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Macroeconomics In The Global Economy Wei wei Shool of Economics and Finance Jiaotong University CHINA - GDP (% real change pa) from 1980 to 2009 CHINA - Nominal GDP (US$ at PPP) from 1980 to 2009 CHINA - Real GDP from 1980 to 2009 CHINA - Real private consumption from 1980 to 2009 CHINA - Real government consumption from 1980 to 2009 CHINA - Real gross fixed investment from 1980 to 2009 Chapter 5 Investment The goal of study investment 1. Enrich our understanding of how the output in a given period is allocated between consumption and investment. 2. Fluctuations in firms’ investments play a role in determining the level of output and unemployment in a economy. 3. Investment spending contributes in significant ways to long-term growth of the economy. Assumptions 1. Labor is always fully employed and that output is therefore at its full-employment level as well. 2. Fluctuations in output is come solely from shifts in the capital stock, or from other supply-side shocks to the production function, but not from shifts in aggregate demand. Investment and Output Growth in the U.S, 1948-1990 20 15 Investment (% GDP) GDP growth rate 10 5 0 1948 -5 1954 1960 1973 1982 1990 Main topics in this chapter 1. Types of capital and investment 2. The basic of theory of investment 3. Extensions to the basic theory 4. Inventory Accumulation 5. Empirical investigations of investment expenditures We will mainly discuss on the topics as follows: 1.The basic of theory of investment 2. Extensions to the basic theory 3. Inventory Accumulation The basic of theory of investment The framework of analysis 1. The optimal investment rule for households simply carries over to the more realistic setting in which business firms make the investment decisions and households own the business firms. 2. The decision of whether or not to invest is to recognize that purchases of capital goods are another way to allocate consumption over time. 3. Investment spending should be increased whenever there is a higher rate of return in saving for the future via purchases of investment goods rather than through the purchase of financial assets. The production function The household’s investment decisions Families now have two different ways to transfer purchasing power across time: they can either lend money in financial markets at the interest rate r or they can invest to increase future output. Q1 - C1 = S1= B1 + I1 C2 = Q2 + ( 1 + r ) B1 C1 + C2 / ( 1 + r ) = (Q1 - I1) + Q2 /( 1 + r ) = W1 It must decide not only how much to consume and save, but also how to divide saving between investment and bonds. 1. Choosing investment I1 so as to maximize total wealth. △W = -1 + MPK2 /( 1 + r ) MPK2 = ( 1 + r ) 2.Choosing optimal consumption path The household’s consumption decision given an optimal investment choice Period 1 A C2 F UL1 C1 W 1 Period 1 The separation of optimal investment and consumption decisions. The investment demand schedule The case of many periods MPK: MPK+1 = (r + d ) Net present value NPV = - △I + △I (MPK +1)/( 1 + r ) + △I (1 - d)/( 1 + r ) The wealth-maximizing level of capital I = K *+1 - K + dK The role of expectations Investments depend on judgments about the future marginal productivity of capital. So they are fraught with uncertainty. Part of the volatility of investment, and thus of the uncertainty that surrounds it, stems from shifts in expectations about the future. Inventory Accumulation 1. Inventory stocks 1) Changes in inventory holdings represent an important and highly volatile type of investment spending. 2) Three basic kinds of inventory stocks: a. Primary inputs to production b. Semi-finished goods in the course of production. c. Finished goods ready for sale to final users. Inventory Stocks as a % of Total inventory in U.S Manufacturing, 1990 31% 32% 37% Primary mterial work-inprocess Finished goods Inventory Stocks As a % of Annual Shipments in U.S Manufacturing, 1990 60 40 20 As a % of annual 0 Primary materials Primary materials Work-inprocess Finished goods 2. Firms need inventories of primary materials to economize on the costs of producing final output. 3. Most formal theories of inventory management focus on final goods inventories. 1) Production smoothing 2) Avoidance of stockouts The firm must balance the costs of inventory holdings against the costs of involuntary stockouts. So, it is important to derive a mathematics rule for optimal inventory management. Empirical Investigations on Investment Expenditure 1. Even armed with these theories of investment, however, it is quite difficult to explain—much less to predict—patterns of investment spending. 2. Several econometric models have been developed to explain actual investment behavior. 1) The accelerator Model of investment 2) The adjustment-cost approach 3) The q theory 4) Theories based on credit rationing Chapter 6 Saving, Investment, and the Current Account Traditionally, I = S always appears in a closed economy. However, it is no longer true in an open economy. In this chapter, we study the determinants of national lending and borrowing from the rest of world. Main topics in this chapter 1. A Formal analysis of saving, investment, and the current account 2. The current account and international trade 3. The determinant of the current account 4. A country’s intertemporal budget constraint 5. Limitations on foreign borrowing and lending We will emphasis on 1. A Formal analysis of saving, investment, and the current account 2. The determinant of the current account 3. A country’s intertemporal budget constraint A Formal analysis of saving, investment, and the current account Assumptions 1. Classical, fully employed economy 2. A stable price level for goods (P = 1) Saving, investment, and the interest rate in a closed economy Effects of Economic shocks on Saving and investment, and interest rate in a closed economy – Supply shock – anticipated future increase in income Lend or borrow from the rest of world and current Claims or liabilities vs the rest of world and current account – current account (CA): the change in its net financial asset position with respect to the rest world: CA = B* - B* -1 Bi* = B 0 * + CA1 + CA2 + … + CAi The Current Account and The Net International Investment in The U.S., 1970-1989 (Billion of Current Dollars) 200 100 0 -100 -200 -300 -400 1988 1986 1984 1982 1980 1978 1976 1974 1972 -600 1970 -500 Net Interna tional Investm ent Current Account Balance The relationship among current account, saving, and investment 1. Budget constrain of an individual household Bi - Bi -1 = Qi + r Bi -1 - Ci - Ii Bi - Bi -1 = Yi - Ci - Ii Bi - Bi -1 = Si - Ii 2. Budget constrain of over all household B* - B* -1 = S - I CA = S - I The determination of current account schedule Saving, Investment, and the Current Account r CA S I S,I CA 0 The Current Account and International Trade The Determination of the Current Account Assumption – Given world interest rate – Small country The effect of different shocks on CA 1. Wold interest rate There is a positive relationship between CA for small open economy and the world interest rate at which its residents borrow and lend 2. Investment shocks The domestic interest rate is given by the world rate. An investment surge has a deteriorating effect on CA. 3. Output shocks The CA deficit after the temporary shock Saving should not fall significantly in response to the permanent shock. 4. Term-of-Trade shocks A transitory rise in the TT induces AS tend to rise. A permanent rise in the TT, saving rate does not necessarily rise, so does the CA. A Country’s Intertemporal Budget Constraint The level of S, I, and CA influence the future path of consumption and income for the economy as a whole. The Intetemporal Budget constraint in the twoperiod model – Intetemporal Budget constraint on the household level B1* = Q1 - C1 - I1 = CA B2* - B1* = Q2 + r B1* - C2 - I2 B2* = Q2 + (1 + r) B1* - C2 - I2 C1 + C2/(1 + r) = (Q1 - I1) + Q2 /(1 + r) – Intetemporal budget constraint on the national level Countries too are bound by a national intetemporal budget constraint – Three fundamental conclusions Trade balance – ∵ TB1 = Q1 - C1 - I1, TB2 = Q2 - C2 – ∴ TB1 + TB2/(1 + r) = 0 The Intertemporal Budget constraint with many periods C1 + C2/(1 + r) + … = (1 + r) B0* + (Q1 - I1) + ( Q2 - I2) /(1 + r) + … (1 + r) D0* = TB1 + TB2/(1 + r) + … – Net resource transfer (NRT) NRT = (D* - D* -1 ) -r D* -1 NRT = - TB (1 + r) D0* = NRT1 + NRT2/(1 + r) + … The Country’s Budget Constraint and CA Period 2 C2 ,Q2 CA surplus CA Balance C Q 2 Q Q1 CA deficit C1 ,Q1 Period 1 Chapter 7 The Government Sector The objective in this chapter – The governmental behavior has important and sometimes subtle effects on overall national S, I, and CA. – Economic effects of fiscal policy Assumption – Output is determined by supply and that shifts in AD do not affect aggregate output. – Price level is constant and equal to 1. The main topics – Government revenues and expenditures – Government saving, investment, and borrowing – The government budget and the CA – The interaction of the private and public sectors – Ricardian Equivalence – Some reasons why governments overspend – Other interactions between the public and private sectors We will mainly discuss on the following topics: – The interaction of the private and public sectors – Ricardian Equivalence – Some reasons why governments overspend Government revenues and expenditures Government revenues – Taxes – Profits of state enterprises and agencies that sell goods and services Government expenditures –G – Ig – Tr – r Dg Government saving, investment, and borrowing When its spending and income differ, the government borrows or lends, just as the private sector does. Bg = Bg-1 + r Bg-1 + T - (G + Ig ) ∵ Dg = - Bg ∴ Dg = Dg-1 + r Dg-1 + G + Ig - T Dg - Dg-1 = G + r Dg-1 + Ig - T Sg = (T - r Dg-1 ) -G DEF = Dg - Dg-1 = Ig - Sg The government Budget and Current Account Integrate the public sector into analysis of CA CA = (Sp + Sg) -( Ip + Ig ) = (Sp - Ip) + (Sg - Ig ) = (Sp - Ip) + DEF Total national saving Yd = Q + r Bp-1 - T Sp = Yd -C = (Q + r Bp-1 - T ) -C S = S p + Sg = [ (Q + r Bp-1 - T ) -C] + [(T - r Dg-1) -G] = Q + r B*-1 -C -G = Y-(C + G) CA = S - I = Y - ( C + G + I ) TB = Q - ( C + G + I ) Sp r S = Sp + Sg Sg S,I The Interaction of the Private and Public Sectors Government fiscal policy decisions affect household actions most directly through the effects of taxes on the household’s intertemporal budget constraint C1 + C2/(1 + r) = (Q1 - T1) + ( Q2 - T2) /(1 + r) A temporary tax-financed increase in Government Spending – Assume G1and T1 rise by an equal amount, while Sg1, as well as G2 and T2 remain unchanged. – Thus, private saving will fall with a temporary rise in taxes, while government saving remains unchanged. So the overall level of national saving declines. – For a small country facing a given world interest rate, the decline in saving for a given investment reduces its CA balance – For a large Country, this decline in S not only deteriorates CA, but also causes a rise in world interest rate. A permanent increase in government spending – The permanent rise in spending and taxes will have no effect on the CA Fiscal “Crowding Out” – Net exports might also get crowded out when G rises – Temporary tax-financed increase A small country with free capital mobility A large country with open capital mobility – A permanent expansion in spending Ricardian Equivalence – Theoretical proposition Under certain circumstances a change in the path of taxes over time—lower taxes in the present, higher taxes in the future, say— does not affect national saving, investment, or CA – A statement of RE theorem C1 + C2/(1 + r) = Q1 + Q2 /(1 + r) - [T1 + T2/(1 + r) ] T1 + △ T2/(1 + r) = -△ T + (1 + r) △ T /(1 + r) =0 – The theoretical importance of considering a current tax cut that leaves unchanged the present value of taxes – Limitations of Ricardian Equivalence Public sectors may have a longer borrowing horizon than households – Barro- Ricardian Equivalence liquidity-constraint households Uncertinty Empirical studies △ Some Reasons Why Governments Overspend Political-economic model – How the political environment a government faces relates to the budgetary decisions it actually makes. What is called fiscal “policy” is not generally one policy after all, but the sum of the effects of decisions made by myriad separate decision makers Fiscal policy is the result of a complex political bargaining process, and not the outcome of some optimizing decision taken by a single agent Other Interactions Between the Public and Private Sector Deadweight losses of taxes The case of tax smoothing Tax rate and Tax Revenues The cyclical pattern of budget deficits Chapter 8 Money Demand The objective Up to this point, we have ignored the fundamental role of money in our analysis, so we start to integrate money into our analytical framework. Main topics in this chapter What is money? Towards a theory of money demand The demand for money Empirical studies of money demand The doctrine of Monetarism What is money The fundamental role of money Medium of exchange: mutual coincidence of wants A unit of account A store of value: Gresham’s law—Bad money drives good money out of the market The definition of money Mh M1 M2 M3 Towards a theory of money demand Interest rates and prices in a monetary economy 1.The current real interest rate is (approximately) equal to the current nominal interest rate minus the rate of inflation between this period and the next. Money and the household budget constraint PYd = PQ + i-1B -1 - PT PSp = PYd - PC PSp = PI + (B - B -1 ) + (M - M -1 ) P2C2 = P2(Q2 - T2)+ (1 + i) B 1 + M 1 P2C2 = P2(Q2 - T2)+ (1 + i) (B 1 + M1) - i M -1 P1C1 = P1(Q1 - T1) - P1I1- (B 1 + M1) C1 + C2/(1 + r) = (Q1 - T1 -I1) + (Q2 - T2 ) /(1 + r) -i [ (M1 /P2) /(1 + r) ] The Demand For Money The Baumol-Tobin Model By holding a lot of wealth in the form of money, the household loses the interest that it would have earned by holding interest-bearing assets instead. Thus, the household must balance the opportunity cost of holding money against the transactions costs of frequently converting other assets into money. Household Money Balances Through Time M M* M*/2 1/3 2/3 1 Time The Cost of Holding Money and the Optimal Money Cost TC i(PQ/2) OC = i(M* /2) Pb CW = Pb(PQ/ M*) M0 * PQ M* The function of money demand Income The interest rate The fixed cost The modification by Merton Miller and Daniel Orr MD = f ( i , Q ) Demand for Money as a Store of Wealth Dominated assets and function of medium of exchange and a unit of account Reasons for money as a store of wealth Anonymity of it holder Currency substitution Speculative demand for money The velocity of money The effects of economic factors on V P I Q b Empirical Studies of Money Demand The Doctrine of Monetarism Chapter 9 The Money Supply Process Main topics in this chapter The money supply and the central bank: an overview Central bank operations and the monetary base The money multiplier and the money supply The money supply and the government budget constraint Equilibrium in the money market The money supply and the central bank: an overview High-powered money(Mh) The amount of Ms(M1, M2, M3) are determined by a combination of how much high-powered money the CB issues,regulations governing the banking system, and the financial instruments people choose for their investment portfolios. Central bank operations and the monetary base The fundamental way of changing the amount of Mh Open market operations The discount window Rediscounting the paper of nonfinancial firms Foreign-Exchange Operations A fundamental equation for changes in the money stock (Mh - Mh-1) = (Dgc - Dgc-1) + E(B*c - B*c-1) + (Lc - Lc-1) (Mh - Mh-1) = (Dgc - Dgc-1) + E( TB ) + (Lc - Lc-1) The money multiplier and the money supply M1 Mh = CU + R R = Dc + VC The reserve-to-deposit ratio: rd = (R/D) M1 = CU + D The rate of currency to deposits: cd = (CU/D) M1/Mh = (CU + D) /(CU + R ) = (cd + 1)/(cd + rd ) M1 = [ (cd + 1)/(cd + rd ) ]Mh The CB Control over the money supply The CB can influence the Ms in important ways, but it can not fully control it. The CB does determine reserve requirements and the discount rate, both of which influence the level of reserves that banks actually hold. It can not directly determine the rd, however, and it has even less control over the cd that public holds.. Different countries take different approaches to monetary control, of course, there has been a long debate over which monetary variable the CB should attempt to control. The Money Supply and the Government Budget Constraint The monetization of the budget deficit. – When the government budget is in deficit, the CB is the most important purchaser of treasury bonds. – The CB purchase of Treasury bonds essentially allows the Government to buy goods and services simply by printing money. So, the government finances its purchases of goods and services by an inflation tax. Dg - Dg-1 = P(G + Ig -T) + i Dg-1 Dgc - Dgc-1 = (Dg - Dg-1 ) - (Dgp - Dgp-1) Mh - Mh-1 = (Dgc - Dgc-1) + E(B*c - B*c-1) Dg - Dg-1 = (Mh - Mh-1) + (Dgp - Dgp-1) -E(B*c - B*c-1) (Mh - Mh-1) + (Dgp - Dgp-1) -E(B*c - B*c-1) = P(G + Ig -T) + i Dg-1 (Mh - Mh-1) + (Dgp - Dgp-1) -E(B*c - B*c-1) = P(G + Ig -T) + i Dgp-1 -E(i * B*c-1) Equilibrium in the Money Market – In equilibrium, the supply of money has to be equal to the demand for money. MD = Pf(i, Y) = ø Mh = MS A presentation of Equilibrium in Money market P MS M S1 MD MS’ P0 A M 0 M1 M The CB makes an open market purchase of bonds, which, in turn, increases the monetary base. – Case 1: A rise in prices, which would raise money demand to equal the higher money supply A presentation of Equilibrium in Money market – Case 2: A fall in interest rates, which would also raise money demand by decreasing the velocity of money. – Case 3: A rise in income ,which would raise the demand for money. – Case 4: An endogenous fall in the money supply, which would bring the money supply back down in line with money demand. Chapter 10 Money, Exchange Rates, and Prices The objective – Examine the repercussions of monetary policy throughout the economy under the framework of general equilibrium analysis. Assumptions – Simple classical model: full-employment – Capital is perfectly mobile between the domestic and international markets: domestic and foreign interest rates are equal. – Only one type of good is produced and consumed in the economy and that it can be imported or exported at fixed international price. The topics in this chapter – Exchange rate arrangements – The building blocks of a general equilibrium model – General equilibrium of price, the exchange rate, and money – Monetary policy under fixed and floating exchange rates – Global fixed exchange-rate arrangements – the effects of devaluation – The case of capital controls – Other kinds of exchange rate regimes Exchange rate arrangements The operation of a fixed exchange-rate regime – fixed exchange rate – Pegged exchange rate – Adjustable peg – The establishment of a particular exchange rate One side peg The operation of a fixed exchange-rate regime – Clean float – Dirty float – The debate on the benefits of having a fixed or a flexible exchange-regime. The building blocks of a general equilibrium model Assumptions – Output and income are always exogenous, and at full-employed level. – only a single good exists PPP – The law of one price: any commodity in a unified market has a single price. P = EP* – The doctrine of PPP attempts to extend the law of one price from individual commodities to the basket of commodities that determines the average price level in an economy. – Because the law of one price should apply for each commodity in international trade, it should apply generally for the home price index(P), which is a weighted average of the individual commodity price. P = EP* If these barriers are stable over time, percentage changes in P should approximately equal percentage changes in EP*. The relationship that it states holds true only under several unrealistic conditions: (1) that there are no natural barriers to trade, such as transport and insurance costs; (2) that there are no artificial barriers, such as tariffs or quotas; (3) that all goods are internationally traded; and (4) that domestic and foreign price indexes have the same commodities. In practice, these conditions never hold exactly. (P - P-1)/ P-1 = (EP* - E -1 P* -1 )/ E -1 P* -1 The percentage change in EP* can be approximated as the sum of the percentage changes in E and P*. (P - P-1)/ P-1 = (E - E –1)/ E –1 + (P* - P* -1 )/ P* -1 Yet even this less restrictive version of PPP is unlikely to hold precisely since many goods are not (easily) traded. Why does the law of once price break down? Very simply, transportation costs are too high for arbitrage to operate. One measure of a country’s overall competitive in international markets is the price of that country’s goods relative to the price of the goods of the competitive countries. The term “real exchange rate” is sometimes applied to the ratio e = EP* /P. When e rises, foreign goods become more expensive that domestic goods, and we speak of a real exchange-rate depreciation. International Interest Arbitrage The wealth held by households and firms is allocated among a portfolio of financial assets according to the characteristics of those assets, principally their risk and return, and the preferences of agents. Assumption: There is a single type of domestic money, M, and a single type of domestic interest-bearing asset, a default-free bond, B. Domestic agents hold only one type of interest-bearing asset denominated in the foreign currency, a bond, which we denote by B*. Nominal value of wealth: W = M + B + EB* Real value of wealth: W/P = M/P + B/P + EB*/P W/P = M/P + B/P + B*/P* If capital moves freely between the home and foreign capital markets,arbitrage will operate to equate the returns on the two assets. (1 + i) = (E +1/E ) (1 + i*) This express can be rewritten as the following approximation: i = i* + (E +1 - E ) /E Interest arbitrage: domestic interest rate must equal the foreign interest rate plus the rate of exchange-rate depreciation. General Equilibrium of Price, the Exchange Rate, and Money Now we put together the three basic relationships that we have analyzed to see how equilibrium in this economy is achieved. MD = PQ/V(i) = M Assumption: prices, the exchange rate, and other variables held constant So, E = E +1 , i = i* + (E +1 - E ) /E can be rewritten as i = i* We now put together all these pieces to find a simple relationship between the money supply and exchange rate. M V(i*) = EP*Q If the exchange rate is fixed by the central bank, we can describe M as a function of the level of E chosen by the central bank: M = (EP*Q )/ V(i*) If the exchange rate is flexible, the level of E should be consist with the level of M chosen by the central bank: E = [MV(i*)] /(P*Q ) MD E α = V(i*)/P*Q M MD P P1 P0 α = V(i*)/Q M M0 M1 If the exchange rate is fixed by the central bank, then E becomes an exogenous variable; M is an endogenous one, that is determined by the equilibrium conditions of economy. If the exchange rate floats, then E is an endogenous variable and M becomes an exogenous variable. For given output and the external interest rate, there is a positive linear relationship between money and prices, just as there is between money and the exchange rate. Chapter 11 Macroeconomic Policies in the Open Economy We take an important step toward realism by adapting our approach for an open economy. To make things as straightforward as possible, two parts are devoted to the open-economy analysis of macroeconomic policies, one focusing on the case of a fixed exchange-rate system, and the other focusing on a floating-rate system. Macroeconomic Policies in the open Economy: the case of Fixed Exchange Rates A Model of Internationally Differentiated Products Assumption: The home country produces a single output, but one that is differentiated from the output produced by the rest of world. The domestic economy produces a single good that is consumed both by domestic and foreign agents. Total production of that good is Q, with a price P. Whatever is produced but not purchased domestically is exported. The local currency price of imported good is PM. PM = EP* The foreign currency price of the domestic good P*X = P/E The Determination of Aggregate Demand Households consume both the domestic and the foreign good. The total nominal value of consumption PCd + PMCM = PcC The CPI can be generally constructed as Pc = λP + (1 -λ)PM The real value of consumption C = (PCd + PMCM) / Pc The total nominal value of investment expenditures as the sum of spending on the domestic goods and on imports: PcC = PId + PMIM Assume for simplicity that all government spending falls on the domestic good, that is PGG = PGd So, the total nominal demand for domestic goods is PQD = (PCd + PMCM) + (PId + PMIM) + PGd + PX -(PMCM + PMIM) the nominal value of imports PMIM is equal to PMCM + PMIM, thus PQD = (PCC + (PII + PGG) + (PX-PMIM) = A + PTB QD = A/P + TB PTB = PX-PMIM TB = X-(PM / P)IM The reduced-form equation for absorption A/P = a (G, T, [Q -T]F, MPKE , i) The reduced-form equation for trade balance TB = TB (A/P, A*/P*M , e) A single equation for AD QD = a (G, T, [Q -T]F, MPKE , i) + TB (A/P, A*/P*M , e) TB is written as a function of A/P, so QD = QD(G, T, [Q -T]F, MPKE , i, A*/P*M , e) The IS—LM Model for the open economy Assumptions The exchange rate E is fixed by the monetary authorities. The levels of G, T, [Q -T]F, MPKE , A*/P* , and P are given. On this basis, we can draw a negative relationship between the interest rate i and the level of domestic demand, QD , that is IS curve for the open-economy model. Properties of the IS Curve The LM Curve Capital Mobility (CM Curve) If capital flows freely across borders, i = i* (P574) In the closed economy, the level of M is a policy choice. The Monetary authorities set M, and that determines the position of the LM curve. In a regime of fixed exchange rates and capital mobility, however, the monetary authorities are not able to choose both the money supply and the exchange rate. When the monetary authorities fix E, households may convert their domestic money into foreign assets as they see fit. The money demand by households is then given by M/P = L (i*, QD ), and the money supply will adjust endogenously. Equilibrium in the IS-LM-CM Framework The monetary authorities undertake an open-market purchase of bonds, the temporarily increasing the money supply. The LM curve would shift down and to the right. In the closed economy, point B would mark the new equilibrium, i would be less than i*. (P575) In open economy, domestic residents would try to sell their domestic bonds to buy foreign bonds at point B. The domestic interest rate would quickly rise back to i*. The economy would remain on the IS curve at point A. In the process, the increase in the money supply would be reversed and the LM curve would shift back to the original position, the central bank is suffering a decline in its international reserves. (P575) The IS curve shifts to the right. The new equilibrium is therefore at point C, there is an excess demand for money at the initial level of M. It is eliminated as households convert some of their wealth into domestic money. The central bank would sell M and buy foreign exchange. The result would be an endogenous increase in the money supply so that the interest rate remains at i = i*. (P577) Under fixed exchange rates and perfect capital mobility, the equilibrium point occurs at the intersection of the IS curve and the CM line. The LM curve adjusts endogenously to intersect the IS curve at that point. The Determination of Output and the Price Level Now we can use our modified IS-LM analysis to study the effects of fiscal and monetary policies on output and prices. To Derive the AD schedule Suppose now that the price level rises to P1, a higher domestic price causes the real exchange rate to appreciate (e falls), hurting the country’s exports and increasing its imports, and thereby deteriorating the trade balance. At every interest rate, then AD will decline, shifting the IS curve down and to left. The new equilibrium is then at point B, at the section of the new IS curve and the CM line. The LM curve now has to adjust endogenously to insect with the IS curve at point B. Effects of a Fiscal Expansion (P580) Suppose that the government increases in expenditures. This shifts the IS curve to the right. The equilibrium must be at point C, along the CM line. The money supply will rise endogenously as households convert foreign assets into domestic money. Therefore, the LM curve shifts to Intersect the IS curve and the CM line at point C. The fiscal expansion is highly effective in raising AD, because there is no rise in the interest rates to crowd out investment or consumption when G rises. As a result of the fiscal expansion, AD increases, the shift in the AD schedule up and to the right. What happens to the equilibrium level of output and prices depends on the nature of the AS schedule. The same diagram would of course describe the effects of several other shocks to the economy, such as a devaluation of the domestic currency, a tax cut, an increase in foreign absorption, or a rise in expected future income. Changes in the fiscal policy of a large economy do have an effect on world interest rates, leading to a smaller multiplier. Effects of a Monetary Expansion (P583) Suppose that central bank undertakes an operation that increases the quantity of money in circulation. This excess supply of money leads households to purchase foreign assets, the exchange rate tending to depreciate. When central bank therefore intervenes by selling foreign exchange and absorbing the domestic currency, the LM curve shifts back to the left as M fall, and the central bank loses reserves. Under fixed exchange rates and perfect capital mobility, fiscal policy is highly effective in shifting AD, but monetary policy is completely ineffective. Effects of Devaluation (P584) Under a fixed exchange-rate regime, the exchange rate itself is a policy variable by the authorities. Suppose that the authorities decide to devalue the domestic currency. Because domestic prices do not respond to the devaluation, the real exchange rate depreciates together with the nominal rate. As a result, the trade balance improves and therefore AD increases at every level of the interest rate. In this framework a devaluation has an effect similar to that of an increase in government spending. Capital Controls In a world of capital controls, i need no longer equal i*, Nor can households convert foreign assets to domestic money rapidly. The central bank of an economy with capital controls stands ready to buy and sell foreign exchange at a given exchange rate, but only for current account transactions. Therefore the domestic interest rate can differ from the world interest rate, and the authorities can determine the position of the LM curve, at least in the short run. Even in the case of capital controls, however, the position of LM curve is still endogenous, but now the LM curve shifts more gradually than with free capital mobility. With capital controls, the monetary expansion is not immediately reversed. Rather, the money expansion causes the trade balance to change. In turn, the shift in the trade balance causes the money supply to change, and the LM curve shift endogenously. The Case of a Monetary Expansion (P589) Suppose that the authorities expand the money supply, shifting the LM curve to the right. The immediate result is a fall in interest rates and a rise in AD. A/P has risen, thereby causing total imports to rise, the economy therefore will move into a trade deficit. The trade deficit implies a drop in money supply. Eventually, the accumulated trade deficits match the initial increase in the money supply, the entire increase in M will have been offset. The LM curve is back at its initial level. As a result of the initial money expansion, there is a permanent loss of foreign exchange reserves equal to the sum of the trade deficit. The Case of a Fiscal Expansion (P590) With the fiscal expansion, say, a rise in G, IS curve shifts to the right, increasing AD. Absorption rises, and as a result, the trade balance goes into deficit. The trade deficit provokes a decline in the money supply. As M declines, the LM schedule shifts upward and to the left until the trade deficit is eliminated. The interest rate rises sharply in the long-run. Fiscal policy is effective only in the short run. When the money supply adjusts to the fiscal shock, AD goes back to its original position. The increase in government spending crowds out private spending partially in the short run, and this crowding out is distributed between reduced private consumption and reduced investment in response to higher interest rates. Over the long term, however, the crowding out is total: the increase interest rates (provoked both by the original increase in government spending and by the reduction in money supply that comes from the accumulated trade deficits) fully crowds out private consumption and investment. Therefore, government spending has increased at the expense of private investment and consumption. Macroeconomic Policies in the Open Economy: The Case of Flexible Exchange Rate The IS-LM-CM Framework with Flexible Exchange Rate The characteristics of IS-LM-CM framework with flexible exchange rate are the same as the case of fixed exchange rate. Under flexible exchange rates, of course, the exchange rate is no longer a policy variable. E moves endogenously to the forces of supply and demand. And because the position of the IS curve depends on E through its effects on trade flows, the IS curve also move endogenously. In particular, it moves to the right when the exchange rate depreciates and moves to the left when E appreciates. When E floats, the monetary authorities lose control over E, but they regain control over the money supply. The CB can determine the level of money supply, and thus the position of the LM curve. Clearly, the LM curve no longer adjusts endogenously as it did in the case of fixed exchange rates. The endogenous shift in the IS curve (P605) If monetary authority decreases the money supply by selling bonds to the public, the LM curve will shift up and intersect the IS schedule at point B. But in an open economy with high capital flow, the domestic interest rate cannot remain higher than i*. Therefore, domestic and foreign wealthholders would shift out of foreign bonds into domestic bonds, prompting a capital inflow. It prompts an appreciation of domestic currency, which, in turn, reduces net exports. When this happens, the IS curve shifts to the left. The final equilibrium is reached at the point along LM line, with Flexible Exchange Rate with Flexible Exchange Rate with Flexible Exchange Rate where the interest rate has gone back to the world level and AD has declined. The shape of aggregate demand schedule under flexible exchange rate (P606) A higher price level reduces real money balance, and this causes the LM curve to shift to the left. The new equilibria will be at point B, the intersection of LM’ curve and the CM line. The IS curve must move endogenously to this new intersection. AD falls when the price level rises. Macroeconomic Policies in a Small Country under Free Mobility Effects of fiscal Expansion (P608) An increase in government expenditure shift the IS curve to the right. Domestic interest rates are higher than world interest rates, prompting capital inflow and an appreciation of the currency. The appreciation of E causes a deterioration of the TB, and IS curve starts to shift back to the left. The final equilibrium is reached at point A. AD remains unchanged. Under fixed E, fiscal expansion provoked an endogenously increase in money supply. By contrast, the fiscal expansion prompts an appreciation of the home currency, which exactly offsets the expansionary demand effect of higher government spending. Fiscal policy, therefore, is totally crowded out by a decline in net exports. In closed economy, a fiscal expansion raises interest rates and crowds out interest-sensitive consumption and investment spending by the same amount as the fiscal expansion. But in the open economy with flexible exchange rates and capital mobility, the interest rate cannot rise; the crowding out occurs with net exports rather than with investment. Expansionary Monetary Policy (P610) The CB increases the money supply through an openmarket purchase of domestic bonds. This action shifts the LM curve downward. The incipient decline in the interest rate provokes a capital outflow. This capital outflow causes the exchange rate to depreciate and improves the trade balance, thereby inducing an endogenous right-ward shift of IS curve. The IS curve has moved endogenously to this intersection from the original intersection, via currency depreciation. For a small open economy with high capital mobility and flexible exchange rates, money policy works through its effect on the E, then on TB rather than through its effect on interest rate, then on C + I, as it would in a closed economy. Since the IS and LM schedules are drawn for a given price level, this implies that the AD schedule shifts to right. Exchange-Rate Dynamics Exchange-rate overshooting (P613) With an increase in the money supply, the E depreciates in the same proportion as the rise in money, wages, and prices in the long run. In this way, M/P is unchanged in the new equilibrium,as is EP*M/P. In the short run, when the money supply rises, the LM curve shifts to LM’. Assuming i = i* because of capital mobility, the new equilibrium is at point B. The IS curve adjusts to point B endogenously, through a depreciate of E . How big is the depreciation in the E needed to shift the IS curve so that it goes through point B? The short-run change can be larger or smaller than the long-run change, depending on how responsive output is to change in the real exchange-rate depreciation. If AD is not very responsive to a real exchange-rate depreciation, the depreciation of E in the short run is greater than the depreciation of E in the long run. In technical terms, the depreciation of E can overshoot its long-run value. When ‘exchange-rate overshooting’ occurs, at the time of the monetary expansion, the E depreciates sharply, by more than in proportion to the money change. Over time, as the economy is adjusting to long-run equilibrium, the E gradually appreciates to its long-run value. Expectations and Floating Exchange Rate (P617) Suppose that it becomes widely expected that money supply will be expanded in the next period, but not in the current period. In the future, the exchange rate will depreciate. Investors will come to expect a depreciation of the E between now and the time that the money supply is increased. The investors will begin to sell domestic assets and buy foreign assets, and the domestic interest rate must exceed the foreign interest rate by the amount of anticipated depreciation. Macroeconomic Policies Under Free Capital Mobility: Large-Country Case A Fiscal Expansion (P619) When a large country undertakes a fiscal expansion, the overall saving-investment balance in the world economy shifts, causing the world interest rate and domestic interest rate to rise. This induces the IS curve shift to the right, and CM line also shifts up. A new equilibrium is reached at point C, an equilibrium characterized by higher AD, a higher interest rate. In the large-country case, the fiscal expansion is not fully offset. The foreign interest rate rises, and the flow of capital into the home country is somewhat less, so that the E appreciation is smaller. In essence, there is less crowding out of net exports in the large- country case. An Increase in the Money Supply (P621) A money expansion reduces the domestic interest rate. Thus, in response, capital begins to fly abroad. Under floating rates, the E will depreciate, thereby improving the TB. Once that happens, the IS curve will shift to the right. At the same time, in the large-country case, the domestic monetary expansion reduces the world interest rate slightly. Capital Controls and Floating Exchange There are relatively few cases in the world of capital controls and floating rates. The implications of this policy regime is that for fiscal policy an expansion in G raises output, but provoking a currency depreciation rather than appreciation. A money supply increase also raises output and causes a currency depreciation. In the case of a fiscal expansion, interest rate rise; with a monetary expansion, interest rates decline. The Policy Mix In practice, policymakers often aim to achieve many targets, in which case they may want to change many policy variables at the same time. In that case, not all goals can be achieved, and various trade-offs must be made. A government with two policy instruments and two targets Suppose that a government wants to keep output unchanged while at the same time reducing the current account deficit and that it has monetary and fiscal policy at its disposal. A fiscal contraction by itself would improve the trade balance, but would reduce output. A monetary expansion by itself would improve the trade TB but would raise output. Therefore, a policy mix of fiscal contraction and monetary expansion would improve the TB while having little effect on output. Empirical Evidence