Addis Ababa College

Department of Business Management

Macroeconomics

By Desalegn N.

1 November 6, 2023
Chapter Four: Aggregate Demand in the Open Economy

Outlines

Introduction

Net Export

Exchange rate

Saving and investment in Small open economy

MF-model
 Introduction
In closed economy spending need equal to output and investment need
equal to saving. Accordingly, Y= C+I+G
In open economy: the country that interacts freely with other economies
around the world in buying (import) and selling goods and service (export)
with the rest of the world.
Investment need not equal to saving
Spending need not equal to output. This is due to grants, foreign
borrowing, remittances, and charities.
 Introduction

 Exports (X) are foreign spending on domestic products.

 Imports (M) are goods and services that are produced abroad and sold

domestically. Country expense for foreign products.

 NX (trade balance) = Export-Import

 Accordingly, the nation output becomes: Y= C+I+G+X-M

 Depending on the level of export and import, the country will have:

Trade deficit Trade surplus Balanced trade

 EX<IM  EX>IM  EX=IM
 Spending>output  NX and NCO >0  Spending=
 S<I  A country is a
output
 A country is a net net lender
 Spending<  S=I
borrower
output  Zero capital
 Negative capital
 S>I outflows
out flows
Determinants of Net Export

Tastes of consumers for domestic and foreign goods

Price of goods at home and abroad

Exchange rate

Income of consumers at home and abroad

Transportation cost for movement of goods

Government policies towards international trade.

 Net capital outflow (NCO)
Its the purchase of foreign assets by domestic residents minus the purchase
of domestic assets by foreigners. NCO can be affected by:

 Real interest rate being paid on foreign and domestic assets

 The perceived economic and political risks holding assets abroad

 Government policies that affect foreign ownership of domestic

assets( government policies of Ethiopia on foreign financial

institutions). i.e, foreigners can not held bank shares in Ethiopia

 Saving and Investment in the Small Open Economy

To build the model of the small open economy, we take three assumptions:

 The economy’s output Y is fixed: Y = Y=𝒀=F(L,K) .

 Consumption C is positively related to disposable income

 Investment I is negatively related to the real interest rate

 A net export is a component of GDP: Y=C+I+G+NX

 Y-C-G = I+NX ---------the left hand side represent national saving(S).

 Saving and Investment in the Small Open Economy

S= I+NX

If our net capital outflow/net export is greater than zero

Our saving exceeded our investment, the revers is true.

In the closed economy, the real interest rate adjusts to equilibrate saving

and investment—that is, the real interest rate is found where the saving

and investment curves cross.

Saving and Investment in the Small Open Economy
In the small open economy, however, the real interest rate equals the
world real interest rate. The trade balance is determined by the
difference between saving and investment at the world interest.
 Saving and Investment in the Small Open Economy
The difference between saving and investment determines the trade
balance. Accordingly,
1. If world interest rate is higher than domestic interest rate, saving
exceed investment and result trade surplus.
2. If world interest rate is lower than domestic interest rate,
investment exceed saving and result trade deficit.
3. If world interest rate is equals to domestic interest rate, saving
equals to investment and result balance trade.
 Exchange rates
The two most important international prices are the nominal exchange
rate and the real exchange rate.
A. Nominal exchange rate is the rate at which a person can trade the
currency of one country for the currency of another.
 For instance, currently the nominal exchange rate of dollar to birr is 1$/56
birr.
B. Real exchange rate is the rate at which a person can trade the goods
and services of one country for the goods and services of another.
 Exchange rates

Nominal exchange rate∗domestic price

 Real exchange rate = .
𝐹𝑜𝑟𝑒𝑖𝑔𝑛 𝑝𝑟𝑖𝑐𝑒

 Appreciation: is rise of domestic currency value in terms of foreign

currency.

 Depreciation: is fall of domestic currency value in terms of foreign

currency
The Mundell–Fleming model (MF Model)

It is an open economy version of the IS-LM model.

The similarities between the IS-LM and Mundell-Fleming model:

Both deal with the interaction between the Goods market and the money

market.

Both assume fixed price and show what causes fluctuation in aggregate

demand not aggregate supply.

 The Mundell–Fleming model (MF Model)
 Differences between this two Models is that the consideration of
openness and closeness of the economy.
 MF model assumes small open economy with perfect capital mobility
that is:
 r=r*↔ domestic interest rate= world interest rate.
 The model concentrates on the exchange rate to analyze the behavior of
the economy.
 Since price are fixed (constant) then 𝑅𝐸𝑅 = 𝑁𝐸𝑅 E=e, since price is
assumed to be fixed.
 Components of the MF Model
MF model has 3 components
1. r=r*------------------ perfect mobility of capital
2. 𝒀 = 𝑪 𝒀 − 𝑻 + 𝑰 𝒓 ∗ + 𝑮 + 𝑵𝑿(𝒆)-------IS

3. MS=MD 𝐨𝐫 𝐌/𝐏 = 𝐋(𝐫 ∗, 𝐘) -------Ms=L(r*,Y)-------------- LM

Our exogenous (fixed) variables are G, T, M, P and r*. Our endogenous
variables are” Y “and “e”. Therefore, the models analyze the effects of
change in “e” on” y”.
Components of the MF Model

The goods market represented by 𝒀 = 𝑪 𝒀 − 𝑻 + 𝑰 𝒓 ∗ + 𝑮 + 𝑵𝑿(𝒆)

since all variables are fixed except “e” NX affect “Y” through “e”. When

“e” NX which results Y to decrease and when “e” NX which

results Y to increase.

Therefore, Y and “e” have an inverse relation. Hence, IS curve will be

downward slopping.
Components of the MF Model
 Components of the MF Model

S D 𝑴
The money market represented by M =M or = 𝑳 𝒓 ∗, 𝒀
𝑷

where LM is vertical because “e” does not exist in its function and all

variables are (M and price are fixed)( fig 2 below).

Interest rate exchange rate

r LM e LM*

r*

Y y* y
Equilibrium in MF-Model

IS LM

Equilibrium level
Equilibrium of Income
Exchange rate
Y
The MF-model under floating exchange rate with perfect capital mobility

In floating exchange “e” is allowed to fluctuate in response

to change in economic conditions. It might be appreciation

(increase in value of a currency) or depreciation (decrease in

vale of a currency).
 The MF-model under floating exchange rate with
Fiscal policies under floating exchange rate can be:
perfect capital mobility
Expansionary fiscal policy or comprationary fiscal policy
Monetary policies under floating exchange rate can be:
Expansionary monetary policy or comprationary monetary policy
We have also trade policies that affect our MF model in floating exchange
let us see all of the above one by one.
 N.B: the type of policy used depend on the prevailing economic
condition
Expansionary fiscal policy under floating exchange rate(Gor T)

 When G IS curve shifts to the right and “e” (appreciate). Here “y”

will remain unchanged because the increase in “Y” due to G offset by

the NX due to the appreciation of “e”

Thus, fiscal policy under floating exchange rate is

ineffective
Expansionary Monetary policy under floating exchange rate (increase
in money supply)

 Ms shifts LM to the righteNXY, so the policy is effective

The MF-model under fixed Exchange Rate

In Fixed exchange rate:

Central bank stands ready to buy or sale the domestic currency for

foreign currency at predetermined price.

Money supply adjusts to the necessary level.

Expansionary fiscal policy under fixed exchange rate(Gor T)

 When GIS shifts to the righte tend to  but we said fixed exchange

rate. e stick on the new IS to bring back the economy to equilibrium

position the central bank should increase the money supply to shift LM

to right until it intersect the new IS.

 Hence the nation income increase from Y0 to Y1. thus, fiscal policy

under fixed exchange rate is effective.

Expansionary fiscal policy under fixed exchange rate(Gor T)
Expansionary monetary policy under fixed exchange rate(increase in money supply

When money supply increases LM shifts to the right which tends to e

but we assumed fixed exchange rate so the central bank should decrease

the money supply by the same amount in order to bring back the LM

curve to the original(initial) position this kind of policies are called”

ineffective nominal monetary policy.”

Expansionary monetary policy under fixed exchange rate(increase in money supply

LM1 LM2

E* IS