EC202A Macroeconomics Handout 2 Laura Povoledo The University of Reading EC202A Macroeconomics The IS-LM-BP model Reading material that you may find useful: - Abel, Bernanke and McNabb, Chapters 5 and 14. - Abel, Bernanke, 5 th ed, Chapters 5 and 13. - Dornbusch, Fisher and Startz, 9 th ed, Chapter 12. - Begg, Fischer an Dornbusch, 7 th ed, Chapters 28 and 29. Outline: 1. The Goods Market Equilibrium in an Open Economy ; 2. The open-economy IS curve ; 3. The Balance of Payments and Capital Flows ; 4. The BP curve ; 5. The Mundell-Fleming model . The Goods Market Equilibrium in an Open Economy Economies are linked internationally through two main channels: • trade in goods and services; • international financial markets. First, let’s consider the effects of trade with the rest of the world on the goods market equilibrium and then we’ll understand how to modify the IS curve. The Goods Market Equilibrium in an Open Economy Previously, we have seen that the goods market equilibrium condition can be expressed in two ways: 1) National saving equals investment: S = I (1) Closed economy Equation 2) Aggregate supply equals aggregate demand: Y = C + I + G (2) Closed economy Eq. The Goods Market Equilibrium in an Open Economy What changes in an open economy? National saving now has two uses: • increase the nation’s capital stock by domestic investment; • increase the stock of net foreign assets by lending to foreigners. We capture this by re-writing the equilibrium condition (1) in the following way: S = I + CA = I + NX + NFP (1)’ Open economy Eq. Change no. 1 The Goods Market Equilibrium in an Open Economy Eq. (1)’ shows the uses of savings in an open economy. Investment I is accrued to the domestic capital stock. The current account balance CA indicates the amount of funds that the country has available for net foreign lending. Hence, Eq. (1)’ states that in goods market equilibrium in an open economy, the amount of national saving S must equal the amount of domestic investment I plus the amount lent abroad CA. The Goods Market Equilibrium in an Open Economy The closed economy equilibrium condition (1) is a special case of the open economy equilibrium condition (1)’, with CA =0. Change no. 2 What else changes in an open economy? Domestic spending on goods and services is no longer equal to domestic output. This happens because: - Part of domestic output is sold to foreigners (exports); - Part of spending by domestic residents purchases foreign goods (imports). The Goods Market Equilibrium in an Open Economy We can also re-write the equilibrium condition (2) - aggregate supply equals aggregate demand – for an open economy. The main change is that domestic spending no longer determines domestic output. Instead, spending on domestic goods determines domestic output. Define: A = spending by domestic residents Then: A = C + I + G The Goods Market Equilibrium in an Open Economy Spending on domestic goods is total spending by domestic residents less their spending on imports plus foreign demand or exports. Therefore: Where: X = exports; Q = imports. Spending on domestic goods = A + NX = = C + I + G + X – Q = Domestic output Note: A is also called absorption. [...]...The Goods Market Equilibrium in an Open Economy In order to obtain an equilibrium condition, we write: Y = C + I + G + NX (2) ’ Open economy Equation Eq (2) ’ states that in goods market equilibrium in an open economy, the supply of domestic goods Y is equal to spending on domestic goods, A + NX The Goods Market Equilibrium in an Open Economy... What about the KA ? Again, we look first at the separate components It is often useful to split the capital account into two separate components: (1) the transactions of the country’s private sector and (2) official reserve transactions, which correspond to the central bank activities: KA Net private capital inflows NPKI Official reserve transactions ORT The Balance of Payments and Capital Flows Example:... case of no capital mobility, the BP line corresponds in practice to the condition that the Current Account is in balance To the left of the BP line, BP > 0 To the right , BP < 0 The BP curve r Case 2: Imperfect capital mobility BP is upward sloping because if Y rises, there will be an increase BP in imports leading to a deficit in the CA, and (to balance this with a surplus in the KA) r must raise... mobility (Why?) The BP curve Shifts in the BP curve • If YF BP then X • If rF r then KA • If there is an expected nominal appreciation then KA Y Changes in YF , rF, and E ΔeNOM/eNOM shift the BP curve Note 2: changes in rF, and E ΔeNOM/eNOM do not affect the BP curve if there is no capital mobility (Why?) The Mundell-Fleming model r LM BP IS Y It can also be extended to cases other than perfect capital mobility . EC202A Macroeconomics Handout 2 Laura Povoledo The University of Reading EC202A Macroeconomics The IS-LM-BP model Reading material that. Fisher and Startz, 9 th ed, Chapter 12. - Begg, Fischer an Dornbusch, 7 th ed, Chapters 28 and 29 . Outline: 1. The Goods Market Equilibrium in an Open Economy ; 2. The open-economy IS curve ; 3 National saving equals investment: S = I (1) Closed economy Equation 2) Aggregate supply equals aggregate demand: Y = C + I + G (2) Closed economy Eq. The Goods Market Equilibrium in an Open Economy What