The Macroeconomic Theory of the Open Economy: Chapter 13 Continued Net Capital Outflow: The Link between the two markets

Transcription

1 The Macroeconomic Theory of the Open Economy: Chapter 13 Continued In an open economy: o National saving o Domestic investment o Net foreign investment (NCO) o The exchange rate o Net exports (NX) Are determined in the market for loanable funds and the market for foreign currency exchange Net Capital Outflow: The Link between the two markets In the market for loanable funds o Supply comes from national saving (s) o Demand comes from domestic investment (i) and net capital outflow (NCO) In the market for Foreign-Currency Exchange o Supply comes from net capital outflow (NCO) o Demand comes from net exports (NX) The link between the two markets is: o Net capital outflows or NCO

2 Trade Policy Trade policy is government policy that directly influences the quantity of goods and services that a country imports or exports Some trade policies to affect quantity of imports: o Tariff: a tax on an imported good o Import Quota: a limit on the quantity of a good produced abroad and sold domestically Lets assume the government imposes an import quota o What is the initial impact of the measure? On net exports (exports - imports): because imports decline at every exchange rate and therefore, net exports rise at every exchange rate On foreign exchange market: since net exports are source of demand for dollars and therefore the demand for dollars rises o What is the impact on the Market for Loanable Funds? That is, on national saving, domestic investment and NCO There is no impact on the market for loanable funds o What is the impact on the Market for Foreign Currency Exchange

3 Surprise Ending: Trade policies do not affect the trade balance The Effect of An Import Quota Because foreigners need dollars to buy Canadian net exports (which intitially increase) There is an increased demand for dollars in the market for foreign currency Leads to an appreciation of the real exchange rate because the supply of dollars is unchanged An appreciation of the dollar encourages imports and discourages exports In the end, trade policies do not affect the trade ba;ance There are Winners and Losers Import Quota: Reduces imports of commodity under quota--beneficial to that industry Leads to appreciation of Canadian dollar which harms all other export industries by increasing export prices--not beneficial to export industries As well, it encourages imports by reducing the prices for imported goods--beneficial to importers Question: "Buy Canadian" Campaign Suppose the Canadian government institutes a Buy Canadian campaign, in order to encourage spending on domestic goods What effect will this have on the Canadian trade balance? Answer: Campaign will increase the demand for domestically produced goods and hence decrease the demand for imports: initially NX (exports - imports) will tend to rise This will increase the demand for dollars in the market for foreign currency, hence the real exchange rate will appreciate, exports will fall and imports will rise. NX will return to its former level In the end, net effect will be no change in the trade balance But there are winners and losers Poitical Instability and Capital Flight

4 Capital Flight Large and sudden reduction in the demand for assets located in a country Usually accompanied by large capital outflow (NCO) Largest impact on the country from which the capital is fleeing If investors become concerned about the safety of their investments: Capital can quickly leave economy Resulting in domestic interest rate rises while domestic currency depreciates

5 Mexican Experience in 1994 When investors around the world observed political problems in Mexico, they sold some of their Mexican assets and used the proceeds to buy assets of other countries Outcome: o There was an increase in capital outflow from Mexico o Domestic investment fall o This increased the supply of pesos in the foreign currency exchange market Which led to a significant depreciation of the peso Aggregate Demand and Aggregate Supply: Chapter 14 First of three chapters dealing with short-term economic flucatuations and policies Objectives: What are economic fluctuations? Develop the model of aggregate demand and aggregate supply Examine the sopes of the aggregate-demand curve and aggregate supply curve What shifts the AD and AS curves? Short Run Economic Fluctuations Economic Activity In most years, production of goods and services rises. On average, real GDP per person has grown by about 2% per year. However, in some years, normal growth does not occur causing a recession of depression Recession: Period of declining production, real incomes, and rising unemployment (over two quarters) Depression:

6 Severe Recession Quotation: Recession is when your neighbour is out of work, depression is when you are out of work and recovery is when the government is out of work. Three Facts about Economic Fluctuations Economic fluctuations are irregular and unpredictable o The fluctuations are often called the business cycle or economic downturns Most macroeconomic variables fluctuate together o However, variables fluctuate by different amounts As output falls, unemployment rises o Normally, the unemployment rate fluctuates around the natural unemployment rate o During times of recession, unemployment rate rises substantially Explaining Short-Run Economic Fluctuations How the short run differs from the long run Long Run Classical theory describes the world in the long run Example: classical dichotomy and assumption of monetary neutrality states that: changes in money supply (monetary developments) affect only nominal variables and not real variables Short Run Monetary neutrality is not appropriate for year to year changes Monetary developments can affect real variables in the short run The Basic Model of Economic Fluctuations Two variables are used to develop the model to analyze short run fluctuations o Real GDP: the economy's output of goods and services o Overall price level: measured by the CPI or the GDP deflator Output is a real variable whereas price level is a nominal variable o Combining a real variable with a nominal variable in one model: setting the stage for monetary policy to affect real variables in the short term The Basic Model of Aggregate Demand and Aggregate Supply Model of aggregate demand and aggregate supply used to explain short-run fluctuations in economic activity around its long-run trend Aggregate demand curve: shows the quantity of goods and services that households, firms and the government wants to buy at each price level Aggregate supply curve: shows the quantity of goods and services that firms want to supply at each price level

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