SAVING AND INVESTMENT IN A SMALL OPEN ECONOMY
IN THE LONG RUN
As we have observed the U.S. economy since the 1960's has increasingly become a more open economy. Moreover, due to its size, its major impact on world financial markets and the role of the U.S. dollar as the world's major reserve currency, it is a dominant large open economy. A large open economy is one that can influence its domestic interest rates, has a substantial impact on world markets and, in particular, on the world interest rate. In contrast, small open economy takes its interest rate as given by world financial markets, and by virtue of its size, has a negligible impact on world markets.
A model of a Small Open Economy in the Long Run.
The U.S. is clearly a large open economy. Nevertheless, we find it useful to begin (as if often the case in constructing economic models) with the somewhat simpler small open economy case.
We can the utilize the insights gained to develop the large open economy model.
Moreover, we will find that although the U.S. is not a small open economy, it will provide approximately the correct answer as to how government policies affect the trade balance, exchange rates, and the level of output.
We begin by restating the national income accounts identity:
Y = C + I + G + NX
And recall that by algebraic manipulations it can be written as:
S-I =NX
Let us now develop a long run small open economy model that reflects this relationship between saving and investment (net foreign investment) and net exports (the trade balance).
The model makes the following assumptions:
1.
We are dealing with a small open economy
2.
There is perfect capital mobility. The government does not impede international lending or borrowing. Residents have full access to world financial markets.
3.
The interest rate in a small open economy equals the world interest rate r*.
The equilibrium of world saving and investment determines the world interest rate.
The model further assumes:
1.
Y = YF(K,L). The output Y of the economy is fixed by the factors of production and the production function.
1

2.
C = (Y-T). Consumption is positively related to disposable income Y-T.
3.
I = I (r*). Investment is negatively related to the interest rate.
4.
NX = (Y-C-G) - I
NX = S-I
Substituting the above three assumptions into number 4:
NX
NX

[ Y

S

C ( Y

I ( r *)

T )

G ]

I ( r *)
The equation shows what determines saving and investment and thus, the trade balance. Budgetary fiscal policy determines saving. High government expenditures and low tax rates result in sizeable deficits (G-T) and lower national saving. Lower government expenditures accompanied by higher tax rates yield budget surpluses and raise the level of national saving. Investment depends on the world interest rate r*. High interest rates decrease the number of profitable projects; low rates increase the number of profitable projects. The Trade Balance NX is determined by the difference between saving and investment at the world interest rate -- see Figure 8-2.
Government Policies and the Trade Balance.
Assume the economy begins with balanced trade: NX = O and S = I. What would be the effects of government fiscal policy at home and abroad? First, let us examine the impact of increase government purchases to expand domestic spending as follows:
1.
The increase in G reduces national saving since S = Y-C-G.
2.
With an unchanged world interest rate I remains the same. Thus, S falls below I and some investment must be financed by borrowing from abroad.
3.
Since NX = S-I, the decline in S implies a reduction in NX. The economy now has a trade deficit.
A decrease in taxes has the same effects although its overall impact on national saving is somewhat muted since a portion of the tax cut finds its way into private saving - see Figure 8-3. Thus, starting from balanced trade a fiscal policy that reduces national saving leads to a trade deficit.
Let us now examine what occurs when foreign governments increase their government purchase. If these countries are a small part of the world economy these changes have a negligible impact on other countries. However, if these foreign countries are a large part of the world economy, their increase in government spending reduces world saving and causes the world interest rate to rise. This in turn, reduces investment in the domestic economy. With no changes in domestic saving, saving S now exceeds investment I. Since NX = S-I, the reduction in I must also increase NX - the trade balance. Thus, fiscal expansion abroad, which increases the world interest rate, leads to a trade surplus - see Figure 8-5.
2

A change (shift) in the investment schedule (curve) in the domestic economy will also affect the trade balance. Assume that a change in the tax law, which provides an investment tax credit, shifts the investment curve (to the right). At a given world interest rate investment is now higher. Since saving is unchanged, increased investment must be financed by borrowing from abroad. Since NX = S-I, the increase in I leads to a decrease in NX. An outward shift in the investment schedule causes a trade deficit - see Figure
8-6.
SAVING AND INVESTMENT IN A LARGE OPEN ECONOMY
IN THE LONG RUN
We begin as we did in the small open economy with the relationship between saving and investment and net exports:
S-I=NX
We recall that S-I is called net foreign investment (NFI).
It is the amount that domestic investors lend abroad minus the amount that foreign investors lend to the U.S.
It may be positive or negative.
In a small open economy, investment (capital) flows in and out of a country freely at a fixed world interest rate. In the large open economy model the interest rate r is largely a function of the domestic economy and central bank monetary policies. If a nation's interest rate is higher than those available abroad for investments of comparable risk, then domestic investors will favor securities in their home country. The higher the interest rates one can earn domestically, the less attractive will be investment abroad.
Investors overseas will act in a similar manner. They also have a choice between domestic and foreign investments. The higher the interest rate in their home country, the less they will be investing in the U.S. and other foreign countries. Conversely the lower the interest rate in their own country the more they will favor overseas investments.
Thus, net foreign investment is negative related to the domestic interest rate r. As the domestic interest rate rises, less U.S. savings flow abroad and larger amounts of foreign capital funds flow to the U.S.:
NFI=NFI(r)
The equation states that net foreign investment is a function of the domestic interest rate.
NFI varies inversely with r. As r rises, NFI declines and as r declines, NFI increases.
Note that NFI can be either positive or negative depending on whether the economy is a lender (has a NX surplus) or a borrower (has a NX deficit) in a world financial markets - see Figure 8-15.
A model of a Large Open Economy.
We can now proceed to develop the model for a large open economy. To do so we need to consider two markets: the market for loanable funds and the market for foreign exchange.
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The Market for Loanable Funds.
An open economy’s saving is used in two ways: to finance domestic investment and to finance net foreign investment. Thus we rewrite the national income identity as follows:
S = I (r) + NFI(r)
The interest rate equilibrates the supply of loanable funds (saving and the demand for loanable funds (domestic investment and net foreign investment) see Figure 8-17.
The Market for Foreign Exchange.
Next we consider the relationship between net foreign investment and the trade balance. We have observed previously that the national income identity can be expressed as:
NX = S – I
Since the trade balance (NX) is a function of the exchange rate and NFI = S – I we can state:
NX(

) = NFI
The real exchange rate

is the price that equilibrates the trade balance and net foreign investment – see Figure 8-18.
Lastly, we need to recall that the nominal exchange rate e is equal to the real exchange rate

times the ratio of the price levels in the foreign countries and the home country: e =

X P* / P
Government Policies and the Trade Balance.
We are now in a position to determine how economic policies influence a large open economy. To do this we need to utilize a three-step process:
1.
how the market for loanable funds determines the equilibrium interest rate;
2.
how the interest rate determines the amount of net foreign investment, which in turn determines the supply of dollars to be exchanged into foreign currency; and
3.
how the real exchange rate adjusts the supply of dollars and the demand for dollars emanating from net exports – see Figure 8-19.
Fiscal Policy at Home.
A policy of fiscal expansion – an increase in government expenditures or a reduction in taxes reduces national saving, thereby reducing the supply of loanable funds and raising the equilibrium interest rate. The higher interest rate reduces both domestic investment I and net foreign investment NFI. In turn, the decline in NFI decreases the supply of dollars causing the exchange rate to rise (appreciate). This in turn causes net exports to fall and a resulting trade deficit – see Figure 8-20.
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A fiscal contraction by reducing government expenditures or raising taxes, increases savings and thus will cause the exchange rate to fall (depreciate) and net exports to rise.
Note that the impact of fiscal policy in a large open economy combines the impact of the closed economy with that of a small open economy. As in the closed economy, a fiscal expansion reduces saving, causing interest rates to rise and crowding out investment. As in the small open a fiscal expansion causes a rise in the exchange rate and a trade deficit.
Shifts in Investment Demand.
Assume that the government institutes an investment tax credit, which shifts the investment demand schedule outward. The demand for loanable funds increases, causing a rise in the interest rate. The higher rate reduces net foreign investment as we make fewer loans abroad and foreigners invest more here. The decline in net foreign investment reduces the supply of dollars in the foreign exchange market causing the exchange rate to rise and net exports to fall – see
Figure 8-21.
Trade Policies.
Protectionist policies such as increases in tariffs or the imposition of import quotas reduces the demand for imports causing an outward shift in the net export schedule. Since the market for loanable funds is unaffected the interest rate is unchanged as is foreign investment. The shift in the net export schedule causes the exchange rate to rise. The rise in the exchange rate makes U.S. goods more expensive relative to foreign goods causing exports to fall and imports to rise. Thus, negative trade restrictions do not change the trade balance – see Figure 8-22.
Shifts in Net Foreign Investment.
Changes in fiscal policy abroad may also affect the exchange rate and net exports. A European Union (EU) policy decision to reduce government deficits would increase the saving of the euro zone countries. This would cause a decline in the interest rate in EU counties and stimulate euro nations lending to the U.S. causing net foreign investment to decline. The exchange rate would appreciate and net exports would fall – see Figure 8-23.
THE IMPACT OF GOVERNMENT POLICIES IN A SMALL OPEN ECONOMY
IN THE SHORT RUN UNDER FLOATING AND FIXED EXCHANGE RATE
SYSTEMS
THE MUNDELL FLEMING MODEL
We now turn our attention to the short run. Again we begin with a small open economy. The principal paradigm for analyzing the impact of government policies in the short run is the Mundell-Fleming model. Robert Mundell and J. Marcus Fleming were economists at the International Monetary Fund in the 1960’s. They extended the
Keynesian closed economy IS/LM model to predict the impacts on monetary, fiscal and trade restriction policies under floating vs. fixed exchange rate systems. Robert Mundell was the 1999 Nobel Laureate in Economic Science. In addition to the Mundell-Fleming
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model he was recognized for his work on optimal currency areas. The latter research has been influential in moving the European Union to a common currency. Indeed, he is referred to as the “euro godfather”.
The Mundell-Fleming Model. The model has the following characteristics:
1.
Like the closed economy IS-LM model, it initially assumes that the price level is fixed.
2.
Also, like the closed IS-LM model it shows the interaction between the goods market and the financial (money) market.
3.
It shows that the behavior of an economy depends on the exchange rate system it has adopted.
4.
It begins by assuming a floating exchange rate system – the nation’s central bank allows the exchange rate to adjust to changing economic conditions.
Components of the Model.
The Mundell-Fleming model is comprised of the following equations:
1. IS*: Y = C(Y-T)+I(r)+G+NX(e)
This equation is quite familiar to us. It describes the goods market (IS).
Income/Output Y is the sum of consumption, investment, government purchases and net exports. Net exports depend negatively on the exchange rate e. The exchange rate is the price at which a home currency can be exchanged for a foreign currency. NX, net exports, depends negatively on the exchange rate e.
The lower the exchange rate the less expensive domestic goods are relative to foreign goods and thus the greater net exports are. The higher the exchange rate the more expensive domestic goods are relative to foreign goods and thus the smaller net exports are. In actuality, while net exports do respond to changes in exchange rates, the response may be slow. Note that the Mundell-Fleming model does not distinguish between real and nominal exchange rates. Since the model assumes prices are fixed, changes in the real exchange rate are proportional to changes in the nominal exchange rate.
2. LM* M/P = L(r,Y)
This equation describes the money market. It states that the supply of real money balance M/P equals the demand L(r,Y). The demand for real money balances depends negatively on the interest rate and positively on income. The money supply M is an exogenous variable controlled by the Federal Reserve.
3. r = r*
In graphing the model we label equation 1 as IS* and equation 2 as LM* to indicate that we are holding the interest rate constant at the world interest rate r*.
The LM* curve is vertical because the exchange rate does not enter into the LM* equation. Given the world interest rate, the LM* equation determines aggregate income regardless of the exchange rate. Figure 12-2 shows how the LM* curve is derived from the world interest rate and the LM curve. The IS* curve slopes
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downward because a high exchange rate lowers net exports and thus lowers aggregate income. Figure 12-1 shows how IS* is derived fro the net export schedule and the Keynesian cross. The intersection is IS* and LM* determines the exchange rate and the level of income – see Figure 12-3.
Floating Exchange Rates.
The model begins by examining the impact of government policies operating with a floating exchange rate system. It is a system where exchange rates are determined by conditions of demand and supply in the foreign exchange market and therefore are allowed to change on a daily basis. It is sometimes referred to as a flexible exchange rate system. Most major economies today utilize a floating exchange rate system.
If the government stimulates the domestic economy by increased purchases or lower taxes – fiscal policy – under the aegis of floating exchange rates, the IS* curve is shifted to the right causing the exchange rate to rise, but leaving output unchanged – see
Figure 12-4. Contrast this result with that which occurs in a closed economy. In the latter case fiscal expansion raises output. However, in an open economy the increase in government expenditures or lower taxes reduces national saving causing net foreign investment to fall and exchange rate to appreciate. This increase in the exchange rate reduces net exports offsetting the expansion in domestic demand for goods and services, thus leaving output unchanged. Another way to understand the difference between an open and a closed economy is to look at the equation describing equilibrium in the money market: M / P = L(r,Y). The supply of real money balances M / P is fixed and the demand must always equal the fixed supply. In a closed economy an expansionary fiscal policy raises the interest rate allowing income to rise. In an open economy, r is fixed at r* so there is only one level of income that can satisfy the equation. The appreciation of the exchange rate and the fall in net exports must be exactly large enough to fully offset the expansionary impact of fiscal policy.
If the Federal Reserve increases the money supply – monetary policy – since the price level is assumed to be fixed the increase in M means an increase in real balances.
This shifts LM* to the right and increases income and lowers the exchange rate – see
Figure 12-5. The effect on the level of income is the same as in a closed economy but the mechanism is different. In a closed economy the lower interest rate stimulates investment. In an open economy the interest rate is fixed by the world interest rate. As soon as the increase in M puts downward pressure on the domestic interest rate capital flows out of the economy seeking higher returns abroad. This capital outflow prevents the interest rate from falling and lowers the exchange rate. The fall in the exchange rate makes domestic goods inexpensive relative to foreign goods, which stimulates net exports. Thus the change in Y is due to the exchange rate rather than the interest rate.
If the government reduces the demand for imported goods by imposing an import quota or a tariff – trade policy – the net export schedule is shifted to the right. This moves the LS* curve to the right causing the exchange rate to rise and leaving the level of income unchanged – see Figure 12-6. A stated goal of these protectionist policies is to raise net exports and thus alter the trade balance. However, since a trade restriction does
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not affect income, consumption, investment or government purchases it cannot affect the trade balance: NX(e) = Y-C(Y-T)-I(r)-G. While the shift in the net export schedule tends to raise NX, the increase in the exchange rate raises the price of domestic goods relative to foreign goods leading to less exports, which offsets the decline in imports. These changes do, however, affect the volume of world trade since both exports and imports are reduced. This reduction in international trade is the reason why economists oppose protectionist policies. In June of 1995 the Clinton administration threatened to impose punitive tariffs on luxury Japanese cars imported in the United States if Japan did not agree to specific steps to open its markets to U.S. car parts. On hundred prominent economists petitioned the federal government not to take this action since it would reduce the world trade.
Fixed Exchange Rates.
Floating exchange rates appeal to those who believe in allowing the market system to operate with minimal interference from the government.
More importantly, as we shall see, unlike a fixed rate system they allow monetary policy to be utilized for purposes other than marinating a fixed exchange rate. However, floating exchange rates create uncertainty and in some instances significant volatility in exchange rates and thus add to the already complex character of international transactions. For these reasons the major industrial nations have historically favored fixed exchange rates.
A fixed exchange rate system is one where exchange rates are set at officially determined levels and are changed only by direct government action. The central bank is given the responsibility of maintaining the fixed exchange rate levels. For example, assume the U.S. and Japanese governments agree to fix the exchange rate of the dollar and yen at 100 yen to the dollar with a 2 per cent band above and below the official rate
(par rate of exchange). Thus, in the case of the U.S. the Federal Reserve would stand ready to buy or sell yen at 100 yen to the dollar any time the exchange rate rose above
102 yen to the dollar or below 98 yen to the dollar. Assume, for example, the exchange rate rose to 103 yen, arbitrageurs would buy yen in the foreign exchange market receiving 103 yen for each dollar. They would sell the yen to an agent of the Fed at the official rate of 100 yen to the dollar thus pocketing the difference. The Fed would pay the arbitrageurs with checks drawn on itself which when they were deposited in the banking system would add to the money base and thus increase the money supply. This would cause the LM* curve to shift to the right lowering the equilibrium exchange rate to its official fixed level – see Figure 12-7(a). Conversely, if the yen/dollar rate fell below
97-yen arbitrageurs would buy yen from the Fed at the official rate of 100 yen for each dollar. They would then sell the yen in the foreign exchange market at the going rate below 98 yen to the dollar, yielding a profit on the spread between the official and market prices. Arbitrageurs would pay for the yen from the Fed with checks drawn on demand deposits with commercial banks. When these checks were cleared, the banking system would lose reserves. This decline in the money base would cause the money supply to fall triggering a shift in the LM* curve to the left which would raise the equilibrium exchange rate to the fixed level – see Figure 12-7(b). As we shall see a fixed exchange rate system virtually eliminates monetary policy as a domestic stabilization tool. It also
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protects the economy form any significant inflation since increases in the money supply are restricted to maintaining the official fixed exchange rate.
Let us now see how government polices under a fixed exchange system impact the level of output. If the government decides to stimulate the domestic economy by higher spending or lower taxes – fiscal policy – this causes the IS* curve to move to the right resulting in an increase in the exchange rate. To maintain the fixed rate the Fed must increase the money supply and shift the LM* curve outward as well. This will keep
(restore) the exchange rate at its announced level. It will also increase the equilibrium level of income. This is in contrast with a floating exchange rate system where fiscal expansion had no impact on Y – see Figure 12-8. If the central bank wishes to stimulate the domestic economy by increasing the money supply ( monetary policy ) this will cause the LM* curve to shift outward. This will result in decreasing the equilibrium exchange rate. However, the Fed is committed under a fixed exchange rate system to buy and sell foreign currencies at a fixed rate. Arbitrageurs will seize the profitable opportunity and sell dollars to the Fed causing the money supply to contract and shifting the LM* curve back to its original position, thereby negating the effort to stimulate the domestic economy. Thus, the central bank by agreeing to maintain a fixed exchange rate gives up its control over the money supply – see Figure 12-9.
A country can, however, practice a type of monetary policy by changing the level at which the foreign exchange rate is fixed. A reduction in the value of a currency is called a devaluation, and an increase is called revaluation. In the Mundell-Fleming model, a devaluation acts just like an increase in the money supply under a floating exchange rate system. It shifts the LM* curve to the right which lowers the exchange rate. This causes net exports to increase, which raises the level of income. Conversely, a revaluation shifts the LM* curve to the left, raises the exchange rate and lowers the level of income – see Figure 12-10.
If the government seeks to reduce imports by imposing an import quota or tariffs
( trade policy ) the impact will be to shift the net export schedule to the right which in turn shifts the IS* curve to the right and raises the exchange rate. To keep the rate at the fixed level the money supply must rise, shifting the LM curve to the right thereby maintaining the fixed exchange rate and causing output to rise. This result is significantly different than trade restraint under a floating exchange rate system. Under a fixed exchange rate a tariff or import quota raises aggregate income. It also raises net exports. In contrast in the case of floating exchange rates neither income nor net exports are increased.
INTEREST RATE DIFFERENTIALS AND CHANGES IN THE PRICE LEVEL
IN A SMALL OPEN ECONOMY
Interest Rate Differentials in the Mundell-Fleming Model.
In the ideal small open economy where the law of one price prevails a country’s interest rate is equal to the world interest rate r*. If the domestic interest rate were above the world rate, investors from abroad would lend to that nation driving down the domestic interest rate.
Alternatively, if the nation’s interest rate were below the world interest rate domestic
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investors would lend abroad to secure higher returns, thereby driving up the national interest rate. Thus, the country rate would stabilize at the world interest rate.
This paradigm assumes a universal fixed exchange rate system such as existed under the international gold standard and the Bretton Woods Agreement. It also assumes that the foreign country where the domestic funds are invested is stable socially and politically. In effect, there is zero country risk.
Where one or both of these conditions do not prevail then lenders will require an interest rate differential. In these cases the interest rate of a small open economy can differ from those of other nations. In the case of possible exchange rate fluctuations assume that the lending country i.e. the U.S. expects the borrowing nation's currency to decline relative to its own. If this occurs interest payments and repayment of principal will be paid in less valuable a currency than investments made domestically. This was the case in the first half of 1999 for U.S. loans made to European Monetary Union countries denominated in euros. The initial euro/U.S. dollar exchange rate at the euro's inception on January 1, 1999 was $1.18. By the early summer it was approaching parity with the dollar. The expectation was that further declines in the euro/dollar exchange rate were likely. Accordingly, U.S. purchases or euro denominated bonds required an interest rate differential to protect them from this possibility.
Similarly, domestic lenders who make foreign investments at the world interest rate assume that the social and political conditions in the borrowing country are stable.
There is virtually little, if any, chance that interest and principal will not be paid according to the terms of the loan contract. However, in the case of less developed nations where there is a possibility of social or political upheaval, lenders require an interest rate differential to compensate them for the country risk.
To incorporate interest rate differentials into the model we assume the small open economy's interest rate is determined by the world interest rate plus a risk premium:
R = r* +

The risk premium is a function of the expected change in the real exchange rate and the perceived country risk. The risk premium (differential) is assumed to be exogenous to the model. We can thus rewrite the model as follows:
IS*: Y = C(Y-T) + I(r* +

) + G + NX (e)
LM*:M/P = L(r* +

, Y)
For any given fiscal policy, monetary policy, price level and risk premium, these equations determine the level of output and the exchange rate that equilibrates the goods market and the money market.
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Given an initial equilibrium any fiscal, monetary or trade policy or risk premium changes will cause an adjustment in the output level and the exchange rate. For example, assume that economic conditions in the European Monetary Union countries worsen causing the risk premium to increase. This leads the domestic interest rate r to rise. The higher interest rate impacts both the IS* and LM* curves. The IS* curve shifts to the left since higher interest rates reduce investment expenditures. The LM* curve shifts to the right because higher interest rates reduce the demand for money, allowing a higher output level for any given money supply. These shifts cause the exchange rate to decline
(depreciate). In turn the lower exchange rate makes foreign goods more expensive and domestic goods cheaper causing imports to fall and exports to rise. The resulting increase in net exports more than offsets the decline in investments allowing the level of output to rise -- see Figure 12-11.
CHANGES IN THE PRICE LEVEL
We need to make one further adjustment in the Mundell-Fleming model to bring it closer to the real world. Thus far we have assumed that prices in the short run are fixed. Although there are some short run prices which exhibit this behavior, most are subject to change. As we have done previously when there are price level changes we must distinguish between nominal and real values. Earlier we observed that the real exchange rate

is equal to the nominal exchange rate e times the ration of the price levels in the domestic and foreign countries P/P*.
In this context the Mundell-Fleming model equations are as we have seen them before:
IS*: Y = C(Y-T) + I (r*) + G + NX (

)
LM*: M/P = L(r*,Y)
Note that net exports depend on the real exchange rate

.
We can now examine the impact of changes in the price level. To do this we utilize the analysis used in the IS/LM closed economy context. Assume the price level falls. The lower price level raises the level of real money balances M / P causing the
LM* curve to shift to the right. This in turn reduces (depreciates) the real exchange rate and increases the level of output - see Figure 12-12 panel (a).
We can now derive an aggregate demand function for a small open economy with a changing price level. Figure 12-12 panel (a) demonstrates that there is a negative relationship between the price level and the quantity of output demanded. By extending the two equilibrium points in Figure 12-12 panel (a) to the relationship between the price level and the level of income we can construct an aggregate demand curve - see Figure
12-12 panel (b). Thus, the Mundell-Fleming aggregate demand curve is similar to that of the IS/LM closed economy model. Policies that raise income in the Mundell-Fleming
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model shift the aggregate demand curve to the right while policies that lower income, shift it to the left.
We can now extend this analysis to show how the short-run Mundell-Fleming model is related to the long run in an open economy. You will observe that it is basically the same analysis utilized in the closed economy context.
We assume initially that short-run prices are fixed. This is shown in Figure 12-
13. Panel (a) indicates that prices are fixed at LM* (P
1
). Point K is the equilibrium point where aggregate supply intersects aggregate demand and equilibrates the exchange rate and the level of output. This level of output is below the natural level Y . The resulting increase in unemployment and decline in consumption demand causes workers to reduce their wage rates and producers to lower the price of their goods, causing the price level to fall over time. The decline in the level of prices shifts the LM* curve to the right. This in turn lowers the real exchange rate causing net exports and the level of income to rise.
At the new equilibrium Point C, the economy is operating at its long run natural equilibrium -- see Figure 12-13 panel (b).
THE IMPACT OF GOVERNMENT POLICIES IN LARGE OPEN ECONOMY IN
THE SHORT RUN
A Model of a Large Open Economy in the Short Run. As was the case in the long run the major difference between a large and small open economy is that interest rate is not fixed by the world financial market. Net foreign investment is a function of the domestic interest rate: NFI = NFI (r). NFI varies inversely with r.
Utilizing the Mundell-Fleming model we can now construct a short run large open economy model of national income. The equations are:
Y = C(Y-T) + I (r) + G + NX(e)
M/P = L(r,Y)
NX(e) = NFI(r)
The first two equations are the same as the small economy model. The third is a restatement of the national income identity that: S - I = NX, where S - I = NFI. NX is a function of the exchange rate e and NFI is a function of r.
By substituting the third equation into the first we can derive the IS and LM equations for a large open economy in the short run:
IS: Y=C(Y-T) + I(r) + G +NFI (r)
LM: M/P = L(r, Y)
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The two equations are similar to those of a closed economy IS/LM model except that the level of expenditures in the goods and service market is now dependent in part on net foreign investment. Higher domestic interest rates not only reduce investments, but net foreign investments and net exports as well. Lower interest rates have the opposite effect.
To see how this model functions we use a three step process:
1.
The IS and LM curves determine the equilibrium interest rate and the level of income;
2.
The interest rate determines the level of net foreign investment;
3.
Net foreign investment and the net export schedule determine the exchange rate- see Figure 12-14. Note that the IS curve is flatter than in the closed economy model. This is due to the net foreign investment term. The more responsive NFI is to the interest rate r the flatter the IS curve is.
Government Policies under a Floating Exchange Rate System.
We can now utilize the model to determine the impact of government policies. Unlike the small open economy model we need only to examine the case of floating exchange rates since most large economies such as the U.S. utilize this exchange rate system.
Let us first look at fiscal policy . A policy of fiscal expansion -an increase in expenditures or a reduction in taxes, shifts the IS curve outward. This causes the level of income and the interest rate to rise. The higher interest rate causes a reduction in net foreign investments which in turn reduces the supply of dollars in the foreign exchange market. The exchange rate rises, causing domestic goods to become more expensive relative to foreign goods and results in a decline in net exports -see Figure 12-15.
Note that as in the long run, the impact of fiscal policy in a large open economy combines the impact of the closed economy with that of a small open economy. As in the closed economy fiscal expansion does cause the level of income to rise unlike the small open economy with floating exchange rates where income is unchanged. However, the increase in income is smaller than in a closed economy. In a closed economy the expansionary force of fiscal policy is partially offset by the crowding out of investment reducing the fiscal policy multiplier. In a large open economy there is an additional dampening influence on the rise in the income level. The higher interest rate also reduces net foreign investment causing the exchange rate to appreciate. This in turn reduces net exports which lowers the level of income. Combined, these effects do no completely neutralize the effects of fiscal expansion but they do reduce its impact.
An increase in the money supply (monetary policy) shifts the LM curve to the right causing the income level to rise and the interest rate to fall. This causes net foreign investment to increase, which raises the supply of dollars in the foreign exchange market.
In turn as the exchange rate depreciates domestic goods become cheaper relative to foreign goods, net exports rise lending to an increase in the level of income -see Figure
12-16.
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Note, once again the result is an average of the closed economy and the small open economy models. In a closed economy a monetary expansion lowers the interest rate and raises the level of income. In a small open economy since the interest rate is fixed by the world interest rate, the domestic interest rate is unchanged. As soon as increases in the money supply puts downward pressure on the domestic interest rate capital (dollars- flows out of the domestic economy seeking higher interest rates abroad.
This in turn stimulates net exports. The large open economy's response to a monetary expansion includes both the lower interest rate of a closed economy and the depreciation of the foreign exchange rate of the small open economy.
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