Chapter 12: AD in Open Economy ƒ The Mundell-Fleming model: IS-LM for the small open economy ƒ Causes and effects of interest rate differentials ƒ Arguments for fixed vs. floating exchange rates ƒ The aggregate demand curve for the small open economy

Ch. 12

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The MundellMundell-Fleming Model ƒ Key assumption:

Small open economy with perfect capital mobility.

r = r*

ƒ Goods market equilibrium---the IS* curve:

Y = C (Y − T ) + I (r *) + G + NX (e ) where e = nominal exchange rate = foreign currency per unit of domestic currency Ch. 12

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The IS* curve Y = C (Y − T ) + I (r *) + G + NX (e ) e

↓ e ⇒ ↑ NX ⇒ ↑ Y

IS* Y

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1

NX(e) NX(e)

A weaker dollar (low e) increases net exports. In recent months the trend in NX in the US has reversed (weak $) Below: x: Euro-USD exchange rate y: changes in real net exports, 1999-2007 50 40 30 20 10 0 -10 0.8

0.9

1

1.1

1.2

1.3

1.4

-20 -30 -40 -50

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The LM* curve M P = L (r *,Y ) e

LM*

Y

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Equilibrium Y = C (Y − T ) + I (r *) + G + NX (e )

M P = L (r *,Y ) e

LM*

IS*

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Y

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2

Floating & fixed exchange rates ƒ Floating exchange rates, e is allowed to fluctuate in response to changing economic conditions.

ƒ Fixed exchange rates, the central bank trades domestic for foreign currency at a predetermined price.

ƒ We now consider fiscal, monetary, and trade

policy: first in a floating exchange rate system, then in a fixed exchange rate system.

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Fiscal policy under flexible e Y = C (Y − T ) + I (r *) + G + NX (e )

M P = L (r *,Y ) e

LM 1*

e2

At any given value of e, a fiscal expansion increases demand, shifting IS* to the right.

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IS 2* IS 1* Y1

AD in Open Economy

Y

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Lessons about fiscal policy ƒ In a small open economy with perfect capital mobility, fiscal policy does not affect GDP

ƒ “Crowding out” • closed economy: Fiscal policy crowds out investment by causing the interest rate to rise. • small open economy: Fiscal policy crowds out net exports by causing the exchange rate to appreciate.

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Mon. policy under flexible e Y = C (Y − T ) + I (r *) + G + NX (e )

M P = L (r *,Y ) e

An increase in M shifts LM* right because Y must rise to restore eq’m in the money market.

LM 1*LM 2*

e1 e2 IS 1* Y1 Y2

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Y

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Lessons about monetary policy ƒ Monetary policy affects output by affecting the components of aggregate demand: closed economy: ↑M ⇒ ↓r ⇒ ↑I ⇒ ↑Y small open economy: ↑M ⇒ ↓e ⇒ ↑NX ⇒ ↑Y

ƒ Expansionary mon. policy shifts demand from foreign to domestic products. Thus, the increases in income and employment at home come at the expense of losses abroad.

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Trade policy under floating exchange rates Y = C (Y − T ) + I (r *) + G + NX (e )

M P = L (r *,Y ) e At any given value of e, a tariff or quota reduces imports, increases NX, and shifts IS* to the right.

LM 1*

e2 e1 IS 2* IS 1* Y1

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Y

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Lessons about trade policy ƒ Import restrictions cannot reduce a trade deficit. ƒ Even though NX is unchanged, there is less trade: – the trade restriction reduces imports – the exchange rate appreciation reduces exports Less trade Æ fewer ‘gains from trade.’

ƒ Import restrictions on specific products save jobs in the domestic industries that produce those products, but destroy jobs in export-producing sectors.

Import restrictions create “sectoral shifts,” which cause frictional unemployment. Ch. 12

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Fixed exchange rates ƒ CB stands ready to buy or sell the domestic currency at a predetermined rate.

ƒ CB shifts the LM* curve as required to keep e at its preannounced rate. ƒ This system fixes the nominal exchange rate. In the long run, when prices are flexible, the real exchange rate can move even if the nominal rate is fixed.

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Fiscal policy under fixed e Under floating rates, a fiscal expansion would raise e. To keep e from rising, the central bank must sell domestic currency, which increases M and shifts LM* right.

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e

LM 1*LM 2*

e1 IS 2* IS 1* Y1 Y2

Y

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Monetary policy under fixed e An increase in M would shift LM* right and reduce e. To prevent the fall in e, the central bank must buy domestic currency, which reduces M and shifts LM* back left.

e

LM 1*LM 2*

e1 IS 1*

Y

Y1 Ch. 12

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Trade policy under fixed e A restriction on imports puts upward pressure on e. To keep e from rising, the central bank must sell domestic currency, which increases M and shifts LM* right.

e

LM 1*LM 2*

e1 IS 2* IS 1*

Y

Y1 Y2 Ch. 12

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Differentials in the MM-F model r may differ from r*. Why? country risk: borrowers might default on loan repayments Lenders require higher r to compensate them for this risk.

expected exchange rate changes:

E(Δe) 0 ⇒ ↓r ⇒ ↑I (though not as much) in a small open economy, > 0 ⇒ ↓ε ⇒ ↑NX (though not as much)

AD in Open Economy

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