where
Ep
t
+1
is the expected price level. Equation A8 states that real money bal-
ances depend on expected inflation. By following steps similar to those above, we
can show that
p
t
=
(
) [
m
t
+
(
)
Em
t
+1
+
(
)
2
Em
t
+2
+
(
)
3
Em
t
+3
+ …
]
.
(A9)
Equation A9 states that the price level depends on the current money supply and
expected future money supplies.
Some economists use this model to argue that credibility is important for end-
ing hyperinflation. Because the price level depends on both current and expect-
ed future money, inflation depends on both current and expected future money
growth. Therefore, to end high inflation, both money growth and expected
money growth must fall. Expectations, in turn, depend on credibility—the per-
ception that the central bank is committed to a new, more stable policy.
How can a central bank achieve credibility in the midst of hyperinflation?
Credibility is often achieved by removing the underlying cause of the hyperin-
flation—the need for seigniorage. Thus, a credible fiscal reform is often neces-
sary for a credible change in monetary policy. This fiscal reform might take the
form of reducing government spending and making the central bank more inde-
pendent from the government. Reduced spending decreases the need for
seigniorage, while increased independence allows the central bank to resist gov-
ernment demands for seigniorage.
g
1
+
g
g
1
+
g
g
1
+
g
1
1
+
g
118
|
P A R T I I
Classical Theory: The Economy in the Long Run
M O R E P R O B L E M S A N D A P P L I C A T I O N S
1.
In the Cagan model, if the money supply is
expected to grow at some constant rate
m
(so
that
Em
t
+
s
=
m
t
+
s
m
), then Equation A9 can be
shown to imply that
p
t
=
m
t
+
gm
.
a. Interpret this result.
b. What happens to the price level p
t
when the
money supply
m
t
changes, holding the money
growth rate
m
constant?
c. What happens to the price level
p
t
when the
money growth rate
m
changes, holding the
current money supply
m
t
constant?
d. If a central bank is about to reduce the rate of
money growth
m
but wants to hold the price
level
p
t
constant, what should it do with m
t
?
Can you see any practical problems that
might arise in following such a policy?
e. How do your previous answers change in the
special case where money demand does not
depend on the expected rate of inflation (so
that
g
=
0)?
119
The Open Economy
5
C H A P T E R
E
ven if you never leave your hometown, you are an active participant in
the global economy. When you go to the grocery store, for instance, you
might choose between apples grown locally and grapes grown in Chile.
When you make a deposit into your local bank, the bank might lend those funds
to your next-door neighbor or to a Japanese company building a factory out-
side Tokyo. Because our economy is integrated with many others around the
world, consumers have more goods and services from which to choose, and
savers have more opportunities to invest their wealth.
In previous chapters we simplified our analysis by assuming a closed economy.
In actuality, however, most economies are open: they export goods and services
abroad, they import goods and services from abroad, and they borrow and lend in
world financial markets. Figure 5-1 gives some sense of the importance of these
international interactions by showing imports and exports as a percentage of GDP
for seven major industrial countries. As the figure shows, exports from the United
States are about 8 percent of GDP and imports are about 15 percent. Trade is even
more important for many other countries—in Canada and Germany, for instance,
imports and exports are about a third of GDP. In these countries, international trade
is central to analyzing economic developments and formulating economic policies.
This chapter begins our study of open-economy macroeconomics. We begin
in Section 5-1 with questions of measurement. To understand how an open
economy works, we must understand the key macroeconomic variables that
measure the interactions among countries. Accounting identities reveal a key
insight: the flow of goods and services across national borders is always matched
by an equivalent flow of funds to finance capital accumulation.
In Section 5-2 we examine the determinants of these international flows. We
develop a model of the small open economy that corresponds to our model of
the closed economy in Chapter 3. The model shows the factors that determine
whether a country is a borrower or a lender in world markets and how policies
at home and abroad affect the flows of capital and goods.
In Section 5-3 we extend the model to discuss the prices at which a country
makes exchanges in world markets. We examine what determines the price of
domestic goods relative to foreign goods. We also examine what determines the
No nation was ever ruined by trade.
—Benjamin Franklin
rate at which the domestic currency trades for foreign currencies. Our model
shows how protectionist trade policies—policies designed to protect domestic
industries from foreign competition—influence the amount of international
trade and the exchange rate.
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