Chapter 9
© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
Chapter 9
Essential
macroeconomic tools
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Background theory
• A quick refresher on basic macroeconomic principles
• Application of these principles to the question of exchange rate
regimes
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Output and prices
• Economic activity is measured by the GDP (gross domestic
product)
• GDP = sum of all production = sum of all sales = sum of all
incomes
• Nominal GDP (measured) vs. Real GDP (computed taking into
account inflation)
• GDP trend is increasing
• Actual GDP is above or below trend, according to business cycles
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Output gap: the difference between trend and
actual GDP
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Output gap and aggregate demand and supply:
short run
• Aggregate supply (AS): upwards sloping
– As output gap increases threat of unemployment moderates wages
and firms cut price
• Aggregate demand (AD): downward sloping
– Higher prices erode purchasing power and external competitiveness
and output gap decreases
• Changes in aggregate demand, e.g. a boom abroad:
– shifts aggregate demand up (AD’)
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The AD-AS diagram
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Long run vs short run effects
• Short term: non-neutrality of money (output gap moves to B in
diagram)
• Long term: neutrality of money
(output gap moves to C in diagram)
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Long Term: Neutrality of Money
• In the long run:
– Vertical aggregate supply
– Money, the price level and the exchange rate tend to move
proportionately
• Rationale:
– prices double overnight public requires double the amount of
money to maintain purchasing power once both double up we
are back to start in real terms (see point C on diagram)
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PPP: An Implication of Long Term Neutrality
• PPP (purchasing power parity) principle:
(Nominal) Exchange rate appreciation =
= foreign inflation rate – domestic inflation rate
• The real exchange rate (measure of competitiveness):  = E x
P/P*
– Where E is nominal exchange rate; P and P* are prices of basket of
goods at home and abroad
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The real exchange rate
Example: real exchange rate of euro in terms of dollar
–
–
–
•
Price of basket of European goods: P= €100
Nominal exchange rate ($/€):
E = 1.3$/€
Price of basket of American goods: P*= $130
real exchange rate:
= E x P/P* = €100x 1.3$/€ : $130 = 1 basket of American
goods for 1 basket of European goods
NOTE: when real exchange rate appreciates, competitiveness
declines as more baskets of goods in the USA would need to be
traded for 1 basket of European goods.
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Real versus nominal exchange rate appreciation
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The Balassa-Samuelson Effect
Increasing real exchange rates in new EU members
(Annual % change, 1996-2008)
Bulgaria
Czech
R.
Inflation
differential
29.0
1.6
3.2
3.7
1.4
Nominal
appreciation
-19.7
2.6
-0.2
0.0
3.2
Real
appreciation
9.3
4.2
3.0
3.7
4.6
Hungary
Poland
Estonia
Romania
Latvia
Slovenia
Lithuania
Slovakia
Inflation
differential
6.2
3.3
28.3
3.8
4.1
Nominal
appreciation
-2.4
-0.2
-20.6
-2.8
1.5
Real
appreciation
3.8
3.1
7.7
1.0
5.6
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© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
The Short Run: IS-LM Interpretation
• IS-LM shows interaction of money and goods market
• The short run goods market (AD focus)
• Assumption: prices constant
• What happens to output when interest rates increase?
– Discourages borrowing and spending
– Reduces aggregate demand (output gap)
– Equilibrium requires supply to drop (IS curve)
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IS-LM framework
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The Short Run: IS-LM Interpretation
• The Money market
• Banks grant loans creating Money Supply
• Public Demand Money for payment
• Central bank might expand money supply partially
• Increase in output increases demand for money and interest rates
(upward sloping LM curve)
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IS-LM framework
Initial Equilibrium:
where goods and
money markets are
simultaneously in
equilibrium
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Fiscal and Monetary Policy in IS-LM
• (Expansionary) Fiscal Policy effects
– IS shifts right to IS’ as aggregate demand strengthens
– Economy moves equilibrium to A’
– Consequence: output and interest rate rise
• (Expansionary) Monetary Policy effects
–
–
–
–
Central bank increases money supply
Interest rates decline at initial output (B)
LM shifts down to LM’
Economy moves equilibrium to C
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Fiscal and Monetary Policy in IS-LM
Equilibrium
with fiscal
expansion
A
’
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Fiscal and Monetary Policy in IS-LM
Equilibrium
with
monetary
expansion
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Open economy and exchange rates
• Integration and significance of exchange rate regime!
• Trade integration
– Foreign conditions and real exchange rate effects
– Higher prices result in a reduction in competitiveness and AD with
unchanged exchange rate
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Open economy and interest rate parity condition
• Financial integration
– Free capital mobility
– Lower interest rates at home than abroad cause financial outflows
and nominal exchange rate drops
HENCE,
• Interest rate parity condition:
Domestic interest rate = Foreign interest rate + expected exchange rate
depreciation
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© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
Exchange Rate Regimes and Policy
Effectiveness
• Fixed exchange rate:
– government keeps exchange rate fixed through reserves and buying
and selling currency
• Flexible exchange rate:
– currencies continuously priced by foreign exchange markets
• Monetary policy with capital flows
– Works with floating exchange rates
– No autonomy in fixed exchange rate regimes
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Monetary policy and free floating (open economy)
• Increase in money supply
– LM shift to right and economy moves to C with lower interest rates
• In open economy, capitals flow out and exchange rate
depreciates
• Result: higher exports and demand
– IS shifts right and economy moves to D, where interest parity is
re-established
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Monetary Policy with floating exchange rates
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Monetary Policy with floating exchange rates
(cont.)
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Monetary policy and fixed exchange rates
(open economy)
• Increase in money supply
– LM shift to right and economy moves to C, with lower interest rates
• Capitals flow out and government intervenes against currency
depreciation
• Result: money supply shrinks and LM shifts back
– IS does not move as competitiveness is unchanged (economy is
back to initial point A)
• Conclusion: monetary policy ineffective given offsetting exchange
market operation!
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Monetary Policy with fixed exchange rates
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Monetary Policy with fixed exchange rates
(cont.)
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