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Discussion 4 (Aug 30, 2007)
1. Gains from financial globalization
TB1
TB2

 ...  0 .
(1  r*) (1  r*)2
LRBC can rewritten as PV (GDP)  PV (GNE ) , hence LRBC says that in the long run, in
present value terms, a country’s expenditure must equal its production.
(1) Long run budget constraint (LRBC): PV (TB)  TB0 
(2) Gains form consumption smoothing
Endowment economy
GDP = Q, GNE = C, TB = Q – C
LRBC: PV(Q) = PV(C)
For a temporary shock: ΔC (1 + 1/r*) = ΔQ
For a permanent shock: ΔC = ΔQ
(3) Gains from efficient investment
Production economy
GDP = Q, GNE = C + I, TB = Q – C – I
LRBC: PV(Q) = PV(C) + PV(I)
An investment opportunity: costing ΔK in year 0, generating ΔQ in all later years
Change in present value of output if the project undertaken: ΔPV(Q) = ΔQ/r*
Change in present value of consumption: ΔPV(Q) = ΔPV(Q) – ΔK
The project is worth investing if and only if ΔPV(Q) > 0, i.e. ΔQ/r* > ΔK
(4) Gains from diversification of risk
2 identical countries, 2 factors, 2 states
GNI = capital income + labor income
Claims to capital income can be traded (stocks).
Countries can smooth their capital income, and hence GNI and consumption by asset
trade.
This is a gain from not putting all your eggs in one basket.
Risk sharing does no help if both countries are experiencing the same global shock.
2. Summary of Ch 18:
(1) Goods market:
D  C (Y  T )  I (i )  G  TB( EP * / P, Y  T , Y * T *)
Demand
Supply
Y
Y
 C (Y  T )  I (i )  G  TB( EP * / P, Y  T , Y * T *) [1]
Equilibrium
Keynesian cross diagram:
Shifts in demand: D  D( T , i , G , E , P *, P , Y *, T *) , here + (–) means shifting up
( ) ( ) (  ) (  ) (  ) ( ) (  )
( )
(down).
Memorize:
Higher tax implies less consumption and less import, on net lower demand.
Higher interest rate implies less investment.
Higher government expenditure means higher demand.
Higher exchange rate implies larger net export (more export, less import).
Higher foreign price level implies larger net export (more export, less import).
Higher home price level implies lower net export (less export, more import).
Higher foreign income implies more export.
Higher foreign tax implies less export.
(2) Money market:
MD  L(i )Y
Demand
Supply
MS  M / P
Equilibrium M / P  L(i )Y [2]
Money market diagram:
(3) Foreign exchange market:
Domestic return
DR  i
Foreign return
FR  i * ( E e  E ) / E
Equilibrium (UIP)
i  i * ( E e  E ) / E [3]
Foreign market diagram:
Analytical summary of (1)-(3):
The whole economy is characterized by three equilibrium conditions:
[1] Y  C (Y  T )  I (i )  G  TB( EP * / P, Y  T , Y * T *) --- Goods mkt eqlm
[2] M / P  L(i )Y --- Money mkt eqlm
[3] i  i * ( E e  E ) / E --- For-ex mkt eqlm
Analytically we can solve these three equations for the three endogenous variables: Y,
i, E.
(4) IS curve
 It shows all combinations of output Y and interest rate i where the goods and for-ex
markets are in equilibrium.
 It is downward-sloping.
 Shifts of IS curve: IS  IS ( T , G , P *, P , Y *, T *, i *, E e ) . Here + (–) means shifting to
( ) (  ) (  ) ( ) ( )
( ) (  ) (  )
the right (left). Memorize: any change that stimulates demand will shift IS curve to
the right.
 Analytically, IS equation is the combination of [1] and [3], by canceling out E.
(5) LM curve
 It shows all combinations of output Y and interest rate i where the money market
clears.
 It is upward-sloping.
 Shifts of LM curve: LM  LM (M , P ) . Here + (–) means shifting to the right (left).
(  ) ( )
LM curve may also shift due to an exogenous change in money demand.
 Analytically, LM equation is exactly [2].
Analytical summary of (4)-(5):
The whole economy is characterized by two equilibrium conditions:
[4] IS equation --- Goods mkt and for-ex mkt eqlm
[5] LM equation --- Money mkt eqlm
Analytically we can solve these two equations for the two endogenous variables: Y
and i.
(6) IS-LM-FX Diagram: shows equilibriums in 3 markets
(7) Policy analysis (focusing on temporary policies in the short run)
Case 1: expansionary monetary policy (M rises) under floating exchange regime
Case 2: expansionary monetary (M rises) policy under fixed exchange regime
Case 3: expansionary fiscal policy (G rises or T cuts) under floating exchange regime
Case 4: expansionary fiscal policy (G rises or T cuts) under fixed exchange regime
Case 1: expansionary monetary policy under floating exchange regime
Results: Y rises, i falls, E rises.
Case 2: expansionary monetary policy under fixed exchange regime
Results: Y does not change, i does not change.
Case 3: expansionary fiscal policy under floating exchange regime
Results: Y rises, i rises, E falls.
Case 4: expansionary fiscal policy under fixed exchange regime
Results: Y rises (a lot!), i does not change.
Summary of the above four cases1:
Important conclusion (the effectiveness of policies in stimulating output):
 Under floating exchange rate regime, both MP and FP are effective in affecting
output;
 Under fixed exchange rate regime, MP is ineffective in affecting output (we don’t
have an independent MP), while FP is incredibly effective in promoting output.
(8) Stabilization policy (to stabilize output when a LM shock or IS shock occurs)2
 Under fixed exchange rate regime, we can merely choose a policy that works directly
against the shock. That means if there comes a LM shock, we can only use MP,
while if facing a IS shock, we must use FP.
 Under floating exchange rate regime generally we can freely choose which policy to
use.
Example 1: an exogenous decrease in money demand (LM shock)
a) Fixed E, use MP (decreases M)
1
2
We assume that MPCF = 0, thus TB is not affected by home disposable income.
We omit the situations when there is an exogenous change in i* or E e, i.e. situations in which FR curve shifts.
Expected return
i
LM0=LM2
LM1
DR
i0
IS
Y0
FR
Y
E0
E
b) Floating E, use MP (decreases M)
Expected return
i
LM0=LM2
LM1
DR
i0
IS
Y0
FR
Y
E0
E
c) Fixed E, use FP (cannot achieve objects)
d) Floating E, use FP (decreases G or increases T)
Expected return
i
LM0
LM1
DR0
i0
i1
DR1
IS0
FR
IS1
Y0
Y
E0
Example 2: an exogenous increase in export (IS shock)
a) Fixed E, use MP (cannot achieve objects)
b) Floating E, use MP (decreases M)
E1
E
LM1
i
Expected return
LM0
i1
DR1
i0
DR0
IS1
FR
IS0
Y0
Y
E1
E0
E
c) Fixed E, use FP (decreases G or increases T)
Expected return
i
LM
DR
i0
IS1
IS0=IS2
Y0
FR
Y
E0
E
d) Floating E, use FP (decreases G or increases T)
Expected return
i
LM
DR
i0
IS1
IS0=IS2
Y0
Y
FR
E0
E