Macroeconomics Week 12

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Macroeconomics Week 12

• Short Run Open Economy Macroeconomics

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Principles of Macroeconomicsby N. Gregory
MankiwChapter 12 Aggregate Demand in the Open
Economy

• Instructor Prof. John M. Veitch

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Small Open Economy IS-LM

• Small Open Economy IS-LM Model described by 2
  equations
• (IS) Y C(Y-T) I(r) G NX(e)
• (LM) M/P L(r, Y)
• Assuming economys financial markets small
  relative to Rest-of-World markets.
• So r r ROW Interest Rate
• Use nominal EXR, e, because assuming Price levels
  constant.
• Both domestic, P, and ROW, P, price levels fixed.

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Open Economy LM Curve
LM Curve
r
LM(M/P)

• Domestic interest rate fixed by ROW interest
  rate, r.
• Domestic Money market (LM Curve) at r r.
• Small Open Economy LM Curve, LM, not affected
  by the exchange rate, e.
• Diagram LM is vertical for relating exchange
  rate, e, and real GDP, Y.
• Increase in M, shifts LM out.

Y
e
Y
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YE
E
Keynesian
Open Economy IS Curve
E(e1)
Cross
Y1
Y
Net Exports Demand
e
e
International
IS Curve
e1
NX(e)
NX(e1)
Y
NX
Y1
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Small Open Economy IS-LM
Exchange
Rate
Income, Output
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Small Open Economy Under Flexible Exchange Rates

• Assume that Foreign Exchange Market determines
  the equilibrium nominal exchange rate .
• This is called a system of floating exchange
  rates and it is the predominant way in which
  exchange rates are determined in the world.
• Will investigate consequences of fiscal and
  monetary policies for small open economy that has
  a floating exchange rate regime.
• Fiscal Policy Trade Policy ineffective.
• Monetary Policy effective.

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Expansionary Fiscal Policy
LM(M/P)
Exchange
Rate
e1
IS(G1 ,T)
Income, Output
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Expansionary Monetary Policy
LM1
Exchange
Rate
e1
IS(G1 ,T)
Y1
Income, Output
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Trade Policy IS-LM Model
IS1
LM
e
e
e1
NX1
NX
Y1
Y
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Small Open Economy Under Fixed Exchange Rates

• Assume instead that government announces EXR to
  Foreign Exchange Market.
• Central bank takes actions to keep EXR fixed .
• This is called a system of fixed exchange rates.
• Fewer countries set exchange rates in this way.
• Investigate consequences of fiscal and monetary
  policies on small open economy that has a fixed
  exchange rate regime.
• Fiscal Policy Trade Policy effective.
• Monetary Policy ineffective.

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Monetary Reaction Fixed EXR

• Central bank announces Fixed EXR level.
• Must act to keep EXR at this level. How?
• Central bank will intervene in FX Market
• If EXR in FX Market less than Fixed EXR.
• Individuals profit by buying with foreign
  currency.
• Sell to central bank for more foreign currency.
• Result of in circulation falls, Money supply
  falls
• LM Curve shifts back, EXR in market rises to
  level of Fixed EXR set by government.
• If EXR in FX Market higher than Fixed EXR.
• exact opposite occurs, so market EXR to fixed
  level.

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Fixed EXR Adjustments
1. Begin with Fixed EXR
above equilib. EXR.
Exchange
LM1
Rate
e
1.
e0
Fixed Exchange Rate
Equilib.
EXR
IS(G,T)
Income, Output, Y
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Fixed EXR Adjustments
1. Begin with Fixed EXR
below equilib. EXR.
Exchange
LM1
Rate
e
Equilib.
EXR
Fixed Exchange Rate
e0
1.
IS(G,T)
Income, Output, Y
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Fiscal Policy Fixed EXR
LM1
Exchange
Rate
Fixed Exchange Rate
e0
IS(G1 ,T)
Y1
Income, Output
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Monetary Policy Fixed EXR
LM1
Exchange
Rate
e0
IS(G1 ,T)
Y1
Income, Output
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Protectionist Trade Policy
LM1
Exchange
Rate
Fixed Exchange Rate
e0
IS(G1 ,T)
Y1
Income, Output
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Interest Rate Differentials

• Assumed for small open economy that r rbut
  not always true because
• Country Risk leads investors to demand risk
  premium.
• Expected Changes in EXR lead investors to demand
  premium (or discount) to compensate for change.
• Assume r r q, where q Country premium
  determined exogenously by investor perceptions.
• Small Open Economy IS-LM Model given by
• (IS) Y C(Y-T) I(r q) G NX(e)
• (LM) M/P L(r q, Y)

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Increase in the Risk Premium
LM1
Exchange
Rate
e1
IS1
Y1
Income, Output
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Intl IS-LM and AD Curve

• Look at Price Changes in Open Economy IS-LM.
• Recall NX depends on e e(P/P), so IS-LM is
• (IS) Y C(Y-T) I(r) G NX(e)
• (LM) M/P L(r, Y)
• Assume Domestic Price Level rises
• Real Money supply falls, shifts LM inwards.
• Real exchange rate rises, NX falls, lower Real
  GDP.
• This is the AD Curve for small open economy.
• Any other variables that shift IS or LM will
  shift AD Curve correspondingly.

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Open Economy AD Curve
e
LM(M/P1)

• Begin at Price Level P1 with IS1 and LM1.
• 1. Increase Price level to P2.
• - LM shifts to LM2.
• 2. Increases exchange rate, e2.
• 3. Lower level of real GDP, Y2, at higher Price
  level P2.
• 4. AD Curve summarizes relationship of P and Y.
• Anything that shifts IS or LM Curve (with Price
  level fixed) will shift AD Curve.

e1
IS1
Y
Price
Y1
Level
P
P1
Y1
Y
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IS-LM AD Curve in SR LR
1. Begin below LR equilibrium at point 1 as
result of shock to economy.
LRAS
LM1
AD
e
P
SRAS1
P1
eSR
1.
1.
IS
YLR
YSR
YSR
Y
Y