200 Y = C + I + G C = 125 + 0.75(Y – T) I = I(r) = 200 – 10r G = G = 150 T = T = 100 NX = 200 - 100 ε c) Suppose that the government purchases rose by 100 to 250. If Y remained equal to 1,200, how would this shift the saving curve and by how much? Assume that there are two factors of production, K and L, and that they are both fully employed. Furthermore, assume that the economy is described by the following set of equations:

7. Answer to [c] Rise in G to 250 • I no change S = Y – C – G = 1200 –[125+0.75(1100)] – 250  S = 1200 – 125-825 -250 = 0 = S • S-I = 0-100 = -100 • In equilibrium, S-I = NX, so S-I = -100 = NX • S-I curve shifts left because S is lower • S-I will shift by 100

8. An open economy Exercises Y = Y = F (K, L) = 1,200 Y = C + I + G C = 125 + 0.75(Y – T) I = I(r) = 200 – 10r G = G = 150 T = T = 100 NX = 200 - 100 ε d) Following the increase in domestic government purchases to 250 net capital outflow changes to? Show the new situation graphically. Assume that there are two factors of production, K and L, and that they are both fully employed. Furthermore, assume that the economy is described by the following set of equations:

9. Answer to [d] In equilibrium, S-I = NX, so S-I = -100 = NX • S-I curve shifts left because S is lower • S-I will shift by 100 • Net capital outflow is -100 • = NEGATIVE net capital outflow • = net capital INFLOW of 100 OR : trade balance (NX) is negative [=-100] E S-I’ S-I A E* NX -100 200 0 NX

10. An open economy Exercises Y = Y = F (K, L) = 1,200 Y = C + I + G C = 125 + 0.75(Y – T) I = I(r) = 200 – 10r G = G = 150 T = T = 100 NX = 200 - 100 ε e) Suppose we start again at point A and due a policy change by a large open economy (like China or the US) there is a FALL in the global supply of loanable funds. How would this change the initial situation? Assume that there are two factors of production, K and L, and that they are both fully employed. Furthermore, assume that the economy is described by the following set of equations:

11. Answer to [e] impact of change in global loanable funds market Start again at initial equilibrium ‘A’. Assume [due to say actions of a large open economy government like China, US] global supply of loanable funds falls. This means world S falls, so PUSHING UP WORLD INTEREST RATE[ i.e. r* rises to (say) r**] S won’t change if r changes But I FALLS to I’, because world r is higher • S – I will get BIGGER • S-I curve shifts RIGHT • Real exchange rate E FALLS to E** • NX gets larger E S-I’ S-I A E*=2 Lower E** NX 200 0 NX Larger NX

12. An open economy Exercises Y = Y = F (K, L) = 1,200 Y = C + I + G C = 125 + 0.75(Y – T) I = I(r) = 200 – 10r G = G = 150 T = T = 100 NX = 200 - 100 ε f) Suppose we start again at point A and the world interest rate rises to 15%. How much would the investment be now? Assume that there are two factors of production, K and L, and that they are both fully employed. Furthermore, assume that the economy is described by the following set of equations:

13. Answer to [f] Start again at initial equilibrium ‘A’. Assume r rises to r** = 15 I will be 200-10r** = 200-150 = 50 = new I = I’’ S in initial situation was 100. S won’t change if r changes • S – I = 100-50 = 50 = net capital outflow • S-I curve shifts right by 50 NOTE Can also work out new E [ this question doesn’t ask you to but useful to know] NX(E) = 200-100E which must = S – I = 50 in equilibrium Or 200 – 100E = 50 Or 150 = 100E Or E = 150/100 = 1.5 = E** E S-I’’ S-I A E*=2 E** = 1.5 NX 200 0 50 NX