Agenda
• How Exchange Rates are Determined (again)
Exchange Rates, Business Cycles,
and Macroeconomic Policy in the
Open Economy,
Part 2
• The IS-LM Model for an Open Economy
• Macroeconomic Policy in an Open Economy
with Flexible Exchange Rates
20-1
20-2
How exchange rates are determined
The supply of and demand for the dollar
• In a flexible exchange-rate system, exchange
rates are determined in the foreign exchange
market where the demand for the currency
equals the supply of the currency.
P$ or enom
Q$
20-3
20-4
1
How exchange rates are determined
How exchange rates are determined
• The supply of dollars come from domestic
residents who want to buy:
• The exchange rate will change whenever there
is a change in the supply of, or demand for, the
currency.
¾ Foreign made goods and services (imports),
and/or
¾ Foreign real and financial assets.
¾ The supply of the currency will increase if
domestic residents want to buy more foreign
goods, services, or assets.
• The demand for dollars comes from foreign
residents who want to buy:
¾ The demand for the currency will increase if
foreign residents want to buy more domestic
goods, services, or assets.
¾ Domestic made goods and services (exports),
and/or
¾ Domestic real and financial assets.
20-5
How exchange rates are determined
20-6
How exchange rates are determined
• Factors that increase the supply of the currency:
• Factors that increase the demand for the currency:
¾ An increase in domestic output, Y.
¾ A decrease in the domestic real interest rate, r.
¾ An increase in the foreign real interest rate, rFOR.
¾ A shift in world demand away from domestic
goods, services, or assets.
¾ An increase in foreign output, YFOR.
¾ A decrease in the foreign real interest rate, rFOR.
¾ An increase in the domestic real interest rate, r.
¾ A shift in world demand towards domestic goods,
services, or assets.
20-7
20-8
2
An increase in the domestic real interest rate
An increase in the foreign real interest rate
P$ or enom
P$ or enom
S$
P$
S$
P$
D$
D$
Q$
Q$
20-9
20-10
The IS-LM Model for an Open Economy
The IS-LM Model for an Open Economy
• Only the IS curve is affected by having an
open economy instead of a closed economy;
the LM curve and FE line are the same.
• Only the IS curve is affected by having an
open economy instead of a closed economy;
the LM curve and FE line are the same.
¾The IS curve is affected because net exports are
part of the demand for goods.
¾ The AD-AS and DAD-SRAS models are not used
because the focus is on what happens to the real
interest rate, which has an important impact on the
exchange rate.
¾The IS curve remains downward sloping.
20-11
20-12
3
Goods market equilibrium, open economy
The IS-LM Model for an Open Economy
• The goods-market equilibrium condition in an
open economy is:
r
Sd – Id = NX
¾ Desired foreign lending MUST equal foreign
borrowing.
Sd – Id, NX
20-13
20-14
The IS-LM Model for an Open Economy
The IS-LM Model for an Open Economy
•
•
Goods market equilibrium, open economy:
¾ The Sd – Id curve slopes upward because a rise in
the real interest rate increases desired national
saving and reduces desired investment.
Goods market equilibrium, open economy:
¾ The NX curve slopes downward because a rise in
the real interest rate increases the real exchange
rate and thus reduces net exports.
•
20-15
Net exports can be positive or negative.
20-16
4
Derivation of the IS curve, open economy
The IS-LM Model for an Open Economy
•
Goods market equilibrium, open economy:
r
Sd – Id
r
¾ Goods market equilibrium in an open economy
occurs where the Sd – Id and NX curves intersect.
r0
•
To derive an open-economy IS curve,
analyze what happens to goods market
equilibrium when domestic output changes.
NX
Sd–Id, NX
20-17
20-18
The IS-LM Model for an Open Economy
The IS-LM Model for an Open Economy
•
• Factors that shift the open-economy IS curve:
The open-economy IS curve:
¾ Because higher output increases saving, the Sd –
Id curve shifts to the right.
¾ Any factor that shifts the closed-economy IS
curve also shifts the open-economy IS curve and
in the same direction.
¾ Because higher output reduces net exports, the
NX curve shifts to the left.
¾ A new equilibrium occurs at a lower real interest
rate and the IS curve is downward sloping.
•
Y
The open-economy IS curve is flatter than the closedeconomy IS curve.
20-19
¾ Any factor that changes net exports (for a given
domestic output and the domestic real interest
rate) also shifts the open-economy IS curve and in
the same direction.
20-20
5
The IS-LM Model for an Open Economy
The IS-LM Model for an Open Economy
•
•
Factors that shift the open-economy IS curve:
¾ The open-economy IS curve shifts to the right
because of:
•
an increase in expected future output,
•
an increase in wealth,
•
an increase in government purchases,
Factors that shift the open-economy IS curve:
¾ The open-economy IS curve shifts to the right
because of:
•
a decline in taxes,
–
if Ricardian equivalence doesn’t hold,
•
an increase in the expected future marginal product of
capital, and/or
•
a decrease in the effective tax rate on capital.
20-21
An increase in government purchases
r
Sd – Id
20-22
The IS-LM Model for an Open Economy
•
r
Factors that shift the open-economy IS curve:
¾ The open-economy IS curve also shifts to the
right because of:
r0
r0
•
IS0
NX
Sd–Id, NX
An increase in net exports that is NOT caused by a
change in domestic output or the domestic real interest
rate.
Y0
Y
20-23
20-24
6
The IS-LM Model for an Open Economy
The IS-LM Model for an Open Economy
•
•
Factors that shift the open-economy IS curve:
¾ Three things could increase net exports for a
given level of domestic output and the domestic
real interest rate.
•
¾ Three things could increase net exports for a
given level of domestic output and the domestic
real interest rate.
First, an increase in foreign output, YFor.
–
•
This increases foreigners’ demand for domestic exports.
»
Factors that shift the open-economy IS curve:
Second, an increase in the foreign real interest rate, rFor.
–
And also causes the currency to appreciate, “crowding out”
some net exports although, on balance, net exports increase.
This makes domestic residents want to buy foreign assets.
»
This causes the currency to depreciate and net exports to rise.
20-25
20-26
An increase in net exports
The IS-LM Model for an Open Economy
• Factors that shift the open-economy IS curve:
r
¾ Three things could increase net exports for a
given level of domestic output and the domestic
real interest rate.
Sd – Id
r0
r
r0
• Third, a shift in worldwide demand toward the domestic
country’s goods.
– This increases the foreign demand for domestic exports.
» And also causes the currency to appreciate, “crowding out” some
net exports although, on balance, net exports increase.
Sd–Id, NX
20-27
IS0
NX
Y0
Y
20-28
7
The IS-LM Model for an Open Economy
The IS-LM Model for an Open Economy
• International transmission of business cycles:
•
International transmission of business cycles:
¾ What would be the effect on Japan of a recession
in the United States?
¾ The impact of foreign economic conditions on the
real exchange rate and net exports is one of the
principal ways by which cycles are transmitted
internationally.
•
A similar effect could occur because of a shift in
preferences (or trade restrictions) for Japanese goods.
20-29
Macro policy in an open economy
A recession in the U.S.
Japan
U.S.
r
20-30
r
LM0
LM0
• Two key questions:
¾ How do fiscal and monetary policy affect a
country’s real exchange rate and net exports?
r0
r0
¾ How do the macroeconomic policies of one
country affect the economies of other countries?
IS0
Y0
IS0
Y
Y0
Y
20-31
20-32
8
Macro policy in an open economy
Macro policy in an open economy
• To analyze these questions:
• The effects of a fiscal expansion :
¾ Use an IS-LM diagram to determine the effects on
domestic output and the real interest rate.
¾ An increase in domestic government purchases
and/or a decrease in taxes.
• With no Ricardian equivalence.
¾ Determine how these changes affect the exchange
rate and net exports.
¾ A fiscal expansion shifts the IS curve to the right.
¾ Use an IS-LM diagram to determine the effects on
foreign output and the real interest rate.
20-33
An increase in domestic government purchases
Macro policy in an open economy
Foreign
Domestic
r
r
LM0
LM0
20-34
• The effects of a fiscal expansion:
¾ On domestic output and the real interest rate:
• Domestic output increases.
r0
r0
• Domestic real interest rates increase.
IS0
Y0
IS0
Y
Y0
Y
20-35
20-36
9
Macro policy in an open economy
Macro policy in an open economy
• The effects of a fiscal expansion:
• The effects of a fiscal expansion:
¾ On the exchange rate:
¾ On net exports:
• Higher domestic output increases the supply of the
currency, causing the currency to depreciate.
• Higher output causes net exports to decrease.
• Higher real interest rates increase the demand for the
currency, causing the currency to appreciate.
• Higher domestic real interest rates increase the demand
for the currency, causing the currency to appreciate,
which in turn causes net exports to decrease.
• The net effect on the exchange rate is ambiguous.
• The net effect is that net exports decrease.
– Typically the interest rate effect is larger.
20-37
20-38
Macro policy in an open economy
Macro policy in an open economy
• The effects of a fiscal expansion :
• The effects of a fiscal expansion:
¾ In the long-run:
¾ On a foreign economy:
• The domestic economy’s LM curve shifts to the left as
the price level rises to restore equilibrium.
• Domestic net exports decrease, implying foreign net
exports increase.
– Domestic real interest rates are higher.
• The foreign country’s IS curve shifts to the right.
» Fiscal expansion “crowds out” both investment and net exports.
– Foreign output increases.
– Foreign real interest rates increase.
– Domestic output is unchanged.
– Domestic price level is higher.
20-39
20-40
10
Macro policy in an open economy
Macro policy in an open economy
• The effects of a fiscal expansion:
• The effects of a fiscal expansion:
¾ In the long-run:
¾ In the long-run:
• The real exchange rate appreciates.
• The foreign economy’s LM curve shifts to the left as the
price level rises to restore equilibrium.
• The nominal exchange rate is ambiguous.
– Foreign real interest rates are higher.
– The nominal exchange rate is given by: enom = ePFor/P
– Foreign output is unchanged.
– It is ambiguous because although the real exchange rate
appreciates, the domestic price level rises (by more than the
foreign price level).
– Foreign price level is higher.
20-41
20-42
A decrease in the domestic money supply
Macro policy in an open economy
Foreign
Domestic
• The effects of a monetary contraction:
r
r
LM0
LM0
¾ A decrease in the money supply.
¾ A monetary contraction shifts the LM curve to
the left.
r0
r0
IS0
Y0
20-43
IS0
Y
Y0
Y
20-44
11
Macro policy in an open economy
Macro policy in an open economy
• The effects of a monetary contraction :
• The effects of a monetary contraction :
¾ On domestic output and the real interest rate:
¾ On the exchange rate:
• Domestic output decreases.
• Lower domestic output decreases the supply of the
currency, causing the currency to appreciate.
• Domestic real interest rates increase.
• Higher domestic real interest rates increases the demand
for the currency, causing the currency to appreciate.
• The net effect on the exchange rate is an appreciation.
20-45
20-46
Macro policy in an open economy
Macro policy in an open economy
• The effects of a monetary contraction :
• The effects of a monetary contraction :
¾ On net exports:
¾ On a foreign economy:
• Lower domestic output causes net exports to increase.
• Domestic net exports increase, implying foreign net
exports decrease.
• Higher domestic real interest rate increase the demand
for the currency, causing the currency to appreciate,
which in turn causes net exports to decrease.
• The foreign country’s IS curve to the left.
– Foreign output decrease.
– Foreign real interest rates decrease.
• Following the J curve analysis, assume the latter effect
is weak in the short run, so that net exports increase.
20-47
20-48
12
Macro policy in an open economy
Macro policy in an open economy
• The effects of a monetary contraction :
• The effects of a monetary contraction :
¾ In the long-run:
¾ In the long-run:
• The domestic economy’s LM curve shifts to the right as
the price level falls to restore long-run equilibrium.
• The foreign economy’s LM curve shifts to the right as
the price level falls to restore long-run equilibrium.
– The LM curve returns to its original position.
– The foreign economy LM curve returns to its original position.
• All real variables return to their original levels.
• All real variables return to their original levels.
– Including net exports and the real exchange rate
– Including net exports and the real exchange rate.
20-49
20-50
Macro policy in an open economy
Macro policy in an open economy
• The effects of a monetary contraction :
• In the short-run:
¾ Monetary policy has a larger effect on the domestic output
than does fiscal policy.
¾ In the long-run:
• The real exchange rate does not change.
• A monetary expansion causes the currency to depreciation.
– This causes a further increase in net exports and economic output.
• The nominal exchange rate appreciates.
• A fiscal expansion has an ambiguous effect on the currency.
– The nominal exchange rate is given by: enom = ePFor/P
– This reduces any increase in net exports (relative to a monetary
expansion) so net exports and economic output do not rise as much.
– The nominal exchange rate appreciates because the real
exchange rate does not change and the domestic price level
falls (by more than the foreign price level).
20-51
20-52
13