Macroeconomic Theory and Policy
ECO202
Chapter 13
Open Economies in the Short Run
Masoud Anjomshoa
1
Nominal Exchange Rate (Recall):
- Nominal Exchange Rate is the relative price of the
domestic currency in terms of foreign currency, e.
e: Number of foreign currency per unit of domestic
currency.
- Nominal Depreciation: if the
domestic currency picks fewer
units of foreign currency (so it is
weaker): e↓
- Nominal Appreciation: if the
domestic currency picks more
units of foreign currency (so it is
stronger): e↑
Country Exchange rate
Euro area
0.70 euro/$
China
5.02 Yuan/$
Japan
90.99 yen/$
Mexico
16.17 pesos/$
Russia
58.80 rubles/$
U.K.
0.58 pounds/$
U.S.
0.79 U.S$/$
Masoud Anjomshoa
2
Real Exchange Rate (Recall):
- Real Exchange Rate is the relative price of
domestic goods in terms of foreign goods, ε.
Number of Japanese Big Macs per one Canadian Big Mac.
Yen
J BMac
Price in Canada: P = 2.5
Price in Japan: P* = 200
Nominal Exchange Rate: e = 100Yen/$
Make prices comparable
$
C BMac
Yen /$
e× P
100
× 2.5
ε=
⇒ε=
Yen
P*
200 J BMac
=
250
Yen
C BMac
200
Yen
J BMac
= 1.25
$
C BMac
J BMac
C BMac
- Real Depreciation: if the domestic goods become relatively
cheaper, or foreign goods become relatively more expensive: ε ↓
- Real Appreciation: if the domestic goods become relatively
more expensive, or foreign goods become relatively cheaper: ε ↑
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3
The Mundell-Fleming Model:
Goods Market Equilibrium in the Short Run:
IS*: Y= C( Y − T) + I(r *) + G + NX(e)
+
−
−
Assuming small open
economy with perfect
capital mobility: r = r*
the short run,
( ) Inprices
are assumed
NX
= NX ε
−
e× P
ε=
P*
to be fixed, so e and
ε are proportional
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()
⇒ NX =
NX e
−
4
The Mundell-Fleming Model:
IS*: Y= C( Y − T) + I(r *) + G + NX(e)
+
e
−
−
IS* curve is downward sloping:
Given G, T, r*, P
IS*
Y
Masoud Anjomshoa
If nominal exchange rate, e, rises
Price level is fixed, so the real
exchange rate, ε, rises
The domestic goods become
more expensive relative to the
foreign goods
 Export falls, import rises
 Net export falls
 Planned expenditure falls
 Inventory levels rises
 Output/income, Y, falls
5
The Mundell-Fleming Model:
Money Market Equilibrium in the Short Run:
M
LM*:
= L(r *, Y)
−
+
P
e
LM*
Y
Given M, r*, P
Y
Given fixed prices,
money supply, and
foreign interest rate,
regardless of nominal
exchange rate, e, the
LM* curve is vertical,
as only one value of
output/income can
bring the money
market to equilibrium,
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Short Run Equilibrium in The
Mundell-Fleming Model:
e
Given G, T, r*, P, M
LM*
()
IS*: Y= C( Y − T) + I(r *) + G + NX e
+
−
−



M
LM*:
= L(Y, r *)

+ −
P

e
IS*
Y
Y
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7
Fiscal Policies Under Floating (Flexible)
Exchange Regime:
e
LM*
e1
A
e
O
IS*: Y= C( Y − T) + I(r *) + G + NX(e)
+
−
−


M
= L(Y, r *)
LM*:
+ −
P

Expansionary fiscal
policy: G↑
IS*1
IS*
Y
Y
Point A: Short
run equilibrium
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8
Fiscal Policies Under Floating (Flexible)
Exchange Regime:
 Real appreciation
Expansionary fiscal policy: G↑
(relatively more expensive
Planned expenditure rises
Output/income, Y, tends to rise domestic goods): ε ↑
 Demand for real money rises Export falls and import rises
 People tend to sell bonds
 Net export falls NX↓
 Bond become cheaper
 Domestic interest rate, r, tends  Planned expenditure falls
Output/income, Y, tends to fall
to rise above r*
 Capital inflow
Overall output/income, Y,
Demand for domestic assets and
remains the same, as NX↓
domestic currency rises
exactly cancels out G↑
 Nominal appreciation (stronger - Also, consumption and
domestic currency): e ↑
investment remain the same.
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9
Fiscal Policies Under Floating (Flexible)
Exchange Regime:
In a small open economy with perfect capital
mobility, fiscal policies cannot affect the real GDP.
√ √
M
√
LM*:
= L Y, r*
+ −
√ P
IS*: Y= C ( Y − T ) + I(r*) + G + NX
√ √√ √ √ ↑ ↓
(
)
Crowding out effect:
- Closed economy: Fiscal policies crowd out private
investment by causing the domestic interest rate to rise.
- Small open economy: Fiscal policies crowd out net
exports by causing the exchange rates to appreciate.
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Monetary Policy Under Floating
(Flexible) Exchange Regime:
e
LM* LM1*
IS*: Y= C( Y − T) + I(r *) + G + NX(e)
+
−
−


M
= L(Y, r *)
LM*:
+ −
P

Expansionary monetary
policy: M↑
O
e
A
e1
Y
Y1
IS*
Point A: Short
run equilibrium
Y
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11
Monetary Policy Under Floating
(Flexible) Exchange Regime:
Export rises and import
Expansionary monetary policy:
falls
M↑
The central bank buys bonds
 Net export rises, NX ↑
 Price of bonds rises
 Planned expenditure rises
Domestic interest rate, r, tends  Inventory level falls
to fall below r*
 Output/income, Y, rises
 Capital outflow
 Consumption, C, rises
Demand for foreign assets and - Also, investment, I, remains
foreign currency rises
the same.
 Nominal depreciation (weaker
domestic currency): e ↓
 Real depreciation (relatively
cheaper domestic goods): ε ↓
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Monetary Policy Under Floating
(Flexible) Exchange Regime:
Monetary policies affect output through a different
transmission mechanism:
Closed Economy: M↑  r↓
(Investment Channel)
 I↑
 Y↑
Small Open Economy: M↑  e↓  ε↓  NX↑
(Trade Channel)
 Y↑
- Expansionary monetary policies do not raise the world
aggregate demand, it merely changes its combination by
shifting demand from foreign to domestic goods.
- So, the increases in domestic income and employment
are at the expense of losses abroad.
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Trade Policies Under Floating (Flexible)
Exchange Regime:
e
LM*
e1
A
e
O
IS*: Y= C( Y − T) + I(r *) + G + NX(e)
+
−
−


M
= L(Y, r *)
LM*:
+ −
P

Applying quotas or tariffs
to improve trade deficits
IS*1
IS*
Y
Y
Point A: Short
run equilibrium
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Trade Policies Under Floating (Flexible)

Nominal
appreciation
Exchange Regime: (stronger domestic currency): e↑
Applying quotas or tariffs to
improve trade deficit:
 Real appreciation (relatively
more expensive domestic
Net export tends to rise, NX↑,
goods): ε↑
at any exchange rate
Net export tends to fall, NX↓
Planned expenditure rises
 Overall, net export remains
 Output/income, Y, rises
 Demand for real money rises the same (These two forces on
 People tend to sell bonds
NX cancel each out)
 Bonds become cheaper
Output/income remains the
 Domestic interest rate, r,
same
tends to rise above r*
 Capital inflow
Demand for domestic assets
and domestic currency rises
- Also, consumption and
investment remain the same.
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Trade Policies Under Floating (Flexible)
Exchange Regime:
- Import restrictions cannot reduce a trade deficit.
- The net export, NX, remains unchanged, but total trade
will be lower, so “gains from trade” will be lower.
1- The trade restriction reduces imports.
2- The exchange rate appreciation reduces exports.
- Import restrictions on specific products save jobs in the
domestic import-competing industries but destroy jobs in
export-producing sectors.
- Hence, import restrictions fail to increase total
employment, as they create sectoral shifts , and cause
frictional unemployment.
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$/Yuan
1995-2005
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Fixed (Pegged) Exchange Regime:
- In the fixed exchange regimes, the policy
makers set the nominal exchange rate: e = ͞e
- Under this regime, the central bank stands
ready to buy or sell the foreign currency for
domestic currency, to defend and support the
predetermined rate, ͞e.
- We assume that the country is a small open
country with perfect capital mobility.
- This system fixes the nominal exchange rate, but in
the long run, when prices are flexible, the real
exchange rate can move even if the nominal rate is
fixed.
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Fixed (Pegged) Exchange Regime:
Excess demand for
foreign exchange:
 the Central
Bank sells foreign
exchange
Excess supply of
foreign exchange:
 the Central
Bank buys foreign
exchange
e
China Exchange  US$ 
 Yuan 
Market


S$
S’$
D$
͞e2
D’$
e
͞e1
Quantity
of US$
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Monetary Policies Under Fixed (Pegged)
Exchange Regime:
e
LM*
T) + I(r *) + G + NX(e)
IS*: Y= C( Y −
+
−
−


M
= L(Y, r *)
LM*:
+ −
P

Expansionary monetary
policy: M↑
͞e
O
IS*
Y
Y
The monetary policy cannot move
the LM* curve. The policy is
ineffective to change output.
In the fixed exchange regimes, the
money supply is endogenous, and
is used to maintain ͞e.
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Monetary Policies Under Fixed (Pegged)
Exchange Regime:  Money supply falls, M↓
Expansionary monetary policy: Overall, the money supply
remains the same (buying
M↑
The central bank buys bonds domestic bonds and selling
foreign assets cancel each out).
 Bonds price rises
The central bank has more
Domestic interest rate, r,
domestic bonds and less
tends to fall below r*
foreign currency.
 Capital outflow
Demand for foreign assets and - Under floating rates,
foreign currency rises
monetary policy is very
 Depreciation pressure
effective at changing output.
But the central bank should
- Under fixed rates,
keep exchange rate fixed, so it
monetary policy cannot be
sells foreign currency.
used to affect output.
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21
Fixed (Pegged) vs. Floating (Flexible)
Exchange Regime:
- Policymakers can choose only one out of money
supply, M, and nominal exchange rate, e, to control.
The other one must be left to Market to determine.
Floating (Flexible) Exchange Regime:
- Market determines exchange rate, e.
- Policymakers set the money supply, M, by
expansionary/contractionary monetary policies.
Fixed (Pegged) Exchange Regime:
- Market determines the needed money supply, M.
- Policymakers sets the exchange rate, e, by
devaluation/revaluation policies.
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Fixed (Pegged) Exchange Regimes:
Revaluation Policy:
If policymakers raise the
fixed rate of exchange, e͞ ,
making domestic currency
stronger: ͞e ↑
Devaluation Policy:
If policymakers reduce the
fixed rate of exchange, e͞ ,
making domestic currency
weaker: ͞e ↓
e
͞e
LM*
IS*
O
Y
Masoud Anjomshoa
Y
23
Devaluation Policy:
e
e͞
͞e1
IS*: Y= C( Y − T) + I(r *) + G + NX(e)
+
−
−


M
= L(Y, r *)
LM*:
+ −
P

LM*
LM*1
Devaluation policy: ͞e ↓
O
Point A: Short
run equilibrium
A
Y
Y1
IS*
Y
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Devaluation Policy:
Devaluation policy: e ↓
 Domestic currency becomes
weaker
 Real depreciation (relatively
cheaper domestic goods): ε ↓
Export rises and import falls
 Net export rises, NX ↑
 Planned expenditure rises
 Inventories fall
 Output/income, Y, rises
Demand for real money rises
 People tend to sell bonds
 Bonds become cheaper
 Domestic interest rate, r,
tends to rise above r*
 Capital inflow
Demand for domestic assets
and domestic currency rises
 Appreciation pressure
 But the central bank should
keep exchange rate fixed, so it
buys foreign currency.
 Money supply, M, rises.
-Also, consumption, C, rises
-The interest rate, r, and
investment, I, remain the
same.
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25
Fiscal Policies Under Fixed Exchange
IS*: Y= C( Y − T) + I(r *) + G + NX(e)
Regime:

+
e
LM*
͞e
O
−

M
= L(Y, r *)
LM*:
+ −
P

LM*1
Expansionary fiscal
policy: G↑
A
IS*1
Y
−
Y1
Point A: Short
run equilibrium
IS*
Y
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Fiscal Policies Under Fixed Exchange
But the central bank should
Regime:
keep exchange rate fixed, so it
Expansionary fiscal policy: G↑
Planned expenditure rises
 Inventories fall
 Output/income, Y, rises
Demand for real money rises
People tend to sell bonds
 Bonds become cheaper
 Domestic interest rate, r,
tends to rise above r*
 Capital inflow
Demand for domestic assets
and domestic currency rises
 Appreciation pressure
buys foreign currency.
 Money supply, M, rises.
-Also, consumption, C, rises
-The interest rate, r, exchange
rates, e, ε, and investment, I,
remain the same.
- Under floating rates, fiscal
policy is ineffective at
changing output.
- Under fixed rates, fiscal
policy is very effective at
changing output.
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27
Trade Policies Under Fixed Exchange
IS*: Y= C( Y − T) + I(r *) + G + NX(e)
Regime:

+
e
LM*
LM*1
−
−

M
= L(Y, r *)
LM*:
+ −
P

Applying import restrictions
to improve the trade deficit
͞e
O
A
IS*1
Y
Y1
Point A: Short
run equilibrium
IS*
Y
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Trade Policies Under Fixed Exchange
Regime:
Applying quotas or tariffs to
improve trade deficit:
Net export rises, NX↑, at any
exchange rate
Planned expenditure rises
 Inventories fall
 Output/income, Y, rises
 Demand for real money rises
 People tend to sell bonds
 Bonds become cheaper
 Domestic interest rate, r,
tends to rise above r*
 Capital inflow
Demand for domestic assets rises
 Appreciation pressure
But the central bank should
keep exchange rate fixed, so
it buys foreign currency.
 Money supply, M, rises.
Also, consumption, C, rises
Note that the interest rate, r,
and the exchange rates, e, ε
remain the same, overall.
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29
Trade Policies Under Fixed Exchange
Regime:
- Under floating exchange rate, import restrictions do
not affect the output/income, Y, or net export, NX.
- Under fixed exchange rate, import restrictions
increase both output/income, Y, and net export, NX.
- The gains under the fixed exchange regime are due
to the monetary policy, which is involved to
maintain the exchange rate.
- But these gains come at the expense of other
countries: the policy merely shifts demand from
foreign goods to domestic goods.
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Comparing Fixed vs. Floating
Exchange Regimes:
Floating: Floating: Floating:
Policy
Fixed:
Fixed:
Fixed:
Impact on: Impact on: Impact on: Impact on: Impact on: Impact on:
Y
e,ε
NX
Y
e,ε
NX
Fiscal
expansion
Monetary
expansion
Import
restriction
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Fixed vs. Floating Exchange Regimes:
- Argument for floating exchange regimes:
- Allow monetary policy to be used to pursue other goals
(stable growth, low inflation).
- Stabilize the economy against many shocks and policies
automatically.
- Argument for fixed exchange regimes:
- avoid uncertainty and volatility, making international
transactions easier.
- discipline monetary policy to prevent excessive money
growth and hyperinflation.
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32
Speculative Attacks (when ͞e >e):
- Under a fixed exchange regime, the central bank should
stand ready to buy/sell the foreign currency against the
domestic currency (in this case the central bank must sell).
Excess demand for foreign exchange: e
- Problem: If people come
to the central bank to buy a
large sum of the foreign
currency, the central bank
foreign reserves may drain to
zero. So, keeping the fixed
rate becomes impossible.
Exchange Market
S$
S’$
D$
͞e
e
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Quantity of US$
33
Speculative Attacks (when ͞e >e):
- Speculative Attack: If due to a change in investors’
perceptions, like rumors about the central bank intention to
abandon the fixed rate or lack of enough reserves to support
the fixed rate, people rush to
Exchange Market
e
buy foreign currency with the
S$
S’$
D$
domestic currency, such that the
central bank is forced to
abandon the fixed regime, due
͞e
to draining of its foreign
reserves.
e
Rumors about speculative
attacks are self-fulfilling.
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Quantity of US$
34
Currency Boards and Dollarization:
- To avoid speculative attacks, economists believe, the fixed
rate must be supported by a currency board.
A currency board is an arrangement by which the central bank
holds enough foreign reserves (currency) to back each unit of
domestic currency. So, even if the whole domestic currency
turned up at the central bank to exchange, the central bank never
run out of foreign currency.
- Dollarization: Once a central bank has adopted a currency
board, it might consider the next step: abandoning the domestic
currency altogether and letting its country use the foreign currency.
- Dollarization can happen on its own in high inflation economies,
not as a public policy.
- Two problems with dollarization:
- Losing government seigniorage (foreign government gets it).
- Losing national pride.
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The Impossible Trinity:
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36
Mundell-Fleming Model and the
Aggregate Demand (AD) Curve:
IS*: Y= C(Y − T) + G + I( r*)+NX( ε )
+
−
−


M
= L(Y, r * )
LM*:
 So, we go back
+
−
P

to the original
- We model the  Because, price,
relation that the net
P, is now variable,
impacts of
export, NX, is a
the nominal and real
changes in the
function of the real
price level, P, in exchange rates, e
exchange rate, ε.
and ε, may not move
the MundellFleming Model. together anymore.
Note: Even in a fixed exchange regime, the real exchange
rate, ε, can change due to changes in price level. Masoud Anjomshoa 37
ε
LM*1 :M/P1=L(Y1, r*)
LM*2 :M/P2=L(Y2, r*)
IS*: Y= C(Y − T) + G + I( r*)+NX( ε )
+
−
−


M
= L( Y , r*)
LM*:
+
−

P
M

IS*=
AD : Y Y  , G, T, r *, ε 
 P + − + −
Y
 +

E1
E2
Y2
Y1
P
P1
E1
P2
E2
Y1
AD
Y2
Y
The AD curve is the
geometric location of
all (P , Y) that bring the
goods and money
markets to equilibrium.
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38
Mundell-Fleming Model and the AD Curve:
Aggregate Demand curve is
P
Given G, T,M
downward sloping, because if
price increases, P↑
 Real money supply shrinks
e× P
 People tend to sell bonds
ε=
P*
 Price of bonds falls
 Domestic interest rate, r,
tends to rise above r*
AD
 Capital inflow
 Demand for domestic assets
Y
and domestic currency rises
 Net export rises, NX ↓
Nominal appreciation
(stronger domestic currency): e ↑  Planned expenditure falls
 Real appreciation (relatively  Inventories rise
 Output/income, Y, falls
more expensive domestic
goods): ε ↑
 AD is downward sloping39
Masoud Anjomshoa
Long Run
Equilibrium:
Point O is the long
run equilibrium.
IS*: Y= C(Y − T) + G + I( r*)+NX( ε )
+
−
−


M
= L( Y , r*)
LM*:
+
−

P
AD :
Y
e× P
ε=
P*
P
P
ε
LRAS
SRAS
O
Y
M

Y  , G, T, r *, ε 
 P + − + −
 +

Y
LM*
ε
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AD
O
Y
IS*
Y 40
Fiscal Policies
P
Under Floating
Exchange Regime:
LRAS
Expansionary fiscal
policy: G↑
P
IS*: Y= C(Y − T) + G + I( r*)+NX( ε )
+
−
−


M
LM*:
= L( Y , r*)

+
−

P
ε
Y
LM*
AD :
ε1
A
Y
e× P
ε=
P*
M

Y  , G, T, r *, ε 
 P + − + −
 +

Point A is the short run
and long run equilibria.
ε
Masoud Anjomshoa
A
O
SRAS
AD
O
Y
Y
IS1*
IS*
Y 41
P
Fiscal Policies
AD
Under Fixed
Exchange Regime: P
LRAS
AD1
SRAS1
B
1
Expansionary fiscal
policy: G↑
P
O
IS*: Y= C(Y − T) + G + I( r*)+NX( ε )
+
−
−


e× P
M
ε=
= L( Y , r*)
LM*:
+
−
P*
P

ε
Y1
Y
Y
LM* LM1*
AD :
Y
M

Y  , G, T, r *, ε 
 P + − + −
 +

Point A is the short
run equilibrium
Point B is the long
run equilibrium
e × P1
= ε1
P*
e×P ε
=
P*
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A
SRAS
=LM2*
B
O
Y
A
IS1*
IS*
Y1
Y 42
Floating vs. Fixed Exchange Regimes
and Fiscal Policies:
In a small open economy with perfect capital
mobility, and floating (flexible) exchange regime,
fiscal policies cause:
Same Long
G↑  NX↓ ε↑ e↑ and Y, P are constant
Short Run:
In a small open economy with perfect capital
mobility, and fixed (pegged) exchange regime, fiscal
policies cause:
Short Run: G↑  Y↑ and NX, e, ε, P are constant
Long Run: G↑  NX↓ ε↑ P↑ and e, Y are constant
Compare the long equilibrium levels for the two regimes.
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43
Floating vs. Fixed Exchange Regimes
and Fiscal Policies:
Comparing the long impacts of an
expansionary fiscal policy under
floating and fixed exchange regimes.
Variable
Y
P
e
ε
NX
Floating
√
√
↑
↑
↓
Fixed
√
↑
√
↑
↓
Masoud Anjomshoa
44
Devaluation Policy P
in the Long Run:
AD
- Devaluation policy: ͞e ↓
IS*: Y= C(Y − T) + G + I( r*)+NX( ε )
+
−
−


M
e× P
LM*:
= L( Y , r*)

ε
=
+
−

P
P*
AD1 LRAS
P1
P
M

AD : Y Y  , G, T, r *, ε 
ε
−
+
+
−
P

 +

IS*
Point A is the short
run equilibrium
e1 × P1
Point B is the long
P* ‖
run equilibrium
e×P
=ε
This policy has no trade
impacts in the long run.
It just increases prices.
P*
B
ε1
e1 × P ‖
P*
Masoud Anjomshoa
SRAS1
A SRAS
O
Y1
Y
Y
LM* LM1*
=LM2*
O
B
Y
A
Y1
Y
45
Devaluation Policy in
the Long Run:
- Devaluation policy: ͞e ↓
O-B: Y = C + I + G
e
Masoud Anjomshoa
ε
P
46