Chapter 4. Model of the Open Economy

4.1 Section Title

Macro Models

Quiz

You must watch the entire tutorial before you can take the quiz.

The Open Economy

Question The Open Economy

EaqZ0uv2TnY3iJUxMRb5eI/ftlYrosGEVXlUWrq0myIvKiF+vkIbQ2/KE+N4JqncmETr3x7NfUcTt9GDBqB+8ERCrCSr+4Dwaq/PLn9YSFF8MWkLHYoQCASTHFuFroBS3Ea/jVTDbKpHYQX74jEXAxEptMaUd01QwIPSRIK2oFUTKRaXPqaGc+R3SrY2j+rNXTbv2EE8M3oGm34uBAWHbp04OcTji8LG6JbrdJ0paBghfCD3s4Rci89ON5fjqfFH1cZRtOSLAPFuuEd0SeWsdN4/BiYQcEM9rtFsZw2Rhw5v7rc7u1SGvhxAyHTvWWkekJUuWAxSMjyy73K342H+UpNC4Jnzcp4ZNvXsKzWbiRngsGHFRREW5cTcGEBZ9EryRutc5GxiClk=

In an open economy Y = C + I + G + NX, national saving (S) is defined as Y – C – G and therefore S = I + NX. Mathematically, if national saving (S) is greater than investment then net exports are greater than zero. Conceptually, the extra saving will flow out of the country, causing the real exchange rate to fall, and net exports to rise. In a small open economy, the interest rate is equal to the world interest rate.

Question Model of the Open Economy

DcoFLjQwFUeRkAtwEw1y3pNr9yvBB5t2aqbFbVhNpZaLRwTXCI9sVTL8ua3/jgZ569rnw8yChEdaADjlbqt+MtCbHUtcAqWQR3f7EPvANXxxGTJWzBqKonvS8B26jri6UfA9oURDaWX+AqMn7SP4LBtXBotyNhmoK9efo6RwCH5W8viIg2XP1vavKZhk4D00Y9zv6DO5E0wNhV9/qvNcTTUnwLZUkTkseTBkxgjtAdIRcScwjCCYnprL/rK5Je+AgQjzE7JGr7Fxy4GTfljtk+BjBgMJjT0fLZSoBvcUlXN+gKX+UkhU/KQ1C3YXxA+Aq6SrR2DJp4Rsab6Z5Ga1Oc5jMJ5SGaw+EEbrjaDzkGEzvL0thQHKZq/H9U51ds5jvhXfrLFQIIxXJtxf

In a small open economy the interest rate is equal to the world interest rate. If the level of saving falls then this will create a shortage of funds and put upward pressure on the interest rate. To rebalance and keep the interest rate equal to the world interest rate, funds will flow into the country. This increases the demand for the currency, causing the real exchange rate to rise. The increase in the real exchange rate causes exports to fall, imports to rise, and net exports to fall.

Question Model of the Open Economy

1wj2NIJnyxLIJVbGyXI1WSkNbqTi8W/YSFqgTV6fIN7a7rHsZ066Kuz144SfHqZleoUNhh/TvibfOodu1ikqLfp28nvtwF84TDyGSDoSmrq0Cf2sM1Ml8lZ7pgkLt8R90/j42co3tbHejrrhF+o0gt3VtjNUKZ4v3eVg+xpF2zLKVZ3CmWoFn7EBZsFoupDhH5t1s59NHUu0n6YWY8Vg1qvD4Q21BlhNi93fRDdDZ3muf6OOLY4bCQDYkLeaSRH+tdE+SlmuMwrTw6phMqdlS27VdZuNcbshIWOuXBxTCD1CvwrDxqUozobLVYT7c40eAcg76ewPWxEYYYJD8UDQdbvWcwyKzC8SpOzgOb3Qnc6tYySDgqfYQRTqizcgLFNvcAPxaqhvxf+cMioV4TgMpOLitqeQMvqBwuqZvje4tyg3Yutb8ucKiH6g3gPWtFRW0eHFng==

In a small open economy the interest rate is equal to the world interest rate. Since the world interest rate does not change, the level of investment spending will not change. As the government decreases spending and/or increases taxes in order to balance the budget, this will increase public saving and therefore national saving. The increase in saving will create a surplus of funds and put downward pressure on the interest rate. To rebalance and keep the interest rate equal to the world interest rate, funds will flow out of the country. This decreases the demand for the currency, causing the real exchange rate to fall. The fall in the real exchange rate causes exports to rise, imports to fall, and net exports to rise.

Question Model of the Open Economy

A0hm4xDe3uqngh4rZvHb6VY84+6XqMKf9hmUmTISun6LsG3bRwh8htR9jsncbLUYaPjIw9oul8BLpzrhfvFoaBGlOWODV9bsuisCi3jW4vq7WH1d0/CiCY3hTussCyrxEyalEs7EWjs9GrwDj1+5v8RUxM2meTxcUttuTaw3tn2VQz4IpdKmjdIkvfQZT4jfV4Kdb/nAX6SztWY3d78g3v10asMRm1FV+8V/CQ+XLfMmkLZfCpfHgOIJBL7Z1Pajhns5nN2vzY/GRScZ2Tk1aP36igAUpoHYmO+OcQsVh8fKAQn4/MbHtEAZ1B6KPQFlBvUGv3Subr3ws0qklgzX6t0+czt4FnNEctaV2Q==

The increase in the world interest rate will cause funds to flow out of the country to take advantage of the higher world interest rate. Funds will flow out of the country until the interest rate in the country is equal to the new higher world interest rate. As funds flow out there is a decrease in the demand for the currency and the real exchange rate will fall. The higher interest rate will reduce investment spending.