copyright © 2008 pearson addison-wesley. all rights reserved. chapter 14 money in the open economy
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Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
Chapter 14
Money in the Open Economy
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Chapter 14 Topics
• Exchange rates and purchasing power parity.
• Flexible and fixed exchange rates.
• Monetary small open economy – fixed and flexible exchange rates.
• Capital controls.
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Equation 14.1
The purchasing power parity relationship – prices are equalized across countries in terms of the currency of one country.
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Table 14.1 Purchasing Power Parity and the Big Mac Index
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Figure 14.1 The Real Exchange Rate for Canada vs. the United States
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A Monetary SOE – Flexible Exchange Rate
• Model is identical to the small open economy model with production and investment in Chapter 13, with an added money market.
• The nominal exchange rate is essentially determined by nominal money demand and supply.
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Figure 14.2 The Goods Market in the Monetary Small Open-Economy Model
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Equation 14.2
In the monetary SOE model, we assume that purchasing power parity always holds.
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Equation 14.3
Money demand depends on P, Y, and the world real interest rate r*.
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Equation 14.4
Substituting in the money demand equation using the purchasing power parity relationship, and equating money demand with money supply gives:
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Figure 14.3 The Money Market in the Monetary Small Open-Economy Model with a Flexible Exchange Rate
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Figure 14.4 An Increase in the Money Supply in the Monetary Small Open-Economy Model with a Flexible Exchange Rate
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Main Results with Flexible Exchange Rate
• Money is neutral – the price level and nominal exchange rate increase in proportion to the money supply increase.
• A flexible exchange rate implies that the domestic price level is insulated from movements in the foreign price level.
• A change in the world real interest rate will affect the domestic price level.
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Figure 14.5 An Increase in the Foreign Price Level in the Monetary Small Open-Economy Model with a Flexible Exchange Rate
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Figure 14.6 An Increase in the World Real Interest Rate with a Flexible Exchange Rate
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Monetary SOE Model – Fixed Exchange Rate
• In this version of the model, the domestic money supply becomes endogenous rather than the exchange rate.
• The money supply changes to equate money supply and money demand at the fixed exchange rate.
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Figure 14.7 The Money Market in the Monetary Small Open-Economy Model with a Fixed Exchange Rate
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Table 14.2 A Simplified Government Balance Sheet
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Main Results with a Fixed Exchange Rate
• The SOE cannot have a monetary policy that is independent of what happens in the rest of the world.
• An increase in the foreign price level causes a proportionate increase in the domestic price level.
• A change in the world real interest rate has no effect on the price level.
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Figure 14.8 An Increase in the Foreign Price Level in the Monetary Small Open-Economy Model with a Fixed Exchange Rate
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Figure 14.9 An Increase in the World Real Interest Rate with a Fixed Exchange Rate
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Capital Controls
• Capital controls can dampen the effects of macroeconomic shocks that come from abroad.
• However, capital controls cause inefficiencies in world credit markets.
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Figure 14.10 A Devaluation in Response to a Temporary Total Factor Productivity Shock
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Figure 14.11 A Temporary Total Factor Productivity Shock, With and Without Capital Controls
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Figure 14.12 A Total Factor Productivity Shock Under a Fixed Exchange Rate,With and Without Capital Controls