the open economy is-lm model the mundell-fleming model 1
TRANSCRIPT
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The Open Economy IS-LM Model
The Mundell-Fleming Model
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Learning Objectives
1. Understand how what BOP equilibrium is and how it is represented by BP curve
2. Understand how internal (IS-LM) and external equilibria interact to produce an unique over equilibrium
3. Understand how the fiscal and monetary policy are affected by the exchange rate regime
4. Understand how fiscal and monetary policy are affected by the SOE\LOE assumption
5. Apply it to some real world cases
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Comment on Mankiw’s Presentation
• Mankiw covers this in chapter 13• Different diagrams (more confusing)• I prefer my way which I think is clearer• You can use whichever appeals to you• If you use mine, Mankiw’s text is still
relevant
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Revision of some basics
1. BOP
2. Exchange rates– Fixed vs floating– Real vs nominal
3. Interest rates and capital flows
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• Record of a country’s economic transactions with the rest of the world.
• Rule: receipt = positive (+) , payment = negative (-)– If receipts > payments = surplus.– If receipts < payments = deficit.
• 2 main accounts: current and capital.– Different implications for the economy. The current account
directly affects AD– It is possible to have a current a/c deficit as long as there is
a capital a/c surplus. Example, USA.
BOP
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Exchange Rate
• What is $ price of domestic currency (€)?– Exchange rate: $ price of one €– what we quote in paper– €1=$1.12– Price of 1$ is 1/1.12=0.89– e=1.12
• Depreciation of €– Losses value– Fewer $ per euro– Or e falls
• This or the reciprocal?– Follow the book– I prefer the other way
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Fixed vs Floating
• In a certain trivial sense the BOP always balances– Supply equals demand
• For floating exchange rate this is achieved by the free market• For fixed exchange rates the government makes up the
difference• Current account surplus is counteracted by cap deficit and/or
changes in reserves– US vs China
• Note a bit inconsistent to have e floating but P fixed– As before our excuse is that’s what happens in reality
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Fixed Erates
• Governments may try to fix the exchange rate (why? See later)– Requires supplying foreign currency to market
when there is excess demand– Requires buying foreign currency when there is
excess supply• Mechanism by which an currency crisis can
occur
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Real Exchange Rate• Compare price levels of different countries
– In a common currency (usually US$)• Related to the concept of purchasing power
parity (PPP)• Simple example is the Hamburger index
– What is the US$ price of a Big Mac in various countries
• What is the effect of an increase in R?– our goods more expensive; their’s relatively cheaper– Expect exports to rise and imports to fall– “loss of compteitiveness”
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• What does this tell you?– “competitiveness”– Are one country’s goods cheaper than
another’s?• Do for all goods in a basket and calculate
the ratio– i.e. CPI or GDP or wages
• Look at R for Ireland over time– Level doesn’t tell much– Trend does
US
IRL
US
IRL
P
P*e
$P
$PR
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Competitiveness
0.000
50.000
100.000
150.000
200.000
250.000
NEER
REER
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• What causes R to change?– e changes– Prices change i.e. inflation can erode
competitiveness– Productivity
• These last two factors are “Long Run” and so will be ignored in this model
• Thus changes in the nominal exchange rate (e) will change the real exchange rate (R) in proportion– We will just talk of “exchange rate” to mean both
• Again note the inconsistent treatment of prices and exchange rates.
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e affects the IS Curve
• NX rises following a depreciation (e down)– Price in $ of goods produced in Ireland falls– Example: furry leprechaun €5– e=1.12 (the $ price of 1€)– 1€ gets $1.12– leprechaun costs 5*1.12=$5.6– Depreciation e=0.5 implies €1 get $0.5– Cost is 5*0.5= $ 2.5– Sales rise
• Note this leads to a shift in IS curve– Every r is associated with higher Y
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r
Y
IS2
IS1
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Interest Rates
• Interest rates can be used to influence capital flows and therefore defend a currency.
• reuro > rus Capital inflow e • reuro < rus Capital outflow e• Usually used to prevent depreciation of the
exchange rate.• Sounds like it might affect the LM curve but
we account for it separately
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Taking Stock
• We have from the last section a definition of equilibrium (IS-LM)– We now call this “Internal Equilibrium”
• We have dealt with the prelimaries that enable us to talk about BP equilibrium
• We need to find the combinations of (r,Y) that lead to BOP equilibrium – external equilibrium
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External Balance
• Define external balance to be where BP=0– Net flow of currency between countries is zero– Current account could be in deficit if capital account in surplus
• Why is this an equlibrium?– Plans consistent– See later how BOP not balanced leads to changes– For now think of exporters and importers plans
• Show this on IS-LM framework– (r,Y) that give BP=0– Assume (for now) that e is fixed
• As with any curve we want to know – The slope– What causes it to shift?
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• Start at initial point (A)– assume eqm, BP=0 – Y up,– Imports up (NX falls), – flow out of $– Or increased supply of €– Either way BP<0 : at B– assume e fixed– To restore equilibrium need to encourage
capital inflows (perhaps borrowing)– r up sufficiently to restore equilibrium, – Connect all such points : BP=0 curve
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Y
r
A
B
CBP=0
BP curve is the locus of External equilibrium i.e. the set of (r,Y)combinations which give BOP=0
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Shifts in BP=0
• Points above BP=0 represent BP surplus– Think if r increases beyond C
• Points below BP=0 represent BP deficit• Location of curve depends on e, world income
(Y*) and world interest rates (r*)– Change in any will shift BP=0 (see diagram)– r* rises: BP shifts up, need higher r for all Y– Y* rises: BP shifts right, NX rises, Y rises for all r– e falls: depreciation, NX up, for all r Y up, BP shifts
right
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Y
r
BP=0
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Slope of BP=0
• Slope depends on– Marginal propensity to import– Capital mobility
• Marginal propensity to import– What portion of every increase in GDP is spent
on imports– If high increase in Y leads to a large deficit– need large capital flows to restore equilibrium– Large increase in r– Steep BP curve
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• Capital Mobility– How sensitive are cap flows to interest
differentials?– How free is capital to flow?– Flatter BP=0 curve– Special Case : “Small Open Economy”
• r=r*
• BP=0 flat• Perfect Capital mobility • No influence on world
– Note what happens when BP=0 “shifts” if SOE• e.g. changes in r*
• Changes in Y*
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BP=0
r
Y
r*
Small Open Economy with Perfect Capital Mobility
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PCM & SOE• This is crucial for the effectiveness of policy – as
we will see• You need the two assumptions to get the flat curve• PCM implies your interest rate is the worlds• SOE implies what you do has no effect on the
world• Think of examples• PCM is relatively recent and was very
controversial• Note we also postpone risk until later
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Overall Equilibrium
• We put the three curves together• The intersection is the overall equilibium
– Internal balance– External balance
• As usual we have to show it is stable (why?)
• We already know that internal eqm is stable• So we concentrate on showing how
economy adjusts to external disequilibrium
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Internal and External Balance
• IS-LM give eqm in goods and money market
• Together they give “internal balance”
• Showed it was stable• Add BP to give
external balance• Show stable
BP=0
LM
IS
Y
r
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External Imbalance
• Need to show that if not in external balance, will go there
• A is point of internal balance (what does this mean?)
• A is BP<0: deficit– r is too low to attract
the capital flows– Plans not consistent
• What will happen?– depends on whether e
is free to adjust
A
LM
IS
BP=0
B
r
Y
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• Assume Fixed e• BP deficit means net
outflow of (foreign) currency
• Money supply falls• LM curve shifts up• Interest rate rises until
sufficient to stem the outflow of funds
• New eqm at B• Note Change in money
supply is automatic – not policy
• Mechanism: CB buys € with $ from reserves
BP=0
LM1
LM2
A
B
r
Y
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• Float Exchange rates• BP deficit means net
outflow of (foreign) currency
• Excess demand for $ and excess supply of €
• Price of € falls: e falls• Depreciation• Net exports rise
– IS shifts right: for every r now Y up
– Also BP shifts down• depr until sufficient to
restore balance• New eqm at B
• Note difference in behaviour of central bank in both cases• Note different effect on output and interest rates
BP2
IS2IS1
BP1 B
A
r
Y
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Imbalance with PCM
• Perfect Capital Mobility provides an interesting special case• Flat BP=0 curve
– Interest rate fixed at world levels– No influence on world– Ireland vs. US
• Assume internal equilibrium is BP surplus (point A)• Fixed exchange rates
– Inflow of foreign currency– Or domestic interest rate too high– Money supply rises: LM shifts down– Keeps going until r=r*
– Forex reserves rise
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A
r
Y
B
IS2
IS1
LM1
LM2
BPr* C
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• Floating exchange rates– Inflow of foreign currency–Excess supply of $ causes their price to
fall–Excess demand for €– e rises: appreciation: more $ per €–Exports fall & imports rise– IS shifts left–BP shifts right onto itself–A B
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• Fixed exchange rates– Inflow of foreign currency–Excess supply of $ has to be soaked up
by CB–CB buys $ with € to keep price constant–Money supply up (more € in circulation)–LM curve shifts down–AC–Note: Change in money supply is
automatic – not policy
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Policy In an Open Economy
• Can look at Monetary, Fiscal and Exchange Rate Policy
• If we think of the purpose of policy is to control Y then we get
• The reason is the automatic effects of BP
Fixed e Float eFiscal Effective IneffectiveMonetary Ineffective Effective
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Method
• Now we will assume SOE & PCM as it makes things easier– Drop SOE later
• To analyse any policy1. First look at its effect on internal balance IS-LM
2. Check what sort of BOP disequilibrium that generates (i.e. we will be off BP curve)
3. Apply the rules for adjustment to external balance
4. Remember: These are different depending on exchange rate regime
• Apply 1-4 in exam
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Fiscal Policy with Fixed e
• G up: IS shifts to right (why?)– Internal balance at B
• At B: BP>0, r>r* (why?)• This BP>0 cannot be equilibrium as plans are
changing (whose?)• fixed e: CB must buy excess $ by printing €
– this leads to money supply up– LM shifts down– Interest rate falls
• Balance restored at C• Note contrast with closed economy
– No change in r– Larger change in Y
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A
B
C
r
Y
LM0
LM1 IS0
IS1
Fiscal policy: Fixed e, SOE
r* BP
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Monetary Policy with Fixed e
• Expand money supply– LM shifts down– Internal balance at B
• At B: BP<0, r<r*
• Net currency out flow• CB must sell $ for € (why?)
– Money supply falls back– LM Shifts up
• Return to A• MP is ineffective• Only change is in central banks balance sheet
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A
B
r
Y
LM0
LM1 IS0
Monetary Policy: Fixed e, SOE
BPr*
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Fiscal Policy with Floating e
• G up: IS shifts to right – Internal balance at B
• BP>0, r>r*
– excess supply of $ and/or excess demand for €– Under float e this leads to an appreciation of €– $ price of € rises– Exports fall– IS curve shifts left
• Balance restored at A• Note contrast with closed economy and fixed e
– No change in r– No change Y– Net exports are crowded out
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A
B
LM0
IS0
IS1
Fiscal policy: Float e, SOE
r
Y
BPr*
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Monetary Policy with Float e• Expand the Money supply
– LM shifts down– Internal balance at B
• BP<0, r<r*
– net outflow of funds– Excess demand for $ (or supply of €)
• Price of € falls: e falls; depreciation in the €– Net exports rise– IS curve shifts to the right
• Overall Balance at C• Note contrast with closed economy and fixed e
– No change in r– Larger change in Y– Net exports are “crowded in”
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A
B
C
Y
LM0
LM1IS0
IS1
Monetary policy: Float e, SOE
r
BP
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Policy In an Open Economy
• Can look at Monetary, Fiscal and Exchange Rate Policy
• If we think of the purpose of policy is to control Y then we get
• The reason is the automatic effects of BP
Fixed e Float eFiscal Effective IneffectiveMonetary Ineffective Effective