WEBVTT 00:00:00.000 --> 00:00:02.450 align:middle line:90% [SQUEAKING] 00:00:02.450 --> 00:00:03.920 align:middle line:90% [RUSTLING] 00:00:03.920 --> 00:00:06.370 align:middle line:90% [CLICKING] 00:00:06.370 --> 00:00:15.898 align:middle line:90% 00:00:15.898 --> 00:00:17.440 align:middle line:84% RICARDO CABALIERO: So now we're going 00:00:17.440 --> 00:00:20.650 align:middle line:84% to go back to the first part of the course in the sense 00:00:20.650 --> 00:00:27.520 align:middle line:84% that we're going to go back to the short term. 00:00:27.520 --> 00:00:31.840 align:middle line:84% So we're going to essentially do the IS-LM model again, but now 00:00:31.840 --> 00:00:33.790 align:middle line:84% in the context of an open economy. 00:00:33.790 --> 00:00:36.220 align:middle line:84% But before I get into that first model 00:00:36.220 --> 00:00:37.720 align:middle line:84% of this part of the course, I want 00:00:37.720 --> 00:00:43.960 align:middle line:84% to finish the previous lecture in which I was introducing 00:00:43.960 --> 00:00:47.560 align:middle line:84% the concept of openness and the key relative prices 00:00:47.560 --> 00:00:49.010 align:middle line:90% in open economy. 00:00:49.010 --> 00:00:52.060 align:middle line:84% And we stopped after discussing this and says, 00:00:52.060 --> 00:00:55.450 align:middle line:84% well, one of the things that opening an economy means 00:00:55.450 --> 00:00:59.988 align:middle line:84% is that now you can buy goods, both at home or abroad. 00:00:59.988 --> 00:01:01.780 align:middle line:84% So you need to be able to compare these two 00:01:01.780 --> 00:01:05.140 align:middle line:84% different kinds of goods and controlling for quality and all 00:01:05.140 --> 00:01:06.980 align:middle line:90% these differences and all that. 00:01:06.980 --> 00:01:08.950 align:middle line:84% At the end of the day, you want some sense 00:01:08.950 --> 00:01:11.110 align:middle line:84% of relative prices, which good is more 00:01:11.110 --> 00:01:12.650 align:middle line:90% expensive than the other one. 00:01:12.650 --> 00:01:16.000 align:middle line:84% And we said for that, we use what is called the "real 00:01:16.000 --> 00:01:17.600 align:middle line:90% exchange," 00:01:17.600 --> 00:01:20.210 align:middle line:84% And we define the real exchange rate as well, 00:01:20.210 --> 00:01:22.430 align:middle line:84% essentially it's the relative prices 00:01:22.430 --> 00:01:27.380 align:middle line:90% of goods at home versus abroad. 00:01:27.380 --> 00:01:29.580 align:middle line:84% But we have to put them in a common currency. 00:01:29.580 --> 00:01:31.372 align:middle line:84% That's the reason we couldn't just directly 00:01:31.372 --> 00:01:34.140 align:middle line:84% compare the prices at home versus the prices abroad. 00:01:34.140 --> 00:01:36.110 align:middle line:84% We have to convert the prices at home 00:01:36.110 --> 00:01:39.420 align:middle line:84% to the unit of account of the other country. 00:01:39.420 --> 00:01:41.332 align:middle line:84% And then we could compare these two things. 00:01:41.332 --> 00:01:43.290 align:middle line:84% And that's what we call the real exchange rate. 00:01:43.290 --> 00:01:45.320 align:middle line:84% When that thing goes up, we call-- 00:01:45.320 --> 00:01:49.310 align:middle line:84% that's a real appreciation of the local currency, 00:01:49.310 --> 00:01:51.650 align:middle line:90% of the local economy. 00:01:51.650 --> 00:01:53.540 align:middle line:90% And that means that the goods-- 00:01:53.540 --> 00:01:55.430 align:middle line:84% domestic goods-- become more expensive 00:01:55.430 --> 00:01:58.140 align:middle line:90% relative to international goods. 00:01:58.140 --> 00:02:01.700 align:middle line:84% When that epsilon goes down, then we call, 00:02:01.700 --> 00:02:04.110 align:middle line:84% we say the real exchange rate has depreciated. 00:02:04.110 --> 00:02:07.280 align:middle line:84% And that means that the domestic goods become cheaper relative 00:02:07.280 --> 00:02:08.370 align:middle line:90% to foreign goods. 00:02:08.370 --> 00:02:12.890 align:middle line:84% So as a key concept in what it means when you open an economy, 00:02:12.890 --> 00:02:16.250 align:middle line:84% you need to have this price is very important to decide 00:02:16.250 --> 00:02:19.480 align:middle line:84% whether you're going to, again, whether you and foreigners are 00:02:19.480 --> 00:02:22.870 align:middle line:84% going to buy goods abroad or domestically. 00:02:22.870 --> 00:02:25.090 align:middle line:84% The second concept of openness that we're 00:02:25.090 --> 00:02:28.960 align:middle line:84% going to explore in this course is openness in capital account, 00:02:28.960 --> 00:02:30.190 align:middle line:90% in financial market. 00:02:30.190 --> 00:02:32.830 align:middle line:84% And openness in financial market means something very similar, 00:02:32.830 --> 00:02:36.850 align:middle line:84% which is now you when you have a to invest-- 00:02:36.850 --> 00:02:39.400 align:middle line:84% financially invest, not physical investment, 00:02:39.400 --> 00:02:41.560 align:middle line:84% not real investment-- well, you can 00:02:41.560 --> 00:02:43.990 align:middle line:84% decide whether to invest in domestic assets 00:02:43.990 --> 00:02:45.350 align:middle line:90% or foreign assets. 00:02:45.350 --> 00:02:46.708 align:middle line:90% We're going in this-- 00:02:46.708 --> 00:02:48.500 align:middle line:84% later on, we're going to talk about equity. 00:02:48.500 --> 00:02:50.240 align:middle line:90% But for now, bonds. 00:02:50.240 --> 00:02:53.870 align:middle line:84% So suppose you have a domestic bond and a foreign bond. 00:02:53.870 --> 00:02:56.470 align:middle line:84% Well, you can decide whether to invest in the domestic bond 00:02:56.470 --> 00:02:58.150 align:middle line:90% or in the foreign bond. 00:02:58.150 --> 00:03:01.810 align:middle line:84% Now to make that comparison, it's 00:03:01.810 --> 00:03:06.130 align:middle line:84% not enough to have the current exchange rate because it doesn't 00:03:06.130 --> 00:03:08.920 align:middle line:84% mean much if I tell you that the British bond is 00:03:08.920 --> 00:03:13.740 align:middle line:84% more expensive than a domestic $1 bond. 00:03:13.740 --> 00:03:16.470 align:middle line:84% What you really need in order to decide where to invest 00:03:16.470 --> 00:03:20.190 align:middle line:84% is some sense of what is expected relative return 00:03:20.190 --> 00:03:21.160 align:middle line:90% of these two things. 00:03:21.160 --> 00:03:24.030 align:middle line:84% Do I expect to make more money in the dollar bond 00:03:24.030 --> 00:03:29.070 align:middle line:90% or in the pound bond? 00:03:29.070 --> 00:03:32.360 align:middle line:84% And that's the comparison I need to be able to make. 00:03:32.360 --> 00:03:35.320 align:middle line:84% There are also risk considerations 00:03:35.320 --> 00:03:38.470 align:middle line:84% and so on that we're not going to discuss in this course. 00:03:38.470 --> 00:03:43.530 align:middle line:84% But the very basic comparison is not the value of things 00:03:43.530 --> 00:03:45.030 align:middle line:84% when you're talking about financial, 00:03:45.030 --> 00:03:46.405 align:middle line:84% but what is the return you expect 00:03:46.405 --> 00:03:47.800 align:middle line:90% to get in one or the other. 00:03:47.800 --> 00:03:51.010 align:middle line:90% So this is what you need to do. 00:03:51.010 --> 00:03:55.930 align:middle line:84% Suppose you have a dollar to invest and you have two options. 00:03:55.930 --> 00:03:57.610 align:middle line:90% One is you buy $1 bond. 00:03:57.610 --> 00:03:59.970 align:middle line:84% The dollar bond gives you an interest rate of it. 00:03:59.970 --> 00:04:04.890 align:middle line:84% So you know that, say, 5% nowadays, more or less, 00:04:04.890 --> 00:04:08.040 align:middle line:84% that if you have a dollar today and you invest it in a dollar 00:04:08.040 --> 00:04:14.040 align:middle line:84% bond, you're going to get next period, you're going to get a-- 00:04:14.040 --> 00:04:15.102 align:middle line:90% how much is it, $100? 00:04:15.102 --> 00:04:16.560 align:middle line:84% So suppose you have $1, then you're 00:04:16.560 --> 00:04:22.260 align:middle line:84% going to get a $0.05 on that dollar at the end of the year. 00:04:22.260 --> 00:04:28.030 align:middle line:84% And so that's what you get if you invest in the dollar bond. 00:04:28.030 --> 00:04:30.210 align:middle line:84% Now, you're giving now an option because we 00:04:30.210 --> 00:04:32.520 align:middle line:84% are open to financial markets, to also 00:04:32.520 --> 00:04:36.630 align:middle line:84% invest in a British bond, in a pound bond that is 00:04:36.630 --> 00:04:38.620 align:middle line:90% as safe as the US bonds, say. 00:04:38.620 --> 00:04:42.190 align:middle line:84% And so we're going to call that the UK bond. 00:04:42.190 --> 00:04:44.970 align:middle line:84% And I know, for example, that the UK bond is 00:04:44.970 --> 00:04:47.850 align:middle line:90% offering a 10% interest rate. 00:04:47.850 --> 00:04:52.900 align:middle line:84% So suppose that I think i star is 10%. 00:04:52.900 --> 00:04:54.400 align:middle line:84% Then I asked you the question, well, 00:04:54.400 --> 00:04:56.410 align:middle line:84% that does mean that obviously, since you 00:04:56.410 --> 00:05:00.900 align:middle line:84% want to compare returns that you should be investing in the pound 00:05:00.900 --> 00:05:03.320 align:middle line:84% bond, in the UK bond rather than the US bond. 00:05:03.320 --> 00:05:07.003 align:middle line:84% So suppose this is 5%, and that's 10%. 00:05:07.003 --> 00:05:09.420 align:middle line:84% And I'll tell you, where do you want to invest your money? 00:05:09.420 --> 00:05:14.820 align:middle line:84% Do you want to invest it in the US bond or in the UK bond? 00:05:14.820 --> 00:05:18.070 align:middle line:90% What is your answer? 00:05:18.070 --> 00:05:20.320 align:middle line:84% I told you, you know, they pay you 10%, 00:05:20.320 --> 00:05:21.465 align:middle line:90% the other one pays you 5%. 00:05:21.465 --> 00:05:28.050 align:middle line:90% 00:05:28.050 --> 00:05:29.760 align:middle line:90% AUDIENCE: [INAUDIBLE] as well? 00:05:29.760 --> 00:05:30.900 align:middle line:90% RICARDO CABALIERO: Exactly. 00:05:30.900 --> 00:05:32.981 align:middle line:90% Why do I need to know that? 00:05:32.981 --> 00:05:34.642 align:middle line:90% AUDIENCE: [INAUDIBLE] 00:05:34.642 --> 00:05:35.850 align:middle line:90% RICARDO CABALIERO: Excellent. 00:05:35.850 --> 00:05:38.910 align:middle line:84% So this is not enough information for me, 00:05:38.910 --> 00:05:42.480 align:middle line:84% because it may happen that what I get in terms of return, 00:05:42.480 --> 00:05:46.910 align:middle line:84% I lose on the currency exposure, for example. 00:05:46.910 --> 00:05:49.210 align:middle line:84% So let's see how that can happen. 00:05:49.210 --> 00:05:50.540 align:middle line:90% So how would I do this? 00:05:50.540 --> 00:05:53.600 align:middle line:84% I have $1 of wealth that I want to invest. 00:05:53.600 --> 00:05:56.420 align:middle line:84% And suppose I want to go the UK bond route. 00:05:56.420 --> 00:05:58.180 align:middle line:84% So the first thing I have to do is 00:05:58.180 --> 00:06:00.370 align:middle line:84% I have to convert the dollar into pounds today 00:06:00.370 --> 00:06:04.610 align:middle line:84% to buy my dollar, which is my UK bond, which will be in pounds. 00:06:04.610 --> 00:06:07.780 align:middle line:84% So the first thing I have to use is suppose 00:06:07.780 --> 00:06:12.280 align:middle line:84% that I get a 0.8 pounds per dollar, 00:06:12.280 --> 00:06:21.100 align:middle line:84% then I can invest 0.8 pounds in, UK bonds with my dollar. 00:06:21.100 --> 00:06:29.080 align:middle line:84% That will give me 0.8 times 1.1, plus i star tomorrow, 00:06:29.080 --> 00:06:31.510 align:middle line:90% but what are the units of this? 00:06:31.510 --> 00:06:32.650 align:middle line:90% What do I get there? 00:06:32.650 --> 00:06:35.680 align:middle line:84% Next year, what do I get next year? 00:06:35.680 --> 00:06:45.250 align:middle line:84% I invested 0.8 pounds and I got 0.8 times 1.1, say, pounds back. 00:06:45.250 --> 00:06:46.180 align:middle line:90% I just told you. 00:06:46.180 --> 00:06:49.540 align:middle line:84% So what I get next year is pounds. 00:06:49.540 --> 00:06:51.760 align:middle line:84% I cannot compare a return in dollars, 00:06:51.760 --> 00:06:55.640 align:middle line:84% which this was $1.05 with a return on pounds. 00:06:55.640 --> 00:06:59.080 align:middle line:84% I need to be able to convert those pounds in the future 00:06:59.080 --> 00:07:01.030 align:middle line:90% to dollars in the future. 00:07:01.030 --> 00:07:02.770 align:middle line:84% And the best I can do here, we're not 00:07:02.770 --> 00:07:06.070 align:middle line:84% going to open four world markets or anything, is well, 00:07:06.070 --> 00:07:08.960 align:middle line:84% I can-- that means I have to divide by the exchange rate 00:07:08.960 --> 00:07:11.600 align:middle line:84% next year to convert from pounds to dollars. 00:07:11.600 --> 00:07:15.040 align:middle line:84% I don't the exchange rate of next year, so the best I can do 00:07:15.040 --> 00:07:17.110 align:middle line:90% is use expected exchange rate. 00:07:17.110 --> 00:07:22.300 align:middle line:84% So I divide this by the expected exchange rate next year 00:07:22.300 --> 00:07:23.980 align:middle line:90% and then I get-- 00:07:23.980 --> 00:07:28.910 align:middle line:84% thus, my return in dollars of having gone the UK bond route. 00:07:28.910 --> 00:07:31.480 align:middle line:84% And so what I need to compare in order 00:07:31.480 --> 00:07:34.970 align:middle line:84% to decide where do I want to put my money 00:07:34.970 --> 00:07:38.920 align:middle line:84% is that return here versus that one there. 00:07:38.920 --> 00:07:40.690 align:middle line:84% That's in the same units of account 00:07:40.690 --> 00:07:45.710 align:middle line:84% is I invest the same today, $1, and I get dollars tomorrow. 00:07:45.710 --> 00:07:47.240 align:middle line:90% So now I can compare. 00:07:47.240 --> 00:07:51.320 align:middle line:84% And as you correctly pointed out, 00:07:51.320 --> 00:07:55.100 align:middle line:84% this thing here therefore requires 00:07:55.100 --> 00:07:57.770 align:middle line:84% that you think about what the exchange 00:07:57.770 --> 00:07:59.370 align:middle line:90% rate is likely to be tomorrow. 00:07:59.370 --> 00:08:01.640 align:middle line:84% So, for example, in my example here, 00:08:01.640 --> 00:08:05.340 align:middle line:84% when I said suppose i is 5% and i 00:08:05.340 --> 00:08:08.190 align:middle line:84% star, the interest rate in the UK bond, is 10%. 00:08:08.190 --> 00:08:11.540 align:middle line:84% Is it obvious that I should invest in the UK bond? 00:08:11.540 --> 00:08:13.310 align:middle line:84% And the answer is no, not so fast. 00:08:13.310 --> 00:08:15.920 align:middle line:84% Because I know I'm going to make 5% more in terms 00:08:15.920 --> 00:08:17.330 align:middle line:90% of return of the bond. 00:08:17.330 --> 00:08:19.220 align:middle line:84% But then when I convert it back to dollars, 00:08:19.220 --> 00:08:23.630 align:middle line:84% I may lose all that gain because the pound has depreciated 00:08:23.630 --> 00:08:25.160 align:middle line:90% vis-a-vis the dollar. 00:08:25.160 --> 00:08:27.860 align:middle line:84% In particular, is the pound, I expect the pound 00:08:27.860 --> 00:08:29.630 align:middle line:84% to depreciate relative to the dollar 00:08:29.630 --> 00:08:33.020 align:middle line:84% or if I expect the dollar to appreciate relative to the pound 00:08:33.020 --> 00:08:35.950 align:middle line:90% by 5%, then I'm indifferent. 00:08:35.950 --> 00:08:36.450 align:middle line:90% Yeah. 00:08:36.450 --> 00:08:38.100 align:middle line:90% In one case, I'll get-- 00:08:38.100 --> 00:08:40.679 align:middle line:84% because if I go the US bond route, 00:08:40.679 --> 00:08:44.950 align:middle line:84% I get 5% next year from this year to the next. 00:08:44.950 --> 00:08:48.480 align:middle line:84% If I go to the UK bond route, I get 10% 00:08:48.480 --> 00:08:51.330 align:middle line:84% in return on the bond minus 5% in the capital 00:08:51.330 --> 00:08:54.760 align:middle line:84% loss due to the appreciation of the dollar. 00:08:54.760 --> 00:08:57.120 align:middle line:90% So net I get 5% as well. 00:08:57.120 --> 00:08:58.555 align:middle line:90% That's what appears here. 00:08:58.555 --> 00:08:59.680 align:middle line:90% That's what I've done here. 00:08:59.680 --> 00:09:03.510 align:middle line:84% So what I did here is says if the markets are very integrated 00:09:03.510 --> 00:09:06.180 align:middle line:84% and the function fairly well, those two returns 00:09:06.180 --> 00:09:09.102 align:middle line:84% should be more or less similar in equilibrium, 00:09:09.102 --> 00:09:10.560 align:middle line:84% because prices are going to adjust, 00:09:10.560 --> 00:09:12.700 align:middle line:84% exchanges are going to adjust and so on. 00:09:12.700 --> 00:09:16.647 align:middle line:84% So there's two ways of investing are more or less the same. 00:09:16.647 --> 00:09:18.480 align:middle line:84% And I'm going to take the extreme assumption 00:09:18.480 --> 00:09:22.650 align:middle line:84% that they are exactly the same here so that this holds. 00:09:22.650 --> 00:09:25.780 align:middle line:84% That in equilibrium, we have to find that equilibrium, 00:09:25.780 --> 00:09:27.730 align:middle line:84% these two things are going to be equal. 00:09:27.730 --> 00:09:30.150 align:middle line:84% That's called-- and it's a very important concept 00:09:30.150 --> 00:09:31.720 align:middle line:90% in international finance-- 00:09:31.720 --> 00:09:34.150 align:middle line:84% the "uncovered interest parity condition." 00:09:34.150 --> 00:09:37.540 align:middle line:84% Don't ask me why it's uncovered, but it's the interest parity 00:09:37.540 --> 00:09:39.110 align:middle line:90% condition. 00:09:39.110 --> 00:09:41.410 align:middle line:84% And again, that one in particular 00:09:41.410 --> 00:09:45.160 align:middle line:84% is called the uncovered interest parity condition. 00:09:45.160 --> 00:09:47.620 align:middle line:84% If you do a little bit of-- and this just tells you 00:09:47.620 --> 00:09:52.030 align:middle line:84% that in equilibrium you have to be indifferent between investing 00:09:52.030 --> 00:09:53.920 align:middle line:90% in one bond or the other. 00:09:53.920 --> 00:09:56.920 align:middle line:84% If you do a little algebra here of the kind 00:09:56.920 --> 00:09:59.320 align:middle line:84% that we have done in the past, like 1 plus i 00:09:59.320 --> 00:10:09.520 align:middle line:84% is i is approximately equal to 1 over 1 minus i or this one, 00:10:09.520 --> 00:10:14.650 align:middle line:84% 1 plus i star is approximately equal to 1 over 1 minus i star, 00:10:14.650 --> 00:10:15.250 align:middle line:90% and so on. 00:10:15.250 --> 00:10:17.830 align:middle line:84% That's a kind of approximation, Taylor expansion, 00:10:17.830 --> 00:10:20.900 align:middle line:90% when these terms are small. 00:10:20.900 --> 00:10:25.870 align:middle line:84% Then you can write this as this expression here. 00:10:25.870 --> 00:10:28.890 align:middle line:84% And this says exactly what I just said in words. 00:10:28.890 --> 00:10:33.820 align:middle line:84% It says, look, if the interest rate in the US bond 00:10:33.820 --> 00:10:42.270 align:middle line:84% is lower than the UK bond's interest rate, that's 00:10:42.270 --> 00:10:44.880 align:middle line:84% OK in the sense that we can be indifferent 00:10:44.880 --> 00:10:48.060 align:middle line:84% when we do those things as long as you're expecting 00:10:48.060 --> 00:10:50.680 align:middle line:90% an appreciation of the dollar. 00:10:50.680 --> 00:10:53.830 align:middle line:84% That is equivalent to the difference in these two interest 00:10:53.830 --> 00:10:54.790 align:middle line:90% rates. 00:10:54.790 --> 00:10:58.650 align:middle line:84% So that's what's called the interest parity condition. 00:10:58.650 --> 00:11:00.450 align:middle line:84% The two, in equilibrium, the two are 00:11:00.450 --> 00:11:02.820 align:middle line:84% going to be the same once you adjust 00:11:02.820 --> 00:11:06.550 align:middle line:84% for the expected appreciation or depreciation of the currency. 00:11:06.550 --> 00:11:11.350 align:middle line:84% So in my example before, we had this interest rate 00:11:11.350 --> 00:11:13.970 align:middle line:90% of 5%, that was 10%. 00:11:13.970 --> 00:11:16.630 align:middle line:84% Then the only way that that's going to be in equilibrium 00:11:16.630 --> 00:11:22.440 align:middle line:84% is that if we also expect the dollar to appreciate by 5%. 00:11:22.440 --> 00:11:26.470 align:middle line:84% OK, so dollar appreciation, remember, is this guy going up. 00:11:26.470 --> 00:11:30.640 align:middle line:84% So if this is 5%, then it's fine to have 5% here, 00:11:30.640 --> 00:11:34.270 align:middle line:84% 10% there, because they both gave me the same return 00:11:34.270 --> 00:11:36.050 align:middle line:90% in expectation, at least. 00:11:36.050 --> 00:11:39.070 align:middle line:84% If I do it in dollars, I say I'm going to get 5% 00:11:39.070 --> 00:11:43.780 align:middle line:84% either way investing in American dollars, or through the UK pound 00:11:43.780 --> 00:11:47.440 align:middle line:84% because in the UK bond and the bond, I'm going to get 10% 00:11:47.440 --> 00:11:50.570 align:middle line:84% and then lose 5% because of the currency. 00:11:50.570 --> 00:11:52.990 align:middle line:84% Or I can do the comparison in pounds 00:11:52.990 --> 00:11:57.140 align:middle line:84% and then I say, well, I'm going to get 10% in pounds directly. 00:11:57.140 --> 00:11:59.860 align:middle line:84% And if I go the US way, I'm going to get 5%, 00:11:59.860 --> 00:12:02.680 align:middle line:84% but I'm going to get also 5% in the currency appreciation. 00:12:02.680 --> 00:12:05.260 align:middle line:90% And that gives me 10%. 00:12:05.260 --> 00:12:06.250 align:middle line:90% Key concept. 00:12:06.250 --> 00:12:08.770 align:middle line:84% Anyways, so these are the two senses 00:12:08.770 --> 00:12:12.430 align:middle line:84% of opening that we can have, opening in goods market, 00:12:12.430 --> 00:12:14.500 align:middle line:90% opening in financial markets. 00:12:14.500 --> 00:12:18.040 align:middle line:84% And the key relative prices and things 00:12:18.040 --> 00:12:22.240 align:middle line:84% that are going to equilibrate both markets. 00:12:22.240 --> 00:12:24.670 align:middle line:84% And one is the real exchange rate in the goods market, 00:12:24.670 --> 00:12:29.130 align:middle line:84% and this one is the uncovered interest parity condition. 00:12:29.130 --> 00:12:33.590 align:middle line:84% I want to shut down this part of openness for a lecture or so, 00:12:33.590 --> 00:12:38.190 align:middle line:84% and I'm going to focus now on the goods market opening only. 00:12:38.190 --> 00:12:39.980 align:middle line:84% And then I'm going to come back to this. 00:12:39.980 --> 00:12:44.450 align:middle line:84% But I just wanted to show you the two senses of opening. 00:12:44.450 --> 00:12:49.070 align:middle line:84% So now let's forget a little bit about financial opening 00:12:49.070 --> 00:12:53.600 align:middle line:84% and let's just focus on opening the goods 00:12:53.600 --> 00:12:55.800 align:middle line:90% markets to international trade. 00:12:55.800 --> 00:12:58.040 align:middle line:84% So that means we're going to have now imports 00:12:58.040 --> 00:12:59.670 align:middle line:90% and exports floating around. 00:12:59.670 --> 00:13:04.355 align:middle line:84% So this is, we'll go back again to our IS-LM model to-- 00:13:04.355 --> 00:13:06.230 align:middle line:84% actually, we're going to go back to our goods 00:13:06.230 --> 00:13:08.360 align:middle line:84% market only model, the very first model we 00:13:08.360 --> 00:13:09.450 align:middle line:90% saw in this course. 00:13:09.450 --> 00:13:11.930 align:middle line:84% But we're going to bring back a couple of terms 00:13:11.930 --> 00:13:15.420 align:middle line:90% that we shut down there. 00:13:15.420 --> 00:13:17.702 align:middle line:84% Now something that will be-- that we didn't 00:13:17.702 --> 00:13:19.160 align:middle line:84% need to worry about, but what we're 00:13:19.160 --> 00:13:21.980 align:middle line:84% going to have to worry about here a lot, 00:13:21.980 --> 00:13:24.080 align:middle line:84% is that there is a distinction between the demand 00:13:24.080 --> 00:13:29.940 align:middle line:84% for domestic goods and the domestic demand for goods. 00:13:29.940 --> 00:13:31.200 align:middle line:90% This can be tricky. 00:13:31.200 --> 00:13:34.020 align:middle line:84% But there is a difference between demand 00:13:34.020 --> 00:13:38.340 align:middle line:84% for domestic goods versus the domestic demand for goods. 00:13:38.340 --> 00:13:43.210 align:middle line:84% This is what residents say, US residents, households firms, 00:13:43.210 --> 00:13:46.780 align:middle line:84% government demand in terms of goods. 00:13:46.780 --> 00:13:50.800 align:middle line:84% This is how those same agents, plus the rest of the world, 00:13:50.800 --> 00:13:53.590 align:middle line:84% demand of domestically-produced goods. 00:13:53.590 --> 00:13:54.880 align:middle line:90% That's the distinction. 00:13:54.880 --> 00:13:57.070 align:middle line:84% When the economy was closed, they were the same, 00:13:57.070 --> 00:13:59.280 align:middle line:90% but now they're not. 00:13:59.280 --> 00:14:05.100 align:middle line:84% So the domestic demand remains the same as before. 00:14:05.100 --> 00:14:07.800 align:middle line:84% Domestic demand is whatever the households demand-- 00:14:07.800 --> 00:14:08.970 align:middle line:90% consumption-- 00:14:08.970 --> 00:14:14.110 align:middle line:84% plus firms investment, plus government expenditure. 00:14:14.110 --> 00:14:17.630 align:middle line:84% That's the same we had in closed economy. 00:14:17.630 --> 00:14:18.490 align:middle line:90% This hasn't changed. 00:14:18.490 --> 00:14:19.960 align:middle line:90% The domestic demand is the same. 00:14:19.960 --> 00:14:22.560 align:middle line:84% It's a function of the same behavioral functions 00:14:22.560 --> 00:14:23.917 align:middle line:90% that we had there. 00:14:23.917 --> 00:14:26.250 align:middle line:84% And the only behavioral function that was-- the only two 00:14:26.250 --> 00:14:29.130 align:middle line:84% that we had was the consumption function and the investment 00:14:29.130 --> 00:14:29.958 align:middle line:90% function, remember? 00:14:29.958 --> 00:14:31.000 align:middle line:90% So that remains the same. 00:14:31.000 --> 00:14:32.160 align:middle line:90% Nothing has changed. 00:14:32.160 --> 00:14:36.000 align:middle line:84% What does change is that this is no longer what 00:14:36.000 --> 00:14:39.090 align:middle line:84% determines the demand for domestically-produced goods. 00:14:39.090 --> 00:14:41.370 align:middle line:84% And remember, that's very key in the short run, 00:14:41.370 --> 00:14:45.250 align:middle line:84% because this is a Keynesian model with very sticky prices. 00:14:45.250 --> 00:14:47.310 align:middle line:84% Demand determines output activity. 00:14:47.310 --> 00:14:51.060 align:middle line:84% So if we're going to determine domestic production from demand, 00:14:51.060 --> 00:14:53.670 align:middle line:84% we better be very careful about what 00:14:53.670 --> 00:14:56.330 align:middle line:84% is the demand for domestically-produced goods. 00:14:56.330 --> 00:14:59.030 align:middle line:84% This is demand for both domestically-produced goods 00:14:59.030 --> 00:15:00.470 align:middle line:90% and foreign-produced goods. 00:15:00.470 --> 00:15:03.320 align:middle line:84% Some of those demands will be satisfied by imports. 00:15:03.320 --> 00:15:05.120 align:middle line:84% That's not demand for domestic production, 00:15:05.120 --> 00:15:08.450 align:middle line:84% and therefore we will not be determining equilibrium output 00:15:08.450 --> 00:15:09.670 align:middle line:90% domestically. 00:15:09.670 --> 00:15:12.500 align:middle line:84% So this is going to be a new concept, which 00:15:12.500 --> 00:15:14.970 align:middle line:90% is demand for domestic goods. 00:15:14.970 --> 00:15:18.350 align:middle line:84% And demand for domestic goods is the same as demand-- 00:15:18.350 --> 00:15:21.170 align:middle line:84% as domestic demand for goods that-- 00:15:21.170 --> 00:15:23.000 align:middle line:84% the thing we have in a closed economy-- 00:15:23.000 --> 00:15:26.370 align:middle line:84% minus that part of demand that is satisfied by imports. 00:15:26.370 --> 00:15:29.030 align:middle line:84% So minus imports and divided by the exchange rate 00:15:29.030 --> 00:15:30.890 align:middle line:84% because imports may be priced in euros, 00:15:30.890 --> 00:15:33.060 align:middle line:84% say, and I have to convert them into dollars. 00:15:33.060 --> 00:15:33.410 align:middle line:90% That's the reason. 00:15:33.410 --> 00:15:34.470 align:middle line:90% It's very, very changing. 00:15:34.470 --> 00:15:36.140 align:middle line:84% But don't worry about this for now. 00:15:36.140 --> 00:15:41.420 align:middle line:84% So I have to subtract from that imports. 00:15:41.420 --> 00:15:46.610 align:middle line:84% Because that's demand by residents, US residents. 00:15:46.610 --> 00:15:50.840 align:middle line:84% That doesn't go to demand for domestically-produced goods. 00:15:50.840 --> 00:15:53.220 align:middle line:90% Is demand for BMW, whatever. 00:15:53.220 --> 00:15:57.320 align:middle line:84% So that's not going to affect the demand for Ford cars 00:15:57.320 --> 00:16:01.190 align:middle line:84% and therefore, will not affect the production of Ford cars 00:16:01.190 --> 00:16:03.530 align:middle line:84% because it's not demand for that. 00:16:03.530 --> 00:16:07.942 align:middle line:84% But against that, we also have a component 00:16:07.942 --> 00:16:09.650 align:middle line:84% of demand for domestically-produced goods 00:16:09.650 --> 00:16:11.750 align:middle line:84% that we didn't have before, which is what 00:16:11.750 --> 00:16:15.950 align:middle line:90% foreigners demand from the US. 00:16:15.950 --> 00:16:19.130 align:middle line:84% Part of the demand that US would-- probably not Ford a lot, 00:16:19.130 --> 00:16:20.450 align:middle line:90% at least. 00:16:20.450 --> 00:16:25.790 align:middle line:84% Part of the demand that US goods perceived-- 00:16:25.790 --> 00:16:29.510 align:middle line:84% US production perceived-- is not due to residents, 00:16:29.510 --> 00:16:34.050 align:middle line:84% it's due to foreigners that are importing US goods. 00:16:34.050 --> 00:16:38.750 align:middle line:84% Apple sells a lot of phones to the rest of the world. 00:16:38.750 --> 00:16:40.730 align:middle line:84% That's determined by foreign demand 00:16:40.730 --> 00:16:42.300 align:middle line:90% for domestically-produced goods. 00:16:42.300 --> 00:16:44.125 align:middle line:90% That's what I call X, exports. 00:16:44.125 --> 00:16:47.180 align:middle line:90% 00:16:47.180 --> 00:16:49.680 align:middle line:84% So this is our new key concept here, 00:16:49.680 --> 00:16:53.690 align:middle line:84% Z. We're just the same as we used to have. 00:16:53.690 --> 00:16:57.210 align:middle line:84% But now we need to understand two more terms-- 00:16:57.210 --> 00:17:01.660 align:middle line:84% the export, and that's going to be a function, and the imports, 00:17:01.660 --> 00:17:03.610 align:middle line:90% which also will be a function. 00:17:03.610 --> 00:17:05.730 align:middle line:90% So let me introduce that. 00:17:05.730 --> 00:17:09.310 align:middle line:84% So exports, we're going to assume to simplify things, 00:17:09.310 --> 00:17:12.460 align:middle line:84% but it's a sensible behavioral assumption. 00:17:12.460 --> 00:17:14.700 align:middle line:84% We're going to assume that exports are 00:17:14.700 --> 00:17:16.859 align:middle line:90% increasing in foreign output. 00:17:16.859 --> 00:17:19.910 align:middle line:90% That's what Y star means. 00:17:19.910 --> 00:17:21.480 align:middle line:90% And it makes sense. 00:17:21.480 --> 00:17:22.680 align:middle line:90% It's the rest of the world. 00:17:22.680 --> 00:17:26.460 align:middle line:84% I mean, emerging market, the commodity-producing economies 00:17:26.460 --> 00:17:30.960 align:middle line:84% today are very excited about the recovery in China. 00:17:30.960 --> 00:17:35.020 align:middle line:84% China is reopening so it's a big boom domestically. 00:17:35.020 --> 00:17:37.320 align:middle line:84% That's great news for the emerging markets, commodity 00:17:37.320 --> 00:17:40.860 align:middle line:84% producers, because that will increase the demand from China 00:17:40.860 --> 00:17:42.930 align:middle line:84% for goods produced around the world, 00:17:42.930 --> 00:17:45.570 align:middle line:84% in particular in commodity-producing economies. 00:17:45.570 --> 00:17:48.120 align:middle line:84% So that's what this is capturing. 00:17:48.120 --> 00:17:51.450 align:middle line:84% It's an important trading partners' output goes up, 00:17:51.450 --> 00:17:53.370 align:middle line:84% income goes up, then they're going 00:17:53.370 --> 00:17:55.650 align:middle line:84% to consume everything, their domestic goods, 00:17:55.650 --> 00:17:58.110 align:middle line:84% but they also going to consume the goods they import, 00:17:58.110 --> 00:17:59.820 align:middle line:90% which are our exports. 00:17:59.820 --> 00:18:04.130 align:middle line:84% So that's the reason this is increasing. 00:18:04.130 --> 00:18:08.860 align:middle line:84% Exports are decreasing on the real exchange rate. 00:18:08.860 --> 00:18:10.400 align:middle line:90% That's a sensible assumption. 00:18:10.400 --> 00:18:12.700 align:middle line:84% Why do you think it's a sensible assumption? 00:18:12.700 --> 00:18:15.420 align:middle line:84% So why do you think that exports-- 00:18:15.420 --> 00:18:21.480 align:middle line:84% US exports-- are decreasing on the real exchange rate? 00:18:21.480 --> 00:18:22.540 align:middle line:90% [INAUDIBLE]? 00:18:22.540 --> 00:18:25.970 align:middle line:90% 00:18:25.970 --> 00:18:29.465 align:middle line:84% AUDIENCE: Major [INAUDIBLE] for foreign customers to buy? 00:18:29.465 --> 00:18:30.590 align:middle line:90% RICARDO CABALIERO: Exactly. 00:18:30.590 --> 00:18:33.080 align:middle line:84% Because then US goods become more expensive 00:18:33.080 --> 00:18:34.553 align:middle line:90% relative to foreign goods. 00:18:34.553 --> 00:18:36.720 align:middle line:84% That's where the real exchange rate appreciation is. 00:18:36.720 --> 00:18:41.030 align:middle line:84% And therefore there is less demand for domestically, for US 00:18:41.030 --> 00:18:41.550 align:middle line:90% goods. 00:18:41.550 --> 00:18:44.610 align:middle line:90% That's the reason we have that. 00:18:44.610 --> 00:18:46.410 align:middle line:90% What about imports? 00:18:46.410 --> 00:18:50.040 align:middle line:84% Well, imports are the dual of that, 00:18:50.040 --> 00:18:52.170 align:middle line:90% meaning of the export function. 00:18:52.170 --> 00:18:56.760 align:middle line:84% Is actually, our imports is what the other countries 00:18:56.760 --> 00:18:58.470 align:middle line:90% sees as their export. 00:18:58.470 --> 00:19:03.900 align:middle line:84% So our imports will tend to go up when domestic output goes up, 00:19:03.900 --> 00:19:06.630 align:middle line:84% because if domestic income goes up, 00:19:06.630 --> 00:19:11.400 align:middle line:84% domestic consumers will both consume more goods at home, 00:19:11.400 --> 00:19:14.580 align:middle line:84% but they will also consume more goods abroad. 00:19:14.580 --> 00:19:16.710 align:middle line:84% They're going to scale up their consumption 00:19:16.710 --> 00:19:19.720 align:middle line:84% and they're going to consume from both places. 00:19:19.720 --> 00:19:26.030 align:middle line:84% So imports is an increasing function of domestic output. 00:19:26.030 --> 00:19:28.670 align:middle line:84% What about the real exchange rate here? 00:19:28.670 --> 00:19:35.410 align:middle line:84% Well, imports are an increasing function of the real exchange 00:19:35.410 --> 00:19:35.910 align:middle line:90% rate. 00:19:35.910 --> 00:19:36.535 align:middle line:90% Why is that? 00:19:36.535 --> 00:19:41.953 align:middle line:90% 00:19:41.953 --> 00:19:43.370 align:middle line:84% It's the same argument of exports, 00:19:43.370 --> 00:19:44.578 align:middle line:90% but seen from the other side. 00:19:44.578 --> 00:19:50.440 align:middle line:90% 00:19:50.440 --> 00:19:54.380 align:middle line:84% Remember when-- why do we use this epsilon for to decide where 00:19:54.380 --> 00:19:56.120 align:middle line:90% do we want to buy our goods? 00:19:56.120 --> 00:20:01.480 align:middle line:84% If epsilon goes up, it means our goods become more expensive. 00:20:01.480 --> 00:20:04.750 align:middle line:84% If our goods become more expensive for any given 00:20:04.750 --> 00:20:07.660 align:middle line:84% level of domestic consumption, where do you 00:20:07.660 --> 00:20:09.890 align:middle line:90% think you'll buy your goods? 00:20:09.890 --> 00:20:13.280 align:middle line:84% You'll buy more abroad, because they're cheaper. 00:20:13.280 --> 00:20:16.250 align:middle line:84% So then that's an increasing function of epsilon. 00:20:16.250 --> 00:20:18.270 align:middle line:90% Good. 00:20:18.270 --> 00:20:19.280 align:middle line:90% Any question about that? 00:20:19.280 --> 00:20:21.322 align:middle line:84% Because these are the only sort of new behavioral 00:20:21.322 --> 00:20:25.650 align:middle line:84% equations that we're going to have for this model. 00:20:25.650 --> 00:20:26.150 align:middle line:90% No? 00:20:26.150 --> 00:20:28.460 align:middle line:84% And what I'm going to do next is I'm 00:20:28.460 --> 00:20:32.390 align:middle line:84% going to start from the same model we had in, I don't know, 00:20:32.390 --> 00:20:35.060 align:middle line:90% lecture 2 or 3. 00:20:35.060 --> 00:20:40.405 align:middle line:84% And I'm going to add these terms and see how things change. 00:20:40.405 --> 00:20:43.130 align:middle line:90% 00:20:43.130 --> 00:20:43.790 align:middle line:90% Good? 00:20:43.790 --> 00:20:44.840 align:middle line:90% Good. 00:20:44.840 --> 00:20:47.090 align:middle line:90% So let's do that. 00:20:47.090 --> 00:20:53.870 align:middle line:84% So remember, I think the first curve that we-- 00:20:53.870 --> 00:20:58.460 align:middle line:84% the very first diagram we had in this class was this one. 00:20:58.460 --> 00:21:04.370 align:middle line:84% This was just a demand for domestic demand, sorry, 00:21:04.370 --> 00:21:08.570 align:middle line:84% which was just C plus I plus G. It's an increasing function here 00:21:08.570 --> 00:21:11.420 align:middle line:84% because consumption and investment are 00:21:11.420 --> 00:21:13.400 align:middle line:90% increasing function of output. 00:21:13.400 --> 00:21:17.840 align:middle line:84% And then in closed economy, what we did is we had a 45-degree 00:21:17.840 --> 00:21:20.000 align:middle line:84% line here and we said in equilibrium, 00:21:20.000 --> 00:21:21.330 align:middle line:90% output equal to demand. 00:21:21.330 --> 00:21:25.430 align:middle line:84% And therefore, the intersection of this curve with the 45-degree 00:21:25.430 --> 00:21:27.630 align:middle line:84% line gave us our equilibrium output. 00:21:27.630 --> 00:21:28.880 align:middle line:90% That's what we had. 00:21:28.880 --> 00:21:30.860 align:middle line:84% We need to change things a little bit. 00:21:30.860 --> 00:21:34.800 align:middle line:84% We're going to put the 45-degree line in the next slide. 00:21:34.800 --> 00:21:37.220 align:middle line:90% But we first need to-- 00:21:37.220 --> 00:21:40.620 align:middle line:84% this is not the relevant demand for domestically-produced goods. 00:21:40.620 --> 00:21:43.940 align:middle line:84% So we need to go from here to the demand that 00:21:43.940 --> 00:21:46.310 align:middle line:84% is relevant for domestic producers. 00:21:46.310 --> 00:21:51.080 align:middle line:84% So the first thing we need to do is we need to subtract imports. 00:21:51.080 --> 00:21:55.220 align:middle line:84% Because part of that demand will go for foreign goods. 00:21:55.220 --> 00:21:59.120 align:middle line:84% And so that's what I'm doing here. 00:21:59.120 --> 00:22:02.360 align:middle line:84% To this domestic demand, I'm subtracting, 00:22:02.360 --> 00:22:06.770 align:middle line:84% the part that is going to foreign goods, 00:22:06.770 --> 00:22:08.600 align:middle line:84% not domestic goods, because this is not 00:22:08.600 --> 00:22:10.730 align:middle line:84% demand for domestically-produced goods. 00:22:10.730 --> 00:22:13.070 align:middle line:84% So obviously, this is a shift down, 00:22:13.070 --> 00:22:14.520 align:middle line:90% but there is also a rotation. 00:22:14.520 --> 00:22:16.350 align:middle line:90% Why is that? 00:22:16.350 --> 00:22:17.160 align:middle line:90% You see? 00:22:17.160 --> 00:22:20.190 align:middle line:84% Obviously, we're subtracting imports from domestic demand, 00:22:20.190 --> 00:22:23.080 align:middle line:90% so that moves us down here. 00:22:23.080 --> 00:22:26.310 align:middle line:84% But it also is not a parallel shift. 00:22:26.310 --> 00:22:27.665 align:middle line:90% This curve becomes flatter. 00:22:27.665 --> 00:22:30.350 align:middle line:90% 00:22:30.350 --> 00:22:31.520 align:middle line:90% Why is that? 00:22:31.520 --> 00:22:34.850 align:middle line:84% In other words, the decline is larger for the difference. 00:22:34.850 --> 00:22:37.430 align:middle line:84% The gap is larger for high levels of income 00:22:37.430 --> 00:22:39.740 align:middle line:84% than for low levels of income, or output. 00:22:39.740 --> 00:22:40.910 align:middle line:90% Why is that? 00:22:40.910 --> 00:22:43.685 align:middle line:84% AUDIENCE: [INAUDIBLE] dependent on output? 00:22:43.685 --> 00:22:44.810 align:middle line:90% RICARDO CABALIERO: Exactly. 00:22:44.810 --> 00:22:48.560 align:middle line:84% It's because there is a positive marginal propensity to import. 00:22:48.560 --> 00:22:52.440 align:middle line:84% And so you'll import more if the output is higher. 00:22:52.440 --> 00:22:55.230 align:middle line:84% And that's the reason we have this curve. 00:22:55.230 --> 00:22:58.190 align:middle line:84% Notice that this also means, well, 00:22:58.190 --> 00:23:01.498 align:middle line:84% let me get to the end of that and of these diagrams 00:23:01.498 --> 00:23:02.790 align:middle line:90% and then I'll get back to this. 00:23:02.790 --> 00:23:04.520 align:middle line:90% So one step more. 00:23:04.520 --> 00:23:08.840 align:middle line:84% Still, this is not what I need to integrate with my 45-degree 00:23:08.840 --> 00:23:11.960 align:middle line:84% line because this is not the demand that domestic producers 00:23:11.960 --> 00:23:12.530 align:middle line:90% will face. 00:23:12.530 --> 00:23:17.120 align:middle line:84% We still have to add the demand that comes from foreigners, 00:23:17.120 --> 00:23:19.130 align:middle line:90% and that's exports. 00:23:19.130 --> 00:23:23.930 align:middle line:84% So to this AA function, I have to add exports. 00:23:23.930 --> 00:23:26.390 align:middle line:84% And exports is a parallel shift because it didn't 00:23:26.390 --> 00:23:27.870 align:middle line:90% depend on domestic output. 00:23:27.870 --> 00:23:29.380 align:middle line:90% It depends on foreign output. 00:23:29.380 --> 00:23:32.010 align:middle line:84% So foreign output is going to be a parameter in this curve, 00:23:32.010 --> 00:23:33.210 align:middle line:90% but it's not-- 00:23:33.210 --> 00:23:35.720 align:middle line:84% it doesn't change the slope of that curve. 00:23:35.720 --> 00:23:39.830 align:middle line:84% So here we went from the DD curve 00:23:39.830 --> 00:23:42.260 align:middle line:84% to the new curve, which is the relevant for equilibrium 00:23:42.260 --> 00:23:46.360 align:middle line:84% domestic equilibrium output, which is this ZZ curve. 00:23:46.360 --> 00:23:46.860 align:middle line:90% OK? 00:23:46.860 --> 00:23:49.460 align:middle line:90% 00:23:49.460 --> 00:23:53.710 align:middle line:84% Now notice two things, or one thing about this ZZ curve 00:23:53.710 --> 00:23:55.590 align:middle line:90% relative to DD. 00:23:55.590 --> 00:23:58.843 align:middle line:84% What is the most obvious difference 00:23:58.843 --> 00:23:59.885 align:middle line:90% between these two curves? 00:23:59.885 --> 00:24:04.310 align:middle line:90% 00:24:04.310 --> 00:24:09.090 align:middle line:84% No, this is the one we use in lecture 2 or 3, I don't know. 00:24:09.090 --> 00:24:11.120 align:middle line:84% And then what we did yesterday and all that. 00:24:11.120 --> 00:24:13.320 align:middle line:84% And this is the one we're going to use now, the ZZ. 00:24:13.320 --> 00:24:16.400 align:middle line:90% 00:24:16.400 --> 00:24:17.630 align:middle line:90% It's flatter. 00:24:17.630 --> 00:24:18.745 align:middle line:90% Yeah, why is that? 00:24:18.745 --> 00:24:21.320 align:middle line:90% 00:24:21.320 --> 00:24:22.730 align:middle line:90% Flatter is low. 00:24:22.730 --> 00:24:26.180 align:middle line:84% Slope will mean lower multiplier. 00:24:26.180 --> 00:24:29.170 align:middle line:84% Why is the multiplier lower then, in open economy? 00:24:29.170 --> 00:24:31.670 align:middle line:84% AUDIENCE: Because part of the demand falls on foreign goods. 00:24:31.670 --> 00:24:32.795 align:middle line:90% RICARDO CABALIERO: Exactly. 00:24:32.795 --> 00:24:36.050 align:middle line:84% Because part of the-- remember the way we got to the multiplier 00:24:36.050 --> 00:24:38.360 align:middle line:84% is that income went up, consumption 00:24:38.360 --> 00:24:42.358 align:middle line:84% went up, that increased income again and so on and so forth. 00:24:42.358 --> 00:24:44.150 align:middle line:84% But if part of that increase in consumption 00:24:44.150 --> 00:24:45.860 align:middle line:84% is going to foreign goods, that's 00:24:45.860 --> 00:24:48.560 align:middle line:84% not reflected in demand for domestically-produced goods, 00:24:48.560 --> 00:24:51.030 align:middle line:84% and therefore there is less of a multiplier. 00:24:51.030 --> 00:24:54.200 align:middle line:84% And that's one characteristic of an open economy, 00:24:54.200 --> 00:24:57.980 align:middle line:84% is that the multipliers are smaller. 00:24:57.980 --> 00:24:59.690 align:middle line:90% The other distinction is that-- 00:24:59.690 --> 00:25:03.090 align:middle line:84% you don't see it here, but we have more parameters. 00:25:03.090 --> 00:25:06.200 align:middle line:84% In particular, a very important parameter 00:25:06.200 --> 00:25:08.750 align:middle line:90% here is Y star, Y star. 00:25:08.750 --> 00:25:12.320 align:middle line:84% We didn't worry about what was the income in Germany When 00:25:12.320 --> 00:25:15.000 align:middle line:84% we look at the IS-LM, the closed economy model. 00:25:15.000 --> 00:25:18.440 align:middle line:84% Now we worry about what the income of our main trading 00:25:18.440 --> 00:25:20.710 align:middle line:90% partners is. 00:25:20.710 --> 00:25:22.540 align:middle line:84% There is an extra parameter there. 00:25:22.540 --> 00:25:24.730 align:middle line:90% OK, good. 00:25:24.730 --> 00:25:26.860 align:middle line:84% Now we still haven't found equilibrium output, 00:25:26.860 --> 00:25:29.860 align:middle line:84% but there is a point that is already interesting here, 00:25:29.860 --> 00:25:33.400 align:middle line:90% which is this one. 00:25:33.400 --> 00:25:35.030 align:middle line:90% What do I know of this point? 00:25:35.030 --> 00:25:38.220 align:middle line:84% Well, in this point, domestic demand for goods 00:25:38.220 --> 00:25:41.130 align:middle line:84% is the same as the demand for domestically-produced goods, 00:25:41.130 --> 00:25:42.720 align:middle line:90% for domestic goods. 00:25:42.720 --> 00:25:46.980 align:middle line:84% And that also means that the trade balance is zero, 00:25:46.980 --> 00:25:51.820 align:middle line:84% meaning at that point, exports is exactly equal to imports. 00:25:51.820 --> 00:25:54.240 align:middle line:90% So net exports are equal to 0. 00:25:54.240 --> 00:25:57.270 align:middle line:84% OK, so that's what I'm plotting here, actually. 00:25:57.270 --> 00:25:59.290 align:middle line:90% This is the net export function. 00:25:59.290 --> 00:26:04.690 align:middle line:84% The net export function is simply 00:26:04.690 --> 00:26:09.070 align:middle line:84% that minus that divided by the exchange rate. 00:26:09.070 --> 00:26:10.480 align:middle line:84% So that's what I'm plotting here. 00:26:10.480 --> 00:26:13.630 align:middle line:84% Is a decreasing function of output. 00:26:13.630 --> 00:26:14.135 align:middle line:90% Why is that? 00:26:14.135 --> 00:26:16.850 align:middle line:90% 00:26:16.850 --> 00:26:20.740 align:middle line:84% Why is this decreasing in domestic output? 00:26:20.740 --> 00:26:23.290 align:middle line:84% Remember, this is export minus import 00:26:23.290 --> 00:26:25.510 align:middle line:90% divided by the exchange rate. 00:26:25.510 --> 00:26:29.900 align:middle line:84% But we're not moving the exchange rate for now. 00:26:29.900 --> 00:26:31.310 align:middle line:90% Why is this decreasing? 00:26:31.310 --> 00:26:34.520 align:middle line:84% That means here, exports exceed imports, 00:26:34.520 --> 00:26:37.290 align:middle line:90% here, imports exceed exports. 00:26:37.290 --> 00:26:38.820 align:middle line:84% So here you have a trade deficit. 00:26:38.820 --> 00:26:40.130 align:middle line:90% Here you have a trade surplus. 00:26:40.130 --> 00:26:41.630 align:middle line:90% Why is that? 00:26:41.630 --> 00:26:43.520 align:middle line:90% Why is that the shape? 00:26:43.520 --> 00:26:44.730 align:middle line:90% Why is it downward sloping? 00:26:44.730 --> 00:26:53.200 align:middle line:90% 00:26:53.200 --> 00:26:55.855 align:middle line:84% AUDIENCE: Because import grows when outgrossed by exports. 00:26:55.855 --> 00:26:56.980 align:middle line:90% RICARDO CABALIERO: Exactly. 00:26:56.980 --> 00:26:59.210 align:middle line:84% Exports is not a function of domestic output. 00:26:59.210 --> 00:27:01.420 align:middle line:84% It's a function of foreign output, 00:27:01.420 --> 00:27:06.010 align:middle line:84% while imports is an increasing function of domestic output, 00:27:06.010 --> 00:27:09.200 align:middle line:84% and net export is exports minus imports. 00:27:09.200 --> 00:27:11.090 align:middle line:84% OK, so that's why this is decreasing. 00:27:11.090 --> 00:27:13.270 align:middle line:84% And this point here happens to be when the two 00:27:13.270 --> 00:27:16.030 align:middle line:90% things are exactly balanced. 00:27:16.030 --> 00:27:20.330 align:middle line:84% Thus, trade balance happens to be the point where 00:27:20.330 --> 00:27:21.988 align:middle line:90% DD is equal to ZZ. 00:27:21.988 --> 00:27:24.530 align:middle line:84% That's just-- there's no reason why equilibrium output should 00:27:24.530 --> 00:27:25.820 align:middle line:90% be at that level, I'm saying. 00:27:25.820 --> 00:27:27.620 align:middle line:84% That's the point where that happens. 00:27:27.620 --> 00:27:30.530 align:middle line:84% OK, now we're going to find the equilibrium output. 00:27:30.530 --> 00:27:32.840 align:middle line:84% And to find equilibrium output, I'm 00:27:32.840 --> 00:27:35.340 align:middle line:84% going to erase all these extra curves here. 00:27:35.340 --> 00:27:37.880 align:middle line:84% And I'm just going to keep the ZZ here, 00:27:37.880 --> 00:27:41.130 align:middle line:84% because that's the demand for domestically-produced goods. 00:27:41.130 --> 00:27:44.340 align:middle line:84% And I'm doing short run here, so I know that domestic 00:27:44.340 --> 00:27:47.010 align:middle line:90% production-- that is the Y-- 00:27:47.010 --> 00:27:49.780 align:middle line:84% is going to be equal to the demand for domestic goods. 00:27:49.780 --> 00:27:52.150 align:middle line:90% It's a demand-determined model. 00:27:52.150 --> 00:27:54.310 align:middle line:84% That's what the short run is all about. 00:27:54.310 --> 00:27:57.390 align:middle line:84% So erase all these curves, and I'm 00:27:57.390 --> 00:28:00.270 align:middle line:84% going to just keep the ZZ curve there. 00:28:00.270 --> 00:28:02.470 align:middle line:90% There you are. 00:28:02.470 --> 00:28:08.580 align:middle line:84% So now I have my 45-degree line because in the short run, 00:28:08.580 --> 00:28:12.420 align:middle line:84% equilibrium output is equal to aggregate demand. 00:28:12.420 --> 00:28:13.630 align:middle line:90% Aggregate demand for what? 00:28:13.630 --> 00:28:15.100 align:middle line:90% For domestically produced goods. 00:28:15.100 --> 00:28:17.940 align:middle line:84% That's the reason I'm using ZZ, not DD. 00:28:17.940 --> 00:28:19.810 align:middle line:90% OK, but there you are. 00:28:19.810 --> 00:28:21.940 align:middle line:84% Then you do exactly the same as we did before. 00:28:21.940 --> 00:28:24.010 align:middle line:90% That's our equilibrium output. 00:28:24.010 --> 00:28:26.272 align:middle line:84% And here you can do all sorts of experiments 00:28:26.272 --> 00:28:28.230 align:middle line:84% and you're going to get the same type of things 00:28:28.230 --> 00:28:29.910 align:middle line:84% that we did there, the multiplier, it's 00:28:29.910 --> 00:28:31.410 align:middle line:84% a small multiplier, but you're going 00:28:31.410 --> 00:28:34.980 align:middle line:84% to still get a multiplier and all these kind of things. 00:28:34.980 --> 00:28:38.700 align:middle line:90% Now, this is just-- 00:28:38.700 --> 00:28:42.630 align:middle line:84% in this example, it happens that this equilibrium output, 00:28:42.630 --> 00:28:45.360 align:middle line:84% this country has a trade deficit. 00:28:45.360 --> 00:28:46.510 align:middle line:90% I just made up that. 00:28:46.510 --> 00:28:50.230 align:middle line:90% 00:28:50.230 --> 00:28:52.460 align:middle line:84% So this is the equilibrium condition 00:28:52.460 --> 00:28:58.150 align:middle line:84% is output equal to Z, output equal to domestic demand 00:28:58.150 --> 00:29:01.550 align:middle line:90% plus exports minus imports. 00:29:01.550 --> 00:29:07.040 align:middle line:84% And then the net export is just, I'm plotting this term here. 00:29:07.040 --> 00:29:08.610 align:middle line:90% That's what we have here. 00:29:08.610 --> 00:29:15.630 align:middle line:84% But equilibrium is just Y equal to Z. Is not this equal to 0. 00:29:15.630 --> 00:29:18.030 align:middle line:90% You can think about equilibrium. 00:29:18.030 --> 00:29:21.520 align:middle line:84% But this is what it is, given that that's equilibrium out. 00:29:21.520 --> 00:29:25.830 align:middle line:90% 00:29:25.830 --> 00:29:26.525 align:middle line:90% This is clear? 00:29:26.525 --> 00:29:27.900 align:middle line:84% I mean, this is the start diagram 00:29:27.900 --> 00:29:29.170 align:middle line:90% of this part of the course. 00:29:29.170 --> 00:29:30.795 align:middle line:84% So you need to understand this diagram. 00:29:30.795 --> 00:29:33.540 align:middle line:90% 00:29:33.540 --> 00:29:35.950 align:middle line:90% Go over it. 00:29:35.950 --> 00:29:37.310 align:middle line:90% Play with it. 00:29:37.310 --> 00:29:39.370 align:middle line:84% Think, what is a parameter in there, and so on. 00:29:39.370 --> 00:29:40.870 align:middle line:84% I'm going to do a little bit of that 00:29:40.870 --> 00:29:44.310 align:middle line:84% now, but make sure that you understand this. 00:29:44.310 --> 00:29:48.810 align:middle line:90% 00:29:48.810 --> 00:29:50.720 align:middle line:90% So there's a few things here. 00:29:50.720 --> 00:29:53.380 align:middle line:84% So let's do things that we did in closed economy. 00:29:53.380 --> 00:29:57.570 align:middle line:84% So suppose that you have a fiscal expansion. 00:29:57.570 --> 00:30:00.810 align:middle line:84% So what did we do when we had a fiscal expansion in lecture 2 00:30:00.810 --> 00:30:01.330 align:middle line:90% or 3? 00:30:01.330 --> 00:30:03.630 align:middle line:84% Well, that moves the ZZ curve up. 00:30:03.630 --> 00:30:07.600 align:middle line:84% Output will go up, and then there will be a multiplier. 00:30:07.600 --> 00:30:10.890 align:middle line:84% So output will go up by more than the initial increase 00:30:10.890 --> 00:30:12.800 align:middle line:90% in government expenditure. 00:30:12.800 --> 00:30:13.970 align:middle line:90% No? 00:30:13.970 --> 00:30:15.530 align:middle line:90% That's what we had before. 00:30:15.530 --> 00:30:19.800 align:middle line:84% It will go up by more, but not as much as it 00:30:19.800 --> 00:30:21.190 align:middle line:90% did in the closed economy. 00:30:21.190 --> 00:30:24.420 align:middle line:84% So the increasing output will be more 00:30:24.420 --> 00:30:26.490 align:middle line:84% than the increase in government expenditure, 00:30:26.490 --> 00:30:29.670 align:middle line:84% but it will be not as much as it would have been had 00:30:29.670 --> 00:30:32.410 align:middle line:90% we had a closed economy. 00:30:32.410 --> 00:30:33.075 align:middle line:90% Why is that? 00:30:33.075 --> 00:30:40.860 align:middle line:90% 00:30:40.860 --> 00:30:44.360 align:middle line:90% Why is the last part true? 00:30:44.360 --> 00:30:47.040 align:middle line:84% Why not as much as it would have been in the closed economy? 00:30:47.040 --> 00:30:51.150 align:middle line:90% 00:30:51.150 --> 00:30:52.830 align:middle line:90% Well, you can read it here. 00:30:52.830 --> 00:30:55.560 align:middle line:84% It's because part of that extra energy, 00:30:55.560 --> 00:30:57.820 align:middle line:84% the demand for consumption, will go to foreign goods. 00:30:57.820 --> 00:31:01.800 align:middle line:84% So it will not come back to demand more domestic production. 00:31:01.800 --> 00:31:05.142 align:middle line:84% And that's reflected in the trade deficit. 00:31:05.142 --> 00:31:07.350 align:middle line:84% In this particular example, we start with a situation 00:31:07.350 --> 00:31:10.810 align:middle line:90% where the trade was balanced. 00:31:10.810 --> 00:31:13.170 align:middle line:84% We had no-- net export was equal to zero 00:31:13.170 --> 00:31:15.920 align:middle line:84% and we ended up with a trade deficit. 00:31:15.920 --> 00:31:18.500 align:middle line:84% That trade deficit is exactly the same reason 00:31:18.500 --> 00:31:20.090 align:middle line:84% why we got a smaller multiplier is 00:31:20.090 --> 00:31:22.250 align:middle line:84% because part of the extra demand that 00:31:22.250 --> 00:31:23.720 align:middle line:84% came from the extra income that's 00:31:23.720 --> 00:31:26.750 align:middle line:84% created by the additional expenditure, 00:31:26.750 --> 00:31:29.960 align:middle line:84% by the aggregate demand effect of additional expenditure 00:31:29.960 --> 00:31:32.110 align:middle line:84% went to the demand for foreign goods. 00:31:32.110 --> 00:31:40.740 align:middle line:90% 00:31:40.740 --> 00:31:41.990 align:middle line:90% Good. 00:31:41.990 --> 00:31:45.480 align:middle line:84% So do the same things we did in closed economy and just practice 00:31:45.480 --> 00:31:45.980 align:middle line:90% here. 00:31:45.980 --> 00:31:50.600 align:middle line:84% Increase taxes, do things like that, increase [INAUDIBLE] 00:31:50.600 --> 00:31:54.140 align:middle line:84% and see what happens both with the equilibrium output. 00:31:54.140 --> 00:31:56.090 align:middle line:84% Qualitatively it will be exactly the same 00:31:56.090 --> 00:31:58.670 align:middle line:84% as you had in closed economy, except that the effects are 00:31:58.670 --> 00:32:00.267 align:middle line:84% going to be smaller, but you're going 00:32:00.267 --> 00:32:02.600 align:middle line:84% to get something new, which is what happens to the trade 00:32:02.600 --> 00:32:04.195 align:middle line:90% deficit as a result? 00:32:04.195 --> 00:32:09.150 align:middle line:90% 00:32:09.150 --> 00:32:11.820 align:middle line:84% This is a shock we couldn't do in the closed economy 00:32:11.820 --> 00:32:15.060 align:middle line:84% case, which is what happens if foreign demand comes up? 00:32:15.060 --> 00:32:17.490 align:middle line:84% That's what I'm saying, even when 00:32:17.490 --> 00:32:19.230 align:middle line:84% it's jubilant in emerging market world 00:32:19.230 --> 00:32:24.040 align:middle line:84% because China's output is going up. 00:32:24.040 --> 00:32:26.380 align:middle line:84% So what are all these economists thinking and say, 00:32:26.380 --> 00:32:29.090 align:middle line:84% well, China's output is going up. 00:32:29.090 --> 00:32:32.940 align:middle line:84% That means they're going to import a lot more from us. 00:32:32.940 --> 00:32:35.700 align:middle line:84% That is, they think our exports are 00:32:35.700 --> 00:32:40.880 align:middle line:84% going to go up because Chinese consumption is going up. 00:32:40.880 --> 00:32:48.760 align:middle line:84% Well, exports going up means that our ZZ curve moves up. 00:32:48.760 --> 00:32:50.850 align:middle line:90% OK, so then what do you get? 00:32:50.850 --> 00:32:57.550 align:middle line:84% Well, you get now an increase in exports 00:32:57.550 --> 00:32:59.440 align:middle line:84% for any given level of income means 00:32:59.440 --> 00:33:02.600 align:middle line:84% that eventually you're going to get higher output immediately. 00:33:02.600 --> 00:33:05.660 align:middle line:84% But higher output also has a multiplier, although smaller. 00:33:05.660 --> 00:33:07.330 align:middle line:84% But at the end of the day, you're 00:33:07.330 --> 00:33:09.290 align:middle line:84% going to get higher equilibrium output. 00:33:09.290 --> 00:33:10.142 align:middle line:90% So it's great news. 00:33:10.142 --> 00:33:11.600 align:middle line:84% That's the reason they're so happy. 00:33:11.600 --> 00:33:13.975 align:middle line:84% It's great news that China is expanding because that also 00:33:13.975 --> 00:33:18.180 align:middle line:84% leads to an expansion in the rest of the world. 00:33:18.180 --> 00:33:20.880 align:middle line:90% 00:33:20.880 --> 00:33:23.460 align:middle line:90% That's what you get. 00:33:23.460 --> 00:33:28.140 align:middle line:84% So in that sense, you know, that if China decides 00:33:28.140 --> 00:33:30.270 align:middle line:84% to do an expansionary fiscal policy, 00:33:30.270 --> 00:33:35.310 align:middle line:84% it also expands US output or more important, 00:33:35.310 --> 00:33:37.380 align:middle line:90% for Chilean output. 00:33:37.380 --> 00:33:38.470 align:middle line:90% It does that. 00:33:38.470 --> 00:33:40.650 align:middle line:90% So it's the same-- 00:33:40.650 --> 00:33:42.240 align:middle line:84% Chile could have done it by having 00:33:42.240 --> 00:33:45.960 align:middle line:84% their own fiscal policy that would also have expanded output. 00:33:45.960 --> 00:33:48.450 align:middle line:84% But it's wonderful that China decides 00:33:48.450 --> 00:33:51.000 align:middle line:84% to do it because that expands output as well, 00:33:51.000 --> 00:33:52.740 align:middle line:90% with one advantage-- 00:33:52.740 --> 00:33:54.090 align:middle line:90% two advantages. 00:33:54.090 --> 00:33:58.270 align:middle line:84% What is-- but there's one that you can see here, which is what? 00:33:58.270 --> 00:34:00.600 align:middle line:84% Why is it that they prefer that China does therefore 00:34:00.600 --> 00:34:02.590 align:middle line:90% rather than me? 00:34:02.590 --> 00:34:04.215 align:middle line:90% What looks better here? 00:34:04.215 --> 00:34:08.420 align:middle line:90% 00:34:08.420 --> 00:34:10.170 align:middle line:84% Assume that they're of comparable size 00:34:10.170 --> 00:34:14.520 align:middle line:84% and so on in terms of the impact in the top diagram. 00:34:14.520 --> 00:34:17.070 align:middle line:84% Suppose you generate the same increase in output 00:34:17.070 --> 00:34:21.338 align:middle line:84% as a result of one policy, which is by domestic expansion in G, 00:34:21.338 --> 00:34:23.130 align:middle line:84% which is what we did in the previous slide, 00:34:23.130 --> 00:34:25.980 align:middle line:84% or because China goes into a boom 00:34:25.980 --> 00:34:29.000 align:middle line:90% and it starts importing a lot? 00:34:29.000 --> 00:34:31.909 align:middle line:84% That is, we can export a lot to them. 00:34:31.909 --> 00:34:33.989 align:middle line:84% So suppose we get the same increase in output. 00:34:33.989 --> 00:34:36.469 align:middle line:90% What looks a little better? 00:34:36.469 --> 00:34:40.190 align:middle line:84% Not a little better, it can look a lot better. 00:34:40.190 --> 00:34:43.969 align:middle line:84% There are two things, but one is in this diagram, which is, 00:34:43.969 --> 00:34:46.159 align:middle line:84% remember, if I did government expenditure, 00:34:46.159 --> 00:34:48.170 align:middle line:84% the net export function wouldn't have moved 00:34:48.170 --> 00:34:50.440 align:middle line:84% and I ended up with higher output. 00:34:50.440 --> 00:34:54.770 align:middle line:84% I would have ended up with a bigger trade deficit. 00:34:54.770 --> 00:34:55.610 align:middle line:90% OK? 00:34:55.610 --> 00:34:58.530 align:middle line:84% In this case, it's export-driven, 00:34:58.530 --> 00:34:59.510 align:middle line:90% so it's the opposite. 00:34:59.510 --> 00:35:03.920 align:middle line:84% Because now the net export function is shifting up. 00:35:03.920 --> 00:35:07.310 align:middle line:84% You know, if I move Y star up, I'm moving exports up. 00:35:07.310 --> 00:35:08.810 align:middle line:84% That means the net export function 00:35:08.810 --> 00:35:11.180 align:middle line:90% is moving up, shifting up. 00:35:11.180 --> 00:35:13.100 align:middle line:84% And then I'm losing some of that because 00:35:13.100 --> 00:35:18.750 align:middle line:84% in increasing domestic output goes into imports. 00:35:18.750 --> 00:35:20.990 align:middle line:84% But at the end of the day, in this case, 00:35:20.990 --> 00:35:26.610 align:middle line:84% I end up with a trade surplus rather than a trade deficit. 00:35:26.610 --> 00:35:30.870 align:middle line:84% So lots of-- that's the reason when you open the world, 00:35:30.870 --> 00:35:32.380 align:middle line:84% there's a lot of free riding here. 00:35:32.380 --> 00:35:35.467 align:middle line:84% You want the other one to do the policies for you because then 00:35:35.467 --> 00:35:36.300 align:middle line:90% you're a lot better. 00:35:36.300 --> 00:35:38.230 align:middle line:84% And you can get the same increasing output. 00:35:38.230 --> 00:35:40.680 align:middle line:84% But here you end up with a trade surplus rather than 00:35:40.680 --> 00:35:42.303 align:middle line:90% a trade deficit. 00:35:42.303 --> 00:35:44.720 align:middle line:84% And there is a second thing that I'm not showing you here. 00:35:44.720 --> 00:35:47.110 align:middle line:84% There is a big difference between doing it domestically 00:35:47.110 --> 00:35:49.780 align:middle line:84% by increasing government expenditure versus the other one 00:35:49.780 --> 00:35:54.100 align:middle line:84% doing it for you and then pulling you through export. 00:35:54.100 --> 00:35:57.850 align:middle line:84% What else will look better in the US in this case, relative 00:35:57.850 --> 00:36:00.790 align:middle line:90% to the previous slide? 00:36:00.790 --> 00:36:02.680 align:middle line:90% AUDIENCE: Do interest affect it? 00:36:02.680 --> 00:36:03.980 align:middle line:84% RICARDO CABALIERO: But that's too sophisticated. 00:36:03.980 --> 00:36:05.938 align:middle line:84% We're still keeping the interest rate constant. 00:36:05.938 --> 00:36:09.910 align:middle line:90% 00:36:09.910 --> 00:36:10.750 align:middle line:90% Aha? 00:36:10.750 --> 00:36:12.100 align:middle line:90% That's even more sophisticated. 00:36:12.100 --> 00:36:14.630 align:middle line:84% This is short run, completely sticky prices. 00:36:14.630 --> 00:36:15.470 align:middle line:90% Forget all that. 00:36:15.470 --> 00:36:23.700 align:middle line:90% 00:36:23.700 --> 00:36:24.690 align:middle line:90% Fiscal deficit. 00:36:24.690 --> 00:36:28.490 align:middle line:84% In the other one, I need to increase G 00:36:28.490 --> 00:36:30.740 align:middle line:90% so I had a fiscal deficit. 00:36:30.740 --> 00:36:32.160 align:middle line:90% Here, I don't need to do that. 00:36:32.160 --> 00:36:35.150 align:middle line:84% And in fact, in reality, taxes are typically 00:36:35.150 --> 00:36:37.170 align:middle line:84% indexed to output-- domestic output. 00:36:37.170 --> 00:36:40.980 align:middle line:84% So that probably will improve the deficit in the US. 00:36:40.980 --> 00:36:45.400 align:middle line:90% So anyways. 00:36:45.400 --> 00:36:48.730 align:middle line:84% The last point I want to talk about 00:36:48.730 --> 00:36:50.260 align:middle line:84% is another variable that we didn't 00:36:50.260 --> 00:36:53.020 align:middle line:84% have in the closed economy, which 00:36:53.020 --> 00:36:55.780 align:middle line:84% is the role for the exchange rate, what the exchange rate can 00:36:55.780 --> 00:36:56.590 align:middle line:90% do. 00:36:56.590 --> 00:36:59.740 align:middle line:84% And so for this, we need to look at, you know, 00:36:59.740 --> 00:37:01.720 align:middle line:84% the only term that depends on the exchange rate 00:37:01.720 --> 00:37:03.760 align:middle line:90% is this net export term. 00:37:03.760 --> 00:37:05.640 align:middle line:90% It's the exports minus imports. 00:37:05.640 --> 00:37:07.650 align:middle line:84% So what you know from net exports, 00:37:07.650 --> 00:37:10.380 align:middle line:84% it's very clear what happens to net exports 00:37:10.380 --> 00:37:12.240 align:middle line:90% when we increase Y star. 00:37:12.240 --> 00:37:13.870 align:middle line:90% We did an experiment before. 00:37:13.870 --> 00:37:15.780 align:middle line:90% That's what increased exports. 00:37:15.780 --> 00:37:19.750 align:middle line:84% So net exports will increase if you increase Y star. 00:37:19.750 --> 00:37:21.810 align:middle line:84% We also know that net exports will 00:37:21.810 --> 00:37:26.640 align:middle line:84% decrease if domestic output goes up because imports increase. 00:37:26.640 --> 00:37:28.860 align:middle line:84% But from this expression, it's a little ambiguous 00:37:28.860 --> 00:37:31.860 align:middle line:84% what happens to net exports when there 00:37:31.860 --> 00:37:35.500 align:middle line:84% is a-- when the real exchange rate appreciates. 00:37:35.500 --> 00:37:39.800 align:middle line:84% And it's a little ambiguous for the following reason. 00:37:39.800 --> 00:37:45.740 align:middle line:84% The volume expression is clearly increasing in the real exchange 00:37:45.740 --> 00:37:46.240 align:middle line:90% rate. 00:37:46.240 --> 00:37:48.520 align:middle line:84% If US goods become more expensive, 00:37:48.520 --> 00:37:49.840 align:middle line:90% you want to import more. 00:37:49.840 --> 00:37:51.510 align:middle line:90% That's what we discussed before. 00:37:51.510 --> 00:37:54.930 align:middle line:84% But the value may not be such because if you are importing 00:37:54.930 --> 00:37:57.900 align:middle line:84% those goods in euros and now the euro is cheaper 00:37:57.900 --> 00:38:02.940 align:middle line:84% for you, than you are paying less for each unit you import. 00:38:02.940 --> 00:38:04.980 align:middle line:84% Now, we're going to assume from now 00:38:04.980 --> 00:38:07.080 align:middle line:84% on that this second effect is not 00:38:07.080 --> 00:38:08.680 align:middle line:90% as strong as the volume effect. 00:38:08.680 --> 00:38:10.530 align:middle line:84% And that's a very realistic assumption 00:38:10.530 --> 00:38:13.380 align:middle line:84% except for the very, very, very short run. 00:38:13.380 --> 00:38:15.280 align:middle line:84% So that's going to be our assumption. 00:38:15.280 --> 00:38:18.930 align:middle line:84% Our assumption will be that net exports decrease 00:38:18.930 --> 00:38:21.750 align:middle line:90% when the currency appreciates. 00:38:21.750 --> 00:38:25.050 align:middle line:84% If your goods become more expensive, then on net, 00:38:25.050 --> 00:38:28.465 align:middle line:84% you're going to have less net exports. 00:38:28.465 --> 00:38:29.340 align:middle line:90% That's an assumption. 00:38:29.340 --> 00:38:32.430 align:middle line:84% It simply says that this guy in the numerator 00:38:32.430 --> 00:38:35.820 align:middle line:84% responds more strongly than the denominator to a depreciation-- 00:38:35.820 --> 00:38:37.770 align:middle line:84% to an appreciation of the exchange rate. 00:38:37.770 --> 00:38:41.823 align:middle line:84% So the quantities effect is much more important 00:38:41.823 --> 00:38:42.740 align:middle line:90% than the price effect. 00:38:42.740 --> 00:38:46.908 align:middle line:90% 00:38:46.908 --> 00:38:49.200 align:middle line:84% Again, I'm not going to have three questions about this 00:38:49.200 --> 00:38:49.750 align:middle line:90% or anything. 00:38:49.750 --> 00:38:51.580 align:middle line:84% I'm going to assume that from now on. 00:38:51.580 --> 00:38:53.040 align:middle line:90% That's your assumption. 00:38:53.040 --> 00:38:58.480 align:middle line:84% If I make a mistake and I try to trick you in the quiz for that, 00:38:58.480 --> 00:39:01.570 align:middle line:90% you can charge me the points. 00:39:01.570 --> 00:39:02.950 align:middle line:90% I don't intend to do that. 00:39:02.950 --> 00:39:06.190 align:middle line:84% Just as I did in a spot when one of the TAs sort of 00:39:06.190 --> 00:39:07.930 align:middle line:90% wrote something there. 00:39:07.930 --> 00:39:12.520 align:middle line:84% And because this is a very realistic assumption. 00:39:12.520 --> 00:39:13.120 align:middle line:90% Good. 00:39:13.120 --> 00:39:15.280 align:middle line:84% So now let's see what happens, then, 00:39:15.280 --> 00:39:17.630 align:middle line:90% when the exchange rate moves. 00:39:17.630 --> 00:39:19.940 align:middle line:90% And let me use it. 00:39:19.940 --> 00:39:22.340 align:middle line:84% Suppose that you are in a situation where you want 00:39:22.340 --> 00:39:25.160 align:middle line:90% to reduce the trade deficit. 00:39:25.160 --> 00:39:27.110 align:middle line:90% What would you do to-- 00:39:27.110 --> 00:39:30.120 align:middle line:84% so the experiment I have here has two components. 00:39:30.120 --> 00:39:32.690 align:middle line:84% But let's talk about the first one. 00:39:32.690 --> 00:39:36.980 align:middle line:84% Suppose that your country has a big trade deficit 00:39:36.980 --> 00:39:41.120 align:middle line:84% and you want to reduce that, and the only tool 00:39:41.120 --> 00:39:45.030 align:middle line:90% you have is the exchange rate. 00:39:45.030 --> 00:39:45.955 align:middle line:90% What would you do? 00:39:45.955 --> 00:39:50.060 align:middle line:90% 00:39:50.060 --> 00:39:52.850 align:middle line:84% Because suppose you have a trade deficit, you don't like that. 00:39:52.850 --> 00:39:56.420 align:middle line:84% And you can move the exchange rate around. 00:39:56.420 --> 00:40:00.040 align:middle line:90% What would you do? 00:40:00.040 --> 00:40:01.120 align:middle line:90% Yes, you depreciate. 00:40:01.120 --> 00:40:03.730 align:middle line:84% You make the domestic goods cheaper relative 00:40:03.730 --> 00:40:04.820 align:middle line:90% to the rest of the world. 00:40:04.820 --> 00:40:09.250 align:middle line:84% So depreciate your currency, which 00:40:09.250 --> 00:40:12.070 align:middle line:84% is the prices are completely sticky, fixed. 00:40:12.070 --> 00:40:16.180 align:middle line:84% Then nominal depreciation means also real depreciation. 00:40:16.180 --> 00:40:18.650 align:middle line:84% And that will increase net exports. 00:40:18.650 --> 00:40:22.000 align:middle line:84% So what that will do if you depreciate, 00:40:22.000 --> 00:40:24.460 align:middle line:84% the exchange rate is also a parameter in this net export 00:40:24.460 --> 00:40:25.280 align:middle line:90% function. 00:40:25.280 --> 00:40:28.900 align:middle line:84% And given my assumption, when you depreciate the exchange 00:40:28.900 --> 00:40:33.640 align:middle line:84% rate, that then moves the net export function up. 00:40:33.640 --> 00:40:37.450 align:middle line:84% Now, the problem is that if you do that, that's also 00:40:37.450 --> 00:40:41.015 align:middle line:84% going to be expansionary because now 00:40:41.015 --> 00:40:42.890 align:middle line:84% you have certain equilibrium level of output. 00:40:42.890 --> 00:40:44.500 align:middle line:84% And now there's going to be expenditure 00:40:44.500 --> 00:40:46.583 align:middle line:84% switching all around the world towards your goods. 00:40:46.583 --> 00:40:49.620 align:middle line:84% So you're going to end up producing more. 00:40:49.620 --> 00:40:54.330 align:middle line:84% And so suppose that you didn't want that extra production. 00:40:54.330 --> 00:40:56.550 align:middle line:84% You just wanted to fix your trade balance. 00:40:56.550 --> 00:40:58.180 align:middle line:90% Then you have to set that. 00:40:58.180 --> 00:40:59.970 align:middle line:90% And that's what I've done here. 00:40:59.970 --> 00:41:01.473 align:middle line:84% So typically-- that's very typical. 00:41:01.473 --> 00:41:04.140 align:middle line:84% So suppose you're in a situation where you have very large trade 00:41:04.140 --> 00:41:07.260 align:middle line:84% deficit, but you're OK with the equilibrium level of output 00:41:07.260 --> 00:41:07.960 align:middle line:90% you have. 00:41:07.960 --> 00:41:10.590 align:middle line:84% Then a typical package is you depreciate your currency, 00:41:10.590 --> 00:41:12.900 align:middle line:84% but you also reduce government expenditure. 00:41:12.900 --> 00:41:16.680 align:middle line:84% Because the depreciation of the currency is expansionary. 00:41:16.680 --> 00:41:17.430 align:middle line:90% It's expansionary. 00:41:17.430 --> 00:41:19.263 align:middle line:84% It improves the trade deficit, but it's also 00:41:19.263 --> 00:41:20.820 align:middle line:84% expansionary because you relocate 00:41:20.820 --> 00:41:23.610 align:middle line:84% expenditure, both of residents and foreigners, 00:41:23.610 --> 00:41:24.580 align:middle line:90% towards your good. 00:41:24.580 --> 00:41:27.360 align:middle line:84% That increases demand for your good, increases output. 00:41:27.360 --> 00:41:34.950 align:middle line:84% But I mean, if I don't like that, I 00:41:34.950 --> 00:41:37.120 align:middle line:90% have many ways of setting that. 00:41:37.120 --> 00:41:40.800 align:middle line:84% One of them is by reducing government expenditure. 00:41:40.800 --> 00:41:42.050 align:middle line:90% So that's what I've done here. 00:41:42.050 --> 00:41:45.810 align:middle line:90% 00:41:45.810 --> 00:41:47.710 align:middle line:90% Again, this is a great package. 00:41:47.710 --> 00:41:49.160 align:middle line:90% You see, this is doing-- 00:41:49.160 --> 00:41:55.090 align:middle line:84% remember I told you here that people tend to prefer. 00:41:55.090 --> 00:41:59.800 align:middle line:84% Remember I said, this is one way of increasing output. 00:41:59.800 --> 00:42:02.250 align:middle line:90% If you want to increase output. 00:42:02.250 --> 00:42:09.095 align:middle line:84% And another way is to do it by exports rising. 00:42:09.095 --> 00:42:11.220 align:middle line:84% If I don't want to increase out, but this is better 00:42:11.220 --> 00:42:16.800 align:middle line:84% because this increases the trade balance, well, suppose I do-- 00:42:16.800 --> 00:42:19.350 align:middle line:84% which is what is [INAUDIBLE] is I do the converse. 00:42:19.350 --> 00:42:21.210 align:middle line:84% Suppose I don't want to change output, 00:42:21.210 --> 00:42:24.750 align:middle line:84% but I want to increase the net export. 00:42:24.750 --> 00:42:27.480 align:middle line:84% Well, these two charts, this and the previous one, 00:42:27.480 --> 00:42:29.670 align:middle line:90% tell me exactly how to do it. 00:42:29.670 --> 00:42:31.740 align:middle line:84% I use this for the expansion of output 00:42:31.740 --> 00:42:34.400 align:middle line:90% and to improve the net exports. 00:42:34.400 --> 00:42:37.770 align:middle line:84% And I use the other one to offset the effect on output, 00:42:37.770 --> 00:42:41.110 align:middle line:90% but with the opposite sign. 00:42:41.110 --> 00:42:45.320 align:middle line:84% I use this, but with declining G. 00:42:45.320 --> 00:42:47.530 align:middle line:90% That's exactly what I did here. 00:42:47.530 --> 00:42:49.690 align:middle line:84% So that's very tempting for a country 00:42:49.690 --> 00:42:55.390 align:middle line:84% to do, to depreciate the currency and at the same time, 00:42:55.390 --> 00:42:57.700 align:middle line:84% if you think that you need to cool off the economy, 00:42:57.700 --> 00:42:59.590 align:middle line:84% then you can use some other instrument, 00:42:59.590 --> 00:43:02.100 align:middle line:90% domestic instrument to. 00:43:02.100 --> 00:43:06.120 align:middle line:84% For a long time, China was accused of doing just this. 00:43:06.120 --> 00:43:09.390 align:middle line:84% It was called the mercantilist policies of China. 00:43:09.390 --> 00:43:15.210 align:middle line:84% And especially sort of in late '90s and 2000s and so on, China 00:43:15.210 --> 00:43:20.850 align:middle line:84% had massive amounts of exports and the US had a huge trade 00:43:20.850 --> 00:43:21.840 align:middle line:90% deficit. 00:43:21.840 --> 00:43:26.200 align:middle line:84% It was called the time of the global imbalances 00:43:26.200 --> 00:43:34.510 align:middle line:84% because big deficits in the US, big surpluses in China. 00:43:34.510 --> 00:43:37.060 align:middle line:84% And the rest of the world kept accusing 00:43:37.060 --> 00:43:41.020 align:middle line:84% China of really maintaining their currency 00:43:41.020 --> 00:43:47.970 align:middle line:84% at artificially low levels with the purpose of doing that. 00:43:47.970 --> 00:43:52.300 align:middle line:84% And anyways, I'm not going to take sides on that. 00:43:52.300 --> 00:43:57.100 align:middle line:84% I think that-- but the reason why 00:43:57.100 --> 00:44:00.430 align:middle line:84% the currency, the Chinese renminbi was so depreciated 00:44:00.430 --> 00:44:01.730 align:middle line:90% was different from that. 00:44:01.730 --> 00:44:04.210 align:middle line:90% But that's a different story. 00:44:04.210 --> 00:44:06.110 align:middle line:90% But the result was this. 00:44:06.110 --> 00:44:10.660 align:middle line:84% It was that they had very large trade surpluses. 00:44:10.660 --> 00:44:14.860 align:middle line:84% And so the result was this, that they had very large trade 00:44:14.860 --> 00:44:15.460 align:middle line:90% surpluses. 00:44:15.460 --> 00:44:20.560 align:middle line:84% And they grew a lot because they had this. 00:44:20.560 --> 00:44:22.310 align:middle line:90% But it was very export-driven. 00:44:22.310 --> 00:44:24.850 align:middle line:84% It was the rest of the world pulling. 00:44:24.850 --> 00:44:27.630 align:middle line:84% In fact the domestic economy in China, they were saving a lot. 00:44:27.630 --> 00:44:29.500 align:middle line:84% So domestic consumption was very low, 00:44:29.500 --> 00:44:31.660 align:middle line:84% but they had massive amount of exports, 00:44:31.660 --> 00:44:36.530 align:middle line:84% and that's what was pulling their output up. 00:44:36.530 --> 00:44:40.370 align:middle line:84% So open economy, you get new tools. 00:44:40.370 --> 00:44:43.250 align:middle line:84% OK, so that's all that I want to say for today. 00:44:43.250 --> 00:44:45.740 align:middle line:90% So summary. 00:44:45.740 --> 00:44:48.830 align:middle line:84% A very important demand for domestic goods 00:44:48.830 --> 00:44:53.810 align:middle line:84% is no longer equal to domestic demand for goods 00:44:53.810 --> 00:44:58.540 align:middle line:84% because part of the latter will go to foreign goods. 00:44:58.540 --> 00:45:03.610 align:middle line:84% And also, part of the former will come from foreign demand. 00:45:03.610 --> 00:45:07.370 align:middle line:84% So that's what is new of this part. 00:45:07.370 --> 00:45:08.575 align:middle line:90% You have an extra component. 00:45:08.575 --> 00:45:11.200 align:middle line:84% And then the other thing that is new of this part of the course 00:45:11.200 --> 00:45:13.523 align:middle line:84% is that, well, these extra components, the exports 00:45:13.523 --> 00:45:15.190 align:middle line:84% and the imports, are functions of things 00:45:15.190 --> 00:45:16.900 align:middle line:90% that we didn't have before. 00:45:16.900 --> 00:45:20.390 align:middle line:84% For an output, the exchange rate, in particular. 00:45:20.390 --> 00:45:23.790 align:middle line:90% 00:45:23.790 --> 00:45:29.700 align:middle line:84% So equilibrium output, again, is determined by a output-- 00:45:29.700 --> 00:45:34.400 align:middle line:84% domestic output-- equal to that, not to that. 00:45:34.400 --> 00:45:37.100 align:middle line:90% 00:45:37.100 --> 00:45:38.540 align:middle line:84% The difference between the two is 00:45:38.540 --> 00:45:41.540 align:middle line:90% reflected in the trade balance. 00:45:41.540 --> 00:45:44.330 align:middle line:84% So the trade-- another way of thinking about the trade balance 00:45:44.330 --> 00:45:50.330 align:middle line:84% is simply the difference between the demand for a domestic goods 00:45:50.330 --> 00:45:52.170 align:middle line:84% and the domestic demand for goods. 00:45:52.170 --> 00:45:53.840 align:middle line:84% So the trade balance is nothing else 00:45:53.840 --> 00:45:57.260 align:middle line:90% than that DD minus the ZZ curve. 00:45:57.260 --> 00:45:59.450 align:middle line:90% That's the trade balance, OK? 00:45:59.450 --> 00:46:00.330 align:middle line:90% Sorry. 00:46:00.330 --> 00:46:04.070 align:middle line:90% The ZZ minus the DD curve. 00:46:04.070 --> 00:46:06.380 align:middle line:90% That's net exports. 00:46:06.380 --> 00:46:07.520 align:middle line:90% OK? 00:46:07.520 --> 00:46:08.150 align:middle line:90% Sorry. 00:46:08.150 --> 00:46:10.910 align:middle line:90% Let me write that down here. 00:46:10.910 --> 00:46:16.550 align:middle line:84% So remember that we started from the demand, which 00:46:16.550 --> 00:46:24.530 align:middle line:84% was C plus I plus G. That's the domestic demand for goods. 00:46:24.530 --> 00:46:34.910 align:middle line:84% We went to Z is equal to demand plus net exports. 00:46:34.910 --> 00:46:43.820 align:middle line:84% So what I'm saying is that net exports is 00:46:43.820 --> 00:46:50.700 align:middle line:84% just equal to Z minus Z. So that's the reason you can-- 00:46:50.700 --> 00:46:55.980 align:middle line:84% very early on when I want to show you this thing here-- 00:46:55.980 --> 00:47:03.700 align:middle line:84% the distance between ZZ and DD is this net export here. 00:47:03.700 --> 00:47:05.770 align:middle line:84% That's the reason when the two of them 00:47:05.770 --> 00:47:10.330 align:middle line:84% are the same, that also means that the export is equal to 0. 00:47:10.330 --> 00:47:14.260 align:middle line:84% Very important also, message from this part of the course 00:47:14.260 --> 00:47:16.990 align:middle line:84% is that a depreciation improves the trade balance 00:47:16.990 --> 00:47:19.490 align:middle line:84% and increases the demand for domestic goods. 00:47:19.490 --> 00:47:22.480 align:middle line:84% Again, that's why it's called expenditure switching mechanism. 00:47:22.480 --> 00:47:26.440 align:middle line:84% The expenditures-- both of domestic residents 00:47:26.440 --> 00:47:28.840 align:middle line:84% and foreigners switches towards domestic goods. 00:47:28.840 --> 00:47:32.060 align:middle line:90% 00:47:32.060 --> 00:47:35.050 align:middle line:90% And that's also very important. 00:47:35.050 --> 00:47:36.850 align:middle line:84% For a given exchange rate, changes 00:47:36.850 --> 00:47:41.110 align:middle line:84% in aggregate demand in one large country induced by policy 00:47:41.110 --> 00:47:42.170 align:middle line:90% or the private sector-- 00:47:42.170 --> 00:47:44.890 align:middle line:90% in this case, China reopening-- 00:47:44.890 --> 00:47:48.240 align:middle line:84% affects other countries through Y star, through exports. 00:47:48.240 --> 00:47:51.070 align:middle line:90% 00:47:51.070 --> 00:47:53.087 align:middle line:90% So I'm going to stop here. 00:47:53.087 --> 00:47:54.670 align:middle line:84% And in the next lecture, what we'll do 00:47:54.670 --> 00:47:59.050 align:middle line:84% is we'll integrate this with the financial opening. 00:47:59.050 --> 00:48:00.815 align:middle line:84% And that will get us to what I think 00:48:00.815 --> 00:48:03.190 align:middle line:84% is one of the most important models in this course, which 00:48:03.190 --> 00:48:05.880 align:middle line:84% is called the Mundell-Fleming model. 00:48:05.880 --> 00:48:17.000 align:middle line:90%