Class 7: Saving and Investment in the open economy. 2. Consider an economy described by the following equations:

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1 Macroeconomics I. Antonio Zabalza. University of Valencia 1 Class 7: Saving and Investment in the open economy 1. Use the model of the small open economy to predict what would happen to the trade balance, the real exchange rate, and the nominal exchange rate in response to each of the following events. a) A fall in consumer confidence about the future induces consumers to spend less and save more. b) The introduction of a stylish line of Toyotas makes some consumers prefer foreign cars over domestic cars. c) The introduction of automatic teller machines reduces the demand for money. 2. Consider an economy described by the following equations: Y = C + I + G+ Y = 5,000 G = 1,000 T = 1,000 C = ( Y T) I = 1,000 50r = ε r = r* = 5

2 Macroeconomics I. Antonio Zabalza. University of Valencia 2 a) In this economy, solve for national saving, investment, the trade balance, and the equilibrium exchange rate. b) Suppose now that G rises to 1,250. Solve for national saving, investment, the trade balance, and the equilibrium exchange rate. Explain what you find. c) Now suppose that the world interest rate rises from 5 to 10 percent. (G is again 1,000).Solve for national saving, investment, the trade balance, and the equilibrium exchange rate. Explain what you find. 3. Switzerland is a small open economy. Suppose that suddenly a change in world fashions makes Swiss exports unpopular. a) What happens in Switzerland to saving, investment, net exports, the interest rate, and the exchange rate? b) The citizens of Switzerland like to travel abroad. How will this change in the exchange rate affect them. c) The Swiss fiscal authorities want to adjust taxes to maintain the exchange rate at its previous level. What should they do? If they do this, what are the overall effects on saving, investment, net exports, and the interest rate?

3 Macroeconomics I. Antonio Zabalza. University of Valencia 3 4. What will happen to the trade balance and the real exchange rate of a small open economy when government purchases increase, such as during a war? Does your answer depend on whether this is a local war o a world war? 5. In 1995, President Clinton considered placing a 100 percent tariff on the import of Japanese luxury cars. Discuss the economics and politics of such a policy. In particular, how would the policy affect the US trade deficit? How would it affect the exchange rate? Who would be hurt by such policy? Who would benefit? 6. Suppose that some foreign countries begin to subsidize investment by instituting an investment tax credit. a) What happens to world investment demand as a function of the world interest rate? b) What happens to the world interest rate? c) What happens to investment in our small open economy? d) What happens to our trade balance? e) What happens to our real exchange rate? 7. Travelling in the US is much cheaper now that it was two years ago, says a friend. Two

4 Macroeconomics I. Antonio Zabalza. University of Valencia 4 years ago, an Euro bought 0.8 Dollars; now an Euro buys 1.3 Dollars. a) Is your friend right or wrong? Do you need more information than the one given above to answer this question? What kind of information? b) In this two year period, accumulated inflation has been about the same in the US and the EU: 4 percent. So, given this, do you think your friend is right or wrong? c) Suppose, for the sake of the argument, that during this period accumulated inflation in the US has been 70 percent, while in the EU it has only been 4 percent. Would then your friend be right or wrong? Write your answer using a concrete example; for instance, compare how the cost of an European cup of coffee versus an American cup of coffee has evolved during this period. 8. You read in a newspaper that the nominal interest rate is 6 percent per year in the US and 3 percent in the EU. Suppose that the real interest rates are equalized in the two countries and that purchasing power parity holds (that is that the real exchange rate is unity, ε = 1). a) Using the Fisher equation, what can you infer about expected inflation in the US and the EU?

5 Macroeconomics I. Antonio Zabalza. University of Valencia 5 b) What can you infer about the expected change in the exchange rate between the Dollar and the Euro? c) A friend proposes a get-rich-quick scheme: borrow from a EU bank at 3 percent, deposit the money in a US bank at 6 percent, and make a 3 percent profit. What s wrong with this scheme?

6 Macroeconomics I. Antonio Zabalza. University of Valencia 6 Answers 1.a) ε S-I S -I ε ε A B (ε) S ; ε ; ; e since relative international prices don't move. b) ε S-I ε ε B A (ε) (ε)

7 Macroeconomics I. Antonio Zabalza. University of Valencia 7 ε ; e ; constant; EX ; IM. c) M d P P * P constant; ε constant; recall that e * P = ε P e 2.a) b) c) S = 5,000 3,250 1,000= 750 I = 1, = 750 S I = = 0 0= ε; ε = 1 S = 500 I = 750 S I = = 250 ε = 1.5 S = 750 I = 500 S I = = 250 ε = 0.5

8 Macroeconomics I. Antonio Zabalza. University of Valencia 8 3.a) S, I and constant; r constant; ε ( EX ; IM ) b) Travelling abroad becomes more expensive. This contributes to the above fall in imports. c) Reduce saving by lowering taxes. This produces the following effects S ; ; ε ; r constant. 4. Local war: G ; S ; ( S I) ; ; ε World war: * * S ; S r I ; S I?;? ( ) 5. IM curve shifts up S I constant constant ε Consumers of Japanese cars are hurt and producers of US luxury cars are benefited. 6. * a) I b) r * c) I

9 Macroeconomics I. Antonio Zabalza. University of Valencia 9 d) ( S I) e) ε 7. Two years ago 1 bought 0.8$ Today 1 buys 1.3$ a) You need information on how prices have evolved over time in the US and the EU. b) US EU π = π = ( say)4%. Example with cup of coffee t=0: 1 cup in EU: 1 ; 1 cup in US: 0.8$ (=1 ) t=2: 1 cup in EU: 1.04 ; 1 cup in US: 0.832$ At t=2 1 buys 1.3$. Therefore, at t=2 1 cup in US costs 0.64 (=0.832/1.3) So, my friend is right. Two years ago 1 cup in US cost the same as 1 cup in EU (ie, 1 ). Now 1 cup in US costs 0.64 and 1 cup in EU costs The relative (EU/US) price was 1 two years ago and is now. A cup of coffee is now 62.5% more expensive now in the EU. d) Repeating the above argument, the answer is taht in this case my friend is not right.

10 Macroeconomics I. Antonio Zabalza. University of Valencia 10 In fact, the question could have been rephrased in the sense of finding the minimum level of US inflation that (given that EU inflation is 4%) beyond which my friend will be right. The answer is given by the solution to the following equation 0.8( 1+ π ) = π = 0.69 So, if inflation in the EU is 4%, levels of inflation in the US above 69% will more than compensate for the dollar/euro depreciation from 0.8 $/ to 1.3 $/. 8. US EU US EU i = 6%; i = 3%; r = r ; ε = 1(purchasing power theory holds) a) i US eus EU eeu eus 6 π = 3 π π eus π = i π eeu eeu π = 6 3= 3 Expected inflation is 3 points of percentage higher in the US as compared with the EU.

11 Macroeconomics I. Antonio Zabalza. University of Valencia 11 b) P ε = e P P 1 = e P P e = P % e= % P % P % e = 3 We would expect the Euro to appreciate 3% respect the Dollar. c) I borrow 1,000 from a EU bank. Next year I ll have to return 1,030. Initially 1 =1$. So I get 1,000$ which I invest at 6%. Next year I obtain 1,060$. But in 1 year the exchange rate will have appreciated by 3%. So in 1 year, 1 will buy 1.03$. This means that with 1,060$ I will get 1,029 (1,060/1.03). So, not only I will not get rich, but I will not even be able to return the money I initially borrowed. Moral: Beware of get-rich-quick schemes.