eco 209y macroeconomic theory and policy 14 - eco... · 2015. 3. 31. · but the bank of canada...

© Gustavo Indart Slide 1

ECO 209YMacroeconomic

Theory and Policy

Lecture 14:The AS and AD in an

Open Economy


Trade Balance and the Price Level In a closed economy, an increase in the price level (P) reduces

the real supply of money (M/P) In the IS-LM model, the increase in P only affects the

position of the LM curve

In an open economy, the increase in P not only affects the real supply of money (M/P) but also the real exchange rate (ePf/P) In the IS-LM model, the increase in P affects the position

of both the LM and the IS curves

Recall the expression for the IS curve: i = AE/b − (1/bαAE)Y, where

AE = C + cTR − cT + I + G + X – Q + (x + s) (ePf/P)


The Effect of an Increase in P on the IS and LM Curves

IS: i = AE/b − (1/bαAE) YLM: i = − (M/P)/h + (k/h) Y

i

Y

IS

IS’

LM

LM’

Y1Y2Y3

In a closed economy, the real money supply would decrease and Y would fall to Y2.

In an open economy, the real exchange rate would also decrease and Y would fall further to Y3.


The Effect of an Increase in P on Exports and Imports

X = X + x(ePf/P) Q = Q − s(ePf/P) + mY

XQ

Y

X

X’

Q

Q’

Y1

Initially, NX = 0 at Y = Y1.

The increase in P causes exports to decrease and imports to increase. Therefore, now NX < 0 at Y = Y1.

Therefore, there is a deterioration in the current account and now NX = 0 at Y = Y2.

Y2


Fixed Exchange Rate and No Capital Mobility In the absence of capital mobility, the balance of

payments (BP) is equal to the balance in the current account (NX)

Under fixed exchange rates, the external sector doesn’t need to be in equilibrium in the short run (i.e., BP ≠ 0) But the Bank of Canada will have to buy or sell foreign

currency to keep the exchange rate unchanged

However, the external sector could also be in equilibrium, and thus NX = 0

What we will do now is to derive a relationship between P and Y for which NX = 0


The Relationship between P and Y when NX = 0

XQ

Y

X(P1)

X(P2)

Q(P1)

Q(P2)

Y1 YY2

P

Y1

P1

Y2

P2

NX

We will assume that the NX curve is steeper than the AD curve.

P2 > P1


Point Off the NX Curve

XQ

Y

X(P1)

X(P2)

Q(P1)

Q(P2)

Y1 YY2

P

Y1

P1

Y2

P2

NX

A

AB

B

C

C1

C2

Trade Surplus

D

D1

D2Trade Deficit


The AS-AD-NX DiagramP

YY1 Y*

AD

AS

NX

The economy could be in equilibrium without achieving internal balance.

Under fixed exchange rates, the economy could be in equilibrium without achieving external balance either.

Trade Surplus

P1


Policy Options to Achieve Internal and External Balance

P

YY*

AD

AS

NX

Suppose that the economy is initially in a situation of internal balance, but with a deficit in the external sector.

What can the government do to move the economy to a situation of both internal and external balance?

Trade Deficit

P1

We will look at two possible policy options the government could follow to move the economy to a situation of both internal and external balance.


Option 1: Classical Adjustment Process

P

YY2 Y*

AD0’

AS2

NX

One option would be to do nothing and let the market achieve both internal and external balance.

Under fixed exchange rates, the Bank of Canada must sell foreign currency to eliminate the deficit in the external sector. Therefore, the money supply decreases and the AD curve shifts down.P1

The decrease in the price level causes the AS curve to shift down the following period.P0’

AD1

AS0’

AD2

P2

Y1

AD0

AS0

P0

AS: P = P-1 [1 + λ(Y – Y*)]

A trade deficit arises again and the Bank of Canada sells foreign currency. The money supply decreases and the AD curve shifts down once again.

This approach is called Internal Devaluation.


Option 2: DevaluationP

YY1 Y*

AD

AS

NX

Another policy option is to devalue the Canadian dollar to improve the balance of payment at each level of income.

A devaluation of the currency (i.e., a revaluation of the exchange rate) will shift the NX curve up.Trade Deficit

P1

NX’Let’s look at the impact of a devaluation on NX.


The Impact of a Devaluation on Net Exports

XQ

Y

X(P1, e1)

X(P1, e2)

Q(P1, e1)

Q(P1, e2)

Y1 YY*

P

Y1

P1

Y*

NX(e1)

When e = e1 and P = P1, NX = 0 at Y = Y1.

B

A A B

NX(e2)

When e = e2 and P = P1, NX = 0 at Y = Y*.

A devaluation of the Canadian dollar (e2 > e1) increases X and decreases Q at all levels of P, including P1.


Option 2: Devaluation and Contractionary Policy

P

YY*

NX

The devaluation of the domestic currency (i.e., revaluation of the exchange rate) shifts the NX curve to the right.

In turn, the increase in NX causes the AD curve to shift to the right.

P1

To maintain internal balance, the government must implement contractionary fiscal or monetary policy at the same time that the Bank of Canada devalues the currency.

AD’

Y1

AD

AS

NX’


Trade Surplus – China Classical Adjustment Process

P

YY2Y*

AS2

NX

P1

The increase in the price level causes the AS curve to shift up until external balance is achieved.

P0’

AD1

AS0’

AD2

P2

Y1

AD0

AS0

P0

AS: P = P-1 [1 + λ(Y – Y*)]

●

AD0’

Trade Surplus


Trade Surplus – China Revaluation

P

YY0Y*

AD

AS

NX

A revaluation of the currency (i.e., a devaluation of the exchange rate) will shift the NX curve down.Trade Surplus

P1

NX’

AS: P = P-1 [1 + λ(Y – Y*)]

To maintain internal balance, the government must implement expansionary fiscal or monetary policy at the same time that the central bank revalues the currency.

AD’


Expansionary Fiscal Policy with Fixed Exchange Rates and Perfect Capital Mobility

Pi

Y

AS0

BP

LM’(P0)

IS(P0)

LM(P0)

IS’(P0)

i*

Y* Y*

BA

A

Y

AD’

AD

Y0 Y0Y1Y1

P1

P0

C

CLM’(P1)

IS’(P1)

AS2

P2

D

D

Y2Y2

AS0’= LM’(P0’)

= IS’(P0’)

B

E

E

P0’LM’(P2)

IS’(P2)

Under fixed exchange rates and perfect capital mobility, fiscal policy is effective with respect to income in the short-run.AS: P = P-1 [1 + λ(Y – Y*)]


Expansionary Monetary Policy with Fixed Exchange Rates and Perfect Capital Mobility

Pi

Y

AS0

BP

LM’(P0)

IS(P0)

LM(P0)

i*

Y* Y*

A

A

Y

AD

P0

Under fixed exchange rates and perfect capital mobility, monetary policy is completely ineffective with respect to income.


Expansionary Fiscal Policy with Flexible Exchange Rates and Perfect Capital Mobility

Pi

Y

AS0

BP

IS’(P0)

IS(P0)

LM(P0)

i*

Y* Y*

A

A

Y

AD

P0

Under flexible exchange rates and perfect capital mobility, fiscal policy is completely ineffective with respect to income: the increase in G completely crowds-out NX.


Expansionary Monetary Policy with Flexible Exchange Rates and Perfect Capital Mobility

Pi

Y

AS0

BP

LM’(P0)

IS(P0)

LM(P0)

IS’(P0)

i*

Y* Y*

BA

A

Y

AD’

AD

Y0 Y0Y1Y1

P1

P0

C

CLM’(P1)

IS’(P1)

AS2

P2

D

D

Y2Y2

AS0’= LM’(P0’)

= IS’(P0’)

B

E

E

P0’LM’(P2)

IS’(P2)

Under flexible exchange rates and perfect capital mobility, monetary policy is effective with respect to income in the short-run.AS: P = P-1 [1 + λ(Y – Y*)]

eco 209y macroeconomic theory and policy 14 - eco... · 2015. 3. 31. · but the bank of canada...

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