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Econ472 (International Trade) ch 14

Econ472 (International Trade) ch 14 - Chapter 14 An...

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Chapter 14  An Introduction to Modeling the Open Economy Learning objectives By the end of this chapter you should be able to understand: why it is helpful to build models to analyze the impact of policy changes. that the exchange rate regime has a profound influence on the effectiveness of public policy. that trade deficits may be due to fundamental factors other than trade barriers or exchange rates. the link between national saving and the trade balance. the impact of openness on a fiscal or monetary expansion. Starting with the simplest model With the basic terminology of the open economy well understood, we are ready to  construct our first model of the international macroeconomy.   We start with a simple  model, because economists employ models to help understand solutions to problems that  are too complex to work out explicitly. If a real-world problem cannot be solved at first,  it is helpful to break it down into several components.  This implies a simplification of  the real world which helps us understand one specific part of the problem. Once we have  understood that one part, we can expand the model to make it more realistic and try to  understand a larger part of the complex world.  Brilliant model builders have a gift for  choosing the crucial parts of the complex world that can be simplified to gain powerful  insights.  How can we know whether our model is a good one?   The test is simply to  question how helpful our model is, or even whether it is helpful at all. In order to figure  out whether our model is insightful, we must compare its predictions to data gathered  from the real world.   This is the path we shall follow in this chapter. We will start  modeling the open economy by first developing the simplest model of the open economy  and use it to analyze the impact of various economic policies under either fixed or  flexible exchange rates. Then we ask whether the implications are born out of the data,  and see whether the results are robust.  Key features of a Basic Open Economy Model  We want to examine how our economy behaves when it is integrated into the global  economy.  How do changes in our international transactions, recorded by the balance of  payments affect domestic output and employment?  Without introducing any additional  assumptions, we know that aggregate demand,  Z,  must be adjusted to include the trade  balance, TB, which represents  net foreign demand (exports,   X,   minus imports,   M).  Strictly speaking we would have to include all components of the current account, not 
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