MA Chapter 4 For Exit Exam

CHAPTER FOUR
Aggregate Demand in the Open Economy

 Chapter objectives
 4.1. International flows of Capital Goods
 4.2. Saving and Investment in the Small Open Economy
 4.3. Exchange rates
 4.4. The Mundell-Fleming model
4.4.1Driving the Mundell-Fleming IS curve
4.4.2 Driving the Mundell-Fleming LM curve
4.4.3 Short run IS-LM equilibrium in Mundell-Fleming Model
 4.5. Fiscal and monetary policies analysis in an open economy with
perfect capital mobility
 4.5.1. Fixed exchange rate
 4.5.2. Floating exchange rate
 4.6 Limitations of the Mundell-Fleming model
Misgana Dereje(BSc,MSc)
dereje.misgana@yahoo.com
In this chapter, You are able to know:
 Accounting identities for the open economy
 International capital flows and trade balance- relationships
 The small open economy model
 What makes it “small”
 How the trade balance and exchange rate are determined
 Exchange rate and its impact on an economy
 Definition and measurement of exchange rate
 Nominal Vs. real exchange rate
 Exchange rate system: Fixed Vs. Floating
 Devaluation, Revaluation, Depreciation and Appreciation
 IS-LM model in an open economy- Mundell-Fleming model
 How policies affect trade balance & exchange rate
 Driving Aggregate demand curve from Mundell-Fleming model
4.1 International flows of Capital Goods
 In an open economy, some output is sold domestically and some is
exported to be sold abroad.
 National income accounts identity in an open economy
Y = C + I + G + NX.
 National income accounts identity in terms of saving and investment
Subtract C and G from both sides and obtain
Y − C − G = I + NX. But Y – C – G is national saving
=> S = I + NX
 The equality of net capital outflow &trade balance is given by:
=> S − I = NX
Net capital outflow Trade balance/Net export

(Net foreign investment)
Trade balance is the difference between exports and imports
Net capital outflow is the difference between saving and investment
 This identity shows that an economy’s net exports must always equal the
difference between its saving and its investment.
Con’t…
=> S − I = NX
 If Saving > Investment
 we are net lenders in world financial markets
 Net Capital Outflow > 0
 NX are positive and we have a trade surplus
 we are exporting more goods than we are importing.
 If Saving < Investment
 we are net borrowers in world financial markets
 Net Capital Outflow < 0
 NX are negative and we have a trade deficit
 we are importing more goods than we are exporting.
If Saving =Investment
 Net Capital Outflow = 0
 NX are exactly zero and we have balanced trade
 the value of imports equals the value of exports.
International Flows of Goods and Capital: Summary
• The three outcomes that an open economy can experience
Trade Surplus Balanced Trade Trade Deficit
Exports > Imports Exports = Imports Exports < Imports
Net Exports >0 Net Exports = 0 Net Exports < 0
Y>C+I+G Y=C+I+G Y<C+I+G
Saving > Investment Saving = Investment Saving < Investment
Net Capital Outflow > 0 Net Capital Outflow = 0 Net Capital Outflow < 0
5
4.2. Saving and Investment in a Small Open Economy
 Assumption:“Small open economy with perfect capital mobility”
A1: Economy is small: This economy is a small part of the world
market and hence, cannot affect the world interest rate, denoted r*.
A2: Perfect capital mobility
=> Residents of the country have full access to world financial markets.
=> The government does not impede/block international borrowing or lending.
=> No restrictions on international trade in assets
 The interest rate, r, in small open economy with perfect capital
mobility must equal the world interest rate r*: r = r*.
 Domestic the interest rate is set by world financial markets and our
small open economy takes the world interest rate as exogenously
given.
 Notation: r = interest rate in our small open economy and
𝒓 ∗ = world interest rate (the real interest rate prevailing
in world financial markets)
What determines the world real interest rate?
The equilibrium of world saving and world investment determines
the world interest rate. Because our small open economy takes the
world interest rate as exogenously given.
The national income accounts identity, expressed in terms of saving
and investment be:
NX = (Y-C(Y-T) - G) - I (r*)
=>NX = S - I (r*)
What determines the world real interest rate?
 Fiscal Policy Abroad: Suppose Foreign government use
expansionary fiscal policy (increase government purchase). What
happens to a small open economy?
 Assuming that foreign countries are a large part of the world
economy, it can influence world saving and investment. i.e When
foreign governments increase their G, it reduces world saving and
causes the world interest rate to rise and these reduce world
investment by raising cost of borrowing.
NX = (Y-C(Y-T) - G) - I (r*)
=>NX= S - I ( r*)
 Since r*=r, rise in r* rises r
 Thus, investment in the small open economy becomes lowered,
causing a trade surplus where S > I. Thus, some of our saving
begins to flow abroad!!
 Having examined the international flows of capital, we now extend
the analysis by considering the prices that apply to these
transactions => exchange rate Misgana Dereje(BSc,MSc)
4.3. Exchange Rates
4.3.1 Meaning and Measurements
1. Exchange rate (E) is the rate at which one currency exchanges for another
and it is also an indicative of the relative price of goods and services
denominated in the currencies of the two countries concerned.
2. The two conventions for measuring the exchange rate that can be the
source of serious confusion
a) Domestic currency units per unit of foreign currency
o Example: 20 birr exchanges for $1, and then the exchange rate is 20.
o Whenever E rises the home currency gets weaker; it depreciates.
o For example, a rise from 20 to 21 means that 21birr exchanged for $1,
less than before.
o When E falls, the domestic currency gets stronger, it appreciates.
b) Foreign currency units per unit of domestic currency
o Example: When 20 birr is exchanged for $1, the exchange rate is 0.05.
o The domestic currency is on the denominator.
o If E rises, the home currency gets stronger, and vice versa.
3.4.2 Real Vs. Nominal Exchange Rates
1.Nominal Exchange Rate (e)
 It is the relative price of the currency of two countries.
 E.g. 20 birr per dollar, then you can exchange one dollar for 20
birr in the world markets for foreign currency.
 e is the units of foreign currency per unit of domestic currency.
 e.g. 0.04 dollar per birr
2. Real Exchange Rate ()
 It is the relative price of the goods of two countries.
 It tells us the rate at which we can trade the goods of one country
for the goods of another.
 It is the relative price of domestic goods in terms of foreign goods.
 E.g. price of a US shoes per unit of Ethiopian shoes
3. The Relationship between  and e
𝑷
 =𝒆 Where P= domestic price level, P*=Foreign price level,
𝑷∗
= real exchange rate an e= Nominal exchange rate
 If the real exchange is high, Foreign goods are relatively cheaper
than domestic goods and vice versa.
 When ε is relatively low, Ethiopian goods are relatively
inexpensive and we can export more.
Worked example
1. Suppose 1kg coffee costs 4USD in New York but 100 birr in Addis
Ababa. If the nominal exchange rate is 1USD = 20 birr, then compute
the real exchange rate.
Solution: e= $1/20 birr=0.04 dollar/birr
𝑷
•=𝒆𝒙 Where P* = foreign price and P = domestic price.
𝑷∗
(100birr Ethiopian coffee
•  =0.04 dollar/birr = 0.8 𝐸𝑡ℎ𝑖𝑜𝑝𝑖𝑎𝑛 𝑐𝑜𝑓𝑓𝑒𝑒
(4dollars US coffee 𝑈𝑆 𝑐𝑜𝑓𝑓𝑒𝑒
Exercise: Suppose an Ethiopian shoes costs birr 2000 and a similar

American shoes costs $150. If a dollar is worth 53 birr, then compute
the cost of American shoe interns of Ethiopian birr.
Graphical determination of real exchange rate and trade balance
 The real exchange rate is determined by the intersection of the
vertical line representing saving minus investment and downward-
sloping net exports schedule.
 NX depends negatively on the real exchange rate, other things equal
12
4.3.3 Fixed Vs. floating exchange system
1) Fixed exchange rate
 It is a policy parameter fixed by the authorities.
 There is no self-correcting mechanism to balance of payments
disequilibria.
 Under fixed exchange rate policy
a) Devaluation: An increase in exchange rate due to political and economic
decision of government.
b) Revaluation: A decrease in exchange rate due to political and economic
decision of government.
2) Floating exchange rate system
 In a system of floating exchange rates, e is allowed to fluctuate in
response to changing economic market conditions.
 It is completely market-determined, without any interference from
government authorities (the central bank).i.e Balance of payments
disequilibria are self-correcting.
 Under flexible exchange rate policy
a) Depreciation: An increase in exchange rate due to market forces
b) Appreciation: A decrease in exchange rate due to market forces
NB. Between two extremes we have: Managed float (Consider the Ethiopian case).
Impact of Exchange rate Fluctuation on BOP
a) Impact of devaluation and depreciation:
 Improve current account balance and/or overall balance of payment
by making export cheaper and imports costly.
b)Impact of revaluation and appreciation:
 Deteriorate external balance by making export costly and import
cheaper than before.
Balance of payment: is a yearly summary statement of a nation’s
transactions with the rest of the world.
BP curve is about the relationship between interest rate and income
in the foreign exchange market.
BP measures the net flow of all forms of resources into a country.
The BP consists of three components:
1. Current account balance (CAB), which shows flows of good and services
2. Capital account balance (KAB), which shows flows of investments and loans
3. Change in official reserve (∆R), which shows the change in the nation’s official
government reserves and liabilities to balance the current and capital accounts.
5.4 The Mundell-Fleming Model
 The Mundell-Fleming model is an IS-LM model developed for the case
of an open economy.
•Basic Assumption: Small open economy with perfect capital mobility.
 A1: The domestic interest rate is equal to the world interest rate (r = r*).
 A2: The price level is exogenously fixed since the model is used to
analyze the short run (P). This implies that the nominal exchange rate is
proportional to the real exchange rate. ( = e (p/p*)
 A3: The money supply is also set exogenously by the central bank (M).
 A4: Our LM* curve will be vertical because the exchange rate does not
enter into our LM* equation.
 Building/Driving the mundel-Fleming model
 Start with these two equations:
Y = C(Y-T) + I(r*) + G + NX(e) ------IS*
M/P = L (r*,Y)-------------------------- LM*
Where
Y represents aggregate income, L is demand for real money, T is taxes, i is interest
,I is a n investment , M is the money supply, and P is the price level.
1. Driving the Mundel-Fleming IS* Curve
•Goods market equilibrium-the IS* curve:
Given Y = C (Y-T) + I(r*) + G + NX (e) Where e = nominal exchange rate
•When e  => NX => Y 
•The IS* curve summarizes these changes in the goods market equilibrium.
•There is a negative relationship b/n Exchange rate and trade balance (NX)
•There is also a negative relationship b/n exchange rate and income or output as
shown by IS* curve in an open economy.
2. Driving the Mundell-Fleming LM* Curve
 Money market equilibrium: LM* curve
 The LM∗ curve equation is: M/P = L (r∗, Y) −−−−−−−−−−−−−−−−−−−−LM∗
 The LM* curve is drawn for a given value of r*. Since r = r* is fixed
 There is only one value of Y that equates money demand with supply. To say Y is
not affected by the exchange rate.
 Hence, the LM curve, which draws the relation of the exchange rate and
aggregate income, is vertical.
3. Equilibrium in Muldell –Fleming Model
a) Fiscal Policy under Fixed Exchange Rates
•Let the government increasing public investment or cutting taxes.
 the IS* curve to the right
 Putting upward pressure on the exchange rate.
 But central bank follows the fixed exchange rate, arbitrageurs
quickly respond to the rising exchange rate by selling foreign
currency to the central bank, leading to an automatic monetary
expansion.
 The rise in the money supply (in the base money) shifts the LM ∗
curve to the right.
 Thus, under a fixed exchange rate, a fiscal expansion raises
aggregate income. (PF is effective in this case).
b) Monetary Policy under Fixed Exchange Rates
 Let the central bank increase the money supply through buying
bonds from the public. What would happen?
 The LM* curve to the right,
 lowering the exchange rate
 By agreeing to fix the exchange rate, the central bank gives up its
control over the money supply.
 Hence, monetary policy is ineffectual under a fixed exchange rate.
C) Fiscal Policy under Floating Exchange Rate
 Let the government increasing G or cutting taxes.
=>The IS* shifts curve to the right.
This raises the exchange rate (exchange rate appreciates)
but has no effect on income.(Fiscal policy is ineffective here)
=> i.e +G, or –T => +e, no  Y
d) Monetary policy under Floating Exchange Rate
 Let the central bank increases the money supply.
 Since price level is assumed to be fixed, an increase in real
balances shifts the LM* curve to the right.
 Hence, in a small open economy, monetary policy influences
income by altering the exchange rate.
 Hence, an increase in the money supply raises income and lowers
the exchange rate. (MP is effective in this case).
d) Monetary policy under Floating Exchange Rate
 Let the central bank increases the money supply.
 Since price level is assumed to be fixed, an increase in real
balances shifts the LM* curve to the right.
 Hence, in a small open economy, monetary policy influences
income by altering the exchange rate.
 Hence, an increase in the money supply raises income and lowers
the exchange rate. (MP is effective in this case).
2.6 Mundell-Fleming and the AD curve
 So far in M-F model, P has been fixed.
 Next: to derive the AD curve, we now write the M-F equations as:
Y = C(Y-T)+I(r*)+G+NX(ε)--------( IS*)
M/P = L(r*, Y) ------------------------(LM*)
 Relaxing the assumptions and price is flexible, so we could write
NX as a function of e instead of ε ).
 Driving AD curve
 As P => (M/P)
=> LM shifts left
=> b/s P > P*
=>NX
=>Y
4.7 Limitations of the Mundell-Fleming model
1. The model analysis considers only differences in interest rates as the cause of
capital movements and neglects other factors such as exchange rate variations.
2. The prescribed policy mix may be unable to correct a current account deficit.
Since the policy mix affects both the capital flows and imports, it can only ensure
that a negative trade balance is offset by a positive capital flow, and vice versa.
3. when the interest rate is raised through monetary policy, it will lead to a decrease
in investment at home. This must be accompanied either by increase in
government expenditure or by tax reductions or by a combination of both. Such a
monetary-fiscal mix wastes the economy’s savings by diverting them into debts
financed government expenditure which retards capital formation.
4. There is the possibility of conflicts between the prescribed policy mixes among
governments of different countries.
5. In reality, capital is neither perfectly mobile nor perfectly immobile. Hence, the
BOP curve is a horizontal line at the level i=i* under perfect capital mobility. It is
a vertical line under imperfect capital immobility. Also, it is upward-sloping
under imperfect capital mobility.
CHAPTER SUMMARY
In closed economy, there are no exports, no imports, and no capital flows where as
in an open economy people, export goods and services to abroad, import goods
and services from abroad, and borrow and lend in world financial market.
International Flows of Goods includes (Exports, Imports, and Net Exports)
International Flows of capitals includes: (Lend, Borrow and Net capital Outflow)
Impact of devaluation and depreciation is to improve current account balance
and/or overall balance of payment by making export cheaper and imports costly.
Impact of revaluation and appreciation is to deteriorate external balance by
making export costly and import cheaper than before.
Balance of payment: is a yearly summary statement of a nation’s transactions with
the rest of the world.
The Mundell-Fleming model shows that the effect of almost any economic policy
on a small open economy depends on whether the exchange rate is floating or
fixed. It states under a flexible exchange rate system; monetary policy proves
more effective. When a fixed exchange rate system is applied, Fiscal policy is
efficient
 The Mundell-Fleming model shows that the power of monetary and fiscal policy
to influence aggregate demand depends on the exchange rate regime.
Chapter Review Questions
Part I: choose the best answer from the given alternative.
1. Which of the following variable affect aggregate demand of an economy
differently from the rest of macro variables?
A. Increase in government expenditure D. Import
B. Increase in money supply E. Export
C. Decrease in tax.
2. Which of the following is true about devaluation?
A. It is an increase in the value of domestic currency under fixed exchange rate
B. It is a yearly summary statement of a nation’s transactions with the rest of the world.
C.It decreases import in the long run for developing countries
D. It improve current account always
E. It causes inflationary condition in developing countries
3. One of the following is not a possible cause of exchange rate depreciation.
A.increase in import
B. Decrease in export
C. BOP deficit
D. increase in money supply.
E. Decrease demand for foreign goods Misgana Dereje(BSc,MSc)
4. The National income accounts identity in an open economy b/n saving and
investment is given by the model: NX = S – I where NX is net export, S is saving
and I is investment. Then identify the correct statement
A. When saving > investment, there exist net capital inflow
B. When saving < investment, there exist net capital outflow
C. When saving = investment, we are net lenders in world financial markets
D. When saving > investment, we are net borrowers in world financial markets
E. When saving < investment, NX are negative and we have a trade deficit
5. One is not the tools of analyzing SR fluctuations in macroeconomics?
A. IS curve D. AD - AS model
B. LM curve E. Mundell-Fleming model
C. IS-LM model F. None of the above
6. Identify wrong statement about Mundell-Fleming model
A. It states short-run relationship b/n output, rate of interest, and exchange rate.
B. Under floating exchange rate system; monetary policy proves more effective.
C. Under a fixed exchange rate system ;fiscal policy is efficient
D. The model is an open economy version of the IS-LM Model.
E. Short run Equilibrium of conventional (closed economy) IS-LM and M-F
model relates the two important variables, income and interest rate
F. None of the above
4. The National income accounts identity in an open economy b/n saving and
investment is given by the model: NX = S – I where NX is net export, S is saving
and I is investment. Then identify the correct statement
A. When saving > investment, there exist net capital inflow
B. When saving < investment, there exist net capital outflow
C. When saving = investment, we are net lenders in world financial markets
D. When saving > investment, we are net borrowers in world financial markets
E. When saving < investment, NX are negative and we have a trade deficit
5. One is not the tools of analyzing SR fluctuations in macroeconomics?
A. IS curve D. AD - AS model
B. LM curve E. Mundell-Fleming model
C. IS-LM model F. None of the above
6. Identify wrong statement about Mundell-Fleming model
A. It states short-run relationship b/n output, rate of interest, and exchange rate.
B. Under floating exchange rate system; monetary policy proves more effective.
C. Under a fixed exchange rate system ;fiscal policy is efficient
D. The model is an open economy version of the IS-LM Model.
E. Short run Equilibrium of conventional (closed economy) IS-LM and M-F
model relates the two important variables, income and interest rate
F. None of the above
7. If the real exchange rate is high, foreign goods are relatively ____,
and domestic goods are relatively _____(Expensive Vs cheap)
8. If the real exchange rate is low, foreign goods are relatively ____,
and domestic goods are relatively ______ (Expensive Vs cheap)
9.When ε is relatively low, Ethiopian goods are relatively inexpensive
and we can ______(import more or export more?)
10. At higher real exchange rate, domestic goods are relatively
____and nations import more. (Expensive, cheap)
11. Suppose 1kg coffee costs 8USD in USA but 300 birr in Addis
Ababa. If the nominal exchange rate is 1USD = 50 birr, then compute
the real exchange rate.
12. Suppose the current exchange rate in Ethiopia is 1USD = 53 birr
a) Write foreign currency per unit of domestic currency
b) Write domestic currency per unit of foreign currency

MA Chapter 4 For Exit Exam

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CHAPTER FOUR

Aggregate Demand in the Open Economy

Net capital outflow Trade balance/Net export

Exports > Imports Exports = Imports Exports < Imports

Net Exports >0 Net Exports = 0 Net Exports < 0

Y>C+I+G Y=C+I+G Y<C+I+G

Saving > Investment Saving = Investment Saving < Investment

Exercise: Suppose an Ethiopian shoes costs birr 2000 and a similar

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