Classical Model of A Small Open Economy Essay Assignment
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Classical Model of A Small Open Economy Essay Assignment
Remember that the module guide states that the exam is covering the last three topics of the module:
- Classical model of a small open economy
- Keynesian model of a small open economy
- Theories of price or inflation expectations
THERE ARE 3 EXAM QUESTIONS.
YOU MUST DO THEM ALL.
TWO ARE 40%, ONE IS 20%.
MAKE SURE YOU CHECK THE WEIGHTINGS ON EACH QUESTION.
Here are some general points to remember that could come up on any question you might get on these areas. I focus mostly on the first two because we’ve covered them and they involve calculation and equations, which some of you have problems with.
Points to remember about the Classical small open economy model topic:
- The model will tell you the various functions (equations) that matter:
C function (where C depends on Y and T).
I function (where I depends on r).
NX or net exports (or ‘trade balance’) function (depends on real exchange rate E.)
- The model will tell you what levels T and G are set at by government.
- The model will also tell you what the ‘natural’ level of output is (Yn- written as Y with a bar above it): this is how you know it is a Classical model.
- The model will finally tell you what the world interest rate r* is. (This is there because it is a ‘small open economy’ model and all small open economies must ‘take’ the world interest rate as their interest rate.)
So ANY question on the Classical small open economy model will give you all this information.
There are many possible things you might have to do with this information.
Here are some things to bear in mind for revision:
[1] It always helps to know the equations for the different concepts of ‘saving’ in this model – private (Sp), public (Sg) and total (which is Sp+Sg or S). You won’t be given these.
[2] You should know what the ‘equilibrium’ condition is in this model:
It is where NX = S- I. If you don’t know [1] you can’t work out [2]. You won’t be given the equilibrium condition.
[3] If you know that NX = S- I, and can work out the numbers for S and I, then you can solve the equation NX = S-I to find the real exchange rate E.
Remember that the key diagram looks like this:
[4] Once the equilibrium NX and E combination has been found, you can be asked to analyse the effects of things changing.
For instance, government policy might change, which means that either the size of T or size of G might change.
You could be asked a question which says
- T [or G] is reduced/increased (either, not both, and no number is given). What is the impact on E and NX? In this case you are being expected to explain in words what happens and use a diagram (which means that the S-I line will shift).
OR
- T [or G] is reduced/increased (either, not both and a new number is given). What is the impact on E and NX? In this case you are being expected to calculate the new levels of E and NX. Only draw a diagram if asked – or if it helps you ‘check’ your calculation. Do explain what you are doing as you do your calculations.
Another possibility is that the policies of governments in the rest of the world might change, which then affect your country. In particular, if the policies of large open economies (like any one of the US or the Eurozone countries or China) change, then this could change world levels of saving. In turn this could change the world interest rate. Since your country ‘takes’ the world interest rates as its own interest rate, changes in the world interest rate r* will affect your country directly.
You should know that a rise [fall] in r* will cause a fall[rise] in I. This will then affect the size of S-I, and so shift the S-I vertical line left [for a rise in I] and right [for a fall in I]. Do this shift for the diagram above yourself.
In your diagram [see above], a new equilibrium NX level [lower if S-I shifts left, higher if S-I shifts right] and a new E equilibrium will result. Draw this for yourself.
Do you understand the economics of this?
Say world savings/loanable funds go down (due to a policy change by the US or China).
(Then r* will rise.
(I in the small open economy will fall.
(So S-I will get bigger: there is a bigger capital outflow.
(This bigger outflow of money abroad increases the supply of the currency, pushing down its ‘price’ – the real exchange rate E.
(When E falls, export prices fall and exports rise, import prices rise so imports fall. Overall then net exports get bigger, that is, NX is higher.
Now do your own analysis for a rise in world savings/loanable funds
Draw a diagram [using the one above] illustrating both possibilities.
Points to remember about the Keynesian small open economy model topic
- The model will tell you the functions (equations) that matter:
C function (which depends on Y and T)
I function (which depends on r)
NX function (which depends on the exchange rate, e or however written)
- The model will tell you what levels T and G are set at by government.
- The model will also tell you about the ‘demand’ for money and the ‘supply’ of money. This is how to tell the model is Keynesian and not Classical.
So the ‘supply’ of money is M divided by P (M/P is the ‘real’ money supply): numbers for M and P will be given.
The ‘demand’ for money will be an equation which depends on Y and r. The equation is usually called ‘L’ (meaning ‘Liquidity Preference’ – because the demand to hold money is a demand for holding liquid assets i.e. cash)
- The model will finally tell you what the world interest rate r* is. (This is there because it is a ‘small open economy’ model and all small open economies must ‘take’ the world interest rate as their interest rate.)
So ANY question about the small open Keynesian model will give you all this.
There are many possible things you might have to do with this information.
Here are some things to bear in mind for revision:
[1] In this model, you will always need to know how to find the equilibrium values of Y and the exchange rate ‘e’.
To do this you need to know the equilibrium conditions for the economy in this Keynesian model. You won’t be given these conditions.
Unlike the classical model, there isn’t just one condition i.e. it ISN’T NX = S-I.
In the Keynesian model there are TWO conditions:
- Equilibrium in the goods market
( where output supplied (or national income) = demand for output
( i.e. where Y = C + I + G + NX
( plug in the numbers for the equations C,I,G and NX
( this gives you the ‘IS*’ line, showing that when e falls, Y gets higher
- Equilibrium in the money market
( where money supply = money demanded
( i.e. where M/P = the L equation
( plug in the numbers for M,P, r*
( you’ll get a number which gives you the LM* line [notice it is vertical because it doesn’t depend on e]
So overall equilibrium is where
- [in a diagram] where the IS* and LM* curves cross
- [mathematically] where the LM* equation [just a number]= the IS* equation
At the overall equilibrium, you’ll have
- The level of Y which makes all demands equal all supplies [Y*]
- The level of e which does the same. [e*]
Check the class exercises again if you can’t remember how to work Y* and e* out. The diagram looks like this.
[2] You might be asked to look at the effects of different government policies.
- Suppose the government wanted to increase [or reduce] Y.
- The exchange rate might be fixed or floating. [The floating or flexible exchange rate case example is given below]
- Which policy would work best – fiscal or monetary?
- How does each policy work?
- Why is one policy more effective?
To be able to answer these, you must know the economics:
(If the government uses fiscal or monetary policy, what will happen to the domestic [i.e. home country] interest rate?
(If this happens, why will there be a big capital inflow [outflow]? Think about what being a small open economy means in a globalised world when there is perfect capital mobility. Go back to the lecture notes on this, and the class exercises.
(If there’s a big capital inflow [outflow], what happens to the exchange rate?
(When the exchange rate changes, what happens to NX and why?
(When NX changes, what happens to the level of demand?
(When the level of demand changes, what happens to Y?
You should be able to use the IS*-LM* diagram above to illustrate your reasoning as well.
Points to remember about the topic on expectations.
Unlike the other two areas, this topic is more about you explaining the ideas, possibly using diagrams, and not about calculation at all.
More about this after the lecture and class on it.
This is to focus your revision. This covers what we’ve done anyway, but I’ve packaged it all together in one place here. I hope that it’s helpful.
FINALLY:
- Draw large, well labelled diagrams, showing large shifts in lines for clarity.
- If the question says ‘no calculations required’ then DON’T do any. [There won’t be enough info to anyway.]
- If the question doesn’t ask you to draw a diagram [‘use a graphical analysis’], you do not have to. You won’t be penalised if you do, however, (and it may help clarify your answer).
- If the question says ‘use a graphical analysis’ or some similar wording, you MUST draw at least one diagram and explain it (you will lose marks if you don’t).
FINALLY FINALLY:
- ALWAYS explain what you are doing, especially when you are manipulating equations. DON’T ASSUME that because the markers ‘know the theory’, you don’t have to explain what you are doing. Remember the marker is LOOKING FOR EVIDENCE OF YOUR UNDERSTANDING. If you get some numbers wrong but you correctly explain what you are doing, the maths errors won’t lose you too many marks.
- I suggest that you give a number to each equation. Then you can say something like ‘I now plug equation [2] into equation [3] because the equilibrium condition blah = bleurgh requires this…’ etc.
Classical Model of A Small Open Economy Essay Assignment
RUBRIC
Excellent Quality
95-100%
Introduction 45-41 points
The background and significance of the problem and a clear statement of the research purpose is provided. The search history is mentioned.
Literature Support
91-84 points
The background and significance of the problem and a clear statement of the research purpose is provided. The search history is mentioned.
Methodology
58-53 points
Content is well-organized with headings for each slide and bulleted lists to group related material as needed. Use of font, color, graphics, effects, etc. to enhance readability and presentation content is excellent. Length requirements of 10 slides/pages or less is met.
Average Score
50-85%
40-38 points
More depth/detail for the background and significance is needed, or the research detail is not clear. No search history information is provided.
83-76 points
Review of relevant theoretical literature is evident, but there is little integration of studies into concepts related to problem. Review is partially focused and organized. Supporting and opposing research are included. Summary of information presented is included. Conclusion may not contain a biblical integration.
52-49 points
Content is somewhat organized, but no structure is apparent. The use of font, color, graphics, effects, etc. is occasionally detracting to the presentation content. Length requirements may not be met.
Poor Quality
0-45%
37-1 points
The background and/or significance are missing. No search history information is provided.
75-1 points
Review of relevant theoretical literature is evident, but there is no integration of studies into concepts related to problem. Review is partially focused and organized. Supporting and opposing research are not included in the summary of information presented. Conclusion does not contain a biblical integration.
48-1 points
There is no clear or logical organizational structure. No logical sequence is apparent. The use of font, color, graphics, effects etc. is often detracting to the presentation content. Length requirements may not be met
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