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1 Open Economy - Introduction

The document discusses how the world is rapidly globalizing through increased connectivity, convergence of tastes, and movement of goods, services, workers, and capital across borders. It defines globalization as the openness of economies, specifically openness in goods markets, financial markets, and factor markets. When goods markets are open, consumers can choose between domestic and foreign goods. When financial markets are open, investors can hold assets in different countries and countries can run trade surpluses and deficits through cross-border capital flows.

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Prakhar SIngh
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114 views13 pages

1 Open Economy - Introduction

The document discusses how the world is rapidly globalizing through increased connectivity, convergence of tastes, and movement of goods, services, workers, and capital across borders. It defines globalization as the openness of economies, specifically openness in goods markets, financial markets, and factor markets. When goods markets are open, consumers can choose between domestic and foreign goods. When financial markets are open, investors can hold assets in different countries and countries can run trade surpluses and deficits through cross-border capital flows.

Uploaded by

Prakhar SIngh
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
You are on page 1/ 13

 The world is rapidly globalizing and this is providing many

opportunities and major challenges to the nations and people


of the world.
 We live in a globalized world. We can connect instantly with
any corner of the world by cellular phone, e-mail, instant
messaging, and teleconferencing, and we can travel anywhere
incredibly fast.

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 Tastes are converging (i.e., more and more people all over the world
generally like the same things) and many goods we consume are
either made abroad or have many imported parts and components.
Many of the services we use are increasingly provided by foreigners.

 Although not as free as the flow of international trade in goods and


services, millions of workers at all skill levels have migrated around
the world, and thousands of jobs have moved from advanced
countries to such emerging markets as India and China.

 Finance has also globalized: We can invest in companies anywhere in


the world and purchase financial instruments (stocks and bonds) from
any company from almost anywhere in the world. Many pension funds
are in fact invested abroad and a financial crisis in one financial
centre quickly spreads across the world at the click of a mouse. We
can exchange dollars for euros and most other currencies easily and
quickly, but the rates at which we exchange our currency often
change frequently and drastically.
3
 Globalization refers to openness of an economy
 Openness has three distinct dimensions:

o Openness in goods markets.


o Openness in financial markets.
o Openness in factor markets.

Note: we shall discuss openness in goods & financial market only

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 When goods markets are open, domestic consumers must
decide not only how much to consume and save, but also
whether to buy domestic goods or to buy foreign goods.

5
 Closed economy

Y = C + I +G
Where
C = (Y-T) is consumption which is a direct function of
disposable income
I = I (Y, r) is investment which is a direct function of
income/production Y and indirect function of real interest
rate ‘r’
G = autonomous

6
 Open economy

Y = C + I +G + X - M

 X and M bring in new dimensions in the macroeconomic


system

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Y = C (Y – T) + I (Y, r)+ G + X (Y*, E) – M (Y, E)
Where E → exchange rate; Y* → foreign income

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 Openness in financial markets allows:
◦ Financial investors to diversify—to hold both domestic and
foreign assets and speculate on foreign interest rate
movements.
◦ Allows countries to run trade surpluses and deficits. A
country that buys more than it sells must pay for the difference
by borrowing from the rest of the world.

9
 The decision whether to invest abroad or at home depends
not only on interest rate differences, but also on your
expectation of what will happen to the nominal exchange rate.

10
 Closed economy: People have demand for two financial
assets: money & bond

M/P = L1 (Y) + L2 (i)


Transaction demand Speculative demand
 L1 (Y) → this is a direct function of ‘Y’
 L2 (i) → this is an indirect function of ‘i’

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 Open Economy
 An additional consideration is: Now people have a choice
between domestic bonds & foreign bonds
 Due to this ne dimension a new equation in the system is the
interest parity equation as shown in the text box below:

it~ it* - (Eet+1 - Et)/Et


Where it*→foreign interest rate in time ‘t’;
it → domestic interest rate in time ‘t’
Et → exchange rate in time ‘t’
Eet+1 → expected exchange rate in time ‘t’

12
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