LECTURE 6:
MACROECONOMIC INTERDEPENDENCE
(I) Interdependence: Y depends on Y*.
(II) The two-country model, to be used for
a country big enough to affect world income Y*.
• Simultaneous determination of Y & Y*.
• Implication of repercussion effects
for the multiplier.
(III) International transmission
under fixed vs. floating exchange rates
• of a disturbance originating domestically.
• of a disturbance originating abroad .
Re-endogenizing Exports
A X  M
Y
sm
where A  C  I  G
}
X  X  m *Y *
=>
A  X  m *Y * M
 Y 
sm
I.e., Y depends on Y*.
“When the US sneezes, Canada catches cold.”
ITF-220 Prof.J.Frankel, HKS
Y depends on Y*.
For every $1 of foreign income,
how much is spent on our goods?
A  X  m *Y * M
Y
sm
For every $1 of demand for our exports,
how much does our income rise?
ITF-220 Prof.J.Frankel, HKS
The other equation of the 2-country model: Y* depends on Y.
Instead of deriving the equation for Y* from scratch,
use equation for Y,
A  X  m *Y * M
Y
sm
For every $1 of domestic income,
how much is spent on foreign goods?
and substitute foreign for domestic
and domestic for foreign:
A *  M  mY  X
Y* 
s * m *
For every $1 of demand for foreign goods,
how much does foreign income rise?
ITF-220 Prof.J.Frankel, HKS
FIGURE 17.A.1
2-COUNTRY MODEL
Combine two simultaneous relationships:
=> equilibrium at B .
Fiscal expansion
shifts Y to D
in small-country
Keynesian model
•
•
•
(too small to affect Y*),
but further, to D´,
in large-country
model.
ITF-220 Prof.J.Frankel, HKS
In two-country model
multiplier is increased
because denominator
is reduced by
m*m / (s*+m*),
•
•
•
of which m is leakage
abroad through imports,
m/(s*+m*) is
the multiplier effect
of our imports on Y*,
and m* [m/(s*+m*)]
is the repercussion effect:
how much comes back
as demand for our goods.
ITF-220 Prof.J.Frankel, HKS
BIG-COUNTRY VS.
SMALL-COUNTRY MODEL
FIGURE 17.5
The same result -- fiscal
expansion raises Y to D
in small-country Keynesian
model, but further, to D´,
in large-country model -can be shown in our
traditional graph.
The X-M line is flatter now,
because it captures the
repercussion effect on TB:
Beyond Y↑ => IM↑,
also X*↑ =>Y*↑ => X↑.
• •
•
● D’’
ITF-220 Prof.J.Frankel, HKS
If both countries expand:
FIG.17.A.1
adverse trend in TB
(D´´ lies above TB=0 line,
which is deficit territory)
can result if either:
A is rising faster
than A * ,
•
or m>m*
(TB=0 line is flat).
But this model may not work
in the long run, when growth
is supply-driven (Y )
rather than demand-driven.
ITF-220 Prof.J.Frankel, HKS
•
International Transmission
I↓
Fix
Float
X↓
Float
Fix
=>
depreciation
=> appreciation
•
• •
Floating increases effect on Y
= “bottling up” of disturbance.
•
•
Floating decreases effect on Y
= “insulation.”
Conclusions regarding transmission
(with no capital mobility)
• (i) Trade makes economies
interdependent
(at a given exchange rate).
– TB can act as a safety valve,
releasing pressure from expansion:
Y  (1 /(s  m)) A .
– Disturbances are transmitted
from one country to another:
Y  (1/(s  m)) X .
Conclusions regarding transmission
(with no capital mobility), continued
• (ii) Floating exchange rates work
to isolate effects of demand disturbances
within the country where they originate:
– Effects of a domestic disturbance tend
to be “bottled up” within the country.
In the extreme, floating reproduces the closed
economy multiplier:
Y  (1 / s) A .
.
– The floating rate tends to insulate the
domestic economy from effects of
foreign disturbances. In the extreme,
floating reproduces a closed economy:
.
ITF-220 Prof.J.Frankel, HKS
Y  0.
End of Lecture 6:
International
Transmission
ITF-220 Prof.J.Frankel, HKS