MACROECONOMIC 2

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Week6StudentSlidesTopic4The4SectorsoftheEconomy-ExternalandAllMelb1.pptx

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The 4 Sectors of the Economy- Adding the External Sector (AE Model)

Topic 4 (Part 4)

The External Sector

(X - M) = net exports

Exports (X) are domestically produced goods and services that are sold overseas.

Imports (M) are foreign produced goods and services that are sold domestically.

The Exchange Rate

The foreign exchange rate for a nation’s currency is the amount of one nation’s money that can be obtained in exchange for a unit of another nation’s money. There are two ways in which it can be expressed:

Units of foreign currency per domestic dollar.

Example: e´ = 0.62€/$ = Value of the Dollar

If the e increases, we are receiving more foreign currency per dollar, the dollar has appreciated.

Units of domestic dollars per unit of foreign currency.

Example: $1.62/€ = Value of the Euro/foreign currency

If the e increases, we are paying more dollars to receive one unit of foreign currency, the dollar has depreciated.

The dollar is said to appreciate (depreciate) if the value of the dollar rises (falls) relative to another currency.

Market for Foreign Exchange

Why do people want AUD dollars?

To buy Australian goods and services  Australian exports lead to D$↑

To buy Australian-denominated financial assets  capital inflows lead to D$↑

For the convenience and of holding AUD  D$↑

Why do people sell Australian dollars?

To buy foreign currencies to buy foreign goods  Australia imports lead to S$↑

To buy foreign currencies to buy foreign $-denominated financial assets  capital outflows lead to S$↑

What determines slopes of D$ and S$?

Price elasticity of foreign demand for Australian X  D$ slope

Price elasticity of Australian demand for (foreign) M  S$ slope

Exchange Rate Market

D0 (exports, capital inflows)

S0 (imports, capital outflows)

Changes in Exports and Imports

DAUD0

Quantity

Exchange rate

SAUD

DAUD1

DAUD

Quantity

Exchange rate

SAUD1

SAUD0

Increased sale of uranium and other natural resources

Increased tariffs on imports to protect domestic industry

Shifts in the Exchange Rate Market

Changes in demand for Australian-produced goods and services and changes in the demand for foreign-produced goods and services (changes in exports and imports).

Changes in the desire to invest in Australia and changes in the desire to invest in foreign countries.

Changes in the expectations of currency traders about the likely future value of the dollar and the likely future value of foreign currencies.

Speculators: Currency traders who buy and sell foreign exchange in an attempt to profit by changes in exchange rates

Check Your Knowledge

A rise in domestic interest rates relative to interest rates in other countries may lead to

an exchange rate depreciation and an increase in net exports.

an exchange rate appreciation and a fall in net exports.

an exchange rate depreciation and a fall in net exports.

an exchange rate appreciation and an increase in net exports.

How Governments Can Affect Exchange Rates

To prevent its currency from being too strong, or equivalently, to make its currency more competitive, a country’s central bank can sell the home currency (and simultaneously buy foreign $)

This would encourage the country’s exports

A central bank has the ability to create an unlimited amount of its home currency  no limit to this FX intervention

To prevent its currency from falling in value, or equivalently, to protect its currency, a country’s central bank can would buy the home currency (and simultaneously sell foreign $)

Exchange Rate Systems

In a (pure) flexible exchange rate system, the foreign exchange rate is free to change every day in order to establish an equilibrium between QS and QD of a nation’s currency

In a fixed exchange rate system, the foreign exchange rate is fixed for long periods of time

Maintained by central bank purchases and sales of the nation’s currency

If the price is fixed below the equilibrium level, the central bank must exchange foreign currency for dollars to meet the excess demand and vice versa

When the CB purchases (sells) foreign currency, its holdings of foreign exchange reserves increase (decrease)

Under a fixed exchange rate system, an increase (decrease) in the value of the currency is known as a revaluation (devaluation)

Central Bank Intervention

When the central bank buys foreign currency, it is selling the domestic currency (↑MS). The domestic currency depreciates against the appreciating foreign currency.

When the central bank buys the domestic currency, it sells its holding of foreign currency (↓MS). The domestic currency appreciates against the depreciating foreign currency.

Leakages-Injections

The income accounting identity states that an economy’s income must equal its expenditures:

Y ≡ E

E = C + I + G + NX

Household income must equal household outlays:

Y + F ≡ C + S + R

Y ≡ C + S + R – F

T = R – F

Y ≡ C + S + T

Leakages-Injections Equation - “Magic Equation”

C + S + T = C + I + G + NX

 S + T = I + G + NX

Leakages-Injections and Savings

Leakages (S + T) describe the portion of total income that is not available for consumption

Injections (I + G + NX) is a term for non-consumption expenditures

To invest, a nation must save

National Saving is the sum of private (S) and government saving (T-G):

NS = S + (T – G)

Leakages-Injections: S + T = I + G + NX

Rearranging  S + (T – G) = I + NX

 NS = I + NX **OR** NX = NS - I

The Balance of Payments

The Current Account Balance (CAB):

Flow of goods and services (NX)

Net Income

Net transfers

Interest repayments

The Financial and Capital Account Balance (KAB):

Foreign investment (direct, portfolio, principle repayments)

Capital transfers

The Balance of Payments (BOP) is the record of a nation’s international transactions.

Algebraically: BOP = CAB + KAB

Trade Balance – Net Exports

GDP (Y) = C + I + G + NX

NX = Y - (C+I+G)

net exports = output - domestic spending

If output exceeds domestic spending, we export the difference; net exports are positive (NX>0)

If output falls short of domestic spending, we import the different: net exports are negative (NX<0)

Leakages, Injections and the Trade Deficit

 NS = I + NX **OR** NX = NS - I

A trade deficit may be caused by:

A fall in national savings

An increase in investment

If I>NS, then a country’s spending will be greater than its output  the only way a country can do this is to import the difference.

IM>EX  NX are negative  trade deficit

How can we Import more from Abroad than we Export Aboard?

To finance an excess of investment over savings, the country can do two things: either run down its financial foreign assets and/or borrow from the rest of the world to finance the net investments, ie capital inflow.

In either case, the excess of I over S leads to a reduction of net foreign assets of the country. If we run a trade deficit year after year, net foreign assets will fall to zero and the country will become a net debtor (assets - liabilities < 0).

Leakages and Injections

National Saving is the amount available to finance domestic investment (I) and net foreign investment, which is the same as net exports (NX).

 NS = I + NX **OR** -NX = I – NS

Recall that a current account deficit  NX < 0

Amount borrowed from foreigners = foreign borrowing = -NX

Foreign borrowing (-NX), which is roughly the same thing as the current account deficit, is raised by higher investment or lower national saving.

Net Foreign Investment (NFI) is equal to Australian purchases of foreign financial assets minus foreign purchases of Australian financial assets

Interesting connection: NX = NFI

Leakages-Injections and Budget Deficit

Leakages-Injections: S + T = I + G + NX

Rearranging  (T – G) = I + NX – S

If T - G < 0  budget deficit

3 possible implications of the deficit (financing of a budget deficit)

Reduced domestic investment (I)

Private savings increases

More borrowing from overseas or decrease in lending to foreigners (larger negative NX) – trade deficit

The External Sector

X = Xα

M = Mα + mY

where m = marginal propensity to import (increase in imports associated with an extra dollar of income).

m = DM/DY

NX = NX α – nxY

Determinants of Net Exports

Net exports are affected by:

Relative Prices

Higher domestic prices, relative to foreign prices ↓exports; ↑imports  NX ↓.

Exchange Rates

If the dollar appreciates and the ↑e, ↓exports; ↑imports  NX ↓.

Foreign and domestic income

Higher domestic income ↑imports  NX ↓

Higher foreign incomes, ↑exports  NX ↑

Tastes and preferences for foreign and domestic goods

Exports & Imports

M & X

Mα + mY

X = Xα

Deficit on Balance of Trade

Surplus on Balance of Trade

Net Exports Function

Exports (X)

Net Exports (X-M)

Imports

Aggregate Expenditures Model

45° line

Ep1 = C + I + G+ NX1

Ep2 = C + I + G+ NX2

Ep0 = C + I + G

The overall position of the AE line depends on whether net exports are positive or negative

Open Economy Multiplier

Thus the open economy multiplier:

The open economy multiplier is smaller than that for a closed economy. The slope of the AE schedule is reduced by the introduction of international trade.

Multipliers

If the level of AP changes over time by ∆AP , then the change in output, ∆Y, is given by: ∆Y = k x ∆AP

k is called the multiplier because it shows how each additional dollar of autonomous spending results in a greater than $1 increase in equilibrium output (the multiplier can also be calculated as 1/marginal leakage rate).

kT is the tax multiplier. Changes in output as a result of a change in taxation is given by: ∆Y = kT x ∆T

	3-Sector	4-Sector
Multiplier (k)
Tax Multiplier (kT)

Check Your Knowledge

Assume that in a closed economy, total consumption is equal to $324bn, investment is $16bn and government spending is $20bn.

What is the equilibrium level of output and income?

With a marginal propensity to save of 0.2, determine the size of the autonomous expenditure multiplier.

If the economy decides to open it borders for international trade, what will be the immediate impact on the slope of the aggregate expenditure function?

Check Your Knowledge

Illustrate the impact on the slope of the aggregate expenditure function if the country exports goods and services to the value of $66bn and imports a total of $71bn of goods and services?

Given an import function of M = 11 + 0.2Y, calculate the impact on the economy if the government increases its level of spending by $8bn.

Putting It All Together - AE Model

The Product Market

National Income Accounting Identity:

Y = C + I + G + NX

Planned Expenditure (EP) = C + IP + G + NX

Only Investment has an unplanned spending component

Goods that are produced, but not sold are counted as unplanned inventories.

EP = Y only at equilibrium (when unplanned spending = 0)

Planned vs Unplanned Expenditure

Algebraically, EP = AP + cY – ctY - nxY where…

AP = Autonomous Spending = Cα – cTα + IP + G + NXα

At equilibrium, Y = EP

Y = AP + cY – ctY – nxY

To find equilibrium Y, solve the above equation for Y:

Y = Cα + cY – cTα – ctY + Ip + G + NXα - nxY

Y = ()Ap

Changes to Planned Spending

Any increase in AP will shift up EP on the Keynesian Cross Diagram.

Effect on Y: ∆Y = k x ∆AP where

If c, t or nx changes, the EP line will rotate

Shift Parameters – Autonomous Spending

Consumption

Wealth; Price Level; Level of Consumer Debt; Expectations; Availability and Cost of Credit; Demographics

Investment

Interest rates

Expected net rate of return/profit (Investment projects with a rate of return greater than the real interest rate undertaken)

Expectations; Acquisition, operating and maintenance costs; Business Taxes; Technological change/innovation; Capital stock.

Fiscal Policy

Net Exports

Relative price levels; Exchange rates; Foreign income; Tastes and preferences

AD Shifts and AE

Until now, the increase in real GDP following an increase in autonomous expenditure has been determined by assuming that the economy is operating in the horizontal or Keynesian range of the AS curve.

What if we are operating in the intermediate/upward sloping portion of the SRAS curve, so that the price level increases when AD increases?

The multiplier effect from any increase in autonomous spending will be reduced by the increase in the price level. The larger the increase in the price level, the smaller the increase in RGDP following an increase in autonomous spending. Why?

AD Shifts and AE

As a result of the price increase, aggregate expenditure will fall back to some extent due to

The real wealth effect; Interest rate effect; Foreign purchases effect

Policy implications?

An expansionary fiscal policy may not increase aggregate expenditure by the full amount of the increase in government expenditure once we drop the assumption of a fixed price level. The increase in the price level may weaken or cancel the stimulus of fiscal policy.

4-Sector Equilibrium (T = Tα + tY) and (NX = NX α – nxY)

C = Cα + c(Y – [Tα + tY])

 C = Cα + cY – cTα – ctY

At equilibrium, EP = C + Ip + G + NX

 Ye = Cα + cY – cTα – ctY + Ip + G + NXα - nxY

 Ye = (Cα – cTα + Ip + G + NXα)

Marginal leakage rate = s(1-t)+t+nx

 Ye =

S + T + M = I + G + X