3. Open Economy Consider an economy where C = 200 + 0.25(Y-T) I = 200 + 0.25Y-10

Question

3. Open Economy

Consider an economy where

C = 200 + 0.25(Y-T)

I = 200 + 0.25Y-1000i

G = 350, T = 300 i=i=.05

X = 0.4Y* and IM = 0.2Y,

(real exchange rate) = 2

Y* (foreign output) = 1000

a. Calculate the multiplier if the economy is closed and the multiplier if the economy opens up. Explain the economic intuition why the two are different

b. Solve for the equilibrium level of income (Y) for the open economy (Yopen) and calculate the trade balance (NX).

c. If government follows an expansionary fiscal policy and G changes by 60, calculate the change in Y for both the closed economy (Yclosed) the open economy (Yopen). Assume no change in the foreign output (Y*). Calculate the new trade balance.

d. If this economy has flexible exchange rate regime, how would the exchange rate respond to a fiscal expansion policy? Appreciation or Depreciation? Explain why.

e. Suppose the interest rate in the foreign economy is 2%, and an investor expects the domestic currency to depreciate relative to the foreign currency by 4%, in which bond market in those two economies should the investor invest?

Explanation / Answer

a) Closed economy: Multiplier = 1/(1 - MPC) = 1/(1 - 0.25) = 1/0.75 = 1.33

Open economy: Multiplier = 1/(1 - MPC + MPCxTax) = 1/(1 - 0.25 + 0.25 x 0.2) = 1/(0.75+0.5) = 1/1.25 = 0.8

b) Y = C + I + G + X - M

Y = 200 + 0.25(Y-T) + 200 + 0.25Y - 1000i + 350 + 0.4Y* - 0.2Y

Y = 200 + 0.25(Y - 300) + 550 + 0.25Y - 1000(0.05) + 0.4(1000) - 0.2Y

Y - 0.25Y + 0.2Y = 750 + 0.25Y - 75 - 50 + 400

Y - 0.05Y - 0.25Y = 1025

0.7Y = 1025

Y = $ 1464.28

NX = X - M = 0.4(1000) - 0.2(1464.28) = 400 - 292.86 = 107.14

c) Open economy:

Change in Y = Change in G x Multiplier = 60 x 0.8 = 48

Output increases by $ 48 in open economy.

New Trade balance = Exports - Imports = 0.4(1000) - 0.2(1512.28) = 400 - 302.456 = 97.54

Change in Y = Change in G x Multiplier in closed economy = 60 x 1.33 = $ 79.8

Output changes by $ 79.8 in closed economy.

New Trade balance = Exports - Imports = 0.4(1000) - 0.2(1544.8) = 400 - 308.82 = 91.18

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