OPEN ECONOMY
MACROECONOMICS
Prof. Alemayehu Geda
Guest Lecture (UoN)
School of Economics
University of Nairobi
(Adopted from Mr. Rup Singh)
Lecture 1
Objectives:
1. Extend the closed economy IS-LM model to include
the external sector.
2. Evaluate the relevance of fiscal and monetary policies
at the disposal of policy makers.
3. Analyze how the domestic economy performs, given
the international macroeconomic conditions.
4. Carry out quantitative analysis of various
polices/shocks to the economy vis-a-vis the extended
IS-LM model.
The international conditions sometimes give us
(domestic economy) opportunities and sometimes,
pose threats to us also.
Therefore, the more an economy is integrated into
the global village (through globalisation), the more
severe these impacts will be. [Being totally closed is
not a viable option for various reasons]
Growing international interdependence implies
booms and recessions in one country spills over to
other country. [When America sneezes, the world
catches cold!]
Economies are linked through trade flows and
changes in interest (exchange) rate. [The first affects
trade accounts and external debt and the second
affects capital account flows.]
For example, the Asian Crisis of 1997-99 was limited
to few countries initially but spread to other countries,
affecting global economic growth. Same with the 2008
Global Crisis in the West We call this
“The Contagion effect”
In this lecture, basic facts (empirical evidence) and
models of international economic linkages are
introduced and discussed.
We will look at the implications of different international
macroeconomic conditions on our economic
fundamentals.
You should read the text: Donbusch et al. (chap. 11-12)
and also read the revised edition (by the same authors)
See also my (Alemayehu, 2002) Chapter 6 and Paper on
the Impact of the Global Economy on Africa.
You should analyse various discussions/arguments
presented on these chapters, as my presentation will be
largely based on them.
Coming back to business:
When we think of open economy the first set of questions
we ask: How a country with a fixed exchange rate adjusts
to balance of payments problems (e.g., persistent deficit in
the trade/overall balance; loss of reserves; rising level of
debt; pressure on the exchange rate)?
[Note that all the major countries have switched to the
floating exchange rate system after 1973 (when the US delinked the dollar from gold), but many countries, most of
them small open economies, continue to maintain a fixed
exchange rate system.]
Solving the balance of payments problems generally
means getting out of a deficit situation, in the trade
account, the current account, the balance of payments
account, or in all three accounts simultaneously.
Balance of payments problems are solved through
automatic adjustment mechanisms or through changes in
economic policy.
Let us see what policy options are there, available to policy
makers
But, first of all let’s discuss what is Exchange Rate - the
first link to the ROW. Exchange rate is the price one
country’s currency expressed in terms of some other
country’s currency.
E.g, if we we relate Ksh to the USD as “how much it takes
to get 1 USD, in terms of Ksn,” the exchange rate is:
Ks72.2:$1US
This gives the definition of the nominal exchange rate that
we will be using now onwards:
E = Ksh/USD
It tell us that the price of 1USD = Ksh72.2.
Kenya’s, currency is tied down to its trading partners’
currencies (Pound, Euro, Japan, and USA).
Most countries in Africa have exchange rate close to
fixed, but operate under the so called a Pegged Exchange
Rate system. Kenya’s exchange rate is floating
Now, given the definition of the nominal exchange rate,
we can define the real exchange rate.
Like any other variable, Real = Nominal /Prices
Therefore the real Exchange rate is Nominal exchange
rate adjusted for relative prices (or inflation differentials).
We denote θ as the real exchange rate
θ = [Ksh/USD]/[Pd/Pf]
θ = E /Pd/Pf
θ = E*Pf/Pd
Note:
If θ [for e.g. if Pd increases] -appreciation of the
Ksh – loss in international competitiveness
θ = Depreciation of Ksh – gain in the international
competitiveness [ for e.g. if pf increases]
Then we need to know what is BOP.
BOP is external equilibrium.
It shows whether we have gained or lost from our net
exports of goods and services (current account) and
whether we are net exporters of importers of investment
funds (capital account).
BOP = CA + KA
If we have current account surplus as well as capital
account surplus, we will have BOP Surplus.
[if CA is in surplus, but KA is in deficit, (or other
combinations), BOP depends on the relative magnitudes
of surplus or deficit]
Under fixed exchange rate system, a BOP surplus means
accumulation of foreign exchange reserves.
On the other hand, a BOP deficit implies a decline in
foreign exchange reserves or de-accumulation of forex.
reserves.
Note the change in the foreign reserves is the basis for
market intervention by the C/Bank under the fixed
exchange rate system.
Money supply becomes endogenous in the model. It is no
longer under the full control of the C/B.
Capital flow - movement of international speculative
investment. One of the determinants of capital flows is the
Interest rate.
If interest rate is higher in Kenya, more capital inflow into
the economy and v-v – in search for higher RR. Investors
look at the differences in returns to investment, which is
called the Interest Rate Differentials.
If there are interest differential which favors us (i > if),
capital will inflow into Kenya. If interest rate differentials
do not favor us, investors will hesitantly invest here, and
we say there is imperfect capital mobility.
Other factors that determine capital mobility are:
1.
2.
3.
4.
Substitutability of investments
Tax structure
Capital controls
Political/macroeconomic conditions (in search of safe
heavens)
(Not also that exchange rate mattera as you may lose what
in exchangre rate what you got as interest rate
differential)
In special cases, there are no difference between the
interest offered here and that abroad.
In other words, there are no interests rate differentials
between the two economies. We call this situation, “perfect
capital mobility” - a scenario where our economy is as
competitive as any one else’s. (i = if)
So investors are indifferent whether they invest here or
anywhere around the globe. Capital flows without
hesitation - Perfect Capital Mobility
So given these briefings, we can extend our simple IS-LM
model to IS-LM-BP model.
The following slides define the three markets - goods,
money and forex markets, from where we derive the IS,
LM and the BP equations.
In our analysis of IS-LM-BP Model we will discuss the
(Mead) -Mundell-Fleming Model as we proceed.
Mundell and Fleming is an interesting extension to the
IS-LM-BP Model, which assumes perfect capital mobility
Open Economy IS-LM-BP Analysis
IS-LM and BP Models
GOODS MARKET
C = C0 + cYD
YD = Y- T +TR
T = T0 + tY
I = I0 - bi
G = G0, TR = TR0
X= X0 + λθ + γYf
M = M0 + mY – ψθ
Y = C + I + G + NX
MONEY MARKET
L = kY- hi
Ms/P = M0 /P +ΔRES/P
L = Ms/P
FOREIGN EXCHANGE MARKET
NX = NX0 – mY + vθ + γYf
CF = CF0 + f(i-if)
NX + CF = ΔRES/P
GOODS MARKET
X= X0 + λθ + γYf
Exports are determined by foreign income (demand for
export) and real exchange rate. If θ real exports will increase
as increase in θ implies a depreciation of the domestic
currency. Cheaper domestic currency will make it easier for
foreigners to purchase our goods.
IM = IM0 + mY – ψθ
Along similar lines of argument, θ will lower imports into
the country. We will find it difficult to purchase outside
goods/services once exchange rate appreciates. Imports also
depend on domestic income.
MONEY MARKET
Ms = M0/P +ΔRES/P
The supply of money is determined in part by the C/Bank and partly by the
BOP situation. If BOP is in deficit, we say that the C/Bank de-accumulates
the foreign exch. reserves, thus MS will fall, and v-v.
The money supply is no longer exogenous ( but it is endogenous) and is
not under the full control of the C/Bank.
FOREIGN EXCHANGE MARKET
NX = NX0 – mY + vθ + γYf
CF = CF0 + f(i-if)
ΔRES/P = NX + CF
The above explains the external equilibrium. BOP is the sum of current
account and capital account. Current account is the net trade of goods and
services (NX). Technically, NX is X-IM.
Capital flows are of two types. Foreign direct investments (exogenous) and
speculative investments - determined by interest rate differentials. The f
measures how responsive is the capital flows to interest rate differentials.
If f is large, a slight change in interest rate differential will cause massive
capital flows, and v-v. So f measures the degree of capital mobility.
If f is large and (i-if) is small (say = 0), perfect capital mobility is implied.
If f is very small, no matter how large is (i-if), imperfect capital mobility is
implied.
GOODS MARKET
C = C0 + cYD
YD = Y- T +TR
T = T0 + tY
I = I0 - bi
G = G0, TR = TR0
X= X0 + λθ + γYf
M = M0 + mY – ψθ
Y = C + I + G + NX
MONEY MARKET
Ms/P = M0/P +ΔRES/P
L = kY- hi
FOREIGN EXCHANGE MARKET
NX = NX0 – mY + vθ + γYf
CF = CF0 + f(i-if)
ΔRES/P = NX + CF
Solving for the Y in each of these markets will give us the IS, LM and BP
equations.
Graphical re-presentation of three equations
LM (M0, P, ΔRES)
i
BP (NX0, CF0, θ, if, Yf )
i0
IS (C0, TR0, T0, I0, G0, X0, Imo, θ, Yf )
Y0
Y
IS = -αG/b < 0, negative slope
LM = k/h > 0, positive slope
BP = m/f > 0, positive, but less then k/h. LM is more
stepper than BP (u find out why!).
Only under the fixed exchange rate system, there is
accumulation or de-accumulation of foreign exchange
reserve, which changes Money Supply (Ms), LM curve
shifts to restore final equilibrium.
Money supply becomes endogenous – is not under full
control of the Central bank. It is made up of domestic base
money supply + foreign exchange reserves (BOP surplus)
.
Thus C/Bank cannot carry out independent monetary
policy under fixed exchange rate.
Numerical Illustration of
the MF Model
Determinants of Output in an Open Economy
•
Aggregate demand depends on consumption, investment,
government spending and net exports.
•
•
•
•
•
Consumption depends on disposable income.
Investment on the real interest rate.
Tax revenues on national income.
Exports on foreign income and the real exchange rates.
Imports on domestic income and the real exchange rate.
•
The real exchange rate is determined by domestic and foreign
price levels and the nominal exchange rates.
•
Nominal interest rate is determined in the money market.
•
Capital inflow/outflow depends on the difference in the
domestic and foreign real interest rates.
•
Aggregate supply depends on capital stock and labour force.
26
Mundell-Fleming Small Open Economy Model
National income
*
f
eP
e
Y  C(Y  T )  I (Y , i  )  G  NX (Y ,Y ,
)
P
Money market:
M
 Li, Y 
P
 r   (3)
eP *
 
P

*
NX

KF
r

r
Balance of payment:
e


Y

Y


P

P
Aggregate supply:

(2)
e
Real and nominal interest rates: i
Real exchange rate:
(1)
Natural rate of output: Y  F K , L


(4)
(5)
(6)
(7)
27
Notations in the Above Open Economy Model
Y= Actual output Y =natural rate of output
i = nominal interest rate r = real interest rate
r* foreign interest rate
ε = real exchange rate
e
P
=
T
p
=
t
K
e
P
E
n
r
d
Y,
i
a
c
x
=
r
c
=
a
e
o
Y
e
g
a
i
p
n
e
t
p
x
e
l
e
e
t
c
u
l
,
G
a
e
o
v
l
t
s
P
=
s
t
e
,
o
P
i
e
m
r
e
b
e
o
l
s
e
r
n
L
,
a
,
f
v
k
d
r
=
o
c
a
, i, r, ε
g
o
d
v
*
s
e
i
m
l
i
n
7
)
r
e
o
i
m
p
t
b
p
o
n
a
c
(
n
g
e
=
t
=
u
c
e
i
r
i
x
n
c
e
f
l
e
l
e
p
r
a
o
v
l
n
r
e
c
e
i
e
l
x
v
d
c
e
e
t
,
h
a
n
g
e
r
a
t
e
.
l
u
r
a
e
n
e
M
=
e
x
p
m
p
o
r
t
s
,
f
Y
d
=
i
=
e
c
f
t
e
o
d
r
i
e
n
i
f
g
n
l
a
i
t
i
n
o
c
n
o
m
e
.
:
.
Exogenous variables (10):
T, G, M,  , P*, r*, P , K , L and
e
e
Y
f
28
An Example of an Open Economy Model
National Income
Consumption
Investment
Tax and Spending
Net exports
Real exchange rate
Financial integration
Demand for Money
Parameters

Y  C Y  T   I i     G  NX Y , Y f , 
Y f  500

C  200  0.8Y  T 
I  50  200i   
T =100 G = 100
NX  10  0.3Y f  0.1Y  20
EP *

P
i  i  5%
*
M
 200  50i  0.5Y
P
  0.02
P*  2 P  2
29
A Solution of the Model
Y  1280
C  1144
I  44
Private Saving:
NX  8
S = Y-T-C = 1280 - 100-1144= 36
Equilibrium Condition:

Y  C Y  T   I i     G  NX Y , Y f , 

=1144 + 44 +100-8=1280
Model Closure:
T  G  S  I   NX 100  100  36  44  8
30
Three GAPs: Investment-Saving, Budget and Trade Gaps
SI
S(Y)
Trade Surplus
S  I   T  G   X  M
NX  0  NX  Cap Flow
K-outflow
i
T G  0
i
Private saving +public saving
= net export
SI
I(r)
Trade deficit
K-inflow NX  0
0
Saving and Investment
Re call : Y  C  S  T  M  C  I  G  X  rK  wL  Tr
31
Keynesian Open Economy Model
How an Expansion in Income causes Trade Deficit?
AD
*
eP
f
e
Y  C (Y  T )  I (Y , i   )  G  NX (Y , Y , )
P
0
Y
M=M(Y)
X=X0
+
Trade
balance
Surplus
0
-
Deficit
Y
32
NX=X-M
Derivation of Net Exports and Investment Saving in an Open Economy
Note:
AD
(a) Shows reduction in AD
following an increase in ER
(b) Shows investment saving
balance in an open economy
(c) Shows net export as
a function of the exchange
rate
(Lower rer=> rise(c)
dd for dom
goods=> rise Nx nb
e2
AD
(a)
ΔNX
Y1
(b)
e2
rer=e=en*(Pd/pf)
Y2 Y
e1
e1
IS*(e)
NX (e)
y1
NX2
NX1
Y2
33
IS-LM Model in an Open Economy: Mundell-Fleming Model
Exchange
Rate
LM (y, i)
Assumption:
Money supply does not
depend on exchange rate
e*
IS*
o
y
Output
34
IS-LM Model in an Open Economy: Mundell-Fleming Model
Exchange
Rate
LM (y, i)
Assumption:
Money supply does not
depend on exchange rate
e*
IS*
o
y
Output
35
Impact of Fiscal Policy under Fixed and Flexible Exchange Rate Systems
Flexible Exchange Rate System
Fixed Exchange Rate System
LM
LM1
LM2
e2
IS*’
e
IS*’
e1
IS*
IS*
Y
No Impact of Fiscal Policy
Y1
Y2
Full Impact of Fiscal Policy
36
Impact of Monetary Policy under Fixed and Flexible Exchange Rate Syste
Flexible Exchange Rate System
Fixed Exchange Rate System
LM
LM1
LM2
e2
IS*’
e
e1
IS*
IS*
Y1
Y2
Full Impact of Monetary Policy
Y1
Y2
No Impact of Monetary Policy
37
Trade Policy under Flexible Exchange Rate Systems
Flexible Exchange Rate System
Fixed Exchange Rate System
LM
LM1
LM2
e2
IS*’
e
e1
IS*
IS*
Y1
Y2
Full Impact of Monetary Policy
Y1
Y2
No Impact of Monetary Policy
38
Trade Policy under Fixed Exchange Rate Systems
Flexible Exchange Rate System
Fixed Exchange Rate System
LM
LM1
LM2
e2
IS*’
e
e1
IS*
IS*
Y1
Y2
Full Impact of Monetary Policy
Y1
Y2
No Impact of Monetary Policy
39
Determinants of Net Export
Net export function
NX  X  eM




NX  X Y *,e  eM Y ,e
NX = net exports
X = exports
e = nominal exchange rate
M = imports
Y* = income level in the foreign country
Y = income level at home
Three sources of changes in net exports:
1. Exports 2. Imports and 3. Exchange rate
40
Marshall-Lerner condition
Devaluation is effective if
ex  em  1
Devaluation is ineffective if
ex  em  1
Devaluation has no effect in trade balance
ex  em  1
ex
em
is elasticity of export
is the elasticity of imports
41
Numerical Example of the Marshall-Lerner Condition
Change in net exports is zero if the sum of exchange
rate elasticity of exports and imports equals 1.
Net export increases if this sum is greater than one.
Net export decreases if this sum is less than one.
Example: There is a devaluation
Export elasticity is 0.9
import elasticity if –0.8
Net export rises because 0.9-(-0.8) =1.7%.
42
A Brief Note on Internal and External Balance
The Accounting Framework
 A major macro problem in the case of Africa/LDCs, is how to finance investment.
This may be addressed by starting from the national income accounting identity
(eq. 1) and re-writing it to yield the accumulation balance (eqs. 2 and 3)
.
Y  C  I G X M
Y C G  I  X  M  F
(I g  S g )  (I p  S p )  M  X  N




I

T

G
 g FiscalDefict   ( I p  S p )  M  X  N






I

T

G
 g FiscalDefict   ( I p  S p )  Fg  Fp


43
A Brief Note on Internal and External Balance



Let us first consider the internal balance and how fiscal policy comes in the
analysis. A superscript ‘f’ shows full employment level while ‘*’ shows foreign (as
opposed to local/domestic) variables. ‘E’ and CA stand for nominal exchange
rate and current account balance, respectively.
Assuming P* and E are fixed, inflation will depend on aggregate demand
pressure which is strictly linked to the fiscal variables.
Internal balance requires that full employment holds (i.e. Aggregate demand
equals aggregate supply at Yf ). This is give by 1st eqn.
  EP * f

Y  C f Y  T  I  G  CA f 
Y  T 

  P
f

f


  EP *
CA f 
, Y f T
  P




  CAt arg et


.Coming to the external balance, if we assume that the government has a target
level of current account balance (CAtarget), achieving this target requires 2nd eqn.44
A Brief Note on Internal and External Balance
45
References

Blanchard (18) Mankiw (2) M&S (20)

Bhattarai (2002) Welfare Gains to the UK from a Global Free Trade, European
Research Studies, vol. IV, Issue 3-4, 2001, pp55-72. pp. 1161-1176.
Fleming J. Marcus (1962) Domestic financial policies under fixed and under
floating
exchange rates, IMF staff paper 9, November , 369-379.
Krugman Paul (1979) A Model of Balance of Payment Crisis, Journal of Money
Credit and Banking, 11, Aug.
Krugman P. and L. Taylor (1978) “Contractionary Effects of Devaluation”
Journal of International Economics, 445-56.
Miller, Marcus; Salmon, Mark When Does Coordination Pay? Journal of
Economic Dynamics and Control, July-Oct. 1990, v. 14, iss. 3-4, pp. 553-69
Mundell R. A (1962) Capital mobility and stabilisation policy under fixed and
flexible exchange rates, Canadian Journal of Economic and Political Science,
29, 475-85.
Sebastian E (1986) Are Devaluations Contractionary? Review of Economics and
Statistics, vol. 68, 3, 501-508.
Taylor Mark (1995) The Economics of Exchange Rates, Journal of Economic
Literature, March, vol 33, No. 1, pp. 13-47.
Whalley (1985) Trade Liberalisation among Major World Trading Areas , MIT
Press for developments on trade arrangement among various trading regions.








46