Question

Consider the following open economy. The real exchange rate is fixed and equal to one. Consumption, investment, government spending and taxes are given by: C = co + ci(Y-T), I = 7, G=G, and T=1 Imports and exports are given by: Q = my and X = rY* where asterisk denotes a foreign variable. a) Solve for equilibrium income in the domestic economy, given Y*. What is the multiplier in this economy? If we were to close the economy (so that exports and imports were equal to zero), what would the multiplier be? Why are the two multipliers different?

Answer 1

Y = c + 1 + G +(X-M). - 6 + 4 (Y - 7) + 1 + 6+ (xy-my (1-ci + m) y = 6 - CT + 1 + y + xy + y = (Co-C, Ft I + 7 + x y*) - (1-ctm) Yonernment expenditure multiplier (1-cit my For closed economy, multiplier dy = dG TI-C1) since m=o. Now, - - > Thom 1-tm 1-

The multiplier in an open economy decreases since there is a leakage from the economy in the form of exports. That is money spend on buying imports does not contribute to Aggregate Demand and in a demand driven model like this one, it results in a lower multiplier. Thus for same level of Government expenditure, the open economy multiplier will be less than the closed economy one since some of it will be spent on imports.