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macroeconomicsfifth edition
N. Gregory Mankiw
PowerPointSlides
by Ron Cronovich
macro
2003 Worth Publishers, all rights reserved
Aggregate Demandin the Open Economy
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CHAPTER 12 Aggregate Demand in the Open Economy slide 1
Chapter objectives
accounting identities for the openeconomy
small open economy model
what makes it small
how the trade balance and exchangerate are determined
how policies affect trade balance &
exchange rate
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CHAPTER 12 Aggregate Demand in the Open Economy slide 2
Learning objectives
The Mundell-Fleming model:IS-LM for the small open economy
Causes and effects of interest ratedifferentials
Arguments for fixed vs. floating exchangerates
The aggregate demand curve for the smallopen economy
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CHAPTER 12 Aggregate Demand in the Open Economy slide 3
The Mundell-Fleming Model
Key assumption:Small open economy with perfect capitalmobility.
r = r*
Goods market equilibrium---the IS* curve:
( ) ( ) ( )*Y C Y T I r G NX e
wheree = nominal exchange rate
= foreign currency per unit of domestic
currency
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CHAPTER 12 Aggregate Demand in the Open Economy slide 4
The IS*curve: Goods Market Eqm
The IS*curve is drawn
for a given value of r*.
Intuition for the slope:
Y
e
IS*
( ) ( ) ( )*
Y C Y T I r G NX e
e NX Y
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CHAPTER 12 Aggregate Demand in the Open Economy slide 5
The LM*curve: Money Market Eqm
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 moneydemand with supply,
regardless of e.Y
e LM*
( , )*
M P L r Y
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CHAPTER 12 Aggregate Demand in the Open Economy slide 7
Float ing & f ixed exchange rates
In a system of floating exchange rates,e is allowed to fluctuate in response tochanging economic conditions.
In contrast, under fixed exchange rates,
the central bank trades domestic for foreigncurrency at a predetermined price.
We now consider fiscal, monetary, and trade
policy: first in a floating exchange ratesystem, then in a fixed exchange rate system.
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CHAPTER 12 Aggregate Demand in the Open Economy slide 8
Fiscal policy under floating exchange rates
Y
e
( , )*M P L r Y ( ) ( ) ( )
*Y C Y T I r G NX e
Y1
e1
1
*LM
1
*IS
2
*IS
e2
At any given value of e,
a fiscal expansionincreases Y,
shifting IS*to the right.
Results:
e> 0, Y= 0
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CHAPTER 12 Aggregate Demand in the Open Economy slide 9
Lessons abou t f iscal po l icy
In a small open economy with perfect capitalmobility, 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 bycausing the exchange rate to appreciate.
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CHAPTER 12 Aggregate Demand in the Open Economy slide 10
Mon. policy under floating exchange rates
Y
e
( , )*M P L r Y ( ) ( ) ( )
*Y C Y T I r G NX e
e1
Y1
1
*LM
1
*IS
Y2
2
*LM
e2
An increase in M shifts
LM* right because Y
must rise to restore eqm
in the money market.
Results:
e< 0, Y > 0
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CHAPTER 12 Aggregate Demand in the Open Economy slide 12
Trade policy under floating exchange rates
( , )*M P L r Y ( ) ( ) ( )
*Y C Y T I r G NX e
Y
e
e1
Y1
1
*LM
1
*IS
2
*IS
e2
At any given value of e,
a tariff or quota reducesimports, increases NX,
and shifts IS* to the right.
Results:
e> 0, Y= 0
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CHAPTER 12 Aggregate Demand in the Open Economy slide 13
Lessons abou t trade pol icy
Import restrictions cannot reduce a trade deficit.
Even though NX is 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 totalemployment.
Worse yet, import restrictions create sectoralshifts, which cause frictional unemployment.
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CHAPTER 12 Aggregate Demand in the Open Economy slide 15
Fiscal policy under fixed exchange rates
Y
e
Y1
e1
1
*LM
1
*IS
2
*IS
Under floating rates, afiscal expansion would
raise e.
Results:
e= 0, Y > 0 Y2
2
*LM
To keep efrom rising,
the central bank mustsell domestic currency,
which increases M
and shifts LM*right.
Under floating rates,fiscal policy ineffective
at changing output.
Under fixed rates,
fiscal policy is veryeffective at changing
output.
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CHAPTER 12 Aggregate Demand in the Open Economy slide 16
Mon. policy under fixed exchange rates
2
*LM
An increase in M would shiftLM* right and reduce e.
Y
e
Y1
1
*LM
1
*IS
e1
To prevent the fall in e,
the central bank mustbuy domestic currency,
which reduces M and
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
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CHAPTER 12 Aggregate Demand in the Open Economy slide 17
Trade policy under fixed exchange rates
Y
e
Y1
e1
1
*LM
1
*IS
2
*IS
A restriction on importsputs 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 Y or NX.
Under fixed rates,
import restrictionsincrease Y and NX.
But, these gains come at
the expense of other
countries, as the policymerely shifts demand from
foreign to domestic goods.
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CHAPTER 12 Aggregate Demand in the Open Economy slide 19
Interest-rate differentials
Two reasons whyr may differ from
r*
country risk:The risk that the countrys borrowers will defaulton their loan repayments because of political or
economic turmoil.Lenders require a higher interest rate tocompensate them for this risk.
expected exchange rate changes:
If a countrys exchange rate is expected to fall,then its borrowers must pay a higher interest rateto compensate lenders for the expected currencydepreciation.
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CHAPTER 12 Aggregate Demand in the Open Economy slide 20
Differentials in the M-F model
where is a risk premium.
Substitute the expression for r into theIS*and LM*equations:
( , )*M P L r Y
( ) ( ) ( )*Y C Y T I r G NX e
*r r
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CHAPTER 12 Aggregate Demand in the Open Economy slide 21
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 Y must rise to restore
money market eqm.
Results:
e< 0, Y > 02
*IS
e2
Y2
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CHAPTER 12 Aggregate Demand in the Open Economy slide 22
The fall in e is intuitive:
An increase in country risk or an expected
depreciation makes holding the countrys
currency less attractive.
Note: an expected depreciation is aself-fulfilling prophecy.
The increase in Y occurs 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
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CHAPTER 12 Aggregate Demand in the Open Economy slide 23
Why income m ight not r ise
The central bank may try to prevent thedepreciation by reducing the money supply
The depreciation might boost the price ofimports enough to increase the price level
(which would reduce the real money supply)
Consumers might respond to the increasedrisk by holding more money.
Each of the above would shift LM* leftward.
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CHAPTER 12 Aggregate Demand in the Open Economy slide 24
CASE STUDY:
The Mexican Peso Crisis
10
15
20
25
30
35
7/10/94 8/29/94 10/18/94 12/7/94 1/26/95 3/17/95 5/6/95
U.S.
CentsperMex
icanPeso
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CHAPTER 12 Aggregate Demand in the Open Economy slide 25
10
15
20
25
30
35
7/10/94 8/29/94 10/18/94 12/7/94 1/26/95 3/17/95 5/6/95
U.S.
CentsperMex
icanPeso
CASE STUDY:
The Mexican Peso Crisis
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CHAPTER 12 Aggregate Demand in the Open Economy slide 26
The Peso Crisis didnt 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
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CHAPTER 12 Aggregate Demand in the Open Economy slide 27
Understanding the crisis
In the early 1990s, Mexico was an attractiveplace for foreign investment.
During 1994, political developments caused anincrease in Mexicos risk premium ( ): peasant uprising in Chiapas assassination of leading presidential
candidate
Another factor:The Federal Reserve raised U.S. interest ratesseveral times during 1994 to prevent U.S.inflation. (So, r* > 0)
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CHAPTER 12 Aggregate Demand in the Open Economy slide 28
Understanding the crisis
These events put downward pressure on thepeso.
Mexicos central bank had repeatedlypromised foreign investors that it
would not allow the pesos value to fall,so it bought pesos and sold dollars to
prop up the peso exchange rate.
Doing this requires that Mexicos centralbank have adequate reserves of dollars.Did it?
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CHAPTER 12 Aggregate Demand in the Open Economy slide 30
the d isaster
Dec. 20: Mexico devalues the peso by 13%
(fixes e at 25 cents instead of 29 cents)
Investors are shocked ! ! !
and realize the central bank must be running
out of reserves
, Investors dump their Mexican assets andpull their capital out of Mexico.
Dec. 22: central banks reserves nearly gone.It abandons the fixed rate and lets e float.
In a week, e falls another 30%.
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CHAPTER 12 Aggregate Demand in the Open Economy slide 31
The rescue package
1995: U.S. & IMF set up $50b line of creditto provide loan guarantees to Mexicos govt.
This helped restore confidence in Mexico,reduced the risk premium.
After a hard recession in 1995, Mexicobegan a strong recovery from the crisis.
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CHAPTER 12 Aggregate Demand in the Open Economy slide 33
Floating vs. Fixed Exchange Rates
Argument for floating rates: allows monetary policy to be used to pursue
other goals (stable growth, low inflation)
Arguments for fixed rates: avoids uncertainty and volatility, making
international transactions easier
disciplines monetary policy to preventexcessive money growth & hyperinflation
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CHAPTER 12 Aggregate Demand in the Open Economy slide 34
Mundell-Fleming and the ADcurve
So far in M-F model, P has been fixed.
Next: to derive theADcurve, consider theimpact of a change in P in the M-F model.
We now write the M-F equations as:
(Earlier in this chapter, Pwas fixed, so we
could write NX as a function of einstead of .)
( ) ( , )*M P L r Y LM*
( ) ( ) ( ) ( )*Y C Y T I r G NX IS*
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CHAPTER 12 Aggregate Demand in the Open Economy slide 35
Y1Y2
Deriving the ADcurve
Y
Y
P
IS*
LM*(P1)LM*(P
2)
AD
P1
P2
Y2 Y1
2
1
WhyADcurve has
negative slope:
P
LMshifts left
NX
Y
(M/P)
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CHAPTER 12 Aggregate Demand in the Open Economy slide 36
From the sho r t run to the long run
LM*(P1)
1
2
then there is
downward pressure on
prices.
Over time, P willmove down, causing
(M/P)
NX
Y
P1 SRAS1
1Y
1Y Y
Y
P
IS*
AD
Y
Y
LRAS
LM*(P2)
P2 SRAS2
1
If ,Y Y
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CHAPTER 12 Aggregate Demand in the Open Economy slide 37
Large: between smal l and closed
Many countries - including the U.S. - are neither
closed nor small open economies.
A large open economy is in between the
polar cases of closed & small open.
Consider a monetary expansion:
Like in a closed economy,
M > 0 r I (though not as much)
Like in a small open economy,M > 0 NX (though not as much)
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CHAPTER 12 Aggregate Demand in the Open Economy slide 38
Chapter summary
1. Mundell-Fleming model
the IS-LM model for a small open economy.
takes Pas given
can show how policies and shocks affect
income and the exchange rate2. Fiscal policy
affects income under fixed exchange rates, butnot under floating exchange rates.
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CHAPTER 12 Aggregate Demand in the Open Economy slide 39
Chapter summary
3. Monetary policy
affects income under floating exchange rates.
Under fixed exchange rates, monetary policy isnot available to affect output.
4. Interest rate differentials exist if investors require a risk premium to hold
a countrys assets.
An increase in this risk premium raises
domestic interest rates and causes thecountrys exchange rate to depreciate.
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CHAPTER 12 Aggregate Demand in the Open Economy slide 40
Chapter summary
5. Fixed vs. floating exchange rates
Under floating rates, monetary policy isavailable for can purposes other thanmaintaining exchange rate stability.
Fixed exchange rates reduce some of theuncertainty in international transactions.
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CHAPTER 12 A D d i h O E