Topic 9

Open-economy Macroeconomics
 Reference

Chapter 14 of Samuelson-Nordhaus
Income Determination in Open Economy

3
Income Determination in Open Economy
(Ex > 0; M = 0)
C,I,
etc C+I +G +Ex

E2 C+I+G

E1

45

Potential output Y 4
Income Determination in Open Economy
(Ex > 0, M > 0; Ex > M)
C,I,
etc
C+I +G +X
E2 C+I+G

E1

45

Potential output Y 5
Income Determination in Open Economy
(Ex > 0, M > 0; M > Ex)
C,I,
etc

C+I+G

C+I +G +X
E1

E2

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Potential output Y 6
 Assumptions
C = C(Y)
I=I
G= G
Imports (M) depend on:
Domestic production and income
Relative prices of domestic and foreign goods
We assume: M = M (Y) at given relative prices

Similarly Exports (Ex) depends on:

Production and income in the rest of world
Relative prices of domestic and foreign goods
We assume: Ex = Ex (i.e., exogenously given)

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 Thus
Slope of (C+I+G) = slope of C = MPC =b =
change in total spending in closed economy
when income changes by a unit
Slope of (C+I+G+X) = (MPC MPm) = (b-m) =
change in total spending in open economy
when income changes by a unit
It follows, slope of the later (= b-m) is less
than that of the former (b)

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 Demand Constrained Open Economy

Ceteris paribus:
Higher exports better
Lower imports better
As marginal propensity to import increases, the total
spending curve will be flatter
As export go up, the total spending curve shifts
upwards
Multiplier in closed economy greater than that in an
open economy

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 Multiplier in Open Economy

Govt exp = G + (b-m) G + (b-m)2 G +..

(= Demand)

Production (= Y) = G + (b-m) G + (b-m)2 G +..

= G (1+ (b-m) + (b-m)2 +.)

= G (1/(1- (b-m)) = X (1/((1- b)+m)

= G (1/(MPS + MPm)

b : marginal propensity to consume

MPS = marginal propensity to save = 1-b
m = MPm = marginal propensity to import

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Monetary policy transmission in open economy

Fixed exchange rate system:

Impossible trinity independent monetary policy
becomes difficult
Flexible exchange rate system
If Fed reduces rate of interest
Capital flows out
Demand for, say Euros increase
$/Euro increases; Euro/$ falls
Net Exports increase
Imports fall
Exports increase
Growth in Open Economy

Some Macroeconomic Issues

 Macroeconomic financing of Investment
Investment vital for economic growth
How to increase Investment when it is sluggish an important
policy issue
Investment:
Increases Demand immediately
Adds to Productive capacity after a lag
Difference between Macroeconomic and Microeconomic
financing of Investment
Printing of Money to finance Investment does not help
under Supply constraints
Resource mobilzation for investment means financing is
such a way that demand- supply balance is ensure and
inflation is avoided
 Demand and Supply Constrained economies

Demand constrained:
Aggregate demand < Potential output
Supply constrained:
Aggregate demand > Potential output
 Equilibrium Conditions
Closed economy with No Govt
Y=C+I
Or Y C + I
Or, S = I
Open economy with No Govt
Y = C + I + Ex - M
Or, (Y C) + M = I + Ex
Or, S + M = I + Ex
Or, I = S + ( (M Ex)
Or I = domestic savings + foreign savings
 Financing Investment in Closed Economy with No Govt

Demand constrained: Supply Constrained:

I can be financed just by I can be financed by

printing of money printing of money
But now as Demand ,
As Demand , Supply also Supply cannot and hence
and hence no Inflation Inflationary
Options:
Additional Savings through Tolerate Inflation
Y expansion forced savings
But inflation
temporary
Sacrifice growth
 Financing Investment in Closed Economy with No Govt

Demand constrained: Supply Constrained:

An increase in savings An increase in savings

propensity reduces demand propensity reduces
and worsens the situation voluntarily or through policy
measures improves the
situation
Growth without
inflation

Money: What it can do and what it cannot

 Closed economy with no govt: Demand constrained

AD
C + I + I

C+I

Printing of Money
not Inflationary

Potential output

Y
Y* 19
Closed economy with no govt: Supply constrained
C + I + I

AD
C+I

Printing of Money
Causes Inflation

Y
Y* 20
Cloased economy with no govt: Supply constrained
C + I + I

AD C+I

Inflation leads to in C
due to forced savings

Y
Y* 21
Closed economy with no govt: Supply constrained

AD

C1 + I + I

New Equilibrium
With higher I
but lower C

Y
Y* 22
 Financing of Investment
Closed Supply constrained economy with no Govt

Difficult Macroeconomic Policy choices

Tolerate Inflation
Sacrifice Growth
Opportunities:
Open economy
Government
 Equilibrium Conditions
Closed economy with No Govt
Y=C+I
Or Y C + I
Or, S = I
Open economy with No Govt
Y = C + I + Ex - M
Or, (Y C) + M = I + Ex
Or, S + M = I + Ex
Or, I = S + ( (M Ex)
Or I = domestic savings + foreign savings
 Financing Investment in Open Economy with No Govt
Demand constrained:
I can be financed just by
printing of money
As Demand , Supply also
and hence no Inflation
Additional Savings through
Y expansion
More Savings domestic
or foreign may have
negative consequences
Supply Constrained:
I can be financed by
printing of money
But now as Demand ,
Supply cannot and hence
Inflation
Options:
Tolerate Inflation
Sacrifice growth
Use foreign savings
But Long term
costs
 Macro financing of I under supply constraints

As I increases, Demand increases

Supply cannot increase under supply constraints
Hence :
Demand > Supply leading to Inflation
If objective is to avoid inflation: use foreign
savings ((M Ex):
Regulate increase in Demand by importing investment
goods or
Increase Supply by importing goods in short supply
 Financing of (M Ex)
From where does the country get foreign
exchange to finance imports in excess of
exports, i.e., foreign savings?
In the short term, use of foreign savings may help
by managing demand-supply gap and hence by
avoiding inflation
But there are long term costs
 Financing of foreign savings (M Ex)
Unless a country has adequate forex reserves
Foreign borrowing:
External assistance
Multilateral sources (IMF, World Bank, ADB etc) -
Bilateral sources (govts of USA, Japan etc) -
Commercial borrowings:
Long term ECBs
Short term ECBs
NRI deposits
Foreign investment:
Foreign Direct Investment (FDI)
Foreign Institutional Investment (FII )

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 Foreign Savings
Very attractive for developing countries
But important: how the deficit is financed and
managed
Cross-country experiences:
Mexico
South Korea
India in 1990/1991
 Equilibrium Conditions
Closed economy with No Govt
Y=C+I
Or Y C + I
Or, S = I
Open economy with No Govt
Y = C + I + Ex - M
Or, (Y C) + M = I + Ex
Or, S + M = I + Ex
Or, I = S + ( (M Ex)
Or I = domestic savings + foreign savings

Open economy with govt

Y = C + I + G + Ex - M
(Y C) + M = I + G + Ex
Or, S + T + M = I + G + Ex
Or, I = S + (T G) + ( (M Ex)
Or I = Total savings
= domestic savings + government savings + foreign savings
 Financing Investment in Open Economy with Govt
Demand constrained:
I can be financed just by
printing of money
As Demand , Supply also
and hence no Inflation
Additional Savings through
Y expansion
More S domestic or
foreign or more Taxes can
worsen situation
Supply Constrained:
I can be financed by
printing of money
But now as Demand ,
Supply cannot and hence
Inflation
Options:
Tolerate Inflation
Sacrifice growth
Use foreign savings
Direct taxation
 Macroeconomic financing of Investment
Open economy with Govt

Options:
Tolerate Inflation
Sacrifice growth
Use foreign savings
Useful under Supply constraints
Deferring the problem rather than solving it?
Direct taxation
Feasibility?
Disincentive effect?
Warren Buffet
Thomas Piketty

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 Macroeconomic financing of Investment
Summing up
Investment vital for economic growth
Investment:
Increases Demand
Adds to Productive capacity
Difference between Macroeconomic and
Microeconomic financing of Investment
Printing of Money to finance Investment does not help
under Supply constraints
Resource mobilzation for investment means financing
is such a way that demand- supply balance is ensure
and inflation is avoided
 Growth and Crises in India
Two examples:
Initial Planning period (1951 to mid-1960s):
Followed by the Crisis in late-1960s
1980s Reforms:
Followed by the Crisis of 1991

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 Rs crores

10000
15000
20000
25000

0
5000
1950-51
1952-53
1954-55
1956-57
1958-59
1960-61
As planned

1962-63
1964-65
1966-67
1968-69
1970-71
Setback

1972-73
1974-75
1976-77
1978-79
1980-81
1982-83
Public Investment at constant prices

1984-85
1986-87
1988-89
1990-91
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 0.0
10.0
20.0
60.0

30.0
40.0
50.0
1950-51
1952-53
1954-55
1956-57
1958-59
1960-61
1962-63
1964-65
1966-67
1968-69
1970-71
1972-73
1974-75
1976-77
1978-79
Public investment share (%)

1980-81
1982-83
1984-85
1986-87
1988-89
1990-91
36
 Crisis of late 1960s
Why did it happen?
Supply shock: Drought in consecutive years
Investment reduced to ensure demand-supply
balance and avoid Inflation

But Options?

37
 Crisis of late 1960s

Options:
Tolerate inflation
Control inflation:
Increasing supply through imports
War with Pakistan and suspension of foreign aid
Reducing consumption demand through direct
taxes
Were direct taxes too high?

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 Is India a high tax country?
Yes, In terms of total tax (indirect tax) ratio
Yes, in terms of direct tax rate in the past
But not, in in terms of direct tax ratio:

Tax revenue = Tax rate x Taxable Income

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 0
2
4
6
8
10
14
16
18
20

12
1950-51
1953-54
1956-57
1959-60
1962-63
1965-66
1968-69
1971-72

Direct
1974-75
1977-78
1980-81
1983-84

Indirect
1986-87
Tax/GDP ratio (%)

1989-90
Total 1992-93
1995-96
1998-99
2001-02
2004-05
2007-08
2010-11
2013-14
 Crisis in late 1960s
Political leadership
neither wanted higher inflation
nor wanted to go for more direct taxes
Hence the worst option
Reducing investment was chosen

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 Growth of 1980s
Compared to late 1960s and 1970s, the
growth rate accelerated in the 1980s
Major changes in the 1980s:
Increased government expenditure including
consumption expenditure
Use of foreign savings
Funded mainly through short term ECBs

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 Crisis of 1991
Main problem:
Increase in exports necessary to earn foreign
exchange to service external debts also did not
increase adequately
 Crisis of 1991
I+G+X = S+M+T
G, I, M increased
S (govt dissaving) decreased
X and T did not increase
Options not explored
Control imports (M)
Increase Direct taxes (T)
Control G (current expenditure)

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Events leading to the crisis of 1991
Iraq-Kuwait war (August 1990) and
consequent oil shock
Within four months fall of two governments:
V P Singh (November 1990)
Chandra Shekhar (March 1991)
Fall in Credit ratings for India in international
capital market and increased difficulty in
borrowing internationally

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Events leading to the crisis of 1991
Capital flight of NRI deposits
Possibility of default in international payments
forex reserves dropped to about fortnights of
imports in January 1991 and again in June 1991
In July 1991, 47 tonnes of gold shipped to vaults
of the Bank of England to raise $ 405 million
IMF and World bank loan by new government (P
V Narasimha Rao as PM and Manmohan Singh as
FM)
Not only Stabilization but Structural Reforms
in India
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Identities and Policy Framing
 Identities
Always true
But to use the identity for policy purposes, we
need to know how the different variables are
related
Important to distinguish between ex-ante and
ex-post
 Closed economy with no govt
Ex-post: S I
To increase I, if we try to increase S i.e.,
MPS (Marginal Propensity to save), it can be
counter productive
 Open economy with no government
Ex-post: S + M I + Ex
Or, I S M Ex
USA:
Current account deficit, M > Ex
I>S
China:
Current account surplus, M < Ex
I<S
Savings Glut hypothesis
USA suffers from CAD because China saves too much
 China
Suppose MPS in China is very low and to start
with, CAD is in balance, M Ex and and I S
Now suppose X :
S in X sector as Y increases
S in C sector
M may or may not - even if it does the will
be less than the in Exports
So, China experiences a CA surplus and S > I
(but not because Chinese MPS is high).
 USA
Suppose MPS in USA is very high to start with,
CA is in balance, M Ex and I S
Now suppose I :
If capital goods (or consumption goods) are
imported from China,
CAD deficit
and S < I
So, CAD deficit in USA and I > S (but not
because US is saving too little)
Is US CAD caused by Savings Glut in China?
Main issue is not that Chinese are saving too much or
US too little
Issues are:
China has been able to export more and import less
(competitiveness?; tariff barriers?; under-valued currency?
etc)
USA has been able to import more than what otherwise
would have been possible due to the International status
of $
In the face of import demand, if not China some other
country would have exported
Despite China, some EU countries had surplus CAD
 USA
Expansionary Monetary Policy
High C and I demand including in real estate
Inflation under control due to ability to import
 Some Crucial Aspects
Level and growth of I (determining potential
output in economy)
Level and growth of exports
Import propensity
Forex rate adjustments and implications
Interest rate adjustments and implications