General equilibrium in the open (trading) economy

conditions in the open economy (the case of small economy).
2.2. The concept of the excess demand function.
2.3. International general equilibrium conditions.

What is small economy?

is small economy?
Demand and supply in small economy (for a specific good) do not affect the world price level on the world market of the good under consideration.
(1) Exogenous parameters of the model:
Production technology (at least 2 goods) – production functions:
Х = fx (Kx, Lx);
Y = fy (Ky, Ly).
Resource endowment in the economy (at least 2 resources) – capital (K) and labor (L):
K = Kx + Ky;
L = Lx + Ly.
Preferences of representative household – utility function:
U = U (X, Y).
World price ratio for final goods: Px*/Py*.
Market structure on the final goods markets – perfect competition.
Market structure on the resource markets – perfect competition.

(continued)

(2) Endogenous parameters of the model:
Equilibrium production of final goods: Xp*, Yp*;
Equilibrium consumption of final goods: Xc*, Yc*:
If (Xc*-Xp*)>0 or (Yc*-Yp*)>0 – the good is imported;
If (Xc*-Xp*)<0 or (Yc*-Yp*)<0 – the good is exported.
(3) Equilibrium conditions:
Producer optimization: MRT*=Px*/Py*;
Consumer optimization: MRS*=Px*/Py*;
Trade balance:
(Px*/Py*) (Xc*-Xp*) + (Yc*-Yp*) = 0.

Which conditions are similar and which ones are different compared to closed economy?

(continued)

(4) Graphical illustration of general equilibrium in small open economy.

Figure 3.1. Open-economy general equilibrium
Source: Markusen et al. (1995), Ch. 4, P. 55

demand function: relates the world price ratio on the one hand and difference between demand and supply, on the other hand
Ex(Px/Py) = Xc(Px/Py) - Xp(Px/Py)
Graphical derivation of the excess demand function for small open economy:
From production possibilities curve of the economy

excess demand function for small open economy: derivation from production possibilities curve.

What are similarities and differences compared to the ‘ordinary’ demand function?

Figure 3.2. Different trade equilibria Figure 3.3. The excess demand for X
Source: Markusen et al. (1995), Ch. 4, P. 56

excess demand function for small open economy: characteristics
Slope of the excess demand curve;
Intersection with vertical axis.

economies (at least 2 – h, f);
Large economy: demand and supply of the large economy (for a specific good) affect the world price level on the market of the good under consideration.
(1) Exogenous parameters of the model (for each economy):
Production technology (at least 2 goods) – production functions (identical in the economies):
Х = fx (Kx, Lx);
Y = fy (Ky, Ly).
Resource endowment in each economy (at least 2 resources) – capital (K) and labor (L):
Kh = Khx + Khy, Kf = Kfx + Kfy;
Lh = Lhx + Lhy, Lf = Lfx + Lfy.
Preferences of representative household in each of the economies – utility functions:
Uh = Uh (Xh, Yh);
Uf = Uf (Xf, Yf).
Market structure on the final goods markets – perfect competition.
Market structure on the resource markets – perfect competition.

production of final goods: Xph*, Yph*, Xpf*, Ypf*;
Equilibrium consumption of final goods: Xсh*, Yсh*, Xсf*, Yсf*:
If (Xc*-Xp*)>0 or (Yc*-Yp*)>0 – the good is imported;
If (Xc*-Xp*)<0 or (Yc*-Yp*)<0 – the good is exported.
World price ratio for final goods: Px*/Py*;
(3) Equilibrium conditions:
Equilibrium conditions for the economy h: MRTh*=Px*/Py*=MRSh*;
Equilibrium conditions for the economy f: MRTf*=Px*/Py*=MRSf*;
Trade balance for both economies:
(Px*/Py*) (Xch*-Xph*) + (Ych*-Yph*) = 0;
(Px*/Py*) (Xcf*-Xpf*) + (Ycf*-Ypf*) = 0.
Market clearing conditions on the world market of two goods:
Xch*+Xсf* = Xph*+Xpf;
Ych*+Yсf* = Yph*+Ypf*.

in the world economy:
With the excess demand curves for two countries;

Figure 3.4. International general equilibrium
Source: Markusen et al. (1995), Ch. 4, P. 58

in the world economy:
With production possibility curves for two countries.
During the lecture.

and work on a paper review (due 1 November 2016)
Office hours: Friday 13:50 – 14:30, room 216.
E-mail: natalya.davidson@gmail.com (Наталья Борисовна Давидсон)

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