Download Week 5

THE GLOBAL BUSINESS ENVIRONMENT:
INTERNATIONAL MACROECONOMICS AND FINANCE
Professor Diamond
Class Notes: 5
SAVING AND INVESTMENT IN THE LONG RUN IN A SMALL
OPEN ECONOMY AND A LARGE OPEN ECONOMY
THE IMPACT OF GOVERNMENT POLICIES IN A SMALL AND A
LARGE OPEN ECONOMY IN THE SHORT RUN
SAVING AND INVESTMENT IN A SMALL OPEN ECONOMY
IN THE LONG RUN
As we have observed the U.S. economy since the 1960's has increasingly become
a more open economy. Moreover, due to its size, its major impact on world financial
markets and the role of the U.S. dollar as the world's major reserve currency, it is a
dominant large open economy. A large open economy is one that can influence its
domestic interest rates, has a substantial impact on world markets and, in particular, on
the world interest rate. In contrast, small open economy takes its interest rate as given
by world financial markets, and by virtue of its size, has a negligible impact on world
markets.
A model of a Small Open Economy in the Long Run. The U.S. is clearly a
large open economy. Nevertheless, we find it useful to begin (as if often the case in
constructing economic models) with the somewhat simpler small open economy case.
We can the utilize the insights gained to develop the large open economy model.
Moreover, we will find that although the U.S. is not a small open economy, it will
provide approximately the correct answer as to how government policies affect the trade
balance, exchange rates, and the level of output.
We begin by restating the national income accounts identity:
Y = C + I + G + NX
And recall that by algebraic manipulations it can be written as:
S-I =NX
Let us now develop a long run small open economy model that reflects this
relationship between saving and investment (net foreign investment) and net exports (the
trade balance).
The model makes the following assumptions:
1. We are dealing with a small open economy
2. There is perfect capital mobility. The government does not impede
international lending or borrowing. Residents have full access to world
financial markets.
3. The interest rate in a small open economy equals the world interest rate r*.
The equilibrium of world saving and investment determines the world interest
rate.
The model further assumes:
1. Y = YF(K,L). The output Y of the economy is fixed by the factors of
production and the production function.
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2. C = (Y-T). Consumption is positively related to disposable income Y-T.
3. I = I (r*). Investment is negatively related to the interest rate.
4. NX = (Y-C-G) - I
NX = S-I
Substituting the above three assumptions into number 4:
NX  [Y  C (Y  T )  G ]  I (r*)
NX  S  I (r*)
The equation shows what determines saving and investment and thus, the trade
balance. Budgetary fiscal policy determines saving. High government expenditures and
low tax rates result in sizeable deficits (G-T) and lower national saving. Lower
government expenditures accompanied by higher tax rates yield budget surpluses and
raise the level of national saving. Investment depends on the world interest rate r*. High
interest rates decrease the number of profitable projects; low rates increase the number of
profitable projects. The Trade Balance NX is determined by the difference between
saving and investment at the world interest rate -- see Figure 8-2.
Government Policies and the Trade Balance. Assume the economy begins
with balanced trade: NX = O and S = I. What would be the effects of government fiscal
policy at home and abroad? First, let us examine the impact of increase government
purchases to expand domestic spending as follows:
1. The increase in G reduces national saving since S = Y-C-G.
2. With an unchanged world interest rate I remains the same. Thus, S falls
below I and some investment must be financed by borrowing from abroad.
3. Since NX = S-I, the decline in S implies a reduction in NX. The economy
now has a trade deficit.
A decrease in taxes has the same effects although its overall impact on national
saving is somewhat muted since a portion of the tax cut finds its way into private saving see Figure 8-3. Thus, starting from balanced trade a fiscal policy that reduces national
saving leads to a trade deficit.
Let us now examine what occurs when foreign governments increase their
government purchase. If these countries are a small part of the world economy these
changes have a negligible impact on other countries. However, if these foreign countries
are a large part of the world economy, their increase in government spending reduces
world saving and causes the world interest rate to rise. This in turn, reduces investment
in the domestic economy. With no changes in domestic saving, saving S now exceeds
investment I. Since NX = S-I, the reduction in I must also increase NX - the trade
balance. Thus, fiscal expansion abroad, which increases the world interest rate, leads to a
trade surplus - see Figure 8-5.
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A change (shift) in the investment schedule (curve) in the domestic economy
will also affect the trade balance. Assume that a change in the tax law, which provides an
investment tax credit, shifts the investment curve (to the right). At a given world interest
rate investment is now higher. Since saving is unchanged, increased investment must be
financed by borrowing from abroad. Since NX = S-I, the increase in I leads to a decrease
in NX. An outward shift in the investment schedule causes a trade deficit - see Figure
8-6.
SAVING AND INVESTMENT IN A LARGE OPEN ECONOMY
IN THE LONG RUN
We begin as we did in the small open economy with the relationship between
saving and investment and net exports:
S-I=NX
We recall that S-I is called net foreign investment (NFI). It is the amount that
domestic investors lend abroad minus the amount that foreign investors lend to the U.S.
It may be positive or negative.
In a small open economy, investment (capital) flows in and out of a country freely
at a fixed world interest rate. In the large open economy model the interest rate r is
largely a function of the domestic economy and central bank monetary policies. If a
nation's interest rate is higher than those available abroad for investments of comparable
risk, then domestic investors will favor securities in their home country. The higher the
interest rates one can earn domestically, the less attractive will be investment abroad.
Investors overseas will act in a similar manner. They also have a choice between
domestic and foreign investments. The higher the interest rate in their home country, the
less they will be investing in the U.S. and other foreign countries. Conversely the lower
the interest rate in their own country the more they will favor overseas investments.
Thus, net foreign investment is negative related to the domestic interest rate r. As
the domestic interest rate rises, less U.S. savings flow abroad and larger amounts of
foreign capital funds flow to the U.S.:
NFI=NFI(r)
The equation states that net foreign investment is a function of the domestic interest rate.
NFI varies inversely with r. As r rises, NFI declines and as r declines, NFI increases.
Note that NFI can be either positive or negative depending on whether the economy is a
lender (has a NX surplus) or a borrower (has a NX deficit) in a world financial markets see Figure 8-15.
A model of a Large Open Economy. We can now proceed to develop the model
for a large open economy. To do so we need to consider two markets: the market for
loanable funds and the market for foreign exchange.
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The Market for Loanable Funds. An open economy’s saving is used in two
ways: to finance domestic investment and to finance net foreign investment. Thus we
rewrite the national income identity as follows:
S = I (r) + NFI(r)
The interest rate equilibrates the supply of loanable funds (saving and the demand
for loanable funds (domestic investment and net foreign investment) see Figure 8-17.
The Market for Foreign Exchange. Next we consider the relationship between
net foreign investment and the trade balance. We have observed previously that the
national income identity can be expressed as:
NX = S – I
Since the trade balance (NX) is a function of the exchange rate and NFI = S – I we can
state:
NX() = NFI
The real exchange rate  is the price that equilibrates the trade balance and net foreign
investment – see Figure 8-18.
Lastly, we need to recall that the nominal exchange rate e is equal to the real
exchange rate  times the ratio of the price levels in the foreign countries and the home
country:
e =  X P* / P
Government Policies and the Trade Balance. We are now in a position to
determine how economic policies influence a large open economy. To do this we need to
utilize a three-step process:
1. how the market for loanable funds determines the equilibrium interest rate;
2. how the interest rate determines the amount of net foreign investment, which in
turn determines the supply of dollars to be exchanged into foreign currency; and
3. how the real exchange rate adjusts the supply of dollars and the demand for
dollars emanating from net exports – see Figure 8-19.
Fiscal Policy at Home. A policy of fiscal expansion – an increase in government
expenditures or a reduction in taxes reduces national saving, thereby reducing the supply
of loanable funds and raising the equilibrium interest rate. The higher interest rate
reduces both domestic investment I and net foreign investment NFI. In turn, the decline
in NFI decreases the supply of dollars causing the exchange rate to rise (appreciate). This
in turn causes net exports to fall and a resulting trade deficit – see Figure 8-20.
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A fiscal contraction by reducing government expenditures or raising taxes,
increases savings and thus will cause the exchange rate to fall (depreciate) and net
exports to rise.
Note that the impact of fiscal policy in a large open economy combines the impact
of the closed economy with that of a small open economy. As in the closed economy, a
fiscal expansion reduces saving, causing interest rates to rise and crowding out
investment. As in the small open a fiscal expansion causes a rise in the exchange rate and
a trade deficit.
Shifts in Investment Demand. Assume that the government institutes an
investment tax credit, which shifts the investment demand schedule outward. The
demand for loanable funds increases, causing a rise in the interest rate. The higher rate
reduces net foreign investment as we make fewer loans abroad and foreigners invest
more here. The decline in net foreign investment reduces the supply of dollars in the
foreign exchange market causing the exchange rate to rise and net exports to fall – see
Figure 8-21.
Trade Policies. Protectionist policies such as increases in tariffs or the
imposition of import quotas reduces the demand for imports causing an outward shift in
the net export schedule. Since the market for loanable funds is unaffected the interest rate
is unchanged as is foreign investment. The shift in the net export schedule causes the
exchange rate to rise. The rise in the exchange rate makes U.S. goods more expensive
relative to foreign goods causing exports to fall and imports to rise. Thus, negative trade
restrictions do not change the trade balance – see Figure 8-22.
Shifts in Net Foreign Investment. Changes in fiscal policy abroad may also
affect the exchange rate and net exports. A European Union (EU) policy decision to
reduce government deficits would increase the saving of the euro zone countries. This
would cause a decline in the interest rate in EU counties and stimulate euro nations
lending to the U.S. causing net foreign investment to decline. The exchange rate would
appreciate and net exports would fall – see Figure 8-23.
THE IMPACT OF GOVERNMENT POLICIES IN A SMALL OPEN ECONOMY
IN THE SHORT RUN UNDER FLOATING AND FIXED EXCHANGE RATE
SYSTEMS
THE MUNDELL FLEMING MODEL
We now turn our attention to the short run. Again we begin with a small open
economy. The principal paradigm for analyzing the impact of government policies in the
short run is the Mundell-Fleming model. Robert Mundell and J. Marcus Fleming were
economists at the International Monetary Fund in the 1960’s. They extended the
Keynesian closed economy IS/LM model to predict the impacts on monetary, fiscal and
trade restriction policies under floating vs. fixed exchange rate systems. Robert Mundell
was the 1999 Nobel Laureate in Economic Science. In addition to the Mundell-Fleming
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model he was recognized for his work on optimal currency areas. The latter research has
been influential in moving the European Union to a common currency. Indeed, he is
referred to as the “euro godfather”.
The Mundell-Fleming Model. The model has the following characteristics:
1. Like the closed economy IS-LM model, it initially assumes that the price level
is fixed.
2. Also, like the closed IS-LM model it shows the interaction between the goods
market and the financial (money) market.
3. It shows that the behavior of an economy depends on the exchange rate
system it has adopted.
4. It begins by assuming a floating exchange rate system – the nation’s central
bank allows the exchange rate to adjust to changing economic conditions.
Components of the Model. The Mundell-Fleming model is comprised of the
following equations:
1. IS*:
Y = C(Y-T)+I(r)+G+NX(e)
This equation is quite familiar to us. It describes the goods market (IS).
Income/Output Y is the sum of consumption, investment, government purchases
and net exports. Net exports depend negatively on the exchange rate e. The
exchange rate is the price at which a home currency can be exchanged for a
foreign currency. NX, net exports, depends negatively on the exchange rate e.
The lower the exchange rate the less expensive domestic goods are relative to
foreign goods and thus the greater net exports are. The higher the exchange rate
the more expensive domestic goods are relative to foreign goods and thus the
smaller net exports are. In actuality, while net exports do respond to changes in
exchange rates, the response may be slow. Note that the Mundell-Fleming model
does not distinguish between real and nominal exchange rates. Since the model
assumes prices are fixed, changes in the real exchange rate are proportional to
changes in the nominal exchange rate.
2. LM* M/P = L(r,Y)
This equation describes the money market. It states that the supply of real money
balance M/P equals the demand L(r,Y). The demand for real money balances
depends negatively on the interest rate and positively on income. The money
supply M is an exogenous variable controlled by the Federal Reserve.
3. r = r*
In graphing the model we label equation 1 as IS* and equation 2 as LM* to
indicate that we are holding the interest rate constant at the world interest rate r*.
The LM* curve is vertical because the exchange rate does not enter into the LM*
equation. Given the world interest rate, the LM* equation determines aggregate
income regardless of the exchange rate. Figure 12-2 shows how the LM* curve is
derived from the world interest rate and the LM curve. The IS* curve slopes
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downward because a high exchange rate lowers net exports and thus lowers
aggregate income. Figure 12-1 shows how IS* is derived fro the net export
schedule and the Keynesian cross. The intersection is IS* and LM* determines
the exchange rate and the level of income – see Figure 12-3.
Floating Exchange Rates. The model begins by examining the impact of
government policies operating with a floating exchange rate system. It is a system where
exchange rates are determined by conditions of demand and supply in the foreign
exchange market and therefore are allowed to change on a daily basis. It is sometimes
referred to as a flexible exchange rate system. Most major economies today utilize a
floating exchange rate system.
If the government stimulates the domestic economy by increased purchases or
lower taxes – fiscal policy – under the aegis of floating exchange rates, the IS* curve is
shifted to the right causing the exchange rate to rise, but leaving output unchanged – see
Figure 12-4. Contrast this result with that which occurs in a closed economy. In the
latter case fiscal expansion raises output. However, in an open economy the increase in
government expenditures or lower taxes reduces national saving causing net foreign
investment to fall and exchange rate to appreciate. This increase in the exchange rate
reduces net exports offsetting the expansion in domestic demand for goods and services,
thus leaving output unchanged. Another way to understand the difference between an
open and a closed economy is to look at the equation describing equilibrium in the money
market: M / P = L(r,Y). The supply of real money balances M / P is fixed and the
demand must always equal the fixed supply. In a closed economy an expansionary fiscal
policy raises the interest rate allowing income to rise. In an open economy, r is fixed at r*
so there is only one level of income that can satisfy the equation. The appreciation of the
exchange rate and the fall in net exports must be exactly large enough to fully offset the
expansionary impact of fiscal policy.
If the Federal Reserve increases the money supply – monetary policy – since the
price level is assumed to be fixed the increase in M means an increase in real balances.
This shifts LM* to the right and increases income and lowers the exchange rate – see
Figure 12-5. The effect on the level of income is the same as in a closed economy but the
mechanism is different. In a closed economy the lower interest rate stimulates
investment. In an open economy the interest rate is fixed by the world interest rate. As
soon as the increase in M puts downward pressure on the domestic interest rate capital
flows out of the economy seeking higher returns abroad. This capital outflow prevents the
interest rate from falling and lowers the exchange rate. The fall in the exchange rate
makes domestic goods inexpensive relative to foreign goods, which stimulates net
exports. Thus the change in Y is due to the exchange rate rather than the interest rate.
If the government reduces the demand for imported goods by imposing an import
quota or a tariff – trade policy – the net export schedule is shifted to the right. This
moves the LS* curve to the right causing the exchange rate to rise and leaving the level
of income unchanged – see Figure 12-6. A stated goal of these protectionist policies is to
raise net exports and thus alter the trade balance. However, since a trade restriction does
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not affect income, consumption, investment or government purchases it cannot affect the
trade balance: NX(e) = Y-C(Y-T)-I(r)-G. While the shift in the net export schedule tends
to raise NX, the increase in the exchange rate raises the price of domestic goods relative
to foreign goods leading to less exports, which offsets the decline in imports. These
changes do, however, affect the volume of world trade since both exports and imports are
reduced. This reduction in international trade is the reason why economists oppose
protectionist policies. In June of 1995 the Clinton administration threatened to impose
punitive tariffs on luxury Japanese cars imported in the United States if Japan did not
agree to specific steps to open its markets to U.S. car parts. On hundred prominent
economists petitioned the federal government not to take this action since it would reduce
the world trade.
Fixed Exchange Rates. Floating exchange rates appeal to those who believe in
allowing the market system to operate with minimal interference from the government.
More importantly, as we shall see, unlike a fixed rate system they allow monetary policy
to be utilized for purposes other than marinating a fixed exchange rate. However,
floating exchange rates create uncertainty and in some instances significant volatility in
exchange rates and thus add to the already complex character of international
transactions. For these reasons the major industrial nations have historically favored
fixed exchange rates.
A fixed exchange rate system is one where exchange rates are set at officially
determined levels and are changed only by direct government action. The central bank is
given the responsibility of maintaining the fixed exchange rate levels. For example,
assume the U.S. and Japanese governments agree to fix the exchange rate of the dollar
and yen at 100 yen to the dollar with a 2 per cent band above and below the official rate
(par rate of exchange). Thus, in the case of the U.S. the Federal Reserve would stand
ready to buy or sell yen at 100 yen to the dollar any time the exchange rate rose above
102 yen to the dollar or below 98 yen to the dollar. Assume, for example, the exchange
rate rose to 103 yen, arbitrageurs would buy yen in the foreign exchange market
receiving 103 yen for each dollar. They would sell the yen to an agent of the Fed at the
official rate of 100 yen to the dollar thus pocketing the difference. The Fed would pay
the arbitrageurs with checks drawn on itself which when they were deposited in the
banking system would add to the money base and thus increase the money supply. This
would cause the LM* curve to shift to the right lowering the equilibrium exchange rate to
its official fixed level – see Figure 12-7(a). Conversely, if the yen/dollar rate fell below
97-yen arbitrageurs would buy yen from the Fed at the official rate of 100 yen for each
dollar. They would then sell the yen in the foreign exchange market at the going rate
below 98 yen to the dollar, yielding a profit on the spread between the official and market
prices. Arbitrageurs would pay for the yen from the Fed with checks drawn on demand
deposits with commercial banks. When these checks were cleared, the banking system
would lose reserves. This decline in the money base would cause the money supply to
fall triggering a shift in the LM* curve to the left which would raise the equilibrium
exchange rate to the fixed level – see Figure 12-7(b). As we shall see a fixed exchange
rate system virtually eliminates monetary policy as a domestic stabilization tool. It also
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protects the economy form any significant inflation since increases in the money supply
are restricted to maintaining the official fixed exchange rate.
Let us now see how government polices under a fixed exchange system impact
the level of output. If the government decides to stimulate the domestic economy by
higher spending or lower taxes – fiscal policy – this causes the IS* curve to move to the
right resulting in an increase in the exchange rate. To maintain the fixed rate the Fed
must increase the money supply and shift the LM* curve outward as well. This will keep
(restore) the exchange rate at its announced level. It will also increase the equilibrium
level of income. This is in contrast with a floating exchange rate system where fiscal
expansion had no impact on Y – see Figure 12-8. If the central bank wishes to stimulate
the domestic economy by increasing the money supply (monetary policy) this will cause
the LM* curve to shift outward. This will result in decreasing the equilibrium exchange
rate. However, the Fed is committed under a fixed exchange rate system to buy and sell
foreign currencies at a fixed rate. Arbitrageurs will seize the profitable opportunity and
sell dollars to the Fed causing the money supply to contract and shifting the LM* curve
back to its original position, thereby negating the effort to stimulate the domestic
economy. Thus, the central bank by agreeing to maintain a fixed exchange rate gives up
its control over the money supply – see Figure 12-9.
A country can, however, practice a type of monetary policy by changing the level
at which the foreign exchange rate is fixed. A reduction in the value of a currency is
called a devaluation, and an increase is called revaluation. In the Mundell-Fleming
model, a devaluation acts just like an increase in the money supply under a floating
exchange rate system. It shifts the LM* curve to the right which lowers the exchange
rate. This causes net exports to increase, which raises the level of income. Conversely, a
revaluation shifts the LM* curve to the left, raises the exchange rate and lowers the level
of income – see Figure 12-10.
If the government seeks to reduce imports by imposing an import quota or tariffs
(trade policy) the impact will be to shift the net export schedule to the right which in turn
shifts the IS* curve to the right and raises the exchange rate. To keep the rate at the fixed
level the money supply must rise, shifting the LM curve to the right thereby maintaining
the fixed exchange rate and causing output to rise. This result is significantly different
than trade restraint under a floating exchange rate system. Under a fixed exchange rate a
tariff or import quota raises aggregate income. It also raises net exports. In contrast in the
case of floating exchange rates neither income nor net exports are increased.
INTEREST RATE DIFFERENTIALS AND CHANGES IN THE PRICE LEVEL
IN A SMALL OPEN ECONOMY
Interest Rate Differentials in the Mundell-Fleming Model. In the ideal small
open economy where the law of one price prevails a country’s interest rate is equal to the
world interest rate r*. If the domestic interest rate were above the world rate, investors
from abroad would lend to that nation driving down the domestic interest rate.
Alternatively, if the nation’s interest rate were below the world interest rate domestic
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investors would lend abroad to secure higher returns, thereby driving up the national
interest rate. Thus, the country rate would stabilize at the world interest rate.
This paradigm assumes a universal fixed exchange rate system such as existed
under the international gold standard and the Bretton Woods Agreement. It also assumes
that the foreign country where the domestic funds are invested is stable socially and
politically. In effect, there is zero country risk.
Where one or both of these conditions do not prevail then lenders will require an
interest rate differential. In these cases the interest rate of a small open economy can
differ from those of other nations. In the case of possible exchange rate fluctuations
assume that the lending country i.e. the U.S. expects the borrowing nation's currency to
decline relative to its own. If this occurs interest payments and repayment of principal
will be paid in less valuable a currency than investments made domestically. This was
the case in the first half of 1999 for U.S. loans made to European Monetary Union
countries denominated in euros. The initial euro/U.S. dollar exchange rate at the euro's
inception on January 1, 1999 was $1.18. By the early summer it was approaching parity
with the dollar. The expectation was that further declines in the euro/dollar exchange rate
were likely. Accordingly, U.S. purchases or euro denominated bonds required an interest
rate differential to protect them from this possibility.
Similarly, domestic lenders who make foreign investments at the world interest
rate assume that the social and political conditions in the borrowing country are stable.
There is virtually little, if any, chance that interest and principal will not be paid
according to the terms of the loan contract. However, in the case of less developed
nations where there is a possibility of social or political upheaval, lenders require an
interest rate differential to compensate them for the country risk.
To incorporate interest rate differentials into the model we assume the small open
economy's interest rate is determined by the world interest rate plus a risk premium:
R = r* + 
The risk premium is a function of the expected change in the real exchange rate and the
perceived country risk. The risk premium (differential) is assumed to be exogenous to
the model. We can thus rewrite the model as follows:
IS*: Y = C(Y-T) + I(r* + ) + G + NX (e)
LM*:M/P = L(r* + , Y)
For any given fiscal policy, monetary policy, price level and risk premium, these
equations determine the level of output and the exchange rate that equilibrates the goods
market and the money market.
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Given an initial equilibrium any fiscal, monetary or trade policy or risk premium
changes will cause an adjustment in the output level and the exchange rate. For example,
assume that economic conditions in the European Monetary Union countries worsen
causing the risk premium to increase. This leads the domestic interest rate r to rise. The
higher interest rate impacts both the IS* and LM* curves. The IS* curve shifts to the left
since higher interest rates reduce investment expenditures. The LM* curve shifts to the
right because higher interest rates reduce the demand for money, allowing a higher output
level for any given money supply. These shifts cause the exchange rate to decline
(depreciate). In turn the lower exchange rate makes foreign goods more expensive and
domestic goods cheaper causing imports to fall and exports to rise. The resulting
increase in net exports more than offsets the decline in investments allowing the level of
output to rise -- see Figure 12-11.
CHANGES IN THE PRICE LEVEL
We need to make one further adjustment in the Mundell-Fleming model to bring
it closer to the real world. Thus far we have assumed that prices in the short run are
fixed. Although there are some short run prices which exhibit this behavior, most are
subject to change. As we have done previously when there are price level changes we
must distinguish between nominal and real values. Earlier we observed that the real
exchange rate  is equal to the nominal exchange rate e times the ration of the price levels
in the domestic and foreign countries P/P*.
In this context the Mundell-Fleming model equations are as we have seen them
before:
IS*: Y = C(Y-T) + I (r*) + G + NX ()
LM*: M/P = L(r*,Y)
Note that net exports depend on the real exchange rate .
We can now examine the impact of changes in the price level. To do this we
utilize the analysis used in the IS/LM closed economy context. Assume the price level
falls. The lower price level raises the level of real money balances M / P causing the
LM* curve to shift to the right. This in turn reduces (depreciates) the real exchange rate
and increases the level of output - see Figure 12-12 panel (a).
We can now derive an aggregate demand function for a small open economy with
a changing price level. Figure 12-12 panel (a) demonstrates that there is a negative
relationship between the price level and the quantity of output demanded. By extending
the two equilibrium points in Figure 12-12 panel (a) to the relationship between the price
level and the level of income we can construct an aggregate demand curve - see Figure
12-12 panel (b). Thus, the Mundell-Fleming aggregate demand curve is similar to that of
the IS/LM closed economy model. Policies that raise income in the Mundell-Fleming
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model shift the aggregate demand curve to the right while policies that lower income,
shift it to the left.
We can now extend this analysis to show how the short-run Mundell-Fleming
model is related to the long run in an open economy. You will observe that it is basically
the same analysis utilized in the closed economy context.
We assume initially that short-run prices are fixed. This is shown in Figure 1213. Panel (a) indicates that prices are fixed at LM* (P1). Point K is the equilibrium point
where aggregate supply intersects aggregate demand and equilibrates the exchange rate
and the level of output. This level of output is below the natural level Y . The resulting
increase in unemployment and decline in consumption demand causes workers to reduce
their wage rates and producers to lower the price of their goods, causing the price level to
fall over time. The decline in the level of prices shifts the LM* curve to the right. This
in turn lowers the real exchange rate causing net exports and the level of income to rise.
At the new equilibrium Point C, the economy is operating at its long run natural
equilibrium -- see Figure 12-13 panel (b).
THE IMPACT OF GOVERNMENT POLICIES IN LARGE OPEN ECONOMY IN
THE SHORT RUN
A Model of a Large Open Economy in the Short Run. As was the case in the
long run the major difference between a large and small open economy is that interest
rate is not fixed by the world financial market. Net foreign investment is a function of
the domestic interest rate: NFI = NFI (r). NFI varies inversely with r.
Utilizing the Mundell-Fleming model we can now construct a short run large open
economy model of national income. The equations are:
Y = C(Y-T) + I (r) + G + NX(e)
M/P = L(r,Y)
NX(e) = NFI(r)
The first two equations are the same as the small economy model. The third is a
restatement of the national income identity that: S - I = NX, where S - I = NFI. NX is a
function of the exchange rate e and NFI is a function of r.
By substituting the third equation into the first we can derive the IS and LM
equations for a large open economy in the short run:
IS: Y=C(Y-T) + I(r) + G +NFI (r)
LM: M/P = L(r, Y)
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The two equations are similar to those of a closed economy IS/LM model except
that the level of expenditures in the goods and service market is now dependent in part on
net foreign investment. Higher domestic interest rates not only reduce investments, but
net foreign investments and net exports as well. Lower interest rates have the opposite
effect.
To see how this model functions we use a three step process:
1.
2.
3.
The IS and LM curves determine the equilibrium interest rate and the level
of income;
The interest rate determines the level of net foreign investment;
Net foreign investment and the net export schedule determine the exchange
rate- see Figure 12-14. Note that the IS curve is flatter than in the closed
economy model. This is due to the net foreign investment term. The more
responsive NFI is to the interest rate r the flatter the IS curve is.
Government Policies under a Floating Exchange Rate System. We can now
utilize the model to determine the impact of government policies. Unlike the small open
economy model we need only to examine the case of floating exchange rates since most
large economies such as the U.S. utilize this exchange rate system.
Let us first look at fiscal policy. A policy of fiscal expansion -an increase in
expenditures or a reduction in taxes, shifts the IS curve outward. This causes the level of
income and the interest rate to rise. The higher interest rate causes a reduction in net
foreign investments which in turn reduces the supply of dollars in the foreign exchange
market. The exchange rate rises, causing domestic goods to become more expensive
relative to foreign goods and results in a decline in net exports -see Figure 12-15.
Note that as in the long run, the impact of fiscal policy in a large open economy
combines the impact of the closed economy with that of a small open economy. As in the
closed economy fiscal expansion does cause the level of income to rise unlike the small
open economy with floating exchange rates where income is unchanged. However, the
increase in income is smaller than in a closed economy. In a closed economy the
expansionary force of fiscal policy is partially offset by the crowding out of investment
reducing the fiscal policy multiplier. In a large open economy there is an additional
dampening influence on the rise in the income level. The higher interest rate also reduces
net foreign investment causing the exchange rate to appreciate. This in turn reduces net
exports which lowers the level of income. Combined, these effects do no completely
neutralize the effects of fiscal expansion but they do reduce its impact.
An increase in the money supply (monetary policy) shifts the LM curve to the
right causing the income level to rise and the interest rate to fall. This causes net foreign
investment to increase, which raises the supply of dollars in the foreign exchange market.
In turn as the exchange rate depreciates domestic goods become cheaper relative to
foreign goods, net exports rise lending to an increase in the level of income -see Figure
12-16.
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Note, once again the result is an average of the closed economy and the small
open economy models. In a closed economy a monetary expansion lowers the interest
rate and raises the level of income. In a small open economy since the interest rate is
fixed by the world interest rate, the domestic interest rate is unchanged. As soon as
increases in the money supply puts downward pressure on the domestic interest rate
capital (dollars- flows out of the domestic economy seeking higher interest rates abroad.
This in turn stimulates net exports. The large open economy's response to a monetary
expansion includes both the lower interest rate of a closed economy and the depreciation
of the foreign exchange rate of the small open economy.
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