Macroeconomics

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Macroeconomics

• Lecture 7
• The open economy

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Outline

• Stabilization policy in the closed economy
• The Mundell-Fleming model

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Money market equilibrium
i
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The goals of monetary policy
The overriding objective of monetary policy is
price stability
Eddie George

• Assume that the CB can set the market real
• interest rate by appropriate OMOs or changes
  in
• the base rate.

Inflation target

• Policy reaction function

• If , then increase r

• If , then decrease r

Long-run real interest rate
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• The Phillips curve

• The policy reaction function

CBs prediction about inflation
r
Y
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Monetary policy and the cycle
r
C
B
A
Y
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Fiscal policy

• Active stabilization policy

The fiscal authorities react to chocks and
adjust the budget to move the economy towards
full- employment.
Via r
Crowding out
Key issue
Via P

• Automatic stabilization policy

Automatic stabilizers work without active
intervention
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Practical problems with stabilization policy

• Inside lags.
• Outside lags.
• Information about the state of the economy.
• Forecasting the economy.
• Evaluating the impact of a change in policy
• Co-ordination of fiscal and monetary policy

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The Mundell-Fleming model
The IS-LM model for a small open economy with
perfect capital mobility.
The propagation mechanism?
Short-run.
Stabilization policy?
Exchange rate regimes?
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Perfect capital mobility

• Domestic and foreign assets
• are perfect substitutes.

• Exchange rate expected to
• stay constant.

• No restrictions on capital
• import/export.

Short run
Constant
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Foreign exchange market
Sources of demand (of )

• Investors who want to invest in the UK

• Buyers of UK goods

Sources of supply (of )

• Investors who want to invest abroad

• Buyers of foreign goods

With perfect capital mobility, the flows
associated with financial transactions dominate
the trade transactions.
Equilibrium in the asset/forex market
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Foreign exchange market
If rgtr, then the demand for increases.
Domestic citizens wanting to invest in F.
S0
S1
Only when rr, there is no tendency for changes
in e.
D1
D0
If rltr, then the supply of increases.
Foreign citizens wanting to invest in H.

0
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Equilibrium in the goods market
Aggregate demand
Output
Unemployed resources gt output is determined
by aggregate demand
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Nominal exchange rate
Depreciation of the exchange rate
Increase in NX and aggregate demand
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Marshall-Lerner Condition
Conversion factor
Exports
imports
Export of domestic goods decreases
Import of foreign goods increases
Terms of trade improves
Marshall-Lerner condition
Export elasticity (-)
Export elasticity ()
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Equilibrium in the money market
For given price level (P) and world interest rate
(r), the nominal stock of money (M) determines Y.
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Exchange rate regimes
The central bank committed to keep e constant.
Fixed exchange rate
The exchange rate is determined at the foreign
exchange market
Floating exchange rate
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The logic of a fixed exchange rate regime
Central banks balance sheet in an open economy
Liabilities
Assets
High-powered money
Domestic reserves
Foreign reserves

multiplier
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e
D0
S
Appreciation pressure
B
SCB
Fixed rate
C
A
D1

1
0
CB supplies to avoid appreciation
CB accumulates FR
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Fixed exchange rate gtloss of control over M
Short-run
Exception Sterilization
Suppose that there is appreciation pressure.
1) CB sells domestic currency to FOREX market
2) CB sells domestic bonds to private sector (OMO)
Accumulation/deccummulation of foreign reserves.
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What is next?

• The business cycle in the open economy
• Economic policy in the open economy
• Using the model to explain the ERM crisis in 1992.

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Definitions
Nominal exchange rate
Indirect quote
Direct quote
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Depreciation
The domestic currency becomes worth less.
Appreciation
The domestic currency becomes worth more.
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The real exchange rate
The relative price of a domestic good, i.e., the
rate at which domestic goods can be exchanged
for foreign goods.
Cost of a domestic good in
Cost of a domestic good in
Cost of a foreign good in
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Long-run equilibrium
Excess supply
Equilibrium
Y
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Long-run results

• In a small open economy with perfect capital
  mobility, the trade balance is, in the long-run,
  determined by net foreign investment at the world
  market real interest rate.
• The real exchange rate adjusts to bring net
  exports into line with net foreign investment.