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Open Economy Macro
and
the Great Recession
1
Agenda for Open Economy Macro
The world economy
Reminder on exchange rates
Short-run open-economy output determination (Mundell Fleming
model)
International financial systems
Final thoughts
Endgame on exam on Wednesday
Remember problem set due Friday
2
Why has the Great Recession Spread
Around the World?
- Trade links (declining exports)
- Financial links (rising risk premiums)
- The results: sharp contraction in output and
employment
3
The Global Scope: Real GDP Growth
15
10
5
0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
-5
Argentina
Canada
China
France
Germany
Iceland
India
Mexico
Russia
United Kingdom
United States
-10
4
The Global Scope
3-month % change,
annual rate.
Source: IMF World
Economic Outlook
5
The collapse of trade
3-month % change,
annual rate.
Source: IMF World
Economic Outlook
6
Deteriorating assets
A loan is delinquent when payments are three or more months past due.
Source: IMF
7
Risk spreads
8
Baa bond rate-10 year Tbond rate
7
6
5
4
3
2
1
0
1920
1930
1940
1950
1960
1970
1980
1990
2000
2010
Baa bond: A rating for bonds that is toward the bottom of investment-grade bond
ratings, being only one grade above junk bond ratings. Source: Federal Reserve.
8
Risk spreads
8
7
Great Recession
6
5
4
3
2
Great Depression
1
29
30
31
32
33
34
35
06
07
08
09
10
Baa bond: A rating for bonds that is toward the bottom of investment-grade bond
ratings, being only one grade above junk bond ratings. Source: Federal Reserve.
9
Risk spreads
Commercial paper: An unsecured obligation issued by a corporation or bank to
finance its short-term credit needs, such as accounts receivable and inventory.
Source: Federal Reserve.
10
Financial contagion
Credit default swaps (CDS) are contracts that insure against default of municipal
bonds, corporate debt and mortgage-backed securities. These are interpreted as
annual default probabilities.
Mature market sovereigns are government debt of high income countries (US,
Germany, …). Source: IMF
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Now let’s move on to short-run output
determination in the open economy:
The Mundell-Fleming model
12
Tree of Macroeconomics
yes
IS-LM,
dynamic AS-AD
longrun
Closed
economy
Short run or
long run?
(full adjustment
of capital,
expectations,
etc.)
shortrun
Classical
or non-classical?
(sticky wages
and prices, rational
expectations, etc.)
no
Keynesian model
(sticky wages
and prices,
upward-sloping
AS
Open
economy
Mundell-Fleming
(fixed ER, flexible ER;
small open economy
and large open
economy)
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Keynes on
Why the models are so confusing!
Professor Planck, of Berlin, the famous originator of the Quantum
Theory, once remarked to me that in early life he had thought of
studying economics, but had found it too difficult!
Professor Planck could easily master the whole corpus of mathematical
economics in a few days.
But the amalgam of logic and intuition and the wide knowledge of
facts, most of which are not precise, which is required for economic
interpretation in its highest form is, quite truly, overwhelmingly
difficult.
(“Biography of Marshall,” Economic Journal, 1924)
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The Mundell-Fleming Model for Small Open Economy
Mundell-Fleming (MF) model is short run Keynesian model for
small open economy.
Very similar to IS-LM model.
It derives impact of policies and shocks in the short run for an
open economy.
Usual stuff for domestic sectors:
- Price and wage stickiness, unemployment, no inflation
- Standard determinants for domestic industries (C, I, G, financial
markets, etc.)
Open economy aspects:
- Small open economy
- Perfectly mobile international capital so rd = rw
- Net exports a function of real exchange rate, NX = NX(R)
Since interest rate is given by world interest rates, relevant
financial variable is real exchange rate, R.
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Goods market
Start with usual expenditure-output equilibrium condition.
New wrinkle is the NX function:
(1)
Y = C(Y - T) + I(rd) + G + NX(R, Y, Yf)
Endogenous variables are (Y, R).
Financial markets
Next we examine the monetary policy equation.
(2)
Ms/P = L(rd, Y)
Important note: This would be exactly the same with a Taylor Rule rather than a
LM curve.
Balance of Payments
Finally, we have the balance of payments equilibrium in small open
economy with mobile capital.
(BP$)
rd = rw (or with risk spread for country, = rw + spread
Substituting (BP$) into (1) and (2), we get equation in Y and R:
(IS$)
Y = C(Y - T) + I(rw) + G + NX(R, Y, Yf)
(LM$)
Ms/P = L(rw, Y)
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Real
exchange
rate (R)
(IS$)
Y = C(Y - T) + I(rw) + G + NX(R, Y, Yf)
IS$
Real output (Y)
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Real
exchange
rate (R)
(LM$)
Ms/P = L(rw, Y)
LM$
The LM curve is
vertical because the
exchange rate per se
does not enter into the
monetary policy
equation.
Real output (Y)
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Overall equilibrium
• As in IS-LM model, in MF we examine equilibrium of financial and
goods market – in this case output and exchange rate.
• Equilibrium of IS$ and LM$ just like that in conventional IS-LM
market, but emphasizes a different endogenous financial market
(ex. rate. rather than int. rate)
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Real
exchange
rate (R)
IS$-LM$ curve
LM$
R*
Notes:
1. Simultaneous
equilibrium of both
goods and financial
markets
2. Note slopes of both
3. What happened to
interest rate?
IS$
Y*
Real output (Y)
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Reminder on exchange rates
Foreign-exchange rates are the relative prices of different
national monies or currencies.
Real exchange rate (R)
R = e × p d/ p f
= domestic prices/foreign prices in a common currency
Major exchange rate regimes:
-
Fixed exchange rate: rates set by government
Flexible exchange rates: rates market determined
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Flexible Exchange Rates
With flexible exchange rates, monetary policy can now be
devoted to domestic objectives.
But this implies that exchange rate is market determined.
(IS$)
(LM$)
Y = C(Y - T) + I(rw) + G + NX(R)
Ms/P = L(rw, Y)
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Fiscal expansion with flexible rates
Real
exchange
rate (R)
Notes:
1. Fiscal expansion
leads to exchange rate
appreciation
2. No impact on output
3. NX down, G up
3. Leads to “twin
deficits” of NX and T-G
LM$
R**
R*
IS$’
IS$
Y*= Y**
Real output (Y)
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Monetary expansion with flexible rates
Real
exchange
rate (R)
LM$’
LM$
1. Monetary expansion
leads to depreciation
2. Output expansion
3. C, NX up; I, G
unchanged
R*
R**
IS$
Y*
Y**
Real output (Y)
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Mundell Fleming in the large open economy
These are much the same, except now the interest rate can
deviate from the world rate:
(IS) Y = C(Y − T) + I (rd) + G + CF(rd, rw)
(LM) Ms/P = L(rd, Y)
[or alternatively and equivalently a Taylor rule r = T(Y, π)
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rd
rd
LM
rd *
IS
CF(rd, rd)
CF*
CF
0
Y
Real exchange
rate, R
Mundell-Fleming for
large open economy:
the case of the US with
a large current account
deficit
R*
NX(R)
NX*
NX
0
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rd
rd
LM
IS’
IS
CF(rd, rd)
CF
Y
0
Real exchange
rate, R
Effect of fiscal stimulus
R*
NX(R)
NX
0
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Interesting polar case: very open
rd
rd
LM
IS
CF(rd, rd)
CF
Y
0
Real exchange
rate, R
Effects of policy just
like small open
economy
R*
NX(R)
NX
0
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Interesting polar case: almost closed
rd
rd
LM
IS
CF(rd, rd)
CF
Y
0
Real exchange
rate, R
Effects of policy just
like closed economy
R*
NX(R)
NX
0
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