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Chapter 10

Chapter 10. Macroeconomics in an Open Economy. The Aggregate Demand for the Aggregate Output. Households, firms, government and the rest of the world interact in goods market, financial market and foreign exchange market.

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Chapter 10

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  1. Chapter 10 Macroeconomics in an Open Economy

  2. The Aggregate Demand for the Aggregate Output • Households, firms, government and the rest of the world interact in goods market, financial market and foreign exchange market. • The three markets are required to be in equilibrium: the supply should equal demand in all those markets. Otherwise, the economy will face problems such as unemployment, inflation etc.

  3. The consumption function • Consumption (C) is the largest part of the aggregate demand. Basically, it is a function of disposable income (Yd). C = C(Yd) • If disposable income increases, so do consumption expenditures. This equation is also called “behavioral equation” because it captures behavior of consumers.

  4. Consumption and disposable income Consumption C = c0 + c1 Yd ΔC c0ΔYd Slope = ΔC/ΔY = c1 0 Yd

  5. C = c0 + c1 Y • C is the total consumption, c0 is called “autonomous consumption”. People must consume even their income level is zero. • c1 is the slope of the function, it is called “Marginal propensity to consume” (MPC). • MPC measures the increased consumption due to the increased disposable income.

  6. The savings function Saving S = -s0 + s1Yd 0 Yd -s0

  7. S = -s0 + s1 Y • s0 is called dissaving. If people don’t have income, they have to borrow or withdraw their saving to spend. • Saving depends on the disposable income. Marginal propensity to save (MPS) is the fraction of a change in income that is saved. • s1 is the MPS. MPS = ΔS/ΔYd

  8. MPC +MPS + MPM = 1 • The total spending line plots various components of demand against output. • Investment, government spending and exports are all assumed to be given. That is, they do not depend on income. • The total spending line is parallel to the consumption function. The slope of the line is the MPC.

  9. The demand for domestic products and imports Aggregate demand (AD) AD = C + I + G + X 500 B C = c0 + c1 Yd 400 300 200 A 100 45º 0 100 200 300 400 500 Aggregate output (Y)

  10. The export and import function • The demand for exports depends on foreign income. Changes in domestic output has no direct impacts on exports. • Imports are the function of income. Marginal propensity to imports (MPM) measures the increase in imports due to the increase in income. MPM = ΔM/ΔYd

  11. The total spending line in an open economy Aggregate demand (AD) AD = C + I + G + X 500 B AD = C + I + G + X - M 400 300 A 200 100 45º 0 100 200 300 400 500 Aggregate output (Y)

  12. Investment spending curve Interest rate (i) A 4% B 3% Investment spending 0 200 300 Investment (I)

  13. IS, LM and BP Curves in an Open Economy • The IS curve represents the equilibrium condition in goods market. • Each point on the IS curve shows the equilibrium point in the goods market for the given interest rate. • Changes in the components of the aggregate demand shifts the IS curve.

  14. IS curve interest rate (i) i0 A B IS’ IS 0 Y0 Y1 Aggregate output (Y)

  15. Money demand is a decreasing function of the interest rate. • LM curve represents the equilibrium condition in the money market. • LM curve is upward sloping. Each point on the LM curve shows equilibrium in the money market for the given value of the aggregate output (Y).

  16. LM curve interest rate (i) LM LM’ i0 A B 0 Y0 Y1 Aggregate output (Y)

  17. IS-LM diagram interest rate (i) Expansionary monetary policy and contractionary fiscal LM policy A LM’ i0 B i1 IS’ IS 0 Y0 Y1 Aggregate output (Y)

  18. BP is the balance of payments which is defined as: BP = CA + KA • BP curve represents the set of aggregate output – interest rate combination that maintain a balance-of-payment equilibrium. • The high level of income causes makes BOP worsening and low level of income improves BOP status.

  19. BP curve interest rate (i) BP B i0 A C 0 Y0 Y1 Aggregate output (Y)

  20. BOP deficit Interest rate (i) BP LM i0 A IS 0 Y0 (Y) BOP surplus Interest rate (i) BP LM i0 A IS 0 Y0 (Y) The IS-LM-BP model

  21. Equilibrium in three markets interest rate (i) LM BP A i0 IS 0 Y0 Aggregate output (Y)

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