Open economy macroeconomics
• Short-run open-economy output determination (Mundell Fleming model)
• International financial system
• The rise, crisis, and (fall?) of the Euro
Open Economy Macro
1
Tree of Macroeconomics
Classical
IS-MP,
dynamic AS-AD
longrun
Closed
economy
Short run or
long run?
(full adjustment
of capital,
expectations,
etc.)
shortrun
Classical
or non-classical?
(sticky wages
and prices, rational
expectations, etc.)
Keynesian model
(sticky wages
and prices,
upward-sloping
AS
Open
economy
Non-classical
Mundell-Fleming;
small open economy
and large open
economy
2
The output decline in
the Great Recession
(real GDP)
Percent change from prior
year
Good reading: IMF, World Economic Outlook
3
Unemployment
during the Great
Recession
Percent of labor force
4
The sharp decline in
world trade during the
Great Recession
(Note that trade
change is > output
change.)
Percent change from prior
three months at annual rate
5
The growth in the public debt around the world
Debt/GDP ratio (%)
6
The risk premium on
corporate securities
in the US and Europe
7
Housing bubble:
The Old and the
New world
8
The Mundell-Fleming Model for Open Economy
Mundell-Fleming (MF) model is short run Keynesian model for
open economy.
Hybrid of IS-MP and open-economy classical model.
It derives the impacts of policies and shocks in the short run for an
open economy.
Usual stuff for domestic sectors:
- Price and wage stickiness, unemployment
- Standard determinants for domestic industries (C, I, G, financial
markets, etc.)
Open economy aspects:
- Small open economy would have rd = rw
- Large open economy financial flows (CF) determined by rd and rw
- Net exports a function of real exchange rate, NX = NX(R)
- We consider primarily a flexible exchange rate.
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Goods market
Start with usual expenditure-output equilibrium condition.
New wrinkle is the NX function:
(Exp)
Y = C(Y - T) + I(rd) + G + NX(R)
Financial markets
Then the monetary policy equation.
(MP$)
r = L (Y)
Mankiw has LM, but there is no difference in the analysis except for monetary policy.
Balance of Payments
Capital flows are determined by domestic and foreign interest rates. This
leads to balance of payments:
(BP)
CF(rd, rw) = NX(R)
Substituting (BP) into (Exp), we get IS$ equation in Y and rd:
(IS$)
Y = C(Y - T) + I(rd) + G + CF(rd, rw)
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Reminder on Exchange rates
Foreign-exchange rates are the relative prices of
different national monies or currencies.
Nominal exchange rate
= e = foreign currency/$
Real exchange rate (R)
R = e × p d/ p f
= domestic prices/foreign prices in a common
currency
11
Real exchange rate of $ relative to major currencies (R)
Appreciation
Dollar bubble with
high interest rates
Dot.com stock
bubble
Flight to $
safety
Depreciation
12
rd
CLOSED ECONOMY
MP
C+I(rd)+G (IS)
Y
13
rd
OPEN ECONOMY
CF=NX=0
MP$
Equilibrium
C+I(rd)+G+CF(rd) (IS$)
C+I(rd)+G (IS)
Y
14
rd
(IS$)
MP$
Tiny open economy
Closed economy
Y
15
Special Case I. Fiscal Stimulus
How does openness change the impact of a stimulus plan?
Multiplier is reduced because some of the stimulus spills
into imports and stimulates other countries
Note that financial crisis and high risk premium is the
opposite (IS$ shift to the left)
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rd
Fiscal Expansion
MP$
IS$’
IS$
Y
17
rd
Fiscal Expansion
IS
MP$
IS’
IS$’
IS$
Open economy
Y
Closed economy
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Special Case II. Normal Monetary Expansion
How does openness change the impact of a
monetary policy?
Double barreled effect of monetary policy
- Lower r → higher I (domestic investment)
- Lower r → higher CF → depreciates exchange rate (R)
→ raises NX (foreign investment)
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rd
Monetary Expansion
MP$
MP$’
IS$
Y
20
rd
Monetary Expansion
MP$
MP$’
IS$
IS
Open economy
Closed economy
Y
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Special Case III
What about a liquidity trap?
Note that monetary policy cannot work on either of the two
mechanisms in a liquidity trap.
- Interest rates stuck and cannot stimulate domestic
investment.
- With no change in interest rates, no change in CF (financial
flows), no change exchange rate, no change NX
So open economy does not change the basic liquidity trap
dilemma!
- Fiscal policy super-effective
- Monetary policy super-ineffective
22
Monetary Expansion in Liquidity Trap
rd
IS$
MP$’
MP$
Equilibrium
Y
23
You do fiscal expansion
rd
IS$
MP$
Equilibrium
Y
24
The International Monetary System
25
What is the international monetary system?
International monetary system denotes the institutions under
which payments are made for transactions that cross national
boundaries and are made in different currencies.
In particular, the international monetary system determines how
foreign exchange rates are set and how governments can
affect exchange rates.
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Exchange rate regimes
I. . Fixed exchange rate
A. Currency union: currencies irrevocably fixed
- US states (1789 - )
- Eurozone (2001- ?)
B. Other fixed exchange rate regimes:
– Gold standard (1717 - 1933)
– Bretton Woods (1945 - 1971)
- Hard and soft fixed rates of different varieties (China)
II. Flexible exchange rates (US, Eurozone, UK pound, BOJ)
- Currencies are market determined
- Governments use monetary policies to affect exchange rates
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What are desirable characteristics
of an international financial system?
1. Stability of exchange rates to lower risk and promote trade
and capital flows.
2. Openness of financial markets to promote efficient allocation
and diffusion of best-practice technologies
3. Adjustment to macroeconomic shocks through monetary
policy
But we will see that these three goals are not compatible in the
“fundamental trilemma”
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Evolution of Exchange Rate Regimes (% of countries)
The Evolution of Exchange Rate Systems: # countries
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The share of floating has increased sharply
(% of world GDP)
Share of world GDP by floaters
100%
80%
60%
40%
20%
0%
1960
1970
1980
1990
2000
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