Chapter 4 General Equilibrium In Open and Closed Economies

1. Chapter 4General Equilibrium In Open and Closed Economies

2. The combination of maximum X & Y is pictured by the Production Possibility Frontier (PPF) • Pa = autarky price ratio. • Assumed producer & consumer to be competitive, these 3 conditions are hold: • Px/Py = Marginal rate of transformation (MRT)(Producer optimization) • Px/Py = Marginal rate of substitution (MRS)(Consumer optimization) • Xc = Xp and Yc = Yp(Market clearing) (4.1) Where c =consumption, p = production

3. Producers produce optimally at point A, where the slope of the production frontier istangent to the price ratio, pa . • Consumer consume optimally at point A, where the slope of their indifference curve is tangent to the price ratio, pa. • Markets clear because the production and consumption points are the same.

4. Equilibrium in the Open (Trading) Economy • Assumed an economy can engage in the trade at a fixed world price ratio, which is p* = px*/py* • The first two optimization conditions mentioned in the previous section remain unchanged. • but the world price (p*) will be differentfrom the prices determined in autarky (closed economy). • Producer optimize when marginal rate of transformation (MRT) equivalent with prices prevail • Consumers optimize when marginal rate of substitution (MRS) equivalent with those prices • The difference in equilibriumbetween the closed and the open economy lies in the third condition, that is the clear market for closed economy but trade balance for open economy.

5. Equilibrium in the Open (Trading) Economy • With international trade, an economy is no longer constrained to consume only what it can produce. • In open economy, there’s no market clearing, instead there’s trade balancewhere the value of what a country sells (export) on world markets EQUIVALENTto what it buys (import).

6. Equilibrium in the Open (Trading) Economy • Assumed the excess demand for goods X and Y as (Xc - Xp ) and (Yc - Yp ) . • If excess demand is positive, the economy is consuming more than it is producing, then it’s goods importer. • If excess demand is negative, the economy is consuming less than it is producing, then it’s goods exporter.

7. Equilibrium in the Open (Trading) Economy • The trade balance constraint requires that the value of all importsbe equal to the value of all export like: Px*(Xc - Xp) + Py* (Yc -Yp) = 0 (4.2) • After rearrange the term (4.2), we’ll get: Px*Xp + Py*Yp = Px*Xc + Py*Yc (4.3) • (Px*Xp + Py*Yp) is the value of production at world prices • (Px*Xc + Py*Yc) is the value of consumption at world prices • Thus, equivalent to the trade condition is the requirementthat the value of production must equal the value if consumption.

8. Assume the fixed world price ratio is p*. • Producers optimize by choosing production at point Q. • Consumers optimize by choosing consumption at point C. • The country imports X (because Xc > Xp) & exports Y ( because Yc < Yp). Px*/ Py* = MRT (condition 1) Px*/ Py* = MRS (condition 2) Px*(Xc -Xp) + Py* (Yc—Yp) = 0 (condition 3)

9. Equilibrium in the Open (Trading) Economy • Market clearing in autarky (closed economy) is a special case of trade balance. • It satisfies the trade balance condition in that both terms in parentheses (i.e. (Xc - Xp) and (Yc -Yp))are zero. • This happens if the world price’s ratio is equivalent with the price of autarky of the country,then the trading equilibrium would be identical with autarky equilibrium.

10. Assume • There’s only 2 country in this world • Autarky price ratio is Pa • At price ratio P1* < Pa, the country produce at Q1 and consumes at C1. • Excess demand for good X is positive; means X is imported. Recalling that P* = Px*/Py*, if the relative price of X is lower on the world markets than on the domestic market, then the country will import X.

11. If X is more expensive in world market than domestic market (P2* > Pa), the country will export X. • when P2* > Pa, producer will choose Q2 & consumer will choose C2. The country will export (goods that is relatively more valuable in world market) & import Y.

12. P* < Pa pictures that the relative price of X is lower (relative price of Y is higher) in world market, X is being imported and there’s excess of demand for X. • P* > Pa pictures that the relative price of Xis higher (relative price of Y is lower) in world market, X is being export and excess demand for X is negative.

13. Figure 4.4 • Excess demand curves (Ex) slope downward with • Relative price P* = Px*/Py* at vertical axis • Excess demand for X or (Xc – Xp) at horizontal axis • Excess demand for X becomes negative (Xc < Xp) means export for X increases as the world price ratio increases over Pa. • Excess demand increases positively (imports for good X increase positively) as the world price ratio decreases over Pa.

14. Excess demand curve (Ex) downward sloping because: • Production effect : When P* < Pa (relative price for X is lower in international market), producer will choose to move sources from production of X to production of Y (Xp ), and vice versa. • Substitution effect: Falling price of X in international market (P* < Pa) makes consumer willing and able to buy more if X (Xc ), and excess demand for X grows as its price falls.

15. International General Equilibrium • Now introduce the second country into the model, international equilibrium is found at the price where total export for country A equals to total import country B. • Equilibrium price lies between the autarky prices of both countries • The autarky price differences determine the direction of trade, where • Country with lower price will export the good and • Country with higher price will import the good.

16. Two countries, F (Foreign) and H (Home) • At first, autarky price for F is Pa1 with excess demand curve Ex* while, autarky price for H is Pa with excess demand curve Ex • General Equilibrium occurs at P* in which positive excess demand (import) for country F equals to negative excess demand (export) for country H.

17. How about Y? • When we have only two goods and we impose a trade balance condition, we need to examine only one market to find the general equilibrium. • If country H is satisfying its trade balance condition, then Px*Ex = - Py*Ey where -Py*Ey is the value of excess demand for Y by H. • Similarly, if country F is satisfying it’s trade balance, then Px*Ex* = - Py*Ey* . - Thus, if Ex = - Ex*, then Ey= - Ey*. • The need to find equilibrium in only one market is known as Walras' Law in economics.