Download BP - of Gerald Pech

Section 4
ECN5302
Advanced
Macroeconomics
Keynesian Model
and Open
Economy
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© Pech 2009
• Sources: Roemer chpt 5
• Dornbusch/Fischer chpt 12
• Hallwood/MacDonald chpt 5
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Keynesian Model
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AD-AS model
P
AS
AD
Y
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Why is the AS curve upward
sloping?
• Neoclassical view: only relative prices are
of interest, price level is irrelevant
• Lack of full nominal flexibility
►Keynes: Wages are sticky
• new classics: based on Phillips curve relationship
►New Keynesians: Rigid goods prices
►imperfect competition
►Labor market imperfections
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Why is the AD curve downward
sloping, Mankiw
• Real balances effect
• real exchange rate effect NX(e, P*,P)
►real exchange rate = P e /P*
• say P* is measured in $
• P is measured in KZT
• e has dimension $/ KZT
– if e increases, our exchange rate appreciates
• i.e. e P* is the price of imports in local currency
►Typical: If P increases the real exchange rate
appreciates (for constant e) and NX falls
• Shift in real money supply (IS-LM model)
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Review of Closed Economy Model
• Aggregate demand or more accurately real
planned expenditure is
E = C(Y-T)+I(i-pe)+G = Y
E=Y
E
E(i’,...)
E(i,...)
where C = Ca + (1-s)(Y-T)
Effect of a decrease in
interest rate
Y
Y’
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Y
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The IS curve
Y  E (Y , i - p , G, T )
e
dY
dE (Y , i - p , G, T ) dY
dE (.)


di |IS
dY
di |IS
di
e
dY
dE (.)
1

di |IS
di 1 - dE (.)
dY
1
 multiplyer
1 - dC / dY
<0
= dC/dY between 0 and 1!
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The LM curve
M
 L(i, Y )
P
dL
dL
with
 0 and
0
di
dY
dL di
dL

0
di dY |LM dY
di
dY |LM
dL
 - dY  0
dL
di
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The AD curve
• An increase in the price level results in a
shift of the LM curve to the right and thus
in a decrease in Y
LM’
LM
i
IS
Y
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Open Economy
Macroeconomics:
Basic Concepts
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The Open Economy, Mankiw
• Open economy expenditures:
• Y=C(Y-T)+I(i - pe)+NX(e, Y, Yf)
►recall, e is real exchange rate = eP/P*
• Balance of payment equation:
• BP = NX(e, Y, Yf) + CF (i - if)
= 0 in the absence of central bank intervention
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Real exchange rate and net exports
depreciation
appreciation
real exchange rate e
NX(real exchange rate)
net exports NX
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Mundell-Fleming Model
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Mundell-Fleming Model
• Suppose investors do not expect the
exchange rate to change, i.e. DeE=0
• P and P* are constant and equal to 1.
• Perfect capital mobility: i = i*
►i.e. local interest rate equals world rate
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Mundell-Fleming: flexible exchange
rates and perfect capital markets
BP  NX (Y , Y f , e )  CF (i - i*)  0
 with perfect capital mobility:
M
 L(i, Y )
P
external equilibrium
i  i*
equilibrium in money market
Y  C (Y , T , G)  I (i - p e )  NX (e )
equilibrium in goods market
The variables of the model are i, Y and e.
T, G, pe, P*, P and i* are parameters.
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Mundell-Fleming: flexible exchange
rates and perfect capital markets
Inserting i
 i*
and recalling that P is given we see that
for each M there exists a Y for which money market is in
equilibrium, i.e.
M
 L(i*, Y ).
P
So the exchange rate must adjust to make sure that the
goods market is in equilibrium, i.e.
Y  C (Y , T , G)  I (i * -p )  NX (e )
e
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Mundell-Fleming: flexible exchange
rates and perfect capital markets
e
LM
IS
LM does not depend on e
As e depreciates (i.e. decreases)
equilibrium Y increases:
Therefore, IS is downward sloping
Y
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Mundell-Fleming: Fiscal policy with
flexible exchange rates
LM
e
IS
IS’
If the government runs an
expansionary fiscal policy,
exchange rate must appreciate
(e must increase) for
equilibrium in the goods market
Fiscal policy creates demand
for the trading partners!
Y
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Mundell-Fleming: Fiscal policy with
flexible exchange rates
• A slightly different representation of the
same relationships using the original i/Ydiagram
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Mundell-Fleming: Fiscal policy with
flexible exchange rates
i
LM
BP
i=i*
IS(e)
on BP:
current account
+ capital account
= 0!
Y
YEq
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Mundell-Fleming: Fiscal policy with
flexible exchange rates
i
slightly different
perspective:
If interest were to increases
above i* there would be huge
influx of foreign capital
LM
i=i*
BP
IS’(e)
IS(e)
Y
YEq
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Mundell-Fleming: Fiscal policy with
flexible exchange rates
i
LM
So there must be an
appreciation along with a
current account deficit which
pulls back the IS-curve
i=i*
BP
IS’(e)
IS(e)
Y
YEq
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Mundell-Fleming: Fiscal policy with
flexible exchange rates
• Fiscal policy with flexible exchange rate
and perfect international capital markets is
totally ineffective:
►fiscal policy crowds out exports
►through appreciation encourages imports
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Mundell-Fleming: Monetary policy with
flexible exchange rates
e
LM
LM’
An increase in money supply
requires an increase in Y for
equilibrium in money market
IS
Y
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Mundell-Fleming: Monetary policy with
flexible exchange rates
LM0
LM1
i
Increasing money supply
lowers interest rate; this
causes outflow of capital.
i=i*
BP
IS
Y
Y0
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Mundell-Fleming: Monetary policy with
flexible exchange rates
LM0
LM1
 Exchange rate must
depreciate with current
account surplus, thereby
shifting IS to the right
i
i=i*
BP
IS
IS (e1 < e0)
Y
Y0
Y1
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Mundell-Fleming: Monetary policy with
flexible exchange rates
LM0
LM1
i
i=i*
 Exchange rate must
depreciate with current
account surplus, thereby
shifting IS to the right
BP
IS
IS (e1 < e0)
Y
Y0
Y1
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Summary and outlook
• Flexible exchange rates + perfect capital
mobility
►monetary policy highly effective
• via exchange rate depreciation
►fiscal policy totally ineffective (at home)
• via exchange rate appreciation
• ... fixed exchange rates
►monetary policy totally ineffective
►fiscal policy highly effective
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Mundell-Fleming: Fixed exchange
rates and perfect capital markets
• Now e = e * where e * is the target rate
• The money supply becomes endogenous:
►the central bank must be willing to buy or sell
local currency at the target rate e*
►prices are constant and equal 1, so e = e.
i  i*
e  e*
M
 L(i, Y )
P
Y  C (Y , T , G )  I (i )  NX (Y , Y f , e)
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Mundell-Fleming: Fixed exchange
rates and perfect capital markets
From the observation that money supply is endogenous,
M must be adjusted such that the condition
M
 L(i*, Y ) is fulfilled (with flexible e, e adjusted instead!)
P
The IS curve:
Y  C (Y , T , G )  I (i*)  NX (Y , Y f , e)
i and e are fixed, hence it is the relationship between
income and planned expenditures which will determine
outcomes!
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Adjustment of money supply:
fixed exchange rates
LM1
LM0
i
i*
BP
A
IS
• in point A there is
BoP deficit
• so central bank
loses foreign
reserves for local
money
• Money supply
contracts
• in the short term
it may sterilize
Y
YE
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Mundell-Fleming: Fiscal policy
with fixed exchange rates,
• In the Y - exchange rate diagram
• Recall that everything is fixed except Y
and C in goods-market equilibrium ISequation.
►in particular, M will adjust to satisfy LM-eq.
• So effect of expansive fiscal policy can be
determined in the simple Keynesian cross
 increase in G shifts IS curve to the right
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Mundell-Fleming: Fiscal policy with
fixed exchange rates
e
IS’ LM
LM’
IS
e=e*
Y
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Fiscal policy under fixed exchange
rates
LM’
LM
i
Fiscal policy now results
in BoP surplus: The
central bank has to sell
local currency for foreign
currency
BP
IS’
IS
Y
Y
Y’
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Mundell-Fleming: Monetary policy with
fixed exchange rates
e
LM
LM’
e=e*
IS
Y
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Monetary policy under fixed
exchange rates
LM0
LM1
i
As i<i* results in capital
outflow, the central bank
ends up selling foreign
currency for local currency
thus reducing M
BP
IS
Y
Y0
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Monetary policy under fixed
exchange rates
LM0
LM1
i
As i<i* results in capital
outflow, the central bank
ends up selling foreign
currency for local currency
thus reducing M
BP
IS
Y
Y0
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How perfectly mobile is capital
internationally?
• Increased openness to trade
►US imports and exports 12 - 18 % of GDP
• On the other hand, national savings and
national investment are still correlated when
with perfect international capital markets
they should not be
►Feldstein-Horioka puzzle
• By that account, the world was considerably
more integrated before the 1st world war
than in the 1980s (Taylor, NBER wp, 1996,
see also Obstfeld/Rogoff 2000)
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Mundell-Fleming model with
imperfectly mobile capital
• Capital inflow as function if i and i*:
• In equilibrium, CF = NX!
• BP: location of i and Y with CF + NX = 0.
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BP-line with imperfect capital mobility
BP for 0<CFi<
i
BP (e1>e0)
BP for CFi
i*
BP is upward sloping because :
Y
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NX CF di

0
Y
i dY
NX
di
 - Y
CF
dY
i
© Pech 2009
Fiscal policy under flexible
exchange rates
LM
i
BP (e0)
IS1 (e0)
IS0
Y
Y0
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Fiscal policy under flexible
exchange rates
LM
i
BP(e1 < e0)
BP (e0)
IS1 (e0)
IS0
IS1 (e1 < e0)
Y
Y0
Y1
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Romer version
• Romer defines an IS**-curve for which
Balance of Payment is in equilibrium (i.e.
by substituting CF(i,i*) for NX.
• This IS** curve is flatter than the
conventional one (and totally flat for
Ci).
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Variants
• Gold standard/single currency (?)
►similar to fixed exchange rates
• now even the same money
►David Hume’s species mechanism predicts long
run equilibrium current account balance
►not particularly descriptive of Europe
• Currency board
►All central bank money issues back by foreign
currency
►Argentina (until 2002), Bulgaria, Denmark, Macao
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