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Sem 5 Prep
← Open Economy MacroInternal and external balance

Formulas for this chapter

Equilibrium with a government sector

I + X + G = S + M + T k = 1 / (MPS + MPM + MPT) Sequence: closed 1/0.25 = 4, open 1/0.40 = 2.5, with government 1/0.50 = 2

Any question involving fiscal policy. G is an injection, T a leakage, and the leakage rate now has three components.

G
Government expenditure, an injection alongside I and X
T
Taxes, a leakage alongside S and M
MPT
The marginal tax rate, the share of extra income taken in tax

Sizing an expenditure-changing policy, and its external cost

required change in autonomous spending = income gap / k induced change in imports = MPM x income gap external cost per unit of fiscal action = k x MPM

Every Zone II and Zone IV question. The first line hits the internal target, the second measures the damage to the external one.

income gap
Full-employment income minus current income; negative for an inflationary gap
k x MPM
Deficit opened per unit of fiscal expansion, e.g. 2 x 0.15 = 0.30

Reading the Swan diagram

Vertical axis R (exchange rate) Horizontal axis D (absorption) EE external balance, slopes UP YY internal balance, slopes DOWN Above EE surplus, below EE deficit Above YY inflation, below YY unemployment Zones anticlockwise from the left: I, II, III, IV

Any draw-and-explain question on internal and external balance. Name the axes first, then justify each slope, then the zones.

F
The intersection of EE and YY, where both balances hold
Zone I
Left of F: surplus with unemployment
Zone III
Right of F: deficit with inflation
Step 1 of 25
The ideaTheory

One tap, two buckets

You are filling two buckets from one tap. Turn it up and the first bucket fills nicely while the second overflows. Turn it down and the second is fine while the first stays empty.

One control, two things to get right. It cannot be done, however clever you are with the tap.

The two buckets are internal balance, full employment without inflation, and external balance, a sustainable balance of payments. This chapter is about needing a second tap, and about the diagram that shows which way to turn each.

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