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Lecture Macroeconomics: Lecture 13 - Prof. Dr.Qaisar Abbas

Lecture 13: Open economy - II. In this chapter you will learn the theory of liquidity preference as a short-run theory of the interest rate, analyze how monetary policy affects interest rates and aggregate demand, analyze how fiscal policy affects interest rates and aggregate demand, discuss the debate over whether policymakers should try to stabilize the economy. | Review of the previous lecture Net exports--the difference between exports and imports a country’s output (Y ) and its spending (C + I + G) Net capital outflow equals purchases of foreign assets minus foreign purchases of the country’s assets the difference between saving and investment Lecture 13 Instructor: Prof.Dr.Qaisar Abbas Open economy - II Lecture Outline Exchange rate Four experiments Purchasing power parity Exchange rate e = nominal exchange rate, the relative price of domestic currency in terms of foreign currency (e.g. Yen per Dollar) The nominal exchange rate The real exchange rate = real exchange rate, the relative price of domestic goods in terms of foreign goods (e.g. Japanese Big Macs per U.S. Big Mac) ε Exchange rate Understanding the units of ε ε Exchange rate ε in the real world & our model In the real world: We can think of ε as the relative price of a basket of domestic goods in terms of a basket of foreign goods In our macro model: There’s just one . | Review of the previous lecture Net exports--the difference between exports and imports a country’s output (Y ) and its spending (C + I + G) Net capital outflow equals purchases of foreign assets minus foreign purchases of the country’s assets the difference between saving and investment Lecture 13 Instructor: Prof.Dr.Qaisar Abbas Open economy - II Lecture Outline Exchange rate Four experiments Purchasing power parity Exchange rate e = nominal exchange rate, the relative price of domestic currency in terms of foreign currency (e.g. Yen per Dollar) The nominal exchange rate The real exchange rate = real exchange rate, the relative price of domestic goods in terms of foreign goods (e.g. Japanese Big Macs per U.S. Big Mac) ε Exchange rate Understanding the units of ε ε Exchange rate ε in the real world & our model In the real world: We can think of ε as the relative price of a basket of domestic goods in terms of a basket of foreign goods In our macro model: There’s just one good, “output.” So ε is the relative price of one country’s output in terms of the other country’s output How NX depends on ε ε U.S. goods become more expensive relative to foreign goods EX, IM NX The net exports function The net exports function reflects this inverse relationship between NX and ε: NX = NX (ε ) The NX curve for the U.S. The net exports function The NX curve for the U.S. The net exports function How ε is determined The accounting identity says NX = S – I We saw earlier how S - I is determined: S depends on domestic factors (output, fiscal policy variables, etc) I is determined by the world interest rate r * So, ε must adjust to ensure How ε is determined Neither S nor I depend on ε, so the net capital outflow curve is vertical. ε adjusts to equate NX with net capital outflow, S - I. Interpretation: supply and demand in the foreign exchange market demand: Foreigners need dollars to buy U.S. net exports. supply: The net capital outflow (S - I ) is the supply of