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1 0 Econ 101 Intermediate Macro Theory Lecture notes Professor Cetorelli UC Davis Fall 2003 Lecture 22 24 macroeconomics fifth edition N Gregory Mankiw PowerPoint Slides by Ron Cronovich macro 2003 Worth Publishers all rights reserved CHAPTER TWELVE Aggregate Demand in the Open Economy CHAPTER 12CHAPTER 12Aggregate Demand in the Open EconomyAggregate Demand in the Open Economy slide 2 Learning objectivesLearning objectives The Mundell Fleming model IS LMfor the small open economy Analysis of small open economy in the short run Hence prices of goods both domestic and foreign are assumed to be fixed CHAPTER 12CHAPTER 12Aggregate Demand in the Open EconomyAggregate Demand in the Open Economy slide 3 Key assumption Small open economy with perfect capital mobility r r r r r Capital flows r r Capital inflows Purchase of US bonds r down again 2 CHAPTER 12CHAPTER 12Aggregate Demand in the Open EconomyAggregate Demand in the Open Economy slide 4 This assumption is really important in this context It changes dramatically the way variables interact with each other and how policy may affect the macroeconomic equilibrium CHAPTER 12CHAPTER 12Aggregate Demand in the Open EconomyAggregate Demand in the Open Economy slide 5 The The MundellMundell Fleming ModelFleming Model Goods market equilibrium the IS curve YC YTI rGNX e where e nominal exchange rate foreign currency per unit of domestic currency Remember P and P are by assumption fixed so we can focus on nominal exchange rate CHAPTER 12CHAPTER 12Aggregate Demand in the Open EconomyAggregate Demand in the Open Economy slide 6 The The IS IS curve Goods Market curve Goods Market Eq mEq m The IS curve is drawn for a given value of r Intuition for the slope Y e IS YC YTI rGNX e eNXY Please pay attention to which variables are now on the axes We now describe the equilibrium in the space of e and Y CHAPTER 12CHAPTER 12Aggregate Demand in the Open EconomyAggregate Demand in the Open Economy slide 7 The The LM LM curve Money Market curve Money Market Eq mEq m The LM curve is drawn for a given value of r is vertical because given r there is only one value of Y that equates money demand with supply regardless of e Y e LM M PL rY 3 CHAPTER 12CHAPTER 12Aggregate Demand in the Open EconomyAggregate Demand in the Open Economy slide 8 Equilibrium in the Equilibrium in the MundellMundell Fleming modelFleming model Y e LM M PL rY IS YC YTI rGNX e equilibrium exchange rate equilibrium level of income CHAPTER 12CHAPTER 12Aggregate Demand in the Open EconomyAggregate Demand in the Open Economy slide 9 Floating fixed exchange ratesFloating fixed exchange rates In a system of floating exchange rates eis allowed to fluctuate in response to changing economic conditions In contrast under fixed exchange rates the central bank trades domestic for foreign currency at a predetermined price We now consider fiscal monetary and trade policy first in a floating exchange rate system then in a fixed exchange rate system CHAPTER 12CHAPTER 12Aggregate Demand in the Open EconomyAggregate Demand in the Open Economy slide 10 Fiscal policy under floating exchange ratesFiscal policy under floating exchange rates Y e M PL rY YC YTI rGNX e Y1 e1 1 LM 1 IS 2 IS e2 At any given value of e a fiscal expansion increases Y shifting IS to the right Results e 0 Y 0 CHAPTER 12CHAPTER 12Aggregate Demand in the Open EconomyAggregate Demand in the Open Economy slide 11 Intuition for the results Intuition for the results As we learned in earlier chapters a fiscal expansion puts upward pressure on the country s interest rate In a small open economy with perfect capital mobility as soon as the domestic interest rate rises even the tiniest bit about the world rate tons of foreign financial capital will flow in to take advantage of the rate difference 4 CHAPTER 12CHAPTER 12Aggregate Demand in the Open EconomyAggregate Demand in the Open Economy slide 12 Intuition for the results Intuition for the results But for foreigners to buy these U S bonds they must first acquire U S dollars Hence the capital inflows result in an increase in foreign demand for dollars in the foreign exchange market causing the dollar to appreciate This appreciation makes exports more expensive to foreigners and imports cheaper to people at home and thus causes NX to fall The fall in NX offsets the effect of the fiscal expansion CHAPTER 12CHAPTER 12Aggregate Demand in the Open EconomyAggregate Demand in the Open Economy slide 13 Lessons about fiscal policyLessons about fiscal policy In a small open economy with perfect capital mobility and floating exchange rates fiscal policy cannot affect real GDP Crowding out closed economy Fiscal policy crowds out investment by causing the interest rate to rise small open economy Fiscal policy crowds out net exports by causing the exchange rate to appreciate CHAPTER 12CHAPTER 12Aggregate Demand in the Open EconomyAggregate Demand in the Open Economy slide 14 Mon policy under floating exchange ratesMon policy under floating exchange rates Y e M PL rY YC YTI rGNX e e1 Y1 1 LM 1 IS Y2 2 LM e2 An increase in Mshifts LM right because Y must rise to restore eq m in the money market Results e 0 CHAPTER 12CHAPTER 12Aggregate Demand in the Open EconomyAggregate Demand in the Open Economy slide 15 Intuition for the results Intuition for the results Initially the increase in the money supply puts downward pressure on the interest rate In a closed economy the interest rate would fall Because the economy is small and open when the interest rate tries to fall below r savers send their loanable funds to the world financial market This capital outflow causes the exchange rate to fall which causes NX and hence Y to increase 5 CHAPTER 12CHAPTER 12Aggregate Demand in the Open EconomyAggregate Demand in the Open Economy slide 16 Lessons about monetary policyLessons about monetary policy Monetary policy affects output by affecting one or more of the components of aggregate demand closed economy M r I Y small open economy M e NX Y Expansionary monetary policy does not raise world aggregate demand it shifts demand from foreign to domestic products Thus the increases in income and employment at home come at the expense of losses abroad CHAPTER 12CHAPTER 12Aggregate Demand in the Open EconomyAggregate Demand in the Open Economy slide 17 Trade policy under floating exchange ratesTrade policy under floating exchange rates M PL rY YC YTI rGNX e Y e e1 Y1 1 LM 1 IS 2 IS e2 At any given value of e a tariff or quota reduces imports increases NX and shifts IS to the right Results e 0 Y 0 CHAPTER 12CHAPTER 12Aggregate Demand in the Open EconomyAggregate Demand in the Open Economy slide 18 Lessons about trade policyLessons about trade policy Import restrictions cannot reduce a trade deficit Even though NXis unchanged there is less trade the trade restriction reduces imports the exchange rate appreciation reduces exports Less trade means fewer gains from trade Import restrictions on specific products save jobs in the domestic industries that produce those products but destroy jobs in export producing sectors Hence import restrictions fail to increase total employment Worse yet import restrictions create sectoral shifts which cause frictional unemployment CHAPTER 12CHAPTER 12Aggregate Demand in the Open EconomyAggregate Demand in the Open Economy slide 19 Fixed exchange ratesFixed exchange rates Under a system of fixed exchange rates the country s central bank stands ready to buy or sell the domestic currency for foreign currency at a predetermined rate In the context of the Mundell Fleming model the central bank shifts the LM curve as required to keep eat its preannounced rate This system fixes the nominal exchange rate In the long run when prices are flexible the real exchange rate can move even if the nominal rate is fixed 6 CHAPTER 12CHAPTER 12Aggregate Demand in the Open EconomyAggregate Demand in the Open Economy slide 20 Fiscal policy under fixed exchange ratesFiscal policy under fixed exchange rates Y e Y1 e1 1 LM 1 IS 2 IS Under floating rates a fiscal expansion would raise e Results e 0 Y 0 Y2 2 LM To keep efrom rising the central bank must sell domestic currency which increases M and shifts LM right Under floating rates fiscal policy ineffective at changing output Under fixed rates fiscal policy is very effective at changing output CHAPTER 12CHAPTER 12Aggregate Demand in the Open EconomyAggregate Demand in the Open Economy slide 21 Mon policy under fixed exchange ratesMon policy under fixed exchange rates 2 LM An increase in Mwould shift LM right and reduce e Y e Y1 1 LM 1 IS e1 To prevent the fall in e the central bank must buy domestic currency which reduces Mand shifts LM back left Results e 0 Y 0 Under floating rates monetary policy is very effective at changing output Under fixed rates monetary policy cannot be used to affect output 2 LM CHAPTER 12CHAPTER 12Aggregate Demand in the Open EconomyAggregate Demand in the Open Economy slide 22 Trade policy under fixed exchange ratesTrade policy under fixed exchange rates Y e Y1 e1 1 LM 1 IS 2 IS A restriction on imports puts upward pressure on e Results e 0 Y 0 Y2 2 LM To keep efrom rising the central bank must sell domestic currency which increases M and shifts LM right Under floating rates import restrictions do not affect Yor NX Under fixed rates import restrictions increase Yand NX But these gains come at the expense of other countries as the policy merely shifts demand from foreign to domestic goods CHAPTER 12CHAPTER 12Aggregate Demand in the Open EconomyAggregate Demand in the Open Economy slide 23 MM F summary of policy effectsF summary of policy effects 0 0 0import restriction 000 mon expansion 00 0fiscal expansion NXeYNXeYPolicy impact on fixedfloating type of exchange rate regime 7 CHAPTER 12CHAPTER 12Aggregate Demand in the Open EconomyAggregate Demand in the Open Economy slide 24 Fixed exchange ratesFixed exchange rates Under a system of fixed exchange rates the country s central bank stands ready to buy or sell the domestic currency for foreign currency at a predetermined rate In the context of the Mundell Fleming model the central bank shifts the LM curve as required to keep eat its preannounced rate This system fixes the nominal exchange rate In the long run when prices are flexible the real exchange rate can move even if the nominal rate is fixed CHAPTER 12CHAPTER 12Aggregate Demand in the Open EconomyAggregate Demand in the Open Economy slide 25 Fiscal policy under fixed exchange ratesFiscal policy under fixed exchange rates Y e Y1 e1 1 LM 1 IS 2 IS Under floating rates a fiscal expansion would raise e Results e 0 Y 0 Y2 2 LM To keep efrom rising the central bank must sell domestic currency which increases M and shifts LM right Under floating rates fiscal policy ineffective at changing output Under fixed rates fiscal policy is very effective at changing output CHAPTER 12CHAPTER 12Aggregate Demand in the Open EconomyAggregate Demand in the Open Economy slide 26 Mon policy under fixed exchange ratesMon policy under fixed exchange rates 2 LM An increase in Mwould shift LM right and reduce e Y e Y1 1 LM 1 IS e1 To prevent the fall in e the central bank must buy domestic currency which reduces Mand shifts LM back left Results e 0 Y 0 Under floating rates monetary policy is very effective at changing output Under fixed rates monetary policy cannot be used to affect output 2 LM CHAPTER 12CHAPTER 12Aggregate Demand in the Open EconomyAggregate Demand in the Open Economy slide 27 Trade policy under fixed exchange ratesTrade policy under fixed exchange rates Y e Y1 e1 1 LM 1 IS 2 IS A restriction on imports puts upward pressure on e Results e 0 Y 0 Y2 2 LM To keep efrom rising the central bank must sell domestic currency which increases M and shifts LM right Under floating rates import restrictions do not affect Yor NX Under fixed rates import restrictions increase Yand NX But these gains come at the expense of other countries as the policy merely shifts demand from foreign to domestic goods 8 CHAPTER 12CHAPTER 12Aggregate Demand in the Open EconomyAggregate Demand in the Open Economy slide 28 MM F summary of policy effectsF summary of policy effects 0 0 0import restriction 000 mon expansion 00 0fiscal expansion NXeYNXeYPolicy impact on fixedfloating type of exchange rate regime CHAPTER 12CHAPTER 12Aggregate Demand in the Open EconomyAggregate Demand in the Open Economy slide 29 InterestInterest rate differentialsrate differentials Two reasons why rmay differ from r country risk The risk that the country s borrowers will default on their loan repayments because of political or economic turmoil Lenders require a higher interest rate to compensate them for this risk expected exchange rate changes If a country s exchange rate is expected to fall then its borrowers must pay a higher interest rate to compensate lenders for the expected currency depreciation CHAPTER 12CHAPTER 12Aggregate Demand in the Open EconomyAggregate Demand in the Open Economy slide 30 Differentials in the MDifferentials in the M F modelF model where is a risk premium Substitute the expression for rinto the IS and LM equations M PL rY YC YTI rGNX e rr CHAPTER 12CHAPTER 12Aggregate Demand in the Open EconomyAggregate Demand in the Open Economy slide 31 The effects of an increase in The effects of an increase in 2 LM IS shifts left because r I Y e Y1 e1 1 LM 1 IS LM shifts right because r M P d so Ymust rise to restore money market eq m Results e 0 2 IS e2 Y2 9 CHAPTER 12CHAPTER 12Aggregate Demand in the Open EconomyAggregate Demand in the Open Economy slide 32 The fall in eis intuitive An increase in country risk or an expected depreciation makes holding the country s currency less attractive Note an expected depreciation is a self fulfilling prophecy The increase in Yoccurs because the boost in NX from the depreciation is even greater than the fall in I from the rise in r The effects of an increase in The effects of an increase in CHAPTER 12CHAPTER 12Aggregate Demand in the Open EconomyAggregate Demand in the Open Economy slide 33 Why income might not riseWhy income might not rise The central bank may try to prevent the depreciation by reducing the money supply The depreciation might boost the price of imports enough to increase the price level which would reduce the real money supply Consumers might respond to the increased risk by holding more money Each of the above would shift LM leftward CHAPTER 12CHAPTER 12Aggregate Demand in the Open EconomyAggregate Demand in the Open Economy slide 34 CASE STUDY CASE STUDY The Mexican Peso CrisisThe Mexican Peso Crisis 10 15 20 25 30 35 7 10 948 29 9410 18 9412 7 941 26 953 17 955 6 95 U S Cents per Mexican Peso CHAPTER 12CHAPTER 12Aggregate Demand in the Open EconomyAggregate Demand in the Open Economy slide 35 10 15 20 25 30 35 7 10 948 29 9410 18 9412 7 941 26 953 17 955 6 95 U S Cents per Mexican Peso CASE STUDY CASE STUDY The Mexican Peso CrisisThe Mexican Peso Crisis 10 CHAPTER 12CHAPTER 12Aggregate Demand in the Open EconomyAggregate Demand in the Open Economy slide 36 The Peso Crisis didn t just hurt MexicoThe Peso Crisis didn t just hurt Mexico U S goods more expensive to Mexicans U S firms lost revenue Hundreds of bankruptcies along U S Mex border Mexican assets worth less in dollars Affected retirement savings of millions of U S citizens CHAPTER 12CHAPTER 12Aggregate Demand in the Open EconomyAggregate Demand in the Open Economy slide 37 Understanding the crisisUnderstanding the crisis In the early 1990s Mexico was an attractive place for foreign investment During 1994 political developments caused an increase in Mexico s risk premium peasant uprising in Chiapas assassination of leading presidential candidate Another factor The Federal Reserve raised U S interest rates several times during 1994 to prevent U S inflation So r 0 CHAPTER 12CHAPTER 12Aggregate Demand in the Open EconomyAggregate Demand in the Open Economy slide 38 Understanding the crisisUnderstanding the crisis These events put downward pressure on the peso Mexico s central bank had repeatedly promised foreign investors that it would not allow the peso s value to fall so it bought pesos and sold dollars to prop up the peso exchange rate Doing this requires that Mexico s central bank have adequate reserves of dollars Did it CHAPTER 12CHAPTER 12Aggregate Demand in the Open EconomyAggregate Demand in the Open Economy slide 39 Dollar reserves of Dollar reserves of Mexico s central bankMexico s central bank December 1993 28 billion August 17 1994 17 billion December 1 1994 9 billion December 15 1994 7 billion December 1993 28 billion August 17 1994 17 billion December 1 1994 9 billion December 15 1994 7 billion During 1994 Mexico s central bank hid the fact that its reserves were being depleted 11 CHAPTER 12CHAPTER 12Aggregate Demand in the Open EconomyAggregate Demand in the Open Economy slide 40 the disasterthe disaster Dec 20 Mexico devalues the peso by 13 fixes eat 25 cents instead of 29 cents Investors are shocked shocked and realize the central bank must be running out of reserves Investors dump their Mexican assets and pull their capital out of Mexico Dec 22 central bank s reserves nearly gone It abandons the fixed rate and lets e float In a week e falls another 30 CHAPTER 12CHAPTER 12Aggregate Demand in the Open EconomyAggregate Demand in the Open Economy slide 41 The rescue packageThe rescue package 1995 U S IMF set up 50b line of credit to provide loan guarantees to Mexico s govt This helped restore confidence in Mexico reduced the risk premium After a hard recession in 1995 Mexico began a strong recovery from the crisis CHA