Economic models of an open economy. The basic model

Date: 2015-10-07; view: 518.

In a closed economy, all output is sold domestically, and expenditure is divided into three components: consumption, investment, and government purchases.

In an open economy, some output is sold domestically and some is exported to be sold abroad. We can divide expenditure on an open economy's output Y into four components: Cd, consumption of domestic goods and services, Id, investment in domestic goods and services, Gd, government purchases of domestic goods and services, X, exports of domestic goods and services. The division of expenditure into these components is expressed in the identity

The sum of the first three terms, Cd + I d + Gd, is domestic spending on domestic goods and services. The fourth term, X, is foreign spending on domestic goods and services(the value of exports). Since, total domestic spendings is a sum of spending on domestic as well as foreign goods and services, we can say that, C = Cd + Cf, I = I d + I f, G = Gd + G f. We substitute these three equations into the identity above:

We can rearrange to obtain

The sum of domestic spending on foreign goods and services (Cf + I f + G f) is expenditure on imports (IM ). We can thus write the national income accounts identity as

Since the value of total imports is a part of domestic spending and it is not a part of domestic output, it is subtracted from the total output.This gives us the value of Net Exports (NX = X − IM ), the identity becomes

In closed economy: National savings= Investment. Closed economy countries can increase its wealth only by accumulating new capital.

If output exceeds domestic spendings, we export the difference: net exports are positive. If output falls short of domestic spending, we import the difference: net exports are negative.