Open-economy: given world interest rate r

w
, S
d
I
d
= CA = NX
Absorption A = C + I + G
CA = NX + NFP + NUT (net unilateral transfers; not good/asset)
(1) Net investment income (previously acquired assets abroad)
(+) American owns British stock => dividend flow into U.S.
(+) Foreign subsidiary of US firms => profit flow into U.S.
() Britain holds U.S. stock => dividend flow out of U.S.
() U.S. subsidiary of foreign firm => profits flow out of U.S.
(2) Net payments to labor (very small for U.S.)
NUT: () foreign aid
() foreigners in U.S. sending money to families abroad
(+) gifts from abroad
(+) remittances from Americans abroad
CA + KFA = 0 (trade//capital flows; CA>0 -> buy assets -> KFA<0)
Large economy: Y + Y
For
= C
d
+ I
d
+ G + (C
d
For
+ I
d
For
+ G
For
)
S
d
+ S
d
For
= I
d
+ I
d
For
; CA + CA
for
= 0 for r
w

S.Econ: Twin Ds: fiscal deficit -> Natl Savings -> CA deficit
L. Econ: S
d
-> S
d
+ S
d
For
< I
d
+ I
d
For
-> interest rate

e
nom
= #FC / #HC (floating v. fixed/pegged; appreciate v. revalue)
e = P * e
nom
/ P
for
(but strong PPP, where e = 1, doesnt hold!)
Real exchange rate depreciation (exports more competitive
abroad, Net exports (NX = X-M) should risebut)
J-curve (SR switch from (higher-price) imports to (lower-price)
domestic may be slow -> NX may fall initially as real value of
imports relative to exports increases)
Currency Mkt: supply (by domestic holders) & demand (foreign)
(perceived) PVLR -> demand for goods/imports -> NX
dom. int rates -> dom. assets sell-off -> currency demand ->
exchange rate -> NX
UIP:
t nom
e
t nom
UK
e
e
i i
,
1 ,
) 1 ( ) 1 (

or i
for
= i + (e
e
nom,t+1
/e
nom, t
1)
CIP:
t nom
t nom
for
e
f
i i
,
1 ,
) 1 ( ) 1 (

IMPLIES: (f
nom
= e
e
nom
)
Weak PPP (LR): e
nom
/e
nom
= p
for
p (low inflation -> strong $$$)
e/e = e
nom
/e
nom
+ -
for


Open Econ. ISLM -> Only change is IS -> I = S -> S I = NX
Factors that shifted IS before have same effect; all factors that
shift NX (except changes in income) also shift IS
Govt Purchase -> IS out -> Y and r -> e
nom
(? In SR) -> NX
Foreign country: NX -> IS out -> Y
for
and r
for

LR: LM shifts up for both dom. and foreign (r and r
for
)
If budget deficit persists and r > r
for
-> e -> NX -> IS down ->
back to old equilibrium
Monetary Contraction -> LM up -> Y and r -> e
nom
-> NX (?
Delayed effect from e
nom
(J-curve), so NX prob. initially)
Foreign: NX -> IS in -> Y
for
and r
for

LR: firms decrease prices -> LM shifts back down -> NX -> P
and P
for
unchanged -> e re-depreciates -> back to FE, but e
nom

Fixed Ex. Rate Regime: Central bank = no indep. monetary policy
Currency Devaluation -> e
nom
permanently -> e (for given Ps)
-> NX (pressure on IS to move out) -> bank MS to prevent rise
in r -> LM shifts down and right
Currency Crisis (currency is overvalued, e
peg
> e
fv/nom
): (1) To
prevent devaluation, central bank buys currency (MS) -> LM up
-> Y and r -> (2) debt burden increased for those who
borrowed in foreign currency -> uncertainty -> financing ->
aggregate C and I -> IS left -> govt spending b/c of deficits ->
IS more left -> further effort to restrict devaluation -> LM up more
-> much lower Y!
Recovery: e
nom
-> NX -> IS back right -> central bank MS ->
LM back down

Y = A*F(K, N) (growth can come from all 3 variables)
Solow Growth Model: (assume: no taxes/govt spend, labor mkt
is stable in LR, money is neutral in LR)
y

= Y/N; c = C/N; k = K/N
y = output-labor ratio; k = the capital-labor ratio
Y/N = A*F(K/N, N/N) = A*F(K/N, 1) = A*f(k)
Assume: f(0) = 0, f(k) > 0, f(k) < 0
Holding A constant, LR equilibrium (A can be excluded):
(n + d)k
*
= sAf(k
*
)
y
*
= Af(k
*
); c
*
= (1 s)Af(k
*
) = f(k
*
) (n + d)k
*
; i
*
= (n + d)k
*


(savings rate or productivity )
(population or dep. growth causes straight line to pivot left)
Golden Rule capital-labor ratio k
g
at line tangent to curve
(consumption per capital only increases up to that pt.)
Only changes in s, f, n, or d can impact steady state
Only (A = g > 0) can increase long run growth of GDP/capita

Temporary (k < k
*
) vs. permanent differences (s, A, d)
Conditional Convergence: countries w/ diff. s, n, d, and A
converge to different k
*
-> those with low levels of k relative to
their k
*
will grow faster!
Taxes of Solow Model: G = t Y (income tax rate)
s(1-t)Af(k*) = (n+d)k* (taxes equiv. to s or A)
Limits to Solow: marginal returns to K, A missing
Causes of Productivity Growth: human capital accumulation, R&D,
better infrastructure, trade and foreign direct investment (FDI)
Also low barriers to entrepreneurial activity/tech. adoption
Endogenous Growth Model: Y/Y = K/K = g = sA d
Y/Y = A/A + a
K
K/K + a
N
N/N