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macroeconomicsfifth edition

N. Gregory Mankiw

PowerPointSlides

by Ron Cronovich

macro

2003 Worth Publishers, all rights reserved

Aggregate Demandin the Open Economy

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m

CHAPTER 12 Aggregate Demand in the Open Economy slide 1

Chapter objectives

accounting identities for the openeconomy

small open economy model

what makes it small

how the trade balance and exchangerate are determined

how policies affect trade balance &

exchange rate

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Learning objectives

The Mundell-Fleming model:IS-LM for the small open economy

Causes and effects of interest ratedifferentials

Arguments for fixed vs. floating exchangerates

The aggregate demand curve for the smallopen economy

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The Mundell-Fleming Model

Key assumption:Small open economy with perfect capitalmobility.

r = r*

Goods market equilibrium---the IS* curve:

( ) ( ) ( )*Y C Y T I r G NX e

wheree = nominal exchange rate

= foreign currency per unit of domestic

currency

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The IS*curve: Goods Market Eqm

The IS*curve is drawn

for a given value of r*.

Intuition for the slope:

Y

e

IS*

( ) ( ) ( )*

Y C Y T I r G NX e

e NX Y

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The LM*curve: Money Market Eqm

The LM*curve

is drawn for a given

value of r*

is vertical because:

given r*, there is

only one value of Y

that equates moneydemand with supply,

regardless of e.Y

e LM*

( , )*

M P L r Y

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Float ing & f ixed exchange rates

In a system of floating exchange rates,e is allowed to fluctuate in response tochanging economic conditions.

In contrast, under fixed exchange rates,

the central bank trades domestic for foreigncurrency at a predetermined price.

We now consider fiscal, monetary, and trade

policy: first in a floating exchange ratesystem, then in a fixed exchange rate system.

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Fiscal policy under floating exchange rates

Y

e

( , )*M P L r Y ( ) ( ) ( )

*Y C Y T I r G NX e

Y1

e1

1

*LM

1

*IS

2

*IS

e2

At any given value of e,

a fiscal expansionincreases Y,

shifting IS*to the right.

Results:

e> 0, Y= 0

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Lessons abou t f iscal po l icy

In a small open economy with perfect capitalmobility, fiscal policy cannot affect real GDP.

Crowding out

closed economy:

Fiscal policy crowds out investment by

causing the interest rate to rise.

small open economy:

Fiscal policy crowds out net exports bycausing the exchange rate to appreciate.

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Mon. policy under floating exchange rates

Y

e

( , )*M P L r Y ( ) ( ) ( )

*Y C Y T I r G NX e

e1

Y1

1

*LM

1

*IS

Y2

2

*LM

e2

An increase in M shifts

LM* right because Y

must rise to restore eqm

in the money market.

Results:

e< 0, Y > 0

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Trade policy under floating exchange rates

( , )*M P L r Y ( ) ( ) ( )

*Y C Y T I r G NX e

Y

e

e1

Y1

1

*LM

1

*IS

2

*IS

e2

At any given value of e,

a tariff or quota reducesimports, increases NX,

and shifts IS* to the right.

Results:

e> 0, Y= 0

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Lessons abou t trade pol icy

Import restrictions cannot reduce a trade deficit.

Even though NX is unchanged, there is less trade:

the trade restriction reduces imports

the exchange rate appreciation reduces exports

Less trade means fewer gains from trade. Import restrictions on specific products save jobs in

the domestic industries that produce those products,but destroy jobs in export-producing sectors.

Hence, import restrictions fail to increase totalemployment.

Worse yet, import restrictions create sectoralshifts, which cause frictional unemployment.

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Fiscal policy under fixed exchange rates

Y

e

Y1

e1

1

*LM

1

*IS

2

*IS

Under floating rates, afiscal expansion would

raise e.

Results:

e= 0, Y > 0 Y2

2

*LM

To keep efrom rising,

the central bank mustsell domestic currency,

which increases M

and shifts LM*right.

Under floating rates,fiscal policy ineffective

at changing output.

Under fixed rates,

fiscal policy is veryeffective at changing

output.

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Mon. policy under fixed exchange rates

2

*LM

An increase in M would shiftLM* right and reduce e.

Y

e

Y1

1

*LM

1

*IS

e1

To prevent the fall in e,

the central bank mustbuy domestic currency,

which reduces M and

shifts LM* back left.

Results:

e= 0, Y = 0

Under floating rates,monetary policy is very

effective at changing

output.

Under fixed rates,

monetary policy cannot be

used to affect output.

2

*LM

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Trade policy under fixed exchange rates

Y

e

Y1

e1

1

*LM

1

*IS

2

*IS

A restriction on importsputs upward pressure

on e.

Results:

e= 0, Y > 0 Y2

2

*LM

To keep efrom rising,

the central bank must

sell domestic currency,

which increases M

and shifts LM*right.

Under floating rates,import restrictions do not

affect Y or NX.

Under fixed rates,

import restrictionsincrease Y and NX.

But, these gains come at

the expense of other

countries, as the policymerely shifts demand from

foreign to domestic goods.

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Interest-rate differentials

Two reasons whyr may differ from

r*

country risk:The risk that the countrys borrowers will defaulton their loan repayments because of political or

economic turmoil.Lenders require a higher interest rate tocompensate them for this risk.

expected exchange rate changes:

If a countrys exchange rate is expected to fall,then its borrowers must pay a higher interest rateto compensate lenders for the expected currencydepreciation.

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Differentials in the M-F model

where is a risk premium.

Substitute the expression for r into theIS*and LM*equations:

( , )*M P L r Y

( ) ( ) ( )*Y C Y T I r G NX e

*r r

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The effects of an increase in

2

*LM

IS* shifts left, because r I

Y

e

Y1

e1

1

*LM

1

*

IS

LM* shifts right, because

r (M/P )d,so Y must rise to restore

money market eqm.

Results:

e< 0, Y > 02

*IS

e2

Y2

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The fall in e is intuitive:

An increase in country risk or an expected

depreciation makes holding the countrys

currency less attractive.

Note: an expected depreciation is aself-fulfilling prophecy.

The increase in Y occurs because

the boost in NX

(from the depreciation)

is even greater than the fall in I

(from the rise in r ).

The effects of an increase in

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Why income m ight not r ise

The central bank may try to prevent thedepreciation by reducing the money supply

The depreciation might boost the price ofimports enough to increase the price level

(which would reduce the real money supply)

Consumers might respond to the increasedrisk by holding more money.

Each of the above would shift LM* leftward.

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CASE STUDY:

The Mexican Peso Crisis

10

15

20

25

30

35

7/10/94 8/29/94 10/18/94 12/7/94 1/26/95 3/17/95 5/6/95

U.S.

CentsperMex

icanPeso

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10

15

20

25

30

35

7/10/94 8/29/94 10/18/94 12/7/94 1/26/95 3/17/95 5/6/95

U.S.

CentsperMex

icanPeso

CASE STUDY:

The Mexican Peso Crisis

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The Peso Crisis didnt just hurt Mexico

U.S. goods more expensive to Mexicans U.S. firms lost revenue

Hundreds of bankruptcies along

U.S.-Mex border

Mexican assets worth less in dollars

Affected retirement savings of

millions of U.S. citizens

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Understanding the crisis

In the early 1990s, Mexico was an attractiveplace for foreign investment.

During 1994, political developments caused anincrease in Mexicos risk premium ( ): peasant uprising in Chiapas assassination of leading presidential

candidate

Another factor:The Federal Reserve raised U.S. interest ratesseveral times during 1994 to prevent U.S.inflation. (So, r* > 0)

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Understanding the crisis

These events put downward pressure on thepeso.

Mexicos central bank had repeatedlypromised foreign investors that it

would not allow the pesos value to fall,so it bought pesos and sold dollars to

prop up the peso exchange rate.

Doing this requires that Mexicos centralbank have adequate reserves of dollars.Did it?

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the d isaster

Dec. 20: Mexico devalues the peso by 13%

(fixes e at 25 cents instead of 29 cents)

Investors are shocked ! ! !

and realize the central bank must be running

out of reserves

, Investors dump their Mexican assets andpull their capital out of Mexico.

Dec. 22: central banks reserves nearly gone.It abandons the fixed rate and lets e float.

In a week, e falls another 30%.

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The rescue package

1995: U.S. & IMF set up $50b line of creditto provide loan guarantees to Mexicos govt.

This helped restore confidence in Mexico,reduced the risk premium.

After a hard recession in 1995, Mexicobegan a strong recovery from the crisis.

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Floating vs. Fixed Exchange Rates

Argument for floating rates: allows monetary policy to be used to pursue

other goals (stable growth, low inflation)

Arguments for fixed rates: avoids uncertainty and volatility, making

international transactions easier

disciplines monetary policy to preventexcessive money growth & hyperinflation

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Mundell-Fleming and the ADcurve

So far in M-F model, P has been fixed.

Next: to derive theADcurve, consider theimpact of a change in P in the M-F model.

We now write the M-F equations as:

(Earlier in this chapter, Pwas fixed, so we

could write NX as a function of einstead of .)

( ) ( , )*M P L r Y LM*

( ) ( ) ( ) ( )*Y C Y T I r G NX IS*

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Y1Y2

Deriving the ADcurve

Y

Y

P

IS*

LM*(P1)LM*(P

2)

AD

P1

P2

Y2 Y1

2

1

WhyADcurve has

negative slope:

P

LMshifts left

NX

Y

(M/P)

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From the sho r t run to the long run

LM*(P1)

1

2

then there is

downward pressure on

prices.

Over time, P willmove down, causing

(M/P)

NX

Y

P1 SRAS1

1Y

1Y Y

Y

P

IS*

AD

Y

Y

LRAS

LM*(P2)

P2 SRAS2

1

If ,Y Y

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Large: between smal l and closed

Many countries - including the U.S. - are neither

closed nor small open economies.

A large open economy is in between the

polar cases of closed & small open.

Consider a monetary expansion:

Like in a closed economy,

M > 0 r I (though not as much)

Like in a small open economy,M > 0 NX (though not as much)

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Chapter summary

1. Mundell-Fleming model

the IS-LM model for a small open economy.

takes Pas given

can show how policies and shocks affect

income and the exchange rate2. Fiscal policy

affects income under fixed exchange rates, butnot under floating exchange rates.

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Chapter summary

3. Monetary policy

affects income under floating exchange rates.

Under fixed exchange rates, monetary policy isnot available to affect output.

4. Interest rate differentials exist if investors require a risk premium to hold

a countrys assets.

An increase in this risk premium raises

domestic interest rates and causes thecountrys exchange rate to depreciate.

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Chapter summary

5. Fixed vs. floating exchange rates

Under floating rates, monetary policy isavailable for can purposes other thanmaintaining exchange rate stability.

Fixed exchange rates reduce some of theuncertainty in international transactions.

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CHAPTER 12 A D d i h O E

chap12. as.gm

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