[00:16] so now we're going to go back to to the
[00:18] first part of the course in the sense
[00:20] that um
[00:23] um that we're going to go back to sort
[00:25] of the the short term okay so so we're
[00:28] going to essentially do the eslm mode
[00:30] again but now in the context of an open
[00:33] economy but before I get into that first
[00:35] model of this part of the course I want
[00:37] to
[00:39] um finish the previous
[00:41] lecture in which I was introducing the
[00:44] concept of openness and the key relative
[00:46] prices H in open economy and we stopped
[00:50] after discussing this and says well one
[00:52] of the things that that open an economy
[00:55] means is that now you can buy Goods both
[00:58] at home or abroad so you need to be able
[01:00] to compare these two different kind of
[01:02] goods and controlling for quality and
[01:04] all these differences and all that at
[01:07] the end of the day you want some sense
[01:08] of relative prices which good is more
[01:11] expensive than the other one and we said
[01:13] for that we use what is called the real
[01:16] exchange rate okay and we Define the
[01:18] real exchange rate as well essentially a
[01:21] it's the relative prices of of goods at
[01:24] home versus abroad H but we had to put
[01:28] them in a common currency that's the
[01:29] reason we we couldn't just directly
[01:30] compare the prices at home versus the
[01:32] prices abroad we had to convert the
[01:35] prices at home to the unit of account of
[01:37] the other country and then we could
[01:40] compare these two things and that's what
[01:41] we call the real exchange rate when that
[01:43] thing goes up we call that's a real
[01:46] appreciation of of of the local currency
[01:49] of the local economy and and that means
[01:52] that the goods domestic Goods become
[01:54] more expensive relative to International
[01:57] Goods when when the that Epsilon goes
[02:00] down then we call we say the real
[02:02] exchange has depreciated and that means
[02:04] that their domestic Goods become cheaper
[02:06] relative to foreign Goods okay so as a
[02:09] key Concept in the in what it means when
[02:11] you open an economy you need to have a
[02:13] this price is very important to decide
[02:16] whether you're going to again whether
[02:18] you and foreigners are going to buy
[02:20] Goods abroad or domestically the second
[02:23] concept of openness that we're going to
[02:25] explore in this course is openness in
[02:28] capital account in financial Market
[02:29] Market an openness in financial Market
[02:31] means something very similar which is
[02:34] now you when you have a dollar to invest
[02:37] financially invest not physical
[02:38] investment not real investment well you
[02:41] can decide whether to invest in domestic
[02:43] assets or foreign assets we're going to
[02:45] in this and later on we're going to talk
[02:47] about Equity but for now bonds so
[02:50] suppose you have a domestic Bond and a
[02:52] foreign bond well you can decide whether
[02:55] to invest in the domestic Bond or in the
[02:56] foreign bond okay now to make that
[02:59] compar
[03:00] Aron is not enough to have the current
[03:03] exchange rate because it doesn't mean
[03:06] much if I tell you that the British bond
[03:08] is more expensive than a domestic a
[03:11] dollar
[03:12] Bond H what you really need in order to
[03:15] decide where to invest is some sense
[03:18] what is the expected relative return of
[03:20] these two things do I expect to make
[03:22] more money in the dollar Bond or in the
[03:25] in the uh pound Bond and and I that's a
[03:30] comparison I need to be able to make
[03:32] okay there are also risk considerations
[03:35] and so on that we're going to not going
[03:36] to discuss in this in this course but
[03:38] the but the very basic comparison is not
[03:42] the value of things when you're talking
[03:44] about financial but what is a return you
[03:46] expect to get in one or the other okay
[03:48] so this is what you need to do suppose
[03:51] you have a dollar of invest dollar to
[03:53] invest and you have two options one is
[03:56] you buy a dollar Bond the dollar Bond
[03:58] gives you an interest rate of it so you
[04:00] know that say 5% nowadays more or less
[04:05] that if you have a dollar today and you
[04:06] invest it in a in a dollar Bond you're
[04:08] going to get Next Period you're going to
[04:11] get a h how much is it $100 supposed you
[04:15] have $1 then you're going to get a a
[04:18] five cents on that dollar at the end of
[04:21] the year okay and so that's what you get
[04:26] if you invest in the dollar Bond now
[04:28] you're given now an option because
[04:29] because we are open to financial markets
[04:32] to also invest in a British bond in a
[04:34] pound bond that is as safe as the US
[04:37] Bond say and uh so we're going to call
[04:40] that the UK Bond and I know for example
[04:43] that the UK bond is offering a 10%
[04:46] interest rate okay so suppose that I
[04:49] that I think IST star is
[04:51] 10% then I ask you the question well
[04:54] does that mean that obviously since you
[04:56] want to compare returns that you should
[04:58] be investing in the
[05:00] in the pound bond in the UK Bond rather
[05:02] than the US Bond so suppose this is 5%
[05:05] and that's 10% and now tell you where do
[05:08] you want to invest your money do you
[05:09] want to invest it in the US Bond or in
[05:12] the UK
[05:13] Bond what is your
[05:17] answer sounds obvious no they pay you
[05:19] 10% the other one pays you 5%
[05:30] exactly why do I need to know
[05:34] that exact so this this is not enough
[05:38] information for me because it may happen
[05:40] that what I get in terms of return I
[05:42] lose on the currency currency
[05:44] exposure for example so so let's see how
[05:48] that can happen so how would I do this I
[05:50] have $1 of wealth that I want to invest
[05:53] and suppose I want to go the UK Bond
[05:55] route so the first thing I have to do is
[05:58] I have to convert the dollar into pounds
[05:59] today to buy my dollar which my UK bond
[06:03] which will be in pounds so I first thing
[06:05] I have to use you know suppose I get
[06:09] 8 pounds per dollar then then I I can
[06:13] invest .8 pounds in in in h in UK bonds
[06:18] with my
[06:19] dollar H that will give me8 * 1 plus 1
[06:24] point one 1 plus is star tomorrow but
[06:29] what are the units of this what do I get
[06:32] there next year what do I get next year
[06:35] I invested
[06:37] 8 ER pounds and I got8 time 1.1 say
[06:44] pounds but I just told you so what I get
[06:47] next year is pounds I cannot compare a
[06:50] return in dollars which this was $
[06:53] 1.05 with a return on pounds I need to
[06:55] be able to convert those pounds pounds
[06:57] in the future to in the future and the
[07:01] best I can do here we're not going to
[07:02] open forward markets or anything is well
[07:06] I can that means I have to divide by the
[07:08] exchange rate next year to convert from
[07:10] pounds to dollars I don't know the
[07:12] exchange rate of next year so the best I
[07:14] can do is use expected exchange rate
[07:17] okay so so I divide this by the expected
[07:20] exchange rate next year and then I get
[07:24] that's my return in dollars of having
[07:26] gone the UK B route okay and so what I
[07:30] need to compare in order to decide where
[07:33] do I want to put my money is that return
[07:36] here versus that one there that's in the
[07:39] same units of account is I invest the
[07:41] same today $1 and I get dollars tomorrow
[07:45] so now I can
[07:48] compare and as you correctly pointed out
[07:51] this this this uh this thing here
[07:53] therefore requires that you you sort of
[07:56] think about what the exchange rate is
[07:58] likely to be tomorrow so for example in
[08:00] my example here when I said suppose I is
[08:03] 5% and I star interest rate in UK bone
[08:07] is 10% is it obvious that they should
[08:09] invest in the in the UK Bond and the
[08:12] answer is no not so fast because I know
[08:14] I'm going to make 5% more in terms of
[08:16] the return of the bond but then when I
[08:18] convert it back to Dollar I may lose all
[08:19] that gain because the the the the pound
[08:22] has depreciated visis the dollar in
[08:25] particular if the pound I expect the
[08:27] pound to depreciate Rel to or if I
[08:30] expect the dollar to appreciate relative
[08:32] to the pound by 5% then I'm
[08:35] indifferent yeah in one case I get
[08:38] because if I go the the US Bond route I
[08:40] get five 5% next year from this year to
[08:44] next if I go the UK bone route I get 10%
[08:48] in return in the bond minus 5% in the
[08:50] capital loss due to the the the
[08:53] appreciation of the dollar so on net I
[08:55] get 5% as well that's what appears here
[08:58] that's what I've done here here so what
[09:00] I did here is say you know if the
[09:02] markets are very integrated and they
[09:03] function fairly well those two returns
[09:06] should be more or less similar in
[09:08] equilibrium because prices are going to
[09:10] adjust exchanges are going to adjust and
[09:12] so on so these two ways of investing are
[09:15] more or less the same I'm going to take
[09:17] the stream assumption that they are
[09:18] exactly the same
[09:20] here so that this holds that the
[09:23] equilibrium we have to find that
[09:24] equilibrium these two things are going
[09:26] to be equal that's called and it's a
[09:29] very important Concept in international
[09:30] finance the uncover inp parity condition
[09:34] don't ask me why it's uncover but it's
[09:36] it's the inp parity condition and and
[09:39] again that one in particular is called
[09:41] the uncover interp condition if you do a
[09:45] little bit of and this just tells you
[09:47] that in equilibrium you have to be more
[09:49] be indifferent between investing to in
[09:52] one bone or the other okay if you do a
[09:55] little algebra here of the kind of we
[09:57] have done in the past like you know 1
[09:58] plus I is I is approximately equal to
[10:04] one is approximately equal to 1 over 1
[10:07] minus I or or this one 1 plus I star is
[10:11] approximately equal to one over 1 minus
[10:14] I star and so on that's that kind of
[10:15] approximation tailor expansion when when
[10:19] these terms are small then you can write
[10:22] this as this expression
[10:24] here okay and this says exactly what I
[10:27] just said in words this says
[10:30] look if the interest rate in the US bond
[10:34] is lower than
[10:36] the than the UK bonds interest rate
[10:42] that's okay in the sense that we can be
[10:44] different between these two things as
[10:45] long as you're expecting a depre an
[10:48] appreciation of the
[10:49] dollar that is equivalent to the
[10:52] difference in this two interest rate
[10:54] okay so that's what's called the
[10:56] interest parity condition the two in
[10:59] equilibrium the two are going to be the
[11:01] same once you adjust for the expected
[11:03] appreciation or depreciation of the
[11:05] currency okay so in my example before we
[11:09] had this interest rate with 5% that was
[11:13] 10% then the only way that will that's
[11:15] going to be an equilibrium is that if we
[11:17] also expect the dollar to appreciate by
[11:21] 5% okay so dollar appreciation remember
[11:24] is this guy going up so if this is 5%
[11:28] then it's fine to have 5% here 10% there
[11:32] because they both gave me the same
[11:33] return in expectation at least okay if I
[11:36] do it in dollars I say I'm going to get
[11:38] 5% either way invest in direct in
[11:41] dollars or through the UK pound because
[11:44] in the in the UK bone in the UK bone I'm
[11:46] going to get 10% and then lose 5%
[11:48] because of the of the currency or I can
[11:51] do the comparison in pounds and and then
[11:53] I say well I'm going to get 10% in
[11:55] pounds directly and if I go the US way
[11:58] I'm going to get 5% but I'm going to get
[12:00] also 5% in the currency appreciation and
[12:02] that gives me 10% okay key concept
[12:06] anyways so these are the two senses of
[12:08] opening that we can have opening in in
[12:11] Goods Market opening in financial
[12:13] markets and the the the key relative
[12:16] prices and and things are going to
[12:19] equilibrate both markets one is the real
[12:23] exchange rate in the Goods Market in
[12:25] this one is the uncovering transparity
[12:28] condition I want to shut down this part
[12:30] of openness H for a lecture or so and
[12:33] I'm going to focus now on the on the
[12:35] Goods Market open opening only okay and
[12:38] then I'm going to come back to this but
[12:40] I just wanted to show you the two senses
[12:43] of opening okay so now let's forget a
[12:46] little bit about financial opening and
[12:49] and uh and let's just focus on opening
[12:53] the goods markets to International Trade
[12:55] okay so that means we're going to have
[12:57] now imports and exports floating around
[12:59] so this is we go back again to our aslm
[13:02] mod H to actually want to go back to our
[13:05] Goods Market only mod the very first
[13:07] model we saw in this course but we're
[13:09] going to bring back a couple of terms
[13:11] that we shut down there okay now
[13:16] something that will be that we didn't
[13:17] need to worry about but we're going to
[13:19] have to worry about here a lot is that
[13:22] there is a distinction between the
[13:23] demand for domestic goods and the
[13:26] domestic demand for goods
[13:29] okay I know this going to be tricky but
[13:31] but okay there's a difference between
[13:33] demand for domestic Goods versus the
[13:36] domestic demand for goods this is what
[13:39] residents us say us residents household
[13:42] firms government demand in terms of
[13:46] goods this is how those same agents plus
[13:49] the rest of the world demand of
[13:51] domestically produced Goods that's the
[13:54] distinction when the economy was closed
[13:56] they were the same but now they're not
[13:59] okay so the domestic demand Remains the
[14:03] Same as before okay domestic demand is
[14:06] whatever the households demand
[14:08] consumption plus firm's investment plus
[14:12] government expenditure that's the same
[14:14] we had in close economy this hasn't
[14:18] changed the domestic demand is the same
[14:19] is a function of the same behavioral
[14:21] functions that we had there and the only
[14:24] behavioral function that was in the only
[14:26] two that we had was the consumption
[14:28] function and investment function
[14:29] remember so That Remains the Same
[14:30] nothing has changed what does change is
[14:33] that this is no longer what determines
[14:36] the demand for domestically produced
[14:38] goods and remember that's very key in
[14:40] the short run because this is so Canan
[14:43] model with very sticky prices demand
[14:45] determines output activity so if we're
[14:48] going to determine domestic production
[14:50] from demand we better be very careful
[14:52] about what is the demand for
[14:54] domestically produced Goods this is
[14:57] demand for both domestically produced
[14:58] good and foreign produced Goods some of
[15:00] those demand will be satisfied by
[15:02] Imports that's not demand for domestic
[15:04] production and therefore will not be
[15:06] determined equilibrium output
[15:08] domestically okay so this is going to be
[15:11] the New Concept which is demand for
[15:13] domestic goods and demand for domestic
[15:16] Goods is the same as demand as domestic
[15:19] demand for goods that the thing we had
[15:21] in close economy minus that part of
[15:24] demand that is Satisfied by Imports so
[15:26] minus Imports and divided by The
[15:28] Exchange because inputs may be priced in
[15:30] euros say and I have to convert them
[15:32] into dollars that's the reason very
[15:33] exchange don't worry about this for now
[15:36] okay so I had to subtract from that
[15:40] Imports because that's Demand by
[15:44] Resident us resident that doesn't go to
[15:47] demand to demand for domestically
[15:50] produced Goods it's demand for BMWs
[15:52] whatever so that's not going to affect
[15:54] the demand for Ford good cars and
[15:57] therefore it will not affect the
[15:58] production of four
[16:00] cars because it's not demand for that
[16:04] but against that we also have the demand
[16:07] a component of demand for domestically
[16:09] produced good that we didn't have before
[16:11] which is what foreigners demand from the
[16:14] US okay part of the demand that probably
[16:18] not for a lot at least part of the the
[16:21] demand that us
[16:24] Goods perceived us production perceived
[16:27] is not due to resident is due to
[16:30] foreigners that are importing us Goods
[16:33] okay Apple s sells a lot of phones to
[16:36] the rest of the
[16:37] world okay that's determined by Foreign
[16:40] demand for domestically produced good
[16:42] that's what we want to call X exports
[16:46] okay so this is our new key concept here
[16:50] Z okay which is the same as what we used
[16:53] to have but now we need to understand
[16:55] two more terms the export and it ask
[16:58] going to be a function and import which
[17:02] also will be a function so let me
[17:04] introduce that so exports we're going to
[17:07] assume simplify things but it's sensible
[17:11] behavioral assumption we're going to
[17:13] assume that exports are increasing in
[17:15] foreign output that's what y star
[17:18] means and it makes sense is the rest of
[17:22] the world I mean Emerging Market the
[17:24] commodity producing economies today are
[17:27] very excited about the recover in China
[17:30] no China is reopening so so it's a big
[17:33] boom domestically that's great news for
[17:36] the Emerging Markets commodity producers
[17:37] because that will increase the demand
[17:40] from China for goods produced around the
[17:42] world in particular in commodity
[17:44] producing economies so so that's what
[17:47] this is capturing if if an important
[17:49] trading partners output goes up income
[17:51] goes up then they're they're going to
[17:53] consume everything they're domestic
[17:55] Goods but they're also going to consume
[17:56] the goods they import which are our
[17:59] exports okay so that's the reason this
[18:01] is
[18:02] increasing ER exports are decreasing on
[18:06] the real exchange
[18:08] rate that's sensible assumption why why
[18:10] do you think it's a sensible assumption
[18:12] so why do you think that exports US
[18:15] exports are decreasing on the real
[18:19] exchange rate
[18:26] Epsilon for for foreign customers to BU
[18:30] exactly because then us Goods become
[18:32] more expensive relative to foreign Goods
[18:34] that's what a real exchange appreciation
[18:36] is and therefore there is L less demand
[18:39] for domestically for for us Goods okay
[18:42] that's that's the reason we have that
[18:43] time what about import well Imports are
[18:48] sort of the the Dual of that meaning of
[18:51] the export function is is is is H is
[18:54] actually our Imports is what the other
[18:56] countries sees as their export okay
[18:59] so our inputs will tend to go up when
[19:02] domestic output goes up because if
[19:04] domestic income goes up domestic
[19:07] consumer say will both consume more
[19:10] Goods at home but they will also consume
[19:12] more Goods abroad no they going to scale
[19:15] up their consumption and they're going
[19:17] to consume consume from from both places
[19:19] so
[19:20] Imports H will is an increaseing
[19:23] function of domestic
[19:25] output what about the the real exchange
[19:27] rate here well inputs are an increasing
[19:31] function of the um real exchange rate
[19:36] why is
[19:40] that it's the same argument of export
[19:43] but seem from the other
[19:49] side remember when why do we use this
[19:52] Epsilon 4 to decide where do we want to
[19:54] buy our Goods if Epsilon goes up means
[19:57] our Goods become more
[20:00] expensive if our Goods become more
[20:03] expensive for any given level of
[20:05] domestic
[20:06] consumption where do you think you'll
[20:08] buy your goods you'll buy more abroad
[20:11] are cheaper okay so then that's an
[20:14] increasing function of NS
[20:17] good any question about that because
[20:19] these are the only sort of new
[20:20] behavioral equations we're going to have
[20:22] for for this
[20:25] model and and what I'm going to do next
[20:28] is I'm going to start from the same
[20:29] model we had in in in I don't know
[20:32] lecture two or three h and uh I'm going
[20:36] to I'm going to add this these terms and
[20:39] see how things change
[20:42] okay okay good so let's do
[20:46] that so
[20:48] remember H I think the first curve that
[20:52] would the the first the very first
[20:54] diagram we had in this class was this
[20:57] one this was just a demand for domestic
[21:01] uh domestic demand sorry which was just
[21:05] C plus I plus G it's an increasing
[21:07] function here because consumption and
[21:10] investment are increasing function of
[21:12] output okay and then in close economy
[21:15] what we did is we had a 45 degree line
[21:18] here and we said in equilibrium output
[21:20] equal to demand and therefore the
[21:22] intersection of this curve with the 45
[21:24] 45 degree line gave us our equilibrium
[21:27] output that's what we have
[21:29] we need to change things a little bit
[21:31] we're going to put the 45 degree line in
[21:32] the next slide but we first need to this
[21:37] is not the relevant demand for
[21:39] domestically produced Goods so we need
[21:40] to go from here to the demand that is
[21:44] relevant for domestic producers okay so
[21:47] the first thing we need to do is we need
[21:49] to subtract Imports because part of the
[21:52] demand will go for foreign
[21:54] Goods okay and so that's what I'm doing
[21:58] here
[21:59] to this domestic demand I'm subract
[22:01] subtracting the part that H that is
[22:05] going to foreign Goods not domestic
[22:07] Goods because this is not demand for
[22:08] domestically produced Goods so obviously
[22:11] this is a shift down but there is also
[22:13] rotation why is
[22:15] that you see obviously we're subtracting
[22:18] imports from domestic demand so that
[22:21] moves us down here but it's also it's
[22:23] not a parallel
[22:25] shift this curve becomes flatter
[22:30] why is that in other words the decline
[22:33] is larger for the different the Gap is
[22:35] larger for high levels of income than
[22:37] for low levels of income or output why
[22:39] is
[22:40] that depend on outut exactly is because
[22:45] there's a positive marginal propensity
[22:47] to import and so you'll import more if
[22:51] output is higher okay and that's the
[22:53] reason we have this C notice that this
[22:57] also means well let me get to the end of
[22:59] that and and of these diagrams and then
[23:01] I'll get back to this so one step more
[23:04] still this is not what I need to
[23:07] integrate with my 45 degree line because
[23:10] this is not the demand that domestic
[23:11] producer will face we still have to add
[23:14] the demand that comes from
[23:16] foreigners and that's exports okay so to
[23:19] this AA function I have to add exports
[23:24] and exports is a parallel shift because
[23:26] it didn't depend on domestic output it
[23:28] depend on foreign output so foreign
[23:29] output is going to be a parameter in
[23:31] this curve but it's not doesn't change
[23:33] the slope of that
[23:35] curve so here we went from the DD curve
[23:40] to the new curve which is the reant for
[23:41] equilibrium domestic equilibrium output
[23:43] which is this ZZ curve
[23:48] okay now notice two things or one thing
[23:52] about this ZZ curve relative to DD what
[23:55] is the most obvious
[23:58] difference between these two
[24:03] curves no this is the one we use in
[24:06] lecture two or three I don't know and
[24:09] then when we did slm and all that and
[24:11] this is the one we're going to use now
[24:12] the
[24:15] ZZ it's flatter yeah why is
[24:20] that flatter is slow a slope will mean
[24:23] lower
[24:25] multiplier why is the multiplier lower
[24:27] then you know open economy part of the
[24:30] Dem falls on for exactly because part of
[24:32] the remember the the way we got to the
[24:35] multiplier is that income went up
[24:37] consumption went up the that increased
[24:40] income again and so on so forth but if
[24:42] part of that increasing consumption is
[24:44] going to foreign Goods that's not
[24:46] reflected in demand for domestically
[24:48] produced goods and therefore there's
[24:49] less of a multiplier okay and that's one
[24:52] characteristic of the open economy is
[24:54] that the multipliers are
[24:57] smaller the distinction is that you
[24:59] don't see it here but we have more
[25:02] parameters in particular a very
[25:05] important parameter here is y star y
[25:08] star didn't we didn't worry about what
[25:09] was income in Germany when we look at
[25:13] the islm the close economy model now we
[25:15] worry about what the income of our main
[25:18] trading partners is so you there's an
[25:21] extra parameter there
[25:23] good now we still haven't found
[25:26] equilibrium output but there is a point
[25:27] that is already interes in here which is
[25:30] this
[25:32] one what do I know of this point well in
[25:35] this point domestic demand for goods is
[25:38] the same as demand for domestically
[25:40] produced goods for domestic goods and
[25:43] that also means that the trade balance
[25:46] is zero meaning that at that point
[25:49] exports is exactly equal to Imports so
[25:51] net exports are equal to zero okay so
[25:55] that's what I'm plotting here actually
[25:57] this is the net export function the net
[25:59] export function is
[26:03] simply that minus that divided by the
[26:07] exchange rate okay so that's what I'm
[26:09] plotting
[26:10] here is a decreasing function of output
[26:13] why is
[26:15] that why is this decreasing in in
[26:18] domestic
[26:19] output remember this is export minus
[26:23] UT divided by the exchanger but we're
[26:26] not moving the exchanger for now
[26:29] why is this decreasing that means here
[26:33] exports exceed Imports here Imports
[26:35] exceed exports so here you have a trade
[26:38] deficit here you have a trade surplus
[26:40] why why is that why is that the shape
[26:43] why is it downward
[26:52] SL import grow outp grows export exactly
[26:57] export is not a function of domestic
[26:58] output it's a function of foreign output
[27:01] while while inputs is an increasing
[27:03] function of domestic output a net export
[27:06] is exports minus Imports okay so that's
[27:10] what this is decreasing and this point
[27:11] here happens to be when the two things
[27:13] are exactly
[27:15] balance that's trade balance happens to
[27:18] be the point where DD is equal to ZZ
[27:22] that's just there's no reason why
[27:23] equilibrium output should be at that
[27:24] level I'm saying that's a point where
[27:26] that happens okay now we're going to
[27:28] find equilibrium output to find to find
[27:31] equilibrium output I'm going to erase
[27:33] all this extra curves here and I'm just
[27:35] going to keep the ZZ here because that's
[27:38] the demand for domestically produced
[27:40] goods and and I'm doing short run here
[27:42] so I know that domestic production is
[27:45] going that is the Y is going to be equal
[27:48] to demand for domestic Goods it's it's a
[27:50] demand determined model that's what the
[27:52] short run is all about so erase all this
[27:56] all these curves and I'm going to just
[27:57] keep this ZZ curve there there you
[28:01] are okay so now I have my 45 degree line
[28:05] because in the short
[28:07] run equilibrium output is equal to
[28:10] aggregate demand aggregate demand for
[28:13] what for domestically produced Goods
[28:14] that's the reason I'm using ZZ not DD
[28:18] okay but there you are then you do
[28:20] exactly the same as we did before boom
[28:22] that's our equilibrium outut and here
[28:24] you can do all sort of experiments and
[28:26] you're going to get the same sort of
[28:27] things things that we there the
[28:29] multiplier is a smaller multiplier but
[28:30] you're going to still get a multiplier
[28:32] and all these kind of things okay now I
[28:36] this is just I I I in this example it
[28:40] happens that at this equilibrium output
[28:42] this country has a trade deficit I just
[28:45] made up that
[28:48] okay so the so this is the equilibrium
[28:52] condition is output equal to Z output
[28:55] equal to then domestic demand plus
[28:58] export minus
[29:00] input okay and then the net export is
[29:03] just I'm plotting this term
[29:06] here that's what we have here but
[29:09] equilibrium is just y equal to Z it's
[29:11] not this equal to
[29:14] zero you can think about equilibrium but
[29:18] this is this is what it is given that
[29:20] that's equilibrium how
[29:24] okay is this clear I mean this is the
[29:27] start diagram of of this part of the
[29:28] course so you need to understand this
[29:32] diagram go over
[29:35] it play with it think what is a
[29:37] parameter in there and so I'm going to
[29:39] do a little bit of that now but make
[29:41] sure that you
[29:43] understand
[29:47] this okay so let a few things here so
[29:50] let's do things that we did in close
[29:52] economy so suppose that you have a f
[29:55] fiscal
[29:56] expansion so so what did we do when we
[29:59] had a fysal expansion in lecture two or
[30:00] three well that moves the ZZ curve up
[30:04] output will go up and then there will be
[30:06] a multiplier so output will go up by
[30:08] more than the initial increasing
[30:11] government expenditure no that's what we
[30:14] had before it will go up by more but not
[30:17] as
[30:18] much as it did in the close economy so
[30:22] the the increas in output will will be
[30:24] more than the increase in government
[30:25] expenditure but it will be not as much
[30:28] as it would have been had we had a close
[30:31] economy why is
[30:39] that why is the last part
[30:43] true why not as much as it would have
[30:45] been in the close
[30:50] economy well you can read it here is
[30:53] because part of that extra energy the
[30:55] man for consumption will go to foreign
[30:57] Goods it will not come back to demand
[30:59] more domestic production okay and that's
[31:03] reflected in that the trade deficit in
[31:05] this particular example we start with a
[31:07] situation where the the we had a the
[31:09] trade was balanced we had no net export
[31:12] was equal to zero and we end up with a
[31:14] trade
[31:15] deficit that trade deficit is exactly
[31:17] the same reason why we got a smaller
[31:19] multiply is because part of the extra
[31:21] demand that comes from the extra income
[31:23] that created by the additional
[31:25] expenditure H by the aggregate demand
[31:28] effect of additional expenditure went to
[31:30] the demand for foreign
[31:32] Goods
[31:39] okay good so do the same things we did
[31:44] in in close Eon just practice here
[31:45] increase taxes do things like that
[31:48] increase
[31:49] czo and see what happens both with
[31:52] equilibrium output qualitatively will be
[31:55] exactly the same as with you had in
[31:56] close economy except that the effects
[31:58] are going to be smaller but you're going
[32:00] to get something new which is what
[32:01] happens to the trade deficit as a result
[32:06] okay
[32:08] so this is a shock we couldn't do in the
[32:10] close economy case which is what happens
[32:13] if foreign demand go comes up that's
[32:15] what I'm saying everyone is jubilant in
[32:18] Emerging Market worlds because
[32:20] China's output is going
[32:23] up so what are all these economists
[32:25] thinking say well China's output is
[32:28] going up that means they're going to
[32:29] import a lot more from
[32:31] us okay that is they think our exports
[32:35] are going to go up because
[32:37] Chinese consumption is going
[32:40] up well exports going up means up that
[32:45] our ZZ curve moves
[32:47] up okay so then what do you get well you
[32:51] get
[32:53] er now an increas in in
[32:56] exports uh for any given level of income
[32:59] means that eventually you you're going
[33:01] to get higher output immediately but
[33:02] higher output also has a multiplier
[33:04] although smaller but at the end of the
[33:06] day you're going to get higher
[33:08] equilibrium out so it's great news
[33:10] that's the reason they're so happy it's
[33:11] great news that China is expanding
[33:13] because it's also lead to an expansion
[33:16] in h the rest of the
[33:18] world okay so that's what you
[33:22] get so that in that sense you know that
[33:26] if if if China decides to do an
[33:28] expansionary fiscal policy it also
[33:31] expands us output or even more important
[33:35] for Chilean output okay it does that so
[33:38] it's the
[33:39] same Chile could have done it by having
[33:42] their own fiscal policy that would also
[33:44] expanded output but it's wonderful that
[33:47] China decides to do it because that
[33:49] expands output as well with one
[33:51] advantage two advantages what is but
[33:55] there's one that you can see here which
[33:57] is what
[33:58] why is it that they prefer that China
[34:00] does the effort rather than
[34:01] me what looks better
[34:07] here assume they are comparable size and
[34:10] so on in terms of the impact in the in
[34:13] the top diagram supposed to generate the
[34:15] same increasing output as a result of
[34:17] one policy which is my domestic
[34:20] expansion in G which is what we did the
[34:22] previous slide or because China's goes
[34:25] into a boom and starts importing a lot
[34:29] that's this we can we can export a lot
[34:30] to them so suppose we get the same
[34:33] increase in output what looks a little
[34:35] better not a little better it can look a
[34:38] lot
[34:39] better there are two things but one is
[34:41] in this
[34:42] diagram which is remember if I did go in
[34:45] expenditure the net export function
[34:47] wouldn't have moved and I ended up with
[34:49] higher output I would have ended up with
[34:52] a bigger trade
[34:53] deficit okay in this case it's export
[34:58] driven so it's the opposite because the
[35:00] now the net export function is Shifting
[35:02] up you know if I move y star up I'm
[35:05] moving export up that means the net
[35:08] export function is moving up shifting up
[35:11] and then I'm losing some of that because
[35:13] in increasing domestic
[35:14] output er um goes into input but at the
[35:19] end of the day in this case I end up
[35:21] with a trade surplus rather than a trade
[35:25] deficit okay so lots of things that's
[35:28] the reason when you open the world
[35:30] there's a lot of free writing here you
[35:32] want the other one to do the policies
[35:33] for you because then then you're a lot
[35:36] better you can get the same increase in
[35:37] output but here you end up with a trade
[35:39] surplus rather than a trade deficit and
[35:42] there's a second thing that I'm not
[35:43] showing you here there's a big
[35:45] difference between you doing it you
[35:46] domestically by increasing government
[35:48] expenditure versus the other one doing
[35:50] it for you and they're pulling you
[35:52] through export what else will look
[35:55] better in the US in this case relative
[35:57] to the previous
[36:01] slide that's but that's too
[36:03] sophisticated we're still keeping the
[36:04] interest rate
[36:08] constant
[36:09] H that's even more sophisticated this is
[36:12] short run completely sticky prices
[36:14] forget all
[36:22] that fiscal deficits in the other one I
[36:26] need to increase G so they had a fiscal
[36:29] deficit here I don't need to do that and
[36:32] in fact in reality taxes are typically
[36:35] indexed to Output domestic output so
[36:37] that that probably will improve the
[36:39] deficit in the US
[36:42] okay so
[36:44] anyways the last point I want to H talk
[36:48] about is another variable that we didn't
[36:50] have in in the close economy which is
[36:53] the role for the exchange rate what the
[36:55] exchange rate can do and so for this we
[36:58] need to look you know the only term that
[37:00] depends on the exchange rate is this net
[37:02] export term no the exports minus inputs
[37:05] so what you know from net exports it's
[37:07] very clear what happens to net exports
[37:10] when we increase y star we did an
[37:12] experiment before that's what increase
[37:15] exports so net exports will increase if
[37:18] you increase y star we also know that
[37:21] net exports will decrease if domestic
[37:23] output goes up because inputs increase
[37:26] but from this expression is a little
[37:28] ambiguous what happens to net exports
[37:31] when there's a when the real exchange it
[37:34] appreciates and it's a little it's a
[37:37] little ambigous for the following
[37:39] reason the volume
[37:42] expression is clearly increasing in the
[37:45] real exchange if us Goods become more
[37:48] expensive you want to import more that's
[37:50] what we discussed before but the value
[37:53] may not be such because if you're
[37:54] importing those goods in euros and now
[37:56] the euro is cheaper for you then then
[37:58] you may you're are paying less for each
[38:01] unit you import okay now we're going to
[38:04] assume from now on that this second
[38:06] effect is not as strong as the volume
[38:08] effect and that's a very realistic
[38:09] assumption except for the very very very
[38:11] short run okay so that's going to be our
[38:14] assumption our assumption will be that
[38:16] net exports decrease when the currency
[38:20] appreciates if your goods become more
[38:23] expensive then on net you're going to
[38:25] have less net exports
[38:27] okay as an assumption it simply says
[38:30] that this guy in the numerator responds
[38:32] more strongly than the denominator to a
[38:34] depreciation to an appreciation of the
[38:38] exchange so the quantity effect is much
[38:41] more important than the price
[38:44] effect so again I'm not going to have
[38:48] trick questions about this or anything
[38:49] I'm going to assume that from now that's
[38:51] your assumption okay if I make a mistake
[38:55] and and I try to trick you in in the
[38:57] quiz for that you can charge me the
[38:59] points okay I don't intend to do that
[39:02] it's just IDE spot when one of the da
[39:05] sort of wrote something there and
[39:08] because this is the a very realistic
[39:11] assumption good so now let's see what
[39:14] happens then when the exchange rate
[39:16] moves and let me use it ER suppose that
[39:20] that you are in a situation where you
[39:22] want to reduce the trade
[39:24] deficit what would you do to so so the
[39:27] experiment I have here has two
[39:29] components but but let's talk about the
[39:31] first one suppose that that you your
[39:34] country has a big trade
[39:36] deficit H and you want to reduce
[39:39] that and the only tool you have is the
[39:44] exchange rate what would you
[39:49] do suppose you have trade deficit you
[39:51] don't like that and you can move the
[39:54] exchange rate around what would you do
[40:00] yes you depreciate you make the domestic
[40:02] Goods cheaper relative to the rest of
[40:04] the world so you depreciate H your
[40:08] currency which is the prices are
[40:10] completely sticky fixed than nominal
[40:13] depreciation means also real
[40:15] depreciation and that will increase
[40:17] increase net exports so what that will
[40:19] do if you depreciate so X The Exchange
[40:22] is also a parameter in this net export
[40:24] function and given my assumption when
[40:27] you depreciate the exchange rate then
[40:29] then moves the net export function up
[40:32] okay now the problem is that if you do
[40:36] that that's also going to be
[40:38] expansionary because now you know you
[40:41] had certain equilibrium level of output
[40:42] and now there's going to be expend
[40:44] switching all around the world towards
[40:46] your goods so you're going to end up
[40:47] producing
[40:48] more okay and so suppose that you didn't
[40:52] want that extra production you just
[40:54] wanted to fix your trade balance then
[40:56] you have to said that and that's what
[40:58] I've done here typ that's very typical
[41:01] is supposed you're a situation where you
[41:03] have very large trade deficit but you
[41:05] are okay with the equilibrium level of
[41:06] output you have and a typical package is
[41:09] you depreciate your currency but you
[41:11] also reduce govern expenditure okay
[41:13] because depreciation of the currency is
[41:15] expansionary it's expansionary improves
[41:18] the trade deficit but it's also
[41:19] expansionary because you relocate
[41:20] expenditure both of residents and
[41:23] foreigners towards your good that
[41:24] increases demand for your good increases
[41:26] out
[41:27] but um
[41:32] um I mean if I don't like that I have
[41:35] many ways of of setting that one of them
[41:37] is by reducing government expenditure
[41:40] okay so that's what I've done
[41:44] here again this is a great package you
[41:47] see this is doing remember I told you
[41:50] here
[41:52] that people tend to prefer remember I
[41:55] said you know this is this is one way of
[41:58] of increasing output if you want to
[42:00] increase output H um another
[42:04] way is is to do it by exports
[42:08] Rising if I don't want to increase out
[42:10] but this is better because this
[42:11] increases the trade balance well suppose
[42:15] I do I which is where index is I do the
[42:18] converse suppose I don't want to change
[42:20] output I want to increase the net export
[42:24] well these two charts this and the
[42:26] previous one tell me exactly how to do
[42:28] it I use this for the expansion of
[42:31] output and to improve the net
[42:33] exports and I use the other one to
[42:35] offset the effect on
[42:37] output but with the opposite
[42:40] sign so I use this but with a decline in
[42:44] G that's exactly what I did here so
[42:47] that's very tempting for a country to
[42:50] okay to depreciate the currency and at
[42:53] the same time H if you think that you
[42:56] need to pull off the economy then you
[42:57] can use some other instrument domestic
[43:00] instrument to to do that for a long time
[43:03] China was accused of doing just this it
[43:06] was called the mercantilist policies of
[43:08] China and and especially sort of in late
[43:12] 90s and 2000s and so on China had
[43:15] massive amount of exports and and the US
[43:18] had huge trade deficit was called was
[43:23] called the the the time of the global
[43:25] imbalances big deficit in the US big
[43:29] Surplus in in in in the in China and and
[43:35] the rest of the world kept accusing
[43:37] China of really M maintaining their
[43:40] currency at artificially low levels okay
[43:44] with the purpose of doing
[43:47] that uh anyways I'm not going to take
[43:51] sight on that I think that
[43:55] that that the reason why the currency
[43:57] was the Chinese REM was so depreciated
[44:00] was different from that but that's a
[44:02] different
[44:03] story but the result was this it was
[44:06] that they had very large trade
[44:09] surpluses and uh the result was this
[44:13] they had very large trade surpluses and
[44:15] they grew a lot
[44:17] so because they had this but it was very
[44:21] export driven it was the rest of the
[44:23] world pulling in fact the domestic
[44:25] economy in China they were saying a lot
[44:27] so domestic consumption was very low but
[44:29] they had massive amount of exports and
[44:31] that's what was P pulling their output
[44:35] up so open economy you get new
[44:39] tools okay so that's all that I want to
[44:41] say for today um so
[44:44] summary uh very important demand for
[44:48] domestic Goods is no longer equal to
[44:50] domestic uh demand for
[44:53] goods because part of the latter will go
[44:55] to a for foreign
[44:57] goods and and also part of the former
[45:01] will come from foreign demand okay so
[45:03] that's that's a the that's what is new
[45:06] of this part you have an extra component
[45:08] and then the other thing that is new of
[45:10] this part of the course is that well
[45:12] these extra components the exports and
[45:13] the Imports are functions of things that
[45:15] w we didn't have before for an output
[45:18] the exchange rate in particular
[45:21] okay
[45:23] um so equilibrium output again is the
[45:26] determined by a output domestic output
[45:31] equal to
[45:32] that not to
[45:36] that the difference between the two is
[45:38] reflecting the trade
[45:40] balance ER so the trade another way of
[45:42] thinking about the trade balance is
[45:44] simply the difference between the demand
[45:47] for a um domestic goods and the domestic
[45:51] demand for goods so the trade balance is
[45:53] nothing else than that DD curve minus
[45:55] the ZZ curve that's a trade balance okay
[45:59] sorry the zzer minus the the deer that's
[46:04] that's net
[46:05] export okay sorry let me write that down
[46:10] because so remember that we started from
[46:14] the demand which was C + I + G that's
[46:21] the domestic demand for
[46:23] goods we went to Z e is equal to
[46:30] demand
[46:32] plus net
[46:34] export okay so what I'm saying
[46:38] is that net
[46:42] export is just equal to Z minus D okay
[46:48] so that's the reason you can very early
[46:51] on
[46:53] when I show you this thing here the if
[46:56] distance between ZZ and d d is this n
[47:02] export here okay that's a reason when
[47:05] the two of them are the same that also
[47:06] means that n export is equal to zero
[47:10] very important also message from this
[47:12] part of of of the course is that a
[47:14] depreciation improves the trade balance
[47:17] and increases the amount for domestic
[47:18] Goods again that's what it's called
[47:20] expenditure switching mechanism the
[47:22] expenditures both of domestic of
[47:26] residents and foreign switches towards
[47:28] domestic
[47:29] good
[47:32] ER and that's also very important for a
[47:35] given exchange rate changes in aggregate
[47:37] demand in one large country H induced by
[47:40] policy or the private sector in this
[47:42] case China
[47:43] reopening ER affects other countries
[47:46] through why star through
[47:49] exports okay so I'm going to stop here
[47:53] and in the next lecture what we'll do is
[47:54] we'll integrate this with the H
[47:58] Financial opening and and that will get
[48:00] us to what I think is one of the most
[48:01] important malls in this course which is
[48:03] called the Mandel flaming Mall