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Open Economy Macro
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1
Agenda for Open Economy Macro
A few slides on the Great Recession in the world economy
Short reminder on the international monetary system
Short-run open-economy output determination (Mundell Fleming
model)
Some important cases
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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
flexible ER;
small open economy
and large open
economy)
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The output decline in
the Great Recession
(industry)
Percent change from prior
three months at annual rate
4
The employment
drop during the
Great Recession
Percent change from prior
three months at annual
rate
5
The sharp decline in
world trade during the
Great Recession
(Note that trade
change is more than
output change.)
Percent change from prior
three months at annual rate
6
The growth in the
public debt around
the world
Debt/GDP ratio (%)
7
The risk premium on
corporate securities
in the US and Europe
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Reminder on Exchange rates
Foreign-exchange rates are the relative prices of
different national monies or currencies.
Nominal exchange rate
= e = foreign currency/$
Real exchange rate (R)
R = e × p d/ p f
= domestic prices/foreign prices in a common
currency
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Real exchange rate against
broad country group
100
90
80
70
1975
1980
1985
Internet bubble
Dollar bubble with
high US interest rates
130
120
110
Flight to safety
Real exchange rate of $ against broad currency group
140
1990
1995
2000
2005
2010
10
The share of floating has increased sharply
(% of world GDP)
Share of world GDP by floaters
100%
80%
60%
40%
20%
0%
1960
1970
1980
1990
2000
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The Mundell-Fleming Model
Mundell-Fleming (MF) model is short run Keynesian model
(usually applies to small open economy but we will do large 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 would have rd = rw
- Large open economy financial flows determined by rd and rw
- Net exports a function of real exchange rate, NX = NX(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)
Financial markets
Then the monetary policy equation.
(2)
r = L (Y)
Important note: This can be interpreted as LM or as Taylor rule. π = 0 for this
discussion.
Balance of Payments
Capital flows are determined by domestic and foreign interest rates. But
have BP balance:
(3)
CF(rd, rw) = NX(R)
Substituting (3) into (1), we get equation in Y and rd:
(IS)
Y = C(Y - T) + I(rd) + G + CF(rd, rw)
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rd
LM
CF=NX=0
Equilibrium
C+I(rd)+G+CF(rd) (IS$)
C+I(rd)+G (IS)
Y
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Two little reminders added after lecture
1.
2.
Remember the difference between real investment and financial
investment. Real investment (I) goes down as domestic interest
rates rise. Financial investment (CF) goes up as domestic interest
rates rise because financial investments are attracted from abroad.
We and Mankiw define CF as the capital outflow. This is the
opposite of the financial account in the balance of payments, so
CF = - Financial surplus. This is somewhat confusing, but that’s
what he does and we follow that. Remember the picture on the
next page.
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Financial capital
outflow(CF +)
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rd
rd *
CF(rd, rw)
CF*
CF (capital outflow) = - Financial surplus
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rd
rd
LM
r*
IS$
CF(r)
CF*
CF
0
Y
Real exchange
rate, R
Mundell-Fleming for
large open economy:
the case of the US with
a large financial
surplus and current
account deficit
R*
NX(R)
NX*
NX
0
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rd
Interesting polar case: veryd open
r
LM
CF(r)
IS$
CF
Y
0
Real exchange
rate, R
Effects of policy just
like small open
economy
R*
NX(R)
NX
0
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rd
Interesting polar case: almost
closed
d
r
LM
CF(r)
IS$
CF
Y
0
Real exchange
rate, R
Effects of policy just
like closed economy
R*
NX(R)
NX
0
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Special Case I. Stimulus plan
How does openness change the impact of a
stimulus plan?
Multiplier is reduced because some of the stimulus
spills into imports and stimulates other
countries
Note that financial crisis and high risk premium is
the opposite (IS$ shift to the left)
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rd
rd
LM
IS$’
IS$
CF(r)
CF
Y
0
Real exchange
rate, R
Effect of fiscal stimulus
R*
NX(R)
NX
0
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Special Case II. Normal Monetary Expansion
How does openness change the impact of a
monetary policy?
Effect is larger because lower i → depreciation →
higher NX.
- Double barreled effect of monetary policy
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rd
LM
rd
LM’
IS$
CF(r)
CF
Y
0
Real exchange
rate, R
Normal monetary
expansion
R*
NX(R)
NX
0
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Special Case III
What about a liquidity trap?
Note that monetary policy cannot work on either of the
two mechanisms in a liquidity trap.
- Interest rates stuck and cannot stimulate domestic investment.
- With no change in interest rates, cannot repel foreign investment
and depreciate currency.
So open economy does not change the basic liquidity trap
dilemma!
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rd
IS$
LM
LM’
Equilibrium
Y
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New Fed policy (QE2)
Use unconventional policies to reduce long-run interest rates:
- verbal language that Fed funds rate will be low for long time.
- Buy long-term securities (add to excess reserves)
This will lower rd, depreciating dollar.
Source of criticism from foreign governments of “competitive
depreciation.”
But this is what monetary policy is supposed to do
5
10/29/2010
Yield on Treasury securities (% per year)
4.5
6/2/2010
1/4/2008
4
3.5
3
2.5
2
6/2/2010
1.5
1
0.5
0
1 mo
3 mo
6 mo
1 yr
2 yr
3 yr
5 yr
7 yr
10 yr
20 yr
30 yr
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Term structure of interest rates
5
10/29/2010
Yield on Treasury securities (% per year)
4.5
6/2/2010
1/4/2008
4
3.5
3
2.5
2
6/2/2010
1.5
1
0.5
0
1 mo
3 mo
6 mo
1 yr
2 yr
3 yr
5 yr
7 yr
10 yr
20 yr
30 yr
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Other cases
Show that protectionism has no effect on net exports or
output.
What about effect of China buying large quantities of US$
securities to appreciate its currency?
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