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Section 4 ECN5302 Advanced Macroeconomics Keynesian Model and Open Economy 1 © Pech 2009 • Sources: Roemer chpt 5 • Dornbusch/Fischer chpt 12 • Hallwood/MacDonald chpt 5 2 © Pech 2009 Keynesian Model 3 © Pech 2009 AD-AS model P AS AD Y 4 © Pech 2009 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 5 © Pech 2009 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) 6 © Pech 2009 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’ 7 Y © Pech 2009 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! 8 © Pech 2009 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 9 © Pech 2009 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 10 © Pech 2009 Open Economy Macroeconomics: Basic Concepts 11 © Pech 2009 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 12 © Pech 2009 Real exchange rate and net exports depreciation appreciation real exchange rate e NX(real exchange rate) net exports NX 13 © Pech 2009 Mundell-Fleming Model 14 © Pech 2009 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 15 © Pech 2009 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. 16 © Pech 2009 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 17 © Pech 2009 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 18 © Pech 2009 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 19 © Pech 2009 Mundell-Fleming: Fiscal policy with flexible exchange rates • A slightly different representation of the same relationships using the original i/Ydiagram 20 © Pech 2009 Mundell-Fleming: Fiscal policy with flexible exchange rates i LM BP i=i* IS(e) on BP: current account + capital account = 0! Y YEq 21 © Pech 2009 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 22 © Pech 2009 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 23 © Pech 2009 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 24 © Pech 2009 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 25 © Pech 2009 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 26 © Pech 2009 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 27 © Pech 2009 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 28 © Pech 2009 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 29 © Pech 2009 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) 30 © Pech 2009 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! 31 © Pech 2009 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 32 © Pech 2009 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 33 © Pech 2009 Mundell-Fleming: Fiscal policy with fixed exchange rates e IS’ LM LM’ IS e=e* Y 34 © Pech 2009 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’ 35 © Pech 2009 Mundell-Fleming: Monetary policy with fixed exchange rates e LM LM’ e=e* IS Y 36 © Pech 2009 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 37 © Pech 2009 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 38 © Pech 2009 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) 39 © Pech 2009 40 © Pech 2009 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. 41 © Pech 2009 BP-line with imperfect capital mobility BP for 0<CFi< i BP (e1>e0) BP for CFi i* BP is upward sloping because : Y 42 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 43 © Pech 2009 Fiscal policy under flexible exchange rates LM i BP(e1 < e0) BP (e0) IS1 (e0) IS0 IS1 (e1 < e0) Y Y0 Y1 44 © Pech 2009 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). 45 © Pech 2009 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 46 © Pech 2009