Criteria Mark 1. Professional Presentation 1 · Well organiz.docx

Criteria / Mark
1. Professional Presentation/ 1
· Well organized, neatly presented, word processed, spelling,
grammar, and punctuation
· Name and student number as well as lab partner/s name, date
and time of experiment
· In-text referencing, reference list at end of report
2. Title and Abstract/ 1
· Title: concise title directly above abstract (even if you have it
on the cover page already)
· Abstract: Brief description of the experiment, the major
results, associated uncertainties, comparison with theoretical
results/expected results.
3. Introduction and Aims/ 1
· A brief paragraph describing key physics and relevant
background
· At the end of the introduction, state the aims of experiment
4. Procedure and Apparatus/ 0.5
· Describe the equipment used, you may include labeled
sketches, drawing, or photographs of apparatus
· Describe how you conducted the experiment. Remember to
use past tense, you are telling the reader what you have done.
5. Risk Assessment/ 0.5
· Use a risk assessment matrix (under lab section of
Blackboard) to:
(i) Consider the health and safety risk of this experiment to
yourself and others in the laboratory.
(ii) Determine what measures you would put in place to
mitigate/reduce these risks where possible.
· Attach the risk assessment at the end of your report after the
references list
6. Data, Critical Analysis and Uncertainties / 2
· Data presented in numbered table format with proper titles and
headings ie. “Table 1: Description of Some Tabulated Data”

· Figures to presented with number headings and with proper
titles and headings ie. “Figure 1: Graph of some Data”
· You should write text which refers to/describes data in tables
and plots
· Show calculations of key parameters and calculations of
uncertainties where necessary
· Present data in scientific notation where applicable
· Use appropriate SI units – eg. metres (m), seconds (s), metres
per second (m/s).
7. Summary and Discussions /2
· Brief summary the experiment and aims
· Describe the results and put them in context with the expected
or theoretical values – do they match? If not, why? You may
need to do some research for this part.
· Identify the major source(s) of uncertainty and how they
contribute to the final uncertainty
· Statements describing ways to improve the precision and/or
accuracy of the final result by improving the method employed
as well as considering alternative equipment
· Unnecessary repetition of method or results will not be
considered as discussion
8. Answers to specific questions /2
MOD001072
MANAGING THE ECONOMY
Weeks 7-8

Classical model- small open economy
*
Weeks 7-12
The three topics
WKS 7-8
CLASSICAL MODEL‘Long run’ –flexible pricesOpen economy
WKS 9-10
IS-LM [‘Keynesian’] MODEL‘Short run’ – fixed pricesOpen
economy
WKS 11-12
INFLATIONARY EXPECTATIONSAdaptive
expectationsRational expectations
HOLIDAY BREAK
*
WEEKS 7-8 SUMMARY
CLASSICAL MODEL0. Classical models –basic features,
closed vs open
1. International flows of goods and money (finance) -
definitions

2. Savings and Investment in an SOE (Small Open Economy) -
analysis
3. How Changes in Savings and Investment affect the Trade
Balance – role of exchange rate
COVERED IN LECTURE AND CLASS WEEK 7
COVERED IN LECTURE AND CLASS WEEK 8
*
0. CLASSICAL models
Basic features
Assume supply side of economy drives the economySpending
power (aggregate demand) created by supply side
forcesAssumes always ENOUGH spending power to buy all the
output supplied
Government DOESN’T NEED TO REGULATE ‘aggregate
demand’
So ‘output’ assumed to be fixed by supply side
Focus a lot on price adjustment to ensure equilibriumRole of
economy model
Government MACRO policy role:

*
0. CLASSICAL models: ‘closed’ vs ‘open’
So far...CLOSED ECONOMY
Now... Focus on a [SMALL] OPEN ECONOMY
Real
interest
rate ‘r’
S
I(r)
National economy decides its own real interest rate ‘r1’
r1
Trade with rest of world: NET EXPORTS
Lend to/borrow from overseas
Supply = demand in national economy determined by real
interest rate ‘r1’ balancing its own S and I
No trade with rest of world
No lending to/borrowing from overseas
World economy (NOT the national economy) decides the real
interest rate
Supply = demand in national economy determined by both
[1] World real interest rate
[2] Real exchange rate
National economy’s S and I may no longer be equalCan lend
capital abroadCan borrow capital from abroad
Loanable funds
Supply side
Govt policy
*

Source: Mankiw CH 5
Evidence: degrees of ‘openness’
Trade-GDP ratio, selected countries, 2004
(Imports + Exports) as a percentage of GDP
Luxembourg275.5%Ireland150.9Czech
Republic143.0Hungary134.5Austria97.1Switzerland85.1Sweden
83.8Korea, Republic
of83.7Poland80.0Canada73.1Germany71.1%Turkey63.6Mexico6
1.2Spain55.6United
Kingdom53.8France51.7Italy50.0Australia39.6United
States25.4Japan24.4

*
This data shows the degree of “openness” (measured by the
trade-to-GDP ratio) of selected OECD countries.
Despite the huge absolute value of U.S. trade, most of the other
countries shown have higher trade-GDP ratios.
Source: OECD.org
WEEKS 7-8 SUMMARY
closed vs open
definitions
analysis

*
1. International flows of goods and money - definitions
Two aspects here
International flows of finance (saving, investment)
*
The idea of ‘net exports’ or NX
Total demand or spending in closed economy was:
Y = C + I + G
In open economy it is
Y = C + I + G + NX
*
International capital flows and net exports

We now know total demand is Y = C + I + G + NX
Subtracting C and G from both sides
Y – C – G = C – C + I + G - G + NX
gives
Y – C - G = I + NX
Or
S = I + NX
or
S- I = NX
*
REMINDER : Why Y – C – G is ‘saving’ (S)
PRIVATE SAVING
Total
Savings S
PUBLIC SAVING
Y - T - C
T - G
SO TOTAL SAVING IS
Y – T – C + (T – G)
OR....Y – C - G
Y
Y-T
T
C

*
So we had Y – C – G = I + NX
Which is S = I + NX
Or S – I = NX
*
S-I = NX
This is the Open Economy Classical equilibrium condition
S – I
We have, in equilibrium:
NX
=
NET CAPITAL
OUTFLOW
S-I>0
NET Lending capital to foreigners
S-I<0
NET Borrowing from foreigners
TRADE BALANCE

NX > 0
Export more than import
NX <0
Import more than export
*
WEEKS 7-8 SUMMARY
closed vs open
definitions
analysis
*
2. Saving and Investment in a SOE (Small Open Economy)
2.1. Two ideas: Capital mobility and world interest rate
2.2. The Classical Model of S and I in a SOE

2.3. How Govt Policy affects Savings, Investment and NX
*
2.1. Two ideas: Capital mobility and the ‘world’ interest rate
So far...CLOSED ECONOMY
Now... Focus on SMALL OPEN ECONOMY [SOE]
Real
interest
rate ‘r’
S
I(r)
National economy decides its own real interest rate
r1
r1
r
S
I(r)
World S
World I
r*
r
Small open economy HAS TO ACCEPT WORLD real interest
rate r*
[a]SOE’s own S and I too small to affect world S, I
[b] SOE allows residents full access to global financial (i.e.
Loanable funds) markets
If both [a] + [b] are true:
Loanable funds
globally
Loanable funds

in country
Loanable funds
in a country
*
2.2. The Classical Model of S and I in a SOE
We know:Total supply of output given at Y =Yn.Government
spending fixed at G = GnGovernment taxation fixed at T =
TnConsumption demand [=consumption function] is C = C(Y-
T)Investment demand [ = investment function] is I = I(r)SOE
must accept world interest rate level r*
We know Net exports NX = S - I or [Y – C(Y-T) – G)] – I (r)
Plug in values for Yn, Tn, Gn and r*
We get NX = [Yn – C(Yn-Tn) – Gn] – I(r*)
Or NX = S(Yn,Tn,Gn) – I(r*)
*
NX = net exports = S(Yn,Tn,Gn) – I(r*)
The level of ‘S’ is determined byGiven supply of output Yn
(which determines total income)Nature of consumption function
(which explains how Y affects C)Government policy (which

fixes G at Gn and T at Tn)
The level of ‘I’ is determined byWorld interest rate r* (because
economy is a SOE)Available investment opportunities
globallyGovernment policy (e.g. Tax incentives to invest)
*
REMINDER of the savings-investment diagram (same as closed
economy case last week)
Loanable funds
Dn a country
S(Yn,Tn,Gn)
Writing S as S(Yn,Tn,Gn) just says that the position of the
vertical line (for Savings) depends on Y,T,G, which are fixed at
levels Yn, Tn, Gn.
I(r)
This line is vertical since S level doesn’t depend on r
So any change in G or T or Y will cause a SHIFT left or right in
the S line.
This line shows that as r falls, more investment projects become
worthwhile, so I rises
Real
interest
Rate (r)
*

3 possible situations for Small Open Economy depending on
level of world interest rate
Here:
S>I at world interest rate
SITUATION 1
S
S
S
I(r)
I(r)
I(r)
Here:
S = I at world interest rate SITUATION 2
Here:
S< I at world interest rate SITUATION 3
White horizontal line = world interest rate,
set by interaction of world S and world I
*
SITUATION 1: capital outflow and trade surplus at world
interest rate r**
r
I,S
S(Yn,Tn,Gn)
Here:
Total S at r** is Sn
Total I at r** is I**
I(r)
r**

So at r**
S > I
If S> I, then NX >0
At r= r**:
Economy ‘exports’ capital (S>I) and has a trade surplus (NX >
0)
Sn
I**
*
SITUATION 2: no capital flow and trade balance at world
interest rate r*
r
I,S
S(Yn,Tn,Gn)
Here:
Total S at r* is Sn
Total I at r* is I*
I(r)
r*
So at r*
S = I
If S= I, then NX =0
At r= r* [ like closed econ case]
Economy has no external capital flows and has trade balance
(NX = 0)
I*=Sn
*

SITUATION 3: capital inflow and trade deficit at world
interest rate r***
r
I,S
S(Yn,Tn,Gn)
Here:
Total S at r*** is Sn
Total I at r*** is I***
I(r)
r***
So at r***
S < I
If S< I, then NX <0
At r= r***:
Economy ‘imports’ capital (S<I) and has a trade deficit (NX <
0)
Sn
I***
*
2.3. How Govt policy affects S and I and therefore the Trade
Balance (i.e. NX)
Mankiw looks at:Effects of SOE’s own Fiscal policyEffects of
Fiscal Policy in rest of world on SOEEffects of shifts in
investment

*
Effects of Changes on Capital flows and Trade Balance: THE
INITIAL EQUILIBRIUM POSITION
r
I,S
S(Yn,Tn,Gn)
Assume SOE always starts where
World int rate = r*
Total S at r* is Sn
Total I at r* is I*
I(r)
r*
So at r*
S = I
If S= I, then NX =0 in the initial position
I*=Sn
*
Effects of Fiscal Policy Changes by SOE
r
I,S
S(Yn,Tn,Gn)
Assume GOVERNMENT SPENDING INCREASED from Gn to
Gn’
I(r)

r*
[2]Private saving (Y – T - C) unchanged
[1]No change in I (because I doesn’t depend on G)
I*=Sn
[3]Public saving falls (because T-G gets lower)
[4] SO S() SHIFTS LEFT TO S’()
[5] Now at r*
Sn’< I*
Sn’
S’(Yn, Tn, Gn’)
*
Effects on SOE of Fiscal Policy Changes in Rest of World
r
I,S
S(Yn,Tn,Gn)
Assume GOVERNMENT SPENDING INCREASED IN BIG
OVERSEAS ECONOMY
I(r)
r*
[2] WORLD real interest rate will RISE to r**
[1] WORLD savings will fall
I*=Sn
[3] At new r**, I is lower in SOE (now I**)
[4] So in SOE,
At r**, S > I
[5] Now in SOE at r**:
Sn > I**

I**
r**
*
Effects on SOE of shifts in Investment demand
r
I,S
S(Yn,Tn,Gn)
Assume SOE GOVERNMENT changed tax regulations to
encourage investment
I(r)
r*
[2] SOE investment line I(r) SHIFTS RIGHT to I’(r)
[1] SOE investment would increase even though world real
interest rate unchanged at r*
I*=Sn
[3] At r*, I is higher in SOE (now I***)
[4] So in SOE,
at r*, S < I
[5] Now in SOE at r*:
Sn< I***
I***
I’(r)
*

WEEKS 7-8 SUMMARY
closed vs open
definitions
analysis
*
3.1. The basic idea – where the exchange rate fits...
3.2. Nominal and real exchange rate
3.3. Linking Real exchange rate and Trade Balance (NX)
3.4.The equilibrium real exchange rate
3.5. Policy effects on real exchange rate

*
3.1. The basic idea – where the exchange rate fits
S – I
NET CAPITAL OUTFLOW
NX
NET EXPORTS
Financial flows
S-I>0
NET Lending capital to foreigners
S-I<0
NET Borrowing from foreigners
‘Real’ flows of goods/services
NX > 0
Export more than import
NX <0
Import more than export
(Real) Exchange rate
*
3.2. Nominal vs real exchange rates
NOMINAL EXCHANGE RATE
= relative price of CURRENCIES of 2 countries
e.g.
1 GBP = 120Yen
1 Yen = 0.0083GBP

We assume:
price of currency = number of units of FOREIGN currency that
ONE unit of
*
3.2. Nominal vs real exchange rates
REAL EXCHANGE RATE
TRADE’
e.g.
UK car costs 10000GBP
Japanese car costs 2,400,000Yen
If 1GBP = 120 Yen
Then UK car costs 10000 x 120
UK car costs 1,200,000Yen
UK car costs 0.5 of Japanese car
*
Definition of real exchange rate ‘E’
Real exchange rate ‘E’
=

Nominal exchange rate ‘e’
X
Price level of domestic goods (Pd)
Price level of foreign goods (Pf)
This is what is quoted
on currency exchanges
This matters
more for classical
theory
‘E’ will be HIGH
when domestic goods price level is relatively HIGH
*
3.3. Link between real exchange rate and Trade Balance (NX)
Because E = e . [ Pd/Pf]
If E ‘higher’ then Pd/Pf is ‘higher’
If Pd/Pf is higher then Exports will be lowerImports will be
higher
NX will be lower
So: NX depends negatively on E
E
0
NX
+
-
NX(E)

E3
E2
E1
NX1
NX2
NX3
*
3.4. The equilibrium real exchange rate E*
For equilibrium we know:
S-I must equal NX
Or
Y – C(Y-T) – G – I(r) = NX(E)
Plug in given values for Yn, Tn, Gn, r*:
Yn – C(Yn – Tn) – Gn – I(r*) = NX(E)
Or
S(Yn,Tn,Gn) – I(r*) = NX(E)
One value of E makes this possible: E*.
E
NX
+
-
NX(E)
E*
NX*
S(Yn,Tn,Gn) - I(r*)
*

Checking understanding of diagram
S(Yn,Tn,Gn) – I(r*) = NX(E)
E
NX
+
-
NX(E)
E*
NX1
S(Yn,Tn,Gn)-I(r*)
This line is VERTICAL because both S and I don’t depend on
E
This line shifts left/right if any changes in Yn, Tn, Gn or r*.
This line SLOPES DOWN because a rise in E leads to a fall in
NX
*
Checking understanding of diagram
Three possible equilibrium positions
E
NX
NX(E)
E***
0
S(Yn,Tn,Gn)-I(r*)
E

E
NX
NX
NX(E)
NX(E)
0
0
NX1
Here S> I
So NX = NX1>0
E*
NX2=
E**
Here S = I
and NX = NX2 = 0
POSSIBILITY 1
Net capital outflow
Trade surplus
POSSIBILITY 2
No capital inflow/outflow
Trade balance
NX3
Here S < I
So NX = NX3 <0
POSSIBILITY 3
Net capital inflow
Trade deficit
S(Yn,Tn,Gn) – I(r*)
S(Yn,Tn,Gn) – I(r*)
*

Doing an example
FINDING EQUILIBRIUM SITUATION
Assume Yn = 5000
Assume Gn = 1000, Tn = 1000
C = 250 + 0.75(Y-T)
I = 1000 – 50r
NX = 500 – 500E and r = r* = 5
FIND INVESTMENT ‘I’ AND SAVINGS ‘S’
I = 1000-50(5) = 750
S = Y – C – G
S= 5000-250-0.75(4000) -1000 = 750
S-I = 750-750 = 0
FIND NET EXPORTS NX
-I = NX, then NX(E) also=0
FIND EQUILIB ‘E’
-I = 0 = NX =500-500E
-
E
NX
NX(E) = 500-500E
E*= 1
0
S-I
DRAW?
S-I is vertical at NX = 0
NX(E) is 0 = 500-500EWhen E = 0, NX = 500
500

*
3.5.Policy impact on equilibrium real exchange rate E*
*
SOE FISCAL POLICY – impact on E
Saving (S) FALLS + I(r*) unchanged
S-I gets lower
S-I line SHIFTS LEFT
Reduced supply of currency [as less capital outflow]
Currency rises in value from E* to E**
So [by E definition] Pd must rise relative to Pf
So exports fall, imports rise
So NX FALL TO NX1’ <0
E
NX
+
-
NX(E)
E*
NX1=0
Assume NX(E) = 0 AS INITIAL POSITION [POSSIBILITY2]
S(Yn,Tn,Gn)-I(r*)
Assume Government of SOE increases G (above Gn) to Gn’
E**

NX1’<0
S(Yn,Tn Gn’)-I(r*)
*
FISCAL POLICY – impact on E
Doing an example
Assume same model, assume original equilibrium.
Assume G rises by 250 to 1250
IMPACT ON ‘I’: NO CHANGE
IMPACT ON ‘S’?
S = Y –C – G = 5000-250-0.75(4000)-1250
S = 500 [it was 750]
-I = 500-750 = -250 <0 CAP INFLOW
IMPACT ON NET EXPORTS?
In new equilibrium, S-I = NX
NX = -250<0
NX have fallen
IMPACT ON EQUILIBRIUM EXCHANGE RATE?
S-I = - 250 = NX = 500-
E
NX
+
-
NX(E) = 500-500E
E* = 1
0
S-I
New
S-I

-250
E** = 1.5
*
BIG OVERSEAS GOVERNMENT
FISCAL POLICY – impact on E
ng FALLS
SOE Saving (S) unchanged but I(r**) in SOE FALLS
S-I gets larger
S-I line SHIFTS RIGHT
Increased supply of currency [as more capital outflow]
Currency FALLS in value to E***
E
NX
+
-
NX(E)
E*
NX1=0
Assume NX(E) = 0 AS INITIAL POSITION [POSSIBILITY2]
S(Yn,Tn,Gn)-I(r*)
Assume LARGE OVERSEAS GOVT increases government
spending
E***
NX1’’>0
S(Yn,Tn Gn’)-I(r**)

*
slide *
WEEK 9-10
OPEN ECONOMY IS-LM FRAMEWORK
THE ‘MUNDELL-FLEMING’ MODEL
G. Mankiw Macroeconomics CH12 slides edited and modified
by C. Fuller
G. Mankiw Macroeconomics CH12 slides edited and modified
by C. Fuller
*
slide *
CHAPTER 11 Aggregate Demand II
IS- LM MODEL
Closed economy
version
IS CURVE
LM CURVE

Goods market equilibrium
Small open economy version
Money market equilibrium
L(Y, r) = M/P
Income = planned spending
Money supply = money demand
L(Y, r) = M/P
Y = C + I + G
Y = C + I + G + NX
OVERALL EQUILIBRIUM
Determines Y and national interest rate r
Determines Y and exchange rate
Given world interest rate (r*) determines national level of r
MAIN DIFFERENCES from closed economy case:
r
Y
IS
LM
Y
E
IS*
LM*
CHAPTER 11 Aggregate Demand II
*
slide *
CHAPTER 12 The Open Economy Revisited
WEEKS 9-10 SUMMARY

0. The Closed Economy IS-LM model
1. The Open Economy IS-LM model
(‘Mundell-Fleming’ model)
2. Flexible (floating) exchange rates
3. Using the closed and open IS-LM models
*
slide *
0.Closed Economy IS-LM model: POLICY
r
Y
r
Y
LM
IS
LM
IS
r1
r1
Y*
Y*
FISCAL POLICY
MONETARY POLICY
Rise in G
Fall in T

Shift in
IS
To right
IS’
Predict:
Rise in r
Rise in Y
Y**
r2
Rise in money supply
Shift in
LM
To right
Predict:
Fall in r
Rise in Y
LM’
Y**
r0
Why does expansionary fiscal policy raise interest rates in a
closed economy?
Government increases G and/or cuts T.This increases planned
spending E.If E rises, this causes Y to rise: economy grows
towards Y**. The IS curve shifts out right.BUT as Y rises, so
the demand for money Md rises (remember, Md depends on Y)If
money supply Ms is unchanged, then Md>Ms at r1 and so r will
have to rise to r2.
Why does expansionary monetary policy increase income in a
closed economy?If Ms increases, then this cuts interest rates: r
starts to go down below r1. As r goes below r1, then investment
(I) starts to rise [remember I = I(r)]As I rises, so planned
spending (E) risesAs E rises, Y starts to rise too until it gets to

Y**.
*
slide *
1.The Mundell-Fleming model:
Open Economy IS-LMKey assumption:
Small open economy (SOE) with perfect capital mobility.
r = r* [because SOE forced to accept world r]Goods
market equilibrium – the IS* curve:
where
e = nominal exchange rate
= foreign currency per unit domestic currency
We could use E instead of e as prices are fixed anyway.
An exam question might have either – won’t make any
difference.
*
As we learned in the Classical Open Economy model, NX
depends on the real exchange rate. However, with price levels
fixed, the real & nominal exchange rates move together.
To see this, remember E = real exchange rate = e.(Pd/Pf). But
since Pd and Pf are assumed fixed in this model, the ratio
(Pd/Pf) never changes, so when e goes up[down], E goes
up[down] as well. So having e instead of E makes no difference
here.
So, for simplicity, we write NX as a function of the nominal
exchange rate here.

slide *
The IS* curve: Goods market eq’m
The IS* curve is drawn for a given value of r*.
Intuition for the slope:
Y
e
IS*
*
Again, “eq’m” is an abbreviation for “equilibrium.”
The text (p.337) shows how the Keynesian Cross can be used to
derive the IS* curve.
Suggestion: Before continuing, ask your students to figure out
what happens to this IS* curve if taxes are reduced.
Answer: The IS* curve shifts rightward (i.e., upward).
Explanation: Start at any point on the initial IS* curve. At
this point, initially, Y = C + I + G + NX. Now cut taxes. At
the initial value of Y, disposable income is higher, causing
consumption to be higher. Other things equal, the goods market
is out of equilibrium: C + I + G + NX > Y. An increase in Y
(of just the right amount) would restore equilibrium. Hence,
each value of e is associated with a larger value of Y. OR, a
decrease in NX of just the right amount would restore
equilibrium at the initial value of Y. But the decrease in NX
requires an increase in e. Hence, each value of Y is associated

with a higher value of e.
slide *
The LM* curve: Money market eq’m
The LM* curveis drawn for a given
value of r*.is vertical because:
given r*, there is
only one value of Y
that equates money demand with supply,
regardless of e.
Y
e
LM*
*
The text (p.316) shows how the LM curve in (Y,r) space,
together with the fixed r*, determines the value of Y at which
the LM* curve here is vertical.
Suggestion: Before continuing, ask your students to figure out
what happens to this LM* curve if the money supply is
increased.

Answer: LM* shifts to the right.
Explanation: The equation for the LM* curve is:
M/P = L(r*, Y)
P is fixed, r* is exogenous, the central bank sets M, then Y must
adjust to equate money demand (L) with money supply (M/P).
Now, if M is raised, then money demand must rise to restore
equilibrium (remember: P is fixed). A fall in r would cause
money demand to rise, but in a small open economy, r = r* is
exogenous. Hence, the only way to restore equilibrium is for Y
to rise.
Rationale: Doing this exercise now will break up your lecture,
and will prepare students for the monetary policy experiment
that is coming up in just a few slides.
slide *
Equilibrium in the Mundell-Fleming model
equilibrium
exchange
rate
equilibrium
level of
income
Y
e
LM*
IS*

*
slide *
2. Floating exchange ratesIn a system of floating exchange
rates,
e is allowed to fluctuate in response to changing economic
conditions.
*
slide *
FLOATING EXCHANGE RATES: Fiscal policy
Y1
At any given value of e,
a fiscal expansion increases Y,
shifting IS* to the right.
Results:

e goes up, no change in Y
WHY IS FISCAL POLICY INEFFECTIVE?
Y
e
e1
e2
*
Intuition for the shift in IS*:
At a given value of e (and hence NX), an increase in G causes
an increase in the value of Y that equates planned expenditure
with actual expenditure.
Intuition for the results:
As we learned in earlier chapters, a fiscal expansion puts
upward pressure on the country’s interest rate. In a small open
economy with perfect capital mobility, as soon as the domestic
interest rate rises even the tiniest bit about the world rate, tons
of foreign (financial) capital will flow in to take advantage of
the rate difference. But in order for foreigners to buy these
U.S. bonds, they must first acquire U.S. dollars. Hence, the
capital inflows cause an increase in foreign demand for dollars
in the foreign exchange market, causing the dollar to appreciate.
This appreciation makes exports more expensive to foreigners,
and imports cheaper to people at home, and thus causes NX to
fall. The fall in NX offsets the effect of the fiscal expansion.
equilibrium in the money market requires that Y be unchanged:

the fiscal expansion does not affect either the real money supply
(M/P) or the world interest rate (because this economy is
“small”). Hence, any change in income would throw the money
market out of whack. So, the exchange rate has to rise until NX
has fallen enough to perfectly offset the expansionary impact of
the fiscal policy on output.
slide *
FLOATING EXCHANGE RATES: Fiscal policy
Y1
Results [from last slide]
e goes up, no change inY
WHY does e rise?
[1] In CLOSED economy:
[2] but
In SMALL OPEN economy:
A rise of domestic ‘r’ above r*..
...causes HUGE CAPITAL INFLOW
[3] Big rise in demand for UK currency
IS
r
Y
LM
IS’
reminder
Y
e

e1
e2
*
Intuition for the shift in IS*:
At a given value of e (and hence NX), an increase in G causes
an increase in the value of Y that equates planned expenditure
with actual expenditure.
As we learned in earlier chapters, a fiscal expansion puts
upward pressure on the country’s interest rate. In a small open
economy with perfect capital mobility, as soon as the domestic
interest rate rises even the tiniest bit about the world rate, tons
of foreign (financial) capital will flow in to take advantage of
the rate difference. But in order for foreigners to buy these
U.S. bonds, they must first acquire U.S. dollars. Hence, the
capital inflows cause an increase in foreign demand for dollars
in the foreign exchange market, causing the dollar to appreciate.
This appreciation makes exports more expensive to foreigners,
and imports cheaper to people at home, and thus causes NX to
fall. The fall in NX offsets the effect of the fiscal expansion.
0? Because maintaining
equilibrium in the money market requires that Y be unchanged:
the fiscal expansion does not affect either the real money supply
(M/P) or the world interest rate (because this economy is
“small”). Hence, any change in income would throw the money
market out of whack. So, the exchange rate has to rise until NX
has fallen enough to perfectly offset the expansionary impact of
the fiscal policy on output.

slide *
FLOATING EXCHANGE RATES: Lessons about fiscal policyIn
a small open economy with perfect capital mobility, fiscal
policy cannot affect Y. “Crowding out”closed economy:
Fiscal policy crowds out investment by causing the interest rate
to rise. small open economy:
Fiscal policy crowds out net exports by causing the exchange
rate to appreciate.
*
slide *
FLOATING EXCHANGE RATES: Monetary policy
Y2
An increase in M
shifts LM* right
Results:
e falls, Y goes up
WHY IS MONETARY POLICY SO EFFECTIVE?

Y
e
e1
Y1
e2
*
Intuition for the rightward LM* shift:
At the initial (r*,Y), an increase in M throws the money market
out of whack. To restore equilibrium, either Y must rise or the
interest rate must fall, or some combination of the two. In a
small open economy, though, the interest rate cannot fall. So Y
must rise to restore equilibrium in the money market.
Initially, the increase in the money supply puts downward
pressure on the interest rate. (In a closed economy, the interest
rate would fall.) Because the economy is small and open, when
the interest rate tries to fall below r*, savers send their loanable
funds to the world financial market. This capital outflow causes
the exchange rate to fall, which causes NX --- and hence Y ---
to increase.
slide *

FLOATING EXCHANGE RATES: Monetary policy
Y2
Results (from last slide)
e falls, Y goes up
WHY does e fall?
[1] In CLOSED economy
[2] BUT
In SMALL OPEN economy..
If domestic ‘r’ falls below r*..
...this causes a HUGE CAPITAL OUTFLOW
[3] Big fall in demand for UK currency
r
Y
LM
IS
reminder
Y
e
e1
Y1
e2
*

Intuition for the rightward LM* shift:
At the initial (r*,Y), an increase in M throws the money market
out of whack. To restore equilibrium, either Y must rise or the
interest rate must fall, or some combination of the two. In a
small open economy, though, the interest rate cannot fall. So Y
must rise to restore equilibrium in the money market.
Initially, the increase in the money supply puts downward
pressure on the interest rate. (In a closed economy, the interest
rate would fall.) Because the economy is small and open, when
the interest rate tries to fall below r*, savers send their loanable
funds to the world financial market. This capital outflow causes
the exchange rate to fall, which causes NX --- and hence Y ---
to increase.
slide *
FLOATING EXCHANGE RATES: Lessons about monetary
policyMonetary policy is very effective at changing Y
Monetary policy affects output by affecting
the components of aggregate demand:
*
()()()
*
YCYTIrGNXe

=-+++
eNXY
¯Þ-Þ-
(,)
*
MPLrY
=
2
*
IS
1
*
IS
1
*
LM
2
*
LM
CLASS WEEKS 7-8
The classical model
(open economy)
Module/Unit title: Managing the Economy
Module Code: MOD001072
Academic Year: 2012/3
Module Leader: Dr Chris Fuller
Campus/ Building/ Room: Cambridge, LAB316
Email: chris.fuller@anglia.ac.uk
1
An open economy

Assume that there are two factors of production, K and L, and
that they are both fully employed. Furthermore, assume that the
economy is described by the following set of equations:
Exercises
Y = Y = 1,200
Y = C + I + G
C = 125 + 0.75(Y – T)
I = I(r) = 200 – 10r
G = G = 150
T = T = 100
NX = 200 - 100 ε
a) If the world interest rate is 10%, then r = 10, solve for I and
S, and thus NX.
NOTE 1:
NX can be called
Net exports
OR
NOTE 2:
This symbol [epsilon]....
...I write as ‘E’
But it will be like epsilon in the exam (if if comes up)
Answer to [a] Find NX
[a] Use the I equation:
I = i(r) = 200—10r* = 200- 10(10) = 100 = I
To find S, note that S = Y – C – G, so:
S = Y – C – G = 1200 –[125+0.75(1100)] – 150
– 125-825 -150 = 100 = S

S-I = 100-100 = 0
You know that in equilibrium, S-I must = NX,
so S-I = 0 = NX
E
0
NX
S-I
3
An open economy
Exercises
b) Determine the real exchange rate ε. Draw the net export and
the net capital outflow and identify equilibrium (label as point
A).
Y = Y = 1,200
Y = C + I + G
C = 125 + 0.75(Y – T)
I = I(r) = 200 – 10r
G = G = 150
T = T = 100
NX = 200 - 100 ε
ANSWER TO [b] Find E
[b] Find [equilibrium] real exchange rate E
We know (from question [a]) that S-I = 0.

In equilibrium, must have NX = S-I
NX = 200-100E = 0 in equilibrium.
100E = 200, so E* = 2
To draw NX line, note:
When E= 2, NX = 0
When E=0, NX = 200
So S-I crosses NX where E = E* = 2
E
200
NX
0
NX(E)
E* =2
S-I
A
5
An open economy
Exercises
c) Suppose that the government purchases rose by 100 to 250. If
Y remained equal to 1,200, how would this shift the saving
curve and by how much?

Y = Y = F (K, L) = 1,200
Y = C + I + G
C = 125 + 0.75(Y – T)
I = I(r) = 200 – 10r
G = G = 150
T = T = 100
NX = 200 - 100 ε
Answer to [c]
Rise in G to 250
I no change
S = Y – C – G = 1200 –[125+0.75(1100)] – 250
– 125-825 -250 = 0 = S
S-I = 0-100 = -100
In equilibrium, S-I = NX, so S-I = -100 = NX
S-I curve shifts left because S is lower
S-I will shift by 100
7
An open economy
Exercises
d) Following the increase in domestic government purchases to
250 net capital outflow changes to? Show the new situation
graphically.
Y = Y = F (K, L) = 1,200
Y = C + I + G
C = 125 + 0.75(Y – T)

I = I(r) = 200 – 10r
G = G = 150
T = T = 100
NX = 200 - 100 ε
Answer to [d]
In equilibrium, S-I = NX, so S-I = -100 = NX
S-I curve shifts left because S is lower
S-I will shift by 100
Net capital outflow is -100
= NEGATIVE net capital outflow
= net capital INFLOW of 100
OR :
trade balance (NX) is negative [=-100]
E
0
NX
200
E*
-100
NX
S-I
S-I’
A
9
An open economy

Exercises
e) Suppose we start again at point A and due a policy change by
a large open economy (like China or the US) there is a FALL in
the global supply of loanable funds. How would this change the
initial situation?
Y = Y = F (K, L) = 1,200
Y = C + I + G
C = 125 + 0.75(Y – T)
I = I(r) = 200 – 10r
G = G = 150
T = T = 100
NX = 200 - 100 ε
Answer to [e] impact of change in global loanable funds market
Start again at initial equilibrium ‘A’.
Assume [due to say actions of a
large open economy government like China, US]
global supply of loanable funds falls.
This means world S falls, so PUSHING UP
WORLD INTEREST RATE[ i.e. r* rises to (say) r**]
S won’t change if r changes
But I FALLS to I’, because world r is higher
S – I will get BIGGER
S-I curve shifts RIGHT
Real exchange rate E FALLS to E**
NX gets larger
E
0
NX
200

E*=2
NX
S-I’
S-I
Lower E**
A
Larger NX
11
An open economy
Exercises
f) Suppose we start again at point A and the world interest rate
rises to 15%. How much would the investment be now?
Y = Y = F (K, L) = 1,200
Y = C + I + G
C = 125 + 0.75(Y – T)
I = I(r) = 200 – 10r
G = G = 150
T = T = 100
NX = 200 - 100 ε
Answer to [f]
Start again at initial equilibrium ‘A’.
Assume r rises to r** = 15
I will be 200-10r** = 200-150 = 50 = new I = I’’
S in initial situation was 100.

S won’t change if r changes
S – I = 100-50 = 50 = net capital outflow
S-I curve shifts right by 50
NOTE
Can also work out new E [ this question doesn’t
ask you to but useful to know]
NX(E) = 200-100E which must = S – I = 50 in equilibrium
Or 200 – 100E = 50
Or 150 = 100E
Or E = 150/100 = 1.5 = E**
E
0
NX
200
E*=2
NX
S-I’’
S-I
50
E** = 1.5
A
13
REVISION
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.
FINIS:
Good luck.
Chris Fuller
April 2014

LM*
e
e*
IS*
Y*
Y
10.4 Calculate the binding energies per nucleon for the
isotopes 5B10, 6C12, 7N14 and 8O16.
Do the results support our guess that odd-odd
isotopes are in a lower class of stability than even-even
isotopes?
Data: Atomic masses in amu.
e 0.000549 p 1.007276

n 1.008665 5B10 10.012938 11Na22
21.994435
1H1 1.007825 6C12 12.000000 15P32
31.973908
1H2 2.014102 7N14 14.003074 26Fe56
55.934939
1H3 3.016049 8O16 15.994915 88Rn222
222.017574
2He4 4.002603 10Ne22 21.991384 88Ra226
226.025406
11.3 You are supplied with a sample containing 7.5 µg of the
isotope I131. Given the decay constant of this isotope is
9.96 10-7 s-1, find
i) the half life of the sample.
ii) the activity of the sample.
iii) the activity of the sample in threeweeks time.
iv) if, in legal terms, the sample is radioactive (I131 is
legally defined as a radioactive substance if it has an activity
greater than 40 kBq.) If it is, how long will it remain so?

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