Model of a large open economy
The model of a large open economy is analogous to the model of a small open economic system, with the exception of a fragment formalizing the condition for the flow of capital flows. Its constituent elements are:
These equations formalize the following positions:
1) the amount of output (national income) is determined by the nature of the production function and the available volumes of labor L and capital K;
2) the basic macroeconomic identity of national accounts;
3) the dependence of the volume of consumption on the amount of disposable income;
4) the dependence of the volume of investment on the real interest rate;
5) the state of the current account of the balance of payments, due to the real exchange rate of the currency;
6) the dependence of the capital account on the value of the internal rate of interest;
7) the need to balance each other with capital account and current transactions.
With the above in mind, the general record of the IS-LM-BP model for a large open economy looks like
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In the third equation, it is argued that the current account always balances the KA's capital flow account, which in turn depends on the internal interest rate r.
For a better understanding of the model under consideration, we substitute the third equation of the model in the first. Then the model of a large open economy will take the form (Figure 7.23)
Let's make some explanations to the graphic model of a large open economy in the short-term period:
- Fig. 7.23, and: due to the introduction of the new parameter of the capital flow - KA ( i ) into IS equation, the IS curve becomes more elastic than it would be in the corresponding model of the closed economy. In this case, the more sensitive the amount of capital flow to the interest rate, the more elastic the IS line becomes;
- Fig. 7.23, b: the equilibrium interest rate і1 determines the capital flow of the spacecraft. The curve has an upward character, as the increase in the interest rate stimulates the inflow of foreign investment;
- Fig. 7.23, in: the exchange rate of the currency is changed in such a way that the net export of goods and services balances this inflow of capital. In other words, the exchange rate serves as a means of establishing a balance between the current account and the capital account.
Consider now with the help of this model the implications for a large open economy of a specific economic policy under conditions of a floating exchange rate.
Fig. 7.23 . The model of a large open economy
Economic policy in a large open economy
Fiscal policy. Let's analyze first of all the influence of the stimulating fiscal policy on the economic system under study: increasing government spending or (and) reducing taxes (Figure 7.24).
Fig. 7.24. Implications of fiscal policy in a large economic system
Growth in government purchases or (and) tax cuts lead to a shift in the IS curve to the right (up). It follows from Fig. 7.24, a, such a shift is accompanied by an increase in the national income Y and the interest rate і. In turn, the growth of the interest rate leads to a reduction in the volume of investments and an increase in capital inflows into the country (Figure 7.24, b).
Due to the fact that the current account XN and the capital account of the SC always balance each other, the SC growth is accompanied by the fall of XN. Since the value of XN is related to the real exchange rate by an inverse relationship, the rate r * should increase in this case.
We note once again that the final impact of fiscal policy in this model is a combination of its consequences for a closed economy and for a small open economic system. As in a closed economy, stimulating fiscal policy in a large open economy raises the interest rate, which displaces domestic investment. As in a small open economy with perfect capital mobility, the stimulating fiscal policy triggers capital inflows, a current account deficit in the balance of payments and an appreciation of the real exchange rate of the national currency.
The consequences of monetary policy will be examined with the help of the graphical model shown in Fig. 7.25.
The increase in the supply of money as a result of the stimulating monetary policy leads to a shift of the LM curve to the right (Fig. 7.25, a). The income level is growing, and the interest rate is decreasing.
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Figure 7.25, b illustrates the reduction in the volume of capital (due to a decrease in the internal interest rate) coming into the country from abroad.
Fig. 7.25. Incentive Monetary Policy in a Large Open Economy
Reducing the flow of capital from abroad is accompanied by an increase in net exports (to maintain a balance between the current account and the capital account). The growth of net exports is due to a decrease in the exchange rate (the supply of the national currency for international payments is increasing and the exchange rate is decreasing).
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