XII. Keynesian stabilization
in an open economy
XII. 1 Aggregate demand in the short
run
Net export and real ExR
• In the short-run, export depends on
foreign demand and real exchange rate,
import depends on domestic AD and real
exchange rate
• Usual assumption: Marshall-Lerner
condition, i.e. net export depends on real
exchange rate only (see Krugman,
Obstfeld)
NX  NXe , NXe  0
• Consequently, assume:
– The lower the real exchange rate, the less
competitive domestic goods and services are,
the higher the current account deficit (NX
drops)
– And vice versa
Aggregate demand and real
ExR
• Considering relation between demand
for real output and real ExR, ceteris
paribus, i.e. when all other variables
(interest, taxes, etc.) unchanged
– and standard assumption: economy at the
potential output (full employment)
equilibrium
• AD = C + I + G + NX , but if only Y and
real ExR allowed to vary, we might
schematically write AD = AD(Y,e)
Output determination in the short
run
• Short run : prices (and wages) assumed fixed,
than real ExR depends of nominal ExR only
• Closed economy in the short run: relation
between output and interest (ISLM)
• Open economy in the short run: relation
between output and ExR (interest considered
as given)
• “ISLM-type” adjustment (see next slide):
– Excess demand → inventories↓ → output↑
– Excess supply, vice versa
• Combinations of output and ExR, keeping
goods market in short run equilibrium: DD
curve (see next slide again)
AD
 
AD E 2
 
AD E1
45 o
E
Y1
Y2
Y
DD
E2
E 2  E1 - depreciati on
E1
Y1
Y2
Y
What shifts DD curve?
• In general: any disturbance, raising AD,
shifts DD to the right; disturbance,
lowering AD, shifts DD to the left
• In our framework, following factors
might be relevant:
– Expenditures G, taxes T, investment I,
domestic price P, foreign price P*, changes
in autonomous consumption, demand
shifts between domestic and foreign
goods
– Check yourself
XII.2 Asset market in the short
run
Output and ExR on the asset
market
• Asset market: interest parity condition
r  r *  E e -E  E
• Interest rate determined by equilibrium on
domestic money market (see LXI):
MS P  LY, r 
• Short run: expectations, foreign interest rate,
price and money supply given
• Infinite combinations of output and ExR,
keeping asset market in equilibrium: AA
curve (see next slide)
E
E
E1
E1
AA
E2
E2
Return on foreign deposits
r1
returns
r2
L(Y1 , r)
L(Y2 , r)
MS
P
Y2  Y1
M
P
Y1
Y2
Y
What shifts AA curve?
•
•
•
•
•
Change in domestic money supply MS
Change in price P
Change in expectations Ee
Change in foreign interest rate r*
Shifts in demand for money function
XII.3 Short run equilibrium in an
open economy
Equilibrium and adjustment
• Equilibrium both on goods and asset
market: intersection of DD and AA curves
• Adjustment speed: faster adjustment on
assets market than on goods market
E
DD
AA
●
C
B●
A
Y
XII.4 Policies
XII.4.1 Temporary policies
• Short term policies, expected to be reversed
in the future, i.e. expections remain constant
• Prices, wages, expectations fixed
• Adjustment obvious – see above what
changes DD and AA curves
Monetary policy
Fiscal policy
E
E
DD
AA
DD1
DD 2
AA 2
AA1
Y
Y
Use (and many warnings)
• Both expansionary monetary and fiscal
policies
– Increase output
– Monetary → depreciation, fiscal →
appreciation
• Application: short term reaction to
exogenous shocks
• Many pitfalls
– Inflation bias
– Time lags
– Unclear origins of disturbances, etc.
XII.4.2 Permanent policies
• Policies that are not reversed →
change of expected ExR
• Considering long term effects – after
full adjustment of prices, wages and
volumes
• Starting point – potential output,
natural values, ExR expectation equals
actual ExR → domestic interest equals
“foreign” interest
Robert Mundell
• 1932 –
• Stanford University
• International
institutions (namely
IMF)
• International
economics
• Mundell-Fleming
model
• Nobel price in 1999
Monetary policy
• Money supply increase → shift of AA curve,
but larger than in case of temporary case
– Shift due to MS increase
– Shift due Ee increase
• Long term adjustment: price increase due to
larger money supply (next slide: red color
means final positions):
– Real appreciation → domestic goods relatively
more expensive → fall of foreign demand → shift of
DD curve “up and left”
– Real money supply falls → AA curve, after an initial
shift „up“, shifts “down and left”
DD2
E
DD1
E2
2
3
E3
AA2
E1
AA3
1
AA1
Yf
Y2
Y
Monetary policy efficiency
• Long term adjustment:
– Return to potential output
– Higher price level
– Nominal depreciation
• However – in the short term (within a
concept of Keynesian policy
stimulation) monetary policy is efficient
– Increase of output and employment
• Remember ExR overshooting (see LXI)
Fiscal policy
• Permanent fiscal expansion
– In reality usually accompanied by
permanent tax increase, otherwise
unsustainable
– Remember: balanced budget multiplier = 1
• Open economy
– Short term shift of DD curve “up and right”
– Permanent fiscal change → increase of Ee
→ shift of AA curve “down and left”
E
DD1
DD2
1
E1
X
AA1
E2
2
Yf
AA2
Y
Fiscal policy efficiency
• Adjustment on the currency market
extremely fast → after initial DD shift, change
in expectation moves the AA curve
immediately „down“
• There is no increase of output (and
employment) even in the short term
(economy will never reach point X)
• Long term adjustment in closed economy
– Return to potential output, government spending
crowds-out private investment, inflation
• Open economy
– Remains at potential output at appreciated
currency
– Aggregate demand for domestic product
crowded-out by demand for foreign products (as
they became cheaper)
• Fiscal policy inefficient
XII.5 Fixed exchange rate
Notice
• When ExR fixed, but market pressures against
the fix, then Central Bank must intervene
– Pressure towards appreciation → purchase of foreign
assets
– Pressure towards depreciation → sale of foreign
assets
• Link between Central Bank intervention and
money supply
– Purchase of (foreign) assets → increase in money
supply
– Sale of (foreign) assets → decrease in money supply
Fixing the rate
• Commitment of Central Bank to trade
domestic currency at given rate
• Why fix?
– There is no ideal floating in reality
– Arrangements for countries in a transitory
stage of economies
– Lessons from the past
– Regional currency areas (e.g. Euro)
Equilibrium under Fix
• Fix – expected ExR equals actual one
• Interest rate parity implies that domestic
interest must equal foreign interest
• Implications for domestic money market –
e.g. in case of output increase:
– Push towards increase of domestic interest rate
→ push towards appreciation
– To keep currency fixed, Central Bank must
intervene → purchase of foreign assets →
increase of money supply → interest rate and ExR
remain at original levels
• Under fix – automatic accommodation of
monetary policy
E
E1


r*  Ee - E E
r1
L(Y1,r)
M1
P
M2
P
M
P
L(Y2,r)
r
Stabilization policies under fix
(1)
• Only short term effects, try to derive
yourselves diagrammatically
• Monetary policies, e.g. increase of money
supply by purchasing domestic assets →
pressure towards decrease of interest and
depreciation (shift in AA) → Central Bank
must intervene selling foreign assets →
decrease of money supply
• No effect on output and employment, but
decrease in foreign reserves exactly equal
to original purchase of domestic assets
Stabilization policies under fix (2)
• Fiscal expansion → increase of AD,
shift of DD → increase of output and
pressure towards appreciation, at the
same excess demand for money and
pressure towards interest increase →
Central Bank must intervene, buying
foreign assets to increase money
supply (and to keep fix) → shift of AA
→ further increase of output, ExR
remains at fix
• Fiscal policy has an impact on output
(and employment)
Stabilization policies under fix (3)
• Changes in ExR, assume that Central
Bank is credible, i.e. people accept new
expected ExR immediately
• Devaluation → increase of exports and
AD (why?) → increase of output, excess
demand for money, pressure towards
interest increase → Central Bank
intervention, buying foreign assets →
expansion of money supply, shift of AA,
new equilibrium
XII.6 Conclusions for stabilization
policies
The efficiency of fiscal, monetary and
trade policy differs according the
exchange rate regime
• Flexible exchange rate (float)
– Fiscal policy very little efficient
– Monetary policy very efficient
• Fixed exchange rate
– Fiscal policy very efficient
– Monetary policy very little efficient
– Changes in ExR efficient
Literature to Ch. XII
• Krugman, Obstfeld, ch.15-17. Basic text
and references there.
• Dornbush, Fischer, ch. 6. Slightly
different way of explanation, but it
might seem more comprehensive to
some