Chapter 13. Aggregate Demand in the Open Economy
We will not cover the Appendix.
Homework: pp. 388-89 # 1, 2 or 3
macromodel mundell_fleming # 1, 4, 10
Chapter 13. Aggregate Demand in the
Open Economy
H.W. p. 388-89 #1, 2 or 3
mundell_fleming #1, 4, 10
Link to syllabus
Won’t do appendix (large open econ)
Mundell-Fleming model. Assumes small open economy with
perfect capital mobility, world interest rate r*. Short run and
long possibilities: mostly short run (prices fixed). Extends
normal IS-LM. Produces stark results. Obvious links to Econ
347.
Preview of Coming Attractions!
Fig. 13-3, p. 361. The Mundell-Fleming Model
More, even better Previews! Table 13-1, p. 372
Preview: Fig. 13-3, p. 361. The
Mundell-Fleming Model
Changed the vertical axis; now uses
nominal exchange rate e. Recall that
increases in e are appreciations of
our exchange rate.
Preview: Table 13-1, p. 372.
Mundell - Fleming Model, summary
of policy effects.
Fiscal policy no effect in float,
monetary policy no effect in fixed.
Mundell and Dornbusch
Robert Mundell, 1932Nobel prize 1999
Rudiger Dornbusch
1942-2002.
Mundell and Dornbusch
No picture of Fleming (IMF
economist)
Mundell was born in Canada;
Dornbusch in Germany
2
Introduces the IS* curve: points e and y corresponding to
equilibrium of goods market.
Fig. 13-1, p. 359. The IS* Curve
Fig. 13-1, p. 359.
The IS* Curve
Derivation: if exchange rate increases (a),
net exports drop (b), and hence income
drops (c).
LM* curve represents points e and Y that correspond to
equilibrium in money markets
Fig. 13-2, p. 360.
The LM* Curve
With a vertical LM*,
all the fun is over before
we even start.
Fig. 13-2, p. 360. The LM* Curve
If r=r*, then only one level of output is
possible.
IS*: Y = C(Y – T) + I(r*) + G + NX(e)
LM*: M/P = L(r*, Y).
Fig. 12-3, p. 317. The Mundell-Fleming Model
Fig. 13-3, p. 360. The MundellFleming Model
Changed the vertical axis; now uses
nominal exchange rate e. Recall that
increases in e are appreciations of our
exchange rate.
3
Depreciation
of US $
Appreciation
of US $
Fig. 13-3 p. 361. Equilibrium in the Mundell Fleming Model
Fig. 13-3
p. 361.
With
exchange
rate info
FondMem
ories
Fond, old memories.
When the textbook expanded from the closed economy loanable funds
model of Chapter 3 to the open economy loanable funds model of
Chapter 6, it kept the same general framework, but we ended up with two
graphs; one with r on the vertical axis [where r always equaled r*],
and the other with the exchange rate on the vertical axis.
Now, from chapter 12 to13, we go from closed economy IS-LM to open
economy IS-LM. This time, however, we don’t bother with the graph
that has r on the vertical axis, but jump right into the graph with the
exchange rate on the vertical axis.
Will first analyze floating exchange rates.
Fig. 13-4, p. 362. Fiscal Expansion Under
Floating Exchange Rates
No change in output without even assuming a vertical AS curve.
mt’s attempt at explaining result of fiscal expansion
(assuming small open economy, flexible x-rates)
An increase in government expenditures
→ would raise interest rates,
→ leading to an inflow of foreign capital (loans),
→ appreciating the currency (higher Y/$),
→ lowering net exports,
→ leaving the economy at the same level of output.
Another part of the story is that these effects are so strong that the
domestic interest rate never really rises above the world interest rate.
Fig. 13-4, p. 362. Fiscal Expansion
Under Floating Exchange Rates
If G increases, e increases. Y constant.
No fiscal impact on income; appreciation
of exchange rate lowers exports.
Complete crowding out, via exports.
mt’s attempt at explaining result of fiscal
expansion under fixed rates, soe
An increase in government expenditures
→ would raise interest rates,
→ leading to an inflow of foreign capital
(loans),
→ appreciating the currency (higher Y/$),
→ lowering net exports,
→ leaving the economy at the same level of output.
Another part of the story is that these effects are so strong that the
domestic interest rate never really rises above the world interest
rate.
4
Fig. 12-5, p. 319. Monetary Expansion under
Floating Exchange Rates
Fig. 13-5, p. 364. Monetary Expansion
Under Floating Exchange Rates
If M increases, LM* moves right, and
income changes.
mt‘s attempt at explaining this result of monetary
expansion
The increase in the money supply would initially
→ lower domestic interest rates
→ cause capital outflows and depreciate the currency
→ raise net exports, increasing real output
mt‘s attempt at explaining this result
of monetary expansion under fixed rates,
soe:
The increase in the money supply would
initially
→ lower domestic interest rates
→ cause capital outflows and depreciate the currency
→ raise net exports, increasing real output
Fig. 13-6, p. 365.
Trade Restriction
under Floating
Exchange Rates
Fig. 13-6, p. 365. Trade Restriction
under Floating Exchange Rates
Tariffs move NX curve out, shifting IS
curve out, leading to an increase in e. No
change in net exports.
Fixed exchange rates. Most recently, under Bretton Woods 1950s
and 1960s. Notes that some economists (like Mundell) desire a
return to fixed rates/gold. (Dornbusch advocated giving up
currencies entirely). Gold standard was earlier example of fixed
x-rates. Key idea is that with perfect capital mobility, a shift of
return to assets will give rise to a large flow of capital which
cannot be sterilized, but will affect domestic money supply.
5
Fig. 13-7, p. 367. How a Fixed Exchange Rate
Governs the Money Supply
Fig. 13-7, p. 367 (again). How a Fixed
Exchange Rate Governs the Money Supply
180
A
150
150
120
At point A, agents borrow$ and convert them
to yen at 180Y/$ overseas, then bring the Yen
for exchange in the US, buying $ at 150
for an automatic profit. The Fed, in
selling $, raises US money supply.
H
Fig. 13-7, p. 367 How a Fixed Exchange
Rate Governs the Money Supply.
In (a), if e is 180>fixed rate (150), then
arbitrageurs sell dollars overseas, buy
them in U.S. to get exchange rate
differential, increasing US money supply.
Vice versa in other graph.
Fig. 13-7, p. 367 again – with explanation.
How a Fixed Exchange Rate Governs the
Money Supply
At H, agents will buy $ at 120
and sell them to the Fed at
150Y/$, making profit. This
reduces the supply of $.
Fig. 13-8, p. 369. Fiscal Expansion under
Fixed Exchange Rates
Fig. 13-9, p. 369. Monetary Expansion under
Fixed Exchange Rates
Monetary policy has no effect with fixed exchange rates, for a s.o.e.
Fig. 13-10, p. 371. Trade Restriction under
Fixed Exchange Rates
Fig. 13-8, p. 369. Fiscal Expansion
under Fixed Exchange Rates
Increase in G shifts IS*, increasing
exchange rate, causing money to flow in,
moving LM* curve. Reinforcing shift of
LM*. Should decrease NX-different
result than in Table 12.1
Fig. 13-9, p. 369. Monetary Expansion
under Fixed Exchange Rates.
Increase in M would lower exchange
rate, causing an outflow, leaving LM*
fixed. Thus, no change in NX.
Fig. 13-10, p. 371. Trade Restriction
under Fixed Exchange Rates
Increase in tariffs moves IS* to right,
which moves LM* to right. Improvement
in NX, because MP Im is <1.
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Table 13-1, p. 372
Table 13-1, p. 372. Mundell Fleming
Model, summary of policy effects.
I disagree with the 0 under NX under
fixed.
Interest rate differentials. Analyzed as caused by exchange rate
expectations. Will denote risk premium by θ, so that r = r* + θ.
And so
IS*: Y = C(Y – T) + I(r* + θ) + G + NX(e)
LM*: M/P = L(r* + θ, Y).
Similarly, LM* moves right, because demand for money falls due
to less confidence in domestic currency. Result is
depreciation, increased income.
Reasons for Y not increasing might be 1) central bank doesn’t
allow money to expand; 2) prices may increase, lowering M/P,
3) residents may increase their demand for M.
Applications to Mexico 1994/5, and Asia 1997/8.
Mexico: NAFTA and its contrarian response, zapatista revolt,
assassination of Colosio. Led to run out of pesos into dollars.
Stock market crashed. Further loss of confidence. Resolved
by US bailout, although there was significant recession.
Expectation of crisis causes crisis.
Asian crisis was one of confidence, vicious circle. Initially,
problems in domestic banking systems (crony capitalism;
zaibatsu), which spread over to stock markets. Interest rates
were rising, and loans were being defaulted.
7
Fig. 13-11, p. 374. An Increase in the Risk Premium
Fig. 13-11, p. 374. An Increase in the
Risk Premium θ
If θ increases, IS* moves left, because
businesses don’t want to invest
Depreciates exchange rate
Fig. 13-12, p. 381. The Impossible Trinity
Figure 13-12 p. 381. Impossible trinity:
fixed rates, free capital mobility,
independent monetary policy.
Result of SOE assumption, not IS-LM
logic.
A devaluation in a fixed rate system works like a rightward shift of
the LM* (because new rate is below previous intersection of IS*
& LM*. This will increase net exports and Y.
Example is 1930s depression, where there were competitive
devaluations. Discusses studies that show faster recovery for
countries that devalued.
Raises issue of fixed versus floating exchange rates. Fundamental
issue is stability, greater confidence.
If fixed: currency board, or outright dollarization. Mankiw does
not espouse a position on this.
Float gives greater independence to monetary policy. Others argue
that fixed exchange rates require more fiscal discipline. In
practice, countries have systems someplace in the middle, and
pursue these and other goals. Float with combination of
consider optimum currency areas-us dollar, euro, yen, pound.
8
Mundell Fleming as a theory of AD.
Fig. 13-13, p. 384. Mundell-Fleming in AD
Fig. 13-13, p. 384. Mundell Fleming as a
theory of AD. Derivation of AD.
If prices drop, LM* moves right,
increasing Y and lowering e.
Fig. 13-14 p. 385 Short Run and Long Run in an SOE
Fig. 13-14, p. 385. Short Run and Long
Run in an SOE.
How changing prices will move LM*,
bringing Y back to equilibrium, so
adjustment from short run to long run is
normal.
US is described as a large economy. A large economy is an
“average” of a closed economy and a SOE.
Putting it all together (Chapter 13 p. 407)
Appendix
The large open economy is an average of the closed economy and the
small open economy. To find how any policy will affect any variable,
find the answer in the extreme cases for the closed and SOE, and
take the ‘average’.
(page 394)
Putting it all together (Chapter 14 p.
424)
Appendix
9
Figure 13.15 p. 391 (appendix). A Short-Run
Model of a Large Open Economy
Earlier edition. Appendix
Figure 13.15 p. 391. (appendix) A
Short-Run Model of a Large Open
Economy
Figure 13.16 p. 392. A Fiscal Expansion in a Large
Open Economy
An increase in Gov’t spending raises
real GDP and the real interest rate,
lowers capital outflows, raises the
exchange rate, and reduces net
exports. The decline in net exports
lowers the increase of real GDP.
In the SOE, there is no change in
GDP because the ∆ G = - ∆ NX.
Figure 13.17 p. 393. A Monetary Expansion in a
Large Open Economy
An increase in M moves LM right,
lowering r. This increase capital
outflow, which lowers the exchange
rate, ultimately increasing net exports.
In a SOE, an increase in M increases
real output in the short run.
Figure 13.16 p. 392. A Fiscal
Expansion in a Large Open Economy
An increase in Gov’t spending raises
real interest rate, lowering capital
outflows, raising the exchange rate,
and reducing net exports
Figure 13.17 p. 393. A Monetary
Expansion in a Large Open Economy.
An increase in M moves LM right,
lowers r. This increase capital outflow,
which lowers the exchange rate,
ultimately increasing net exports.