Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Advanced International Economics

ECON 758 Professor Yamin Ahmad Lecture 12: Open Economy ISLM model Macroeconomic Policy

I This In Thi Lecture L t

1. Demand in the Open Economy F Focus On: O Trade T d Balance B l and d the th Real R lE Exchange h R Rate t
1. 2. 3.

Exchange Rate Pass-Through J-Curve J Curve and Current Account Dynamics Marshall Lerner Condition

2. Keynesian Cross in the Open Economy 3. Goods and Foreign Exchange Market Equilibria 4. Money Market Equilibrium 5. Macroeconomic Policy in the short run

Fixed versus Flexible Exchange Rate

6. Stabilization Policy
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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

D Demand di in th the O Open E Economy

To analyze macroeconomic fluctuations fluctuations, study how short-run shocks affect three markets.

P li i i and Preliminaries dA Assumptions ti

Two countries: home and rest of the world (ROW). Home and foreign price levels are fixed. Government spending and taxes are fixed. Foreign goods market and money market conditions are fixed and taken as given. GDP is taken to be the equivalent to Gross National Disposable Income (GDNI) Net Factor Income from Abroad ( (NFIA) ) = Net Unilateral Transfers (NUT) = 0, so Trade Balance (TB) = Current Account (CA).

Goods market (output) Money y market (money ( y and interest rates) ) Forex market (exchange rates)

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

C Consumption ti
Consumption is a function of disposable income:

C Consumption ti
Marginal effects

Slope of the consumption function is the marginal propensity to consume (MPC), 0 < MPC < 1.

Keynesian consumption function. As disposable income rises, consumption increases.

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Note: These lecture notes are incomplete without having attended lectures.

Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

I Investment t t
Firms engage in capital investment projects only if real return on the project > cost of borrowing.

I Investment t t
Investment demand is therefore:

Firm s borrowing cost is the expected real interest Firms rate:

Fixed prices means e = 0, so re = i. As nominal interest rate rises, expected real interest rate rises, so the volume of projects that are profitable declines and investment declines declines.
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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Th Government The G t
The government budget

Th Government The G t
Fiscal policy

Government collects taxes, T, and spends government consumption, g p , G, , on goods g and services.
G

Decisions about taxes and government consumption. p These values are taken as given:

does not include government transfer programs, designed to redistribute income income.

Governments tax revenue may not exactly equal its g government consumption p spending. p g
G G G

> T: Budget surplus. < T: Budget deficit. = T: T Balanced B l db budget. d t

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Th Trade The T d Balance B l

Factors affecting the trade balance

Th Trade The T d Balance B l

Factors affecting the trade balance

E Expenditure dit switching it hi

The

real exchange rate, q, is defined as:

Changes in home income, Y - T

(Y

- T) home country increases spending home country imports rise, TB

Changes

in q lead to expenditure switching between home and foreign goods and services:
q (real ( ld depreciation) i i ) foreign goods relatively more expensive home exports and home imports, TB

Changes in foreign income, Y* - T*

( (Y*

- T*) ) foreign country increases spending home country exports rise, TB

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Th Trade The T d Balance B l

Combining the three factors above (expenditure switching, home disposable income and foreign g disposable p income): )

Th Trade The T d Balance B l

Example: Increase in home income (Y - T)

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Soa g Loonie Soaring oo e Drives es Ca Canadian ad a Shoppers South

Background

Soa g Loonie Soaring oo e Drives es Ca Canadian ad a Shoppers South

Lessons

In 2007, Canadian dollar (loonie) reached U.S. dollar p parity y for the first time in three decades. Historically, E$/C$ < 1. Bellingham, WA dramatic increase in sales to Canadian consumers, with as much as one-half of business coming from Canada. The weaker U.S. U S dollar is coupled with lower taxes and sales designed to attract customers away from Canadian retailers.
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Inflow of Canadian customers means an increase not only y in p products that can be taken back to Canada, but also in spending at local restaurants and similar businesses in the U.S. There are barriers to expenditure switching: duties payable at the border, long waits at the border, and the cost of travel.

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

The Trade Balance

Marginal Effects

The e Trade ade Balance a a ce a and d Real ea Exchange c a ge Rates

Real effective exchange rate

Effect of a change g in output p on trade balance. Changes in income affect consumption:

MPC = marginal propensity to consume (all goods). MPCH = marginal i l propensity it t to consume h home goods. d MPCF = marginal propensity to consume foreign goods.

Measures real depreciation/appreciation in the U.S. relative to a basket of other countries (weighted by U.S. trade with each country). Empirical measure of q in the model. Expect to see a negative relationship between q and the trade balance.

The terms above divide consumption expenditures into two parts.

Consumption of home goods. Consumption of foreign goods goods.

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

The e Trade ade Balance a a ce a and d Real ea Exchange c a ge Rates

Empirical observations

The e Trade ade Balance a a ce a and d Real ea Exchange c a ge Rates

Empirical observations

Real effective exchange rate has a positive relationship p with the trade balance, , as expected. p

Negative correlation is not perfect.

Appears

to be a lag between when a real depreciation (appreciation) occurs and when the trade balance increases (decreases). lag is attributed to exchange rate pass-through and the J-curve effect.

This

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Barriers a e s to o Expenditure pe d u e S Switching: c g Pass-Through and the J Curve

Two key mechanisms at work when the real exchange rate changes.

Barriers a e s to o Expenditure pe d u e S Switching: c g Pass-Through and the J Curve

Trade Dollarization, Dollarization Distribution Distribution, and PassThrough

Local pricing. pricing

We

A nominal depreciation is associated with a real depreciation (since prices are fixed). The implied change in relative prices (increase in the relative price of foreign goods) reduces imports and increases exports.

assumed all prices are set in local currency and that these prices are fixed in the short run. h home goods d may b be priced i di in l local l currency. understand how this affects trade, define these two pricing schemes (treating the U.S. as the home country).
A share d of home-produced goods are priced in homecountry dollar at price: A share (1 - d) of home-produced goods are priced in local currency at price:

Some S To

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Barriers a e s to o Expenditure pe d u e S Switching: c g Pass-Through and the J Curve

Trade Dollarization, Dollarization Distribution Distribution, and PassThrough

Barriers a e s to o Expenditure pe d u e S Switching: c g Pass-Through and the J Curve

Trade Dollarization, Dollarization Distribution Distribution, and Pass PassThrough

Local pricing. pricing

The real exchange rate with local pricing. pricing

Define

the price of foreign goods relative to dollar-priced home goods and relative to local-currency priced home goods. goods

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Barriers a e s to o Expenditure pe d u e S Switching: c g Pass-Through and the J Curve

Trade Dollarization, Dollarization Distribution Distribution, and Pass PassThrough

Barriers a e s to o Expenditure pe d u e S Switching: c g Pass-Through and the J Curve

Trade Dollarization, Dollarization Distribution Distribution, and PassThrough

The real exchange rate with local pricing. pricing

Price

The real exchange rate with local pricing.

of goods sold in the home country, weighted by d, relative to those sold in the foreign country, weighted by (1 d) is the real exchange rate rate.
A

change in nominal exchange rate may not fully pass g to the real exchange g rate, , q. through
A 1% increase in E leads to a (1-d)% increase in q. This is known as exchange rate pass-throughthe degree g in nominal exchange g rates are p passed to which changes through to real exchange rates. In the model in the text, we assume d=0.

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Barriers a e s to o Expenditure pe d u e S Switching: c g Pass-Through and the J Curve

Trade Dollarization, Dollarization Distribution Distribution, and PassThrough

Barriers a e s to o Expenditure pe d u e S Switching: c g Pass-Through and the J Curve

Trade Dollarization, Dollarization Distribution Distribution, and Pass PassThrough

Limitations on pass-through pass through.

Trade

Limitations on pass-through pass through.

Distribution.

dollarization.

If a large share of the trade balance is denominated in U.S. dollars then a depreciation/appreciation of the U dollars, U.S. S dollar relative to the home currency will have little effect on the trade of these goods.

Time and cost associated with moving a good from the port to the local retailer. retailer Changes in the exchange rate affect the price of the good at the port, but have no effect on the mark-ups between the port and the retailer retailer.

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Barriers a e s to o Expenditure pe d u e S Switching: c g Pass-Through and the J Curve

The J-Curve

Barriers a e s to o Expenditure pe d u e S Switching: c g Pass-Through and the J Curve

The J-Curve

Model versus the data.

Model: Data:

Example: depreciation in home currency.

While

a real depreciation improves a countrys country s trade balance through boosting exports and reducing imports.

exports continue to sell, in same quantity at same domestic price, domestic price paid for imports rises.
Thus, the quantity of imports into the country stays the , but these goods g cost more, , increasing g total spending p g same, on imports. So, before firms adjust orders, total spending on imports rises, total spending on exports remains the same, so trade balance drops.

depreciation in currency is associated with an increase in imports in the very short run run, followed by the expected increase in the trade balance thereafter. the disconnect?
Adj Adjustment t ti in t trade d b balance l t takes k ti time b because orders d f for exports and imports are placed in advance.

Why

Eventually,

firms adjust their orders, and trade balance recovers, consistent with expenditure switching.

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Barriers a e s to o Expenditure pe d u e S Switching: c g Pass-Through and the J Curve

The J-Curve

Th Marshall-Lerner The M h ll L C diti Condition

Overview

Example: depreciation p in home currency

Reconsider the assumption that a depreciation leads to an increase in the trade balance. For simplicity, assume TB = 0, therefore EX = IM. q = home country real exchange rate. q* = foreign country real exchange rate. q

1% real depreciation in home country.

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Th Marshall-Lerner The M h ll L C diti Condition

Elasticity

Th Marshall-Lerner The M h ll L C diti Condition

Home imports and foreign exports

Elasticity of home exports with respect to home real exchange g rate, , :

Home imports (in units of home output)

Foreign exports (in units of home output)

Elasticity of foreign exports with respect to foreign real exchange rate, *:

Notice EX* = IM, from the home countrys perspective. Therefore:

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Th Marshall-Lerner The M h ll L C diti Condition

Real exchange rate

Th Marshall-Lerner The M h ll L C diti Condition

Marshall-Lerner condition

The real exchange rate converts foreign exports into home country y output p ( (recall q = ratio of home to foreign basket of goods). In % changes, the previous expression is:

The trade balance will increase following a depreciation only if trade volume changes are sufficiently large (e.g. they are sufficiently elastic) to offset the price effects effects. Helps us to explain the J-curve effect.
Volumes

In percentage changes, assuming a 1% real depreciation in the home country:

relatively unchanged in the very short run following a depreciation, but price effect still affects the value of imports, causing a decrease in trade balance. the volume effects overwhelm the price effect, effect so the trade balance rises.
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Eventually, Eventually
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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Th Marshall-Lerner The M h ll L C diti Condition

Two effects from a depreciation

Exogenous Changes in Demand

An exogenous change in consumption, C.

Exogenous increase in consumption

C(Y For

T) shifts up.

any given level of disposable income, consumption increases, shifting the consumption function upward.

Volume Effect: -*% Foreigners export a lower volume of more expensive goods measured in foreign output units. Price Effect: +1% Goods cost more in terms of home output.
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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Demand in the Open Economy

Exogenous Changes in Demand

Exogenous Changes in Demand

An exogenous change in the trade balance

An exogenous change in investment investment, I I.

Exogenous

Exogenous increase trade balance

TB()shifts For

increase investment: I(i) shifts right. For any given interest rate, investment is higher, shifting the investment function to the right right. decrease investment: I(i) shifts left.

up.

any given real exchange rate, trade balance is higher, shifting hifti th the t trade d b balance l f function ti upward. d

Exogenous

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

S Supply l and dD Demand d

The total aggregate supply of final goods and services is equal to total output, GDP = Y: Supply = GDP = Y The demand for goods and services is given by the components defined above: Demand = D = C + I + G + TB
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S Supply l and dD Demand d

National income accounting identity shows supply of output is equal to demand for final goods and services. g

The national income accounting identity, using the functions given above, is expressed as:

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

D t Determinants i t of f Demand D d
Changes in income income, Y

Goods Market Equilibrium: the Keynesian Cross

Determinants of Demand

Consumption increases when Y increases.

Keynesian cross.
Demand

for goods and services. services

D = C + I + G + TB. Slope = MPCH.

Trade balance decreases when Y increases.

45-degree 45 d

li line.

D = Y (from national income identity). Slope = 1.

Goods

Therefore, the total change in output is:

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market equilibrium is given by the intersection of demand and supply (Y = C + I + G + TB).

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

D t Determinants i t of f Demand D d
Keynesian cross

D t Determinants i t of f Demand D d
Income and demand

Keynesian Cross
Adjustment

to equilibrium.

Point 2: Y2 < Y1 D > Y inventories decline firms expand production until D = Y. Point 3: Y3 > Y1 D < Y inventories rise firms d decrease production d ti until til D = Y Y.
Note:

fixed-price assumption is crucial here.

Employment and production will change according to the demand for goods and services (since prices cannot adjust to achieve equilibrium).

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

F t Factors that th t Shift the th Demand D d Curve C

Changes in taxes taxes, T T.

F t Factors that th t Shift the th Demand D d Curve C

Changes in the interest rate rate, I I.

Changes in government consumption, G.

Changes in the nominal exchange rate, E.

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

F t Factors that th t Shift the th Demand D d Curve C

Example: increase in demand.

Expenditure pe d u e S Switching c ga and d the e Dollar o a Devaluation: Some Headlines

Background

20012004, U.S. dollar depreciated against major currencies. Model predictions

US$

depreciation leads to an increase in exports and the U.S. trade balance, as this implies a real depreciation in the U.S. dollar (assuming fixed prices). the rest of the world, this would lead to a decrease in ROWs exports (a decrease in U.S. imports) and an increase in ROWs imports (an increase in U.S. exports).

For

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Expenditure pe d u e S Switching c ga and d the e Dollar o a Devaluation: Some Headlines

Financial Times Times, January 9 9, 2004

Expenditure pe d u e S Switching c ga and d the e Dollar o a Devaluation: Some Headlines

Financial Times Times, January 13 13, 2004

Dollars dive set to delight exporters as well as tourists U.S. exports rise and tourists visiting the U.S. from abroad enjoy relatively cheaper U.S. goods. Euros E rapid id rise i worries i ECB ECB policy makers concerned with excessive volatility y in forex markets and how euro appreciation will affect regions competitiveness.

Euro erodes Germanys role as an industrial p powerhouse Dollars depreciation speeds up industrial decline in Germany, as companies struggle to cut costs and increase productivity. productivity Strong currency hits Australians Australian manufacturers consider moving g operations overseas as the Australian dollar appreciates. The appreciation in the Australian dollar means decreased export returns returns.
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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

G d Market Goods M k t Equilibrium: E ilib i S Summary

The Keynesian cross is derived based on the relationship between the demand for goods and services, which depends on income, and the supply, or output, t t Y. Y Changes in demand NOT associated with ith changes in output (Y) lead to a shift in the demand curve for goods and services.

E ilib i Equilibrium i in T Two M Markets k t

The IS curve shows combinations of output Y and interest rate i such that the goods and forex markets are in equilibrium. q IS curve plotted with interest rate i on the vertical e t ca a axis sa and d output Y o on t the e horizontal o o ta axis.

The goods market shares the same horizontal axis. The forex market shares the interest rate i as its vertical ertical axis. a is
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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

F Forex Market M k t Recap R

Forex market equilibrium is given by the uncovered interest parity condition (UIP).

D i i th Deriving the IS C Curve

Initial equilibrium

Equilibrium output and interest rate are given from the g goods market and forex market.
Goods

Arbitrage g

Return on domestic deposits equals expected return on foreign deposits (in home currency terms). Forex market equilibrium determines equilibrium interest rate, rate i and nominal exchange rate rate, E. E
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market: the level of output (Y) from the goods market equilibrium must be a point on the IS curve. This is a level of output where demand and supply are equal equal, D = Y.

Forex

market: the equilibrium interest rate (i) and exchange rate (E) insure the UIP condition is met met, where Domestic Return (DR) = Foreign Return (FR).

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Goods and Forex Market Equilibria: The IS Curve

Deri Deriving ing the IS Curve

Deriving the IS Curve

A Fall in the Interest Rate

Effects on the markets

Goods Forex

A fall in the Interest Rate

A decrease in the interest rate leads to an increase in demand (a) and an increase in the domestic return (c).

market: i I(i)DY market: i DRETBDY Negative relationship between i and Y in goods and forex markets illustrated as a downward sloping IS curve

Two channels: investment demand and external demand

Decrease

in interest rate reduces the cost of borrowing, so more investment projects are profitable. Expenditure switching: a decrease in the interest rate y and a real leads to a depreciation in the home currency, depreciation, increasing the trade balance.
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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Factors that Shift the IS Curve

Government consumption, G.

Factors that Shift the IS Curve

Foreign interest rate, i*, or expected p exchange g rate Ee.

G D Y for given i and E IS shifts right right. G D Y for given i and E IS shifts left.

i* or Ee FR E D IS shifts right. i* or Ee FR E D IS shifts left.

Taxes, T.

T (Y T) C D Y for given i and E IS shifts right. T (Y T) C D Y for given i and E IS shifts left. left
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Home or foreign price level, P or P*. P.

P or P* q TB D IS shifts right. P or P P* q TB D IS shifts left.

IS curve can be expressed as:

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Note: These lecture notes are incomplete without having attended lectures.

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Factors that Shift the IS Curve

Example: exogenous increase in demand.

Summing Up the IS Curve

IS curve is downward sloping

A decrease in the interest rate leads to an increase in investment demand and the trade balance. This increases the demand for goods and therefore output, in the short run run.

Shifts in the IS curve are associated with shifts in demand for a given home interest rate. Changes in interest rates have indirect effects on demand through their effect on exchange rates ( (expenditure dit switching). it hi )
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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Money Market Recap

The LM curve shows combinations of output and the nominal interest rate such that the money market is in equilibrium.

Deriving the LM Curve

The money market and the LM diagram share a vertical axis (the interest rate). Example: Increase in output.

Money market equilibrium

When output increases, money demand increases. MD shifts to the right and the interest rate rises. Hence, we observe a positive relationship between the interest rate and output in the money market market. This implies the LM curve is upward sloping.

Real

money demand (MD) varies inversely with the nominal interest rate, so the demand for real money balances is downward sloping. money supply (MS) is fixed, with the price level fixed pp y of money y chosen by y the central bank. and the supply
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Real

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Deriving the LM Curve

Example: Increase in output.

Factors that Shift the LM Curve

The only exogenous factor that shifts the LM curve is the real money supply, M/P.

M/P i for given Y LM shifts right/down. right/down M/P i for given Y LM shifts left/up.

LM curve can be expressed as:

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Factors that Shift the LM Curve

Example: Increase in the money supply.

Summing Up the LM Curve

The LM curve is upward sloping

An increase in output leads to an increase in real money demand. This increases the nominal interest rate in the short run. Similarly, Si il l a d decrease i in output reduces d real l money demand and the nominal interest rate.

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Short Run IS-LM-FX Short-Run IS LM FX Model of an Open Economy

Overview

Macroeconomic Policies in the Short Run

Two policy actions

Combine the IS-LM diagram with the forex market diagram to study how changes in the economy affect ff t key k macroeconomic i variables. i bl

Monetary policy: central bank changes in the money supply. Fiscal policy: government changes in taxes and government spending.

The effects of these policies depend critically on the nations exchange rate regime.

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Macroeconomic Policies in the Short Run

Assumptions p

Short Run IS-LM-FX Short-Run IS LM FX Model of an Open Economy

Monetary Policy under Floating Exchange Rates

Economy begins at long-run equilibrium. Sticky prices at home and abroad. Fl ti exchange Floating h rate t regime. i

Monetary expansion: M/P LM shifts right i

Direct

effects

i IY

Temporary Policies, Policies Unchanged Expectations

E TB Y i
Indirect

To examine temporary shocks to the economy, we assume investors do not change exchange rate expectations. Simplifies Si lifi th the study t d h how t temporary policies li i (d (designed i dt to affect ff t output in the short run) affect the economy.

effects

Y C Y IM TB (net TB if MPCF small)

A

monetary expansion leads to an exchange rate depreciation and a decrease in the interest rate both of these imply an increase in output output.
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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Monetary Policy under Floating Exchange Rates

Example: Monetary expansion

Monetary Policy under Fixed Exchange Rates

Consider possible monetary changes.

A monetary contraction will have the reverse effects.

Monetary expansion: M/P LM shifts right LM must shift back to keep the exchange rate fixed. Monetary contraction: same basic result result.

If committed to a fixed exchange rate regime, central bank cannot change real money supply.

Changing the real money supply affects the interest rate, and therefore exchange rate through affecting the return on domestic deposits. Therefore, a fixed exchange rate regime implies that autonomous monetary policy is not an option option.
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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Example: Monetary expansion

Monetary o e a y Policy o cy u under de Fixed ed Exchange c a ge Rates

Fiscal sca Policy o cy u under de Floating oa g Exchange c a ge Rates

Fiscal expansion: p G IS shifts right g

Direct effect
GY

Indirect effects
i

I TB

A fiscal expansion leads to crowding out because it leads to an increase in the interest rate.
Investment

demand decreases. decreasing trade balance.

Appreciation,

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Fiscal sca Policy o cy u under de Floating oa g Exchange c a ge Rates

Fiscal expansion p

Fiscal Policy under Fixed Exchange Rates

Mechanics of a fixed exchange rate regime.

Real money supply must adjust to keep the E fixed fixed. This implies that any fiscal policy action will require a central bank action, shifting the LM curve.

A fiscal contraction will have the reverse effects.

Fiscal expansion: p G IS shifts right g LM must shift right to keep the i and E unchanged.

Effects
GY. M/P

i and E unchanged.

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Notice, N ti i in thi this case, a fi fiscal l expansion i d does not tl lead d to crowding out.
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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Fiscal Policy under Fixed Exchange Rates

Fiscal expansion

Summary
The responses to expansionary policy are summarized below. below

A fiscal contraction will have the reverse effects effects.

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Summary
Floating exchange rate regime: two channels for monetary policy and fiscal policy to affect demand.

The e Rise se a and d Fall a o of the e Dollar o a in the e 1980s

Policy actions circa 1980

Monetary policy: effects are magnified by appreciation/depreciation. Fiscal p policy: y crowding g out means effects of p policy y are weakened by appreciation/depreciation.

The Fed implemented contractionary monetary policy p y 19791982. LM curve shifts left. At the same time, the Reagan administration implemented a fiscal expansion through a combination of tax cuts and increases in government spending. IS curve shifts right. U.S. U S suffered recessions 1980 and 198182 198182, suggesting monetary contraction has a larger effect than the fiscal expansion.
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Fi Fixed d exchange h rate t regime: i autonomous t monetary policy not possible, but fiscal policy still an option option.
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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

The e Rise se a and d Fall a o of the e Dollar o a in the e 1980s

Model predictions

The e Rise se a and d Fall a o of the e Dollar o a in the e 1980s

Model predictions

Increase in nominal interest rate. Appreciation in the U U.S. S dollar dollar. Decrease in investment and the trade balance. Roughly 25% real appreciation in U.S. Investment declines from 19% to 16% of GDP GDP. Trade balance declines from -1% to -3% of GDP (with a lag). ( g)
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Data

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

The e Rise se a and d Fall a o of the e Dollar o a in the e 1980s

St bili ti Policy Stabilization P li

Stabilization policy refers to monetary and fiscal policies designed to keep output at its full employment p y level.

If the economy experiences an adverse shock

fiscal

policy can increase demand through shifting the IS curve to the right, or, policy can expand the money supply, shifting the LM curve to the right.

monetary

Stabilization policy can be challenging in practice. Mistimed or inappropriate policies can push output beyond full employment, employment creating instability. instability
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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Australia, us a a, New e Zealand, ea a d, a and d the e Asian sa Crisis of 1997

Australia and New Zealand are open economies that rely on export demand from East Asian economies.

Australia, us a a, New e Zealand, ea a d, a and d the e Asian sa Crisis of 1997

Stabilization policythe policy the model

Fiscal or monetary expansion.

Central

In 1997, the East Asian economic crisis lead to a recession in these countries, reducing demand for exports from Australia and New Zealand. A decrease in foreign output Y* leads to a decrease in the home countrys country s trade balance (through decreasing exports). This would lead to an economic contraction in Australia and New Zealand.
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banks in both countries expanded real money supply, shifting LM curve right, reducing interest rates. Model: net effect of decrease in export demand and monetary expansion is as follows:
No change in output. Decrease in nominal interest rateinvestment increases. Increase in exchange rateambiguous effect on the trade b l balance b because d decrease i in f foreign i i income reduces d exports while depreciation increases exports.

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Australia, us a a, New e Zealand, ea a d, a and d the e Asian sa Crisis of 1997

Stabilization policy policythe the model

Australia, us a a, New e Zealand, ea a d, a and d the e Asian sa Crisis of 1997

Stabilization policy the data

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Australia, us a a, New e Zealand, ea a d, a and d the e Asian sa Crisis of 1997

Stabilization policy policythe the data

Problems ob e s in Policy o cy Design es g & Implementation

Policy Constraints

Both countries experienced a sharp decrease in nominal interest rates accompanied p by y depreciations. The declines in the trade balance were slowed and even reversed by 1999.

Policy makers may not have the freedom to implement p stabilization p policies. Fixed exchange rates or other rules for policy may limit their ability to respond.

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Problems ob e s in Policy o cy Design es g & Implementation

Incomplete Information and the Inside Lag

Problems ob e s in Policy o cy Design es g & Implementation

Policy Response and the Outside Lag

Model assumes policy makers observe state of the economy y in real time. In practice, they observe macroeconomic data with a lag.
The In

Even with perfect information on the economy, it may y take time for a p policy, y, once implemented p to have real economic effects. This is known as an outside lag. With monetary policy, it may take time for a change in the money supply to affect the long-term interest rates that matter for investment.

lag between the timing of the shock and the policy action is known as an inside lag. addition, , institutional factors severely y limit the timely y implementation of fiscal policy.

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Problems ob e s in Policy o cy Design es g & Implementation

Long-Horizon Long Horizon Plans

Problems ob e s in Policy o cy Design es g & Implementation

Weak Links from the Nominal Exchange Rate to the Real Exchange Rate.

If households and businesses making decisions about consumption p and investment p plan over long g horizons, they may be less responsive to policy changes.
Example: E l

Model assumes changes in nominal exchange rates translate into changes in real exchange rate. In practice, limited pass-through between nominal and real exchange rates for several reasons:
dollarization large

ab business i considers id b borrowing i t to fi finance capital expansion

Business is likely borrow over a long period of time. Slightly higher interest rates today may be unsuccessful in deterring this investment decision, since the business knows higher interest rates are temporary.

of trade,

distribution margins that create a wedge between port prices relative to retail, imperfect competition, and to market.

pricing

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Problems ob e s in Policy o cy Design es g & Implementation

Pegged Currency Blocs

Problems ob e s in Policy o cy Design es g & Implementation

Weak Links from the Real Exchange Rate to the Trade Balance.

Some countries use a combination of fixed and floating g exchange g rates in a way y that limits one country from boosting export demand through a real effective depreciation. If a large country in the currency bloc pegs to a country like the U.S., this limits the U.S. ability to increase external demand through g a depreciation p in the dollar

Model assumes changes in real exchange rate imply changes in trade balance. In practice, the link between the two may be weak because of transactions costs.
The

existence of these costs suggests a neutral band (band of inaction) where it is not worthwhile for businesses to engage in expenditure switching and lead to the J-curve effect.

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

K P Key Points i t
1 The key short-run 1. short run assumptions are that prices are fixed and there are two countries: home and rest of the world. 2. The demand for goods and services is determined dete ed by

K P Key Points i t
3 The demand for goods and services must be 3. equal to supply.

Y = C + I + G + TB. TB This condition is used to derive the goods market equilibrium using the Keynesian cross. Exogenous changes in demand arise from changes in C, I, G, or TB, unrelated to a change in output output.

Consumptiondepends on disposable income. Investmentdepends p on the interest rate. Government consumption. Trade balancedepends p on the real exchange g rate, home income, and foreign income.
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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

K P Key Points i t
4. The IS curve represents equilibrium in two markets: k t the th goods d and df forex markets. k t

K P Key Points i t
5. The LM curve represents money market equilibrium.

The uncovered interest parity condition defines the forex market equilibrium in terms of the interest rate and exchange rate. If the interest rate falls, output p increases for two reasons

The interest rate adjusts in the money market to ensure real money demand equals real money supply. S s in the Shifts e LM cu curve ea are e caused by c changes a ges in real money supply.

an increase in investment, and an increase in trade balance (from a real depreciation)

Shifts in the IS curve are caused by exogenous changes g in demand, , unrelated to changes g in output or the real interest rate.
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6. The IS-LM diagram g combines the IS and LM curves, identifying a unique combination of output, interest rate, and exchange rate such th t all that ll th three markets k t are i in equilibrium. ilib i
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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

K P Key Points i t
7. Floating exchange rate regime.

K P Key Points i t
9 Stabilization policy can be used to keep 9. output unchanged when the economy experiences p shocks. 10. There are problems with stabilization policy that t at limit t the t e policy po cy makers a e s in p practice. act ce

Monetary expansion: LM shifts right, output rises, interest rate falls, and exchange rate depreciation. Fiscal expansion: IS shifts right, output rises, interest rate rises, and exchange rate appreciation. No autonomous monetary policy. Fiscal expansion: IS shifts right and LM shifts right i ht t to keep k exchange h rate t fixed, fi d output t t rises, i and interest rate and exchange rate unchanged.
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8. Fixed exchange rate regime.

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