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