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Macroeconomics. Short Run Open Economy Macroeconomics. Principles of Macroeconomics by N. Gregory Mankiw Large Open Economy IS-LM Model. Instructor: Prof. John M. Veitch. Interest Rate Differentials. Assumed for small open economy that r = r * …but not always true because:

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Macroeconomics

Macroeconomics

Short Run Open Economy Macroeconomics


Principles of macroeconomics by n gregory mankiw large open economy is lm model

Principles of Macroeconomicsby N. Gregory MankiwLarge Open Economy IS-LM Model

Instructor: Prof. John M. Veitch


Interest rate differentials

Interest Rate Differentials

  • Assumed for small open economy that r = r*…but not always true because:

    • Country Risk leads investors to demand risk premium.

    • Expected Changes in EXR lead investors to demand premium (or discount) to compensate for change.

  • Assume r = r* + q, where q = Country premium determined exogenously by investor perceptions.

  • Small Open Economy IS-LM Model given by:

    (IS) Y = C(Y-T) + I(r* + q) + G + NX(e)

    (LM)M/P = L(r* + q, Y)


Large open economy is lm model

1. Increase in Country Risk

- increases risk premium .

LM*2

- higher domestic interest rate.

2. I falls, shifts IS Curve inward.

2.

3.

3. Money Demand decreases.

- shifts LM Curve outwards.

4. Results:

- EXR depreciates.

- Real GDP rises.

4.

e2

IS*2

Y2

Increase in the Risk Premium

LM*1

Exchange

Rate

e1

IS*1

Y1

Income, Output


Int l is lm and ad curve

Int’l IS-LM and AD Curve

  • Look at Price Changes in Open Economy IS-LM.

  • Recall NX depends on e = e(P/P*), so IS-LM is:

    (IS) Y = C(Y-T) + I(r*) + G + NX(e)

    (LM)M/P = L(r*, Y)

  • Assume Domestic Price Level rises;

    • Real Money supply falls, shifts LM inwards.

    • Real exchange rate rises, NX falls, lower Real GDP.

  • This is the AD Curve for small open economy.

  • Any other variables that shift IS or LM will shift AD Curve correspondingly.


Open economy ad curve

LM*(M/P2)

e2

3.

2.

Y2

4.

P2

1.

AD(G,T,M,r*)

Y2

Open Economy AD Curve

e

LM*(M/P1)

Begin at Price Level P1 with IS1 and LM*1.

1. Increase Price level to P2.

- LM* shifts to LM*2.

2. Increases exchange rate, e2.

3. Lower level of real GDP, Y2, at higher Price level P2.

4. AD Curve summarizes relationship of P and Y.

Anything that shifts IS or LM Curve (with Price level fixed) will shift AD Curve.

e1

IS1

Y

Price

Y1

Level

P

P1

Y1

Y


Large open economy is lm model

2. YSR < YLR so Unemployed resources lead to fall in input prices.

3. SRAS shifts down, Price level falls, LM* shifts out as M/P increases.

4. New LR equilibrium at YLR, lower Price level P2 and exchange rate, e2.

LM*2

3.

2.

P2

4.

e2

SRAS2

4.

YLR

IS-LM & AD Curve in SR & LR

1. Begin below LR equilibrium at point 1 as result of shock to economy.

LRAS

LM*1

AD*

e

P

SRAS1

P1

eSR

1.

1.

IS*

YSR

YLR

YSR

Y

Y


Large open economy is lm model

Principles of Macroeconomicsby N. Gregory MankiwChapter 11 Appendix: Large Open Economy in the Short Run

Instructor: Prof. John M. Veitch


Large open economy solution

Large Open Economy Solution

  • Large open economy sets own interest rate.

  • IS-LM Model with Price Levels fixed

    • (IS) Y = C(Y-T) + I(r) + G + NX(e)

    • (LM) M/P = L(r,Y)

    • Solve for equilibrium levels of r1 and Y1.

  • Net Foreign Investment

    • Solve for NFI(r1) at Domestic real interest rate.

  • Market for Foreign Exchange

    • Take NFI(r1) as “Supply” of domestic currency.

    • Draw NX(e) as “Demand” for domestic currency.

    • Find exchange rate, e0, where NFI(r0) =NX(e0).


Large open economy is lm

Large Open Economy IS-LM

  • Combine 3 equations of Large Open Economy into 2 equations for IS-LM.

  • Modified IS-LM Model

    • substitute Currency Mkt Equilib. (NX = NFI) into IS.

    • (IS*) Y = C(Y-T) + I(r) + G + NFI(r)

    • (LM) M/P = L(r,Y)

    • Solve for equilibrium levels of r1 and Y1.

  • Adding NFI(r) makes Large Open Economy IS Curve flatter than Closed Economy IS Curve.

    • Flatter is NFI(r) Curve, flatter is the IS* Curve.


Is lm for large open economy

IS-LM for Large Open Economy

Real

LM

Interest

Rate

r

r1

IS*

Y1

Income, Output


Large open economy is lm model

Net Foreign Investment

Real

Interest

Rate

NFI

0

NFI

NFI negative

NFI positive


Market for foreign exchange

Market for Foreign Exchange

  • Market for foreign currency exchange.

    • “Supply” of Dollars: Net Foreign Investment, NFI(r1).

    • “Demand” for Dollars: Net Exports, NX(e).

      • Higher real exchange rate reduces Net Exports.

    • Equilibrium: NFI(r1) = NX(e)

      • determines the real exchange rate and the quantity of dollars exchanged for foreign currency.

  • NFI determined by IS-LM diagram but determines “Supply” in Market for Foreign Exchange.


Market for foreign exchange1

Market for Foreign Exchange

NFI(r1)

Exchange

Rate

(Supply of $)

e1

NX(e)

(Demand for $)

$1

# of $ Exchanged


Large open economy is lm model

r1

Y1

NFI(r1)

e1

Net Foreign Investment

r

LM

r

NFI

IS*

Income, Ouput

NFI

IS-LM Diagram

Exchange

Rate

NX(e)

Large Open

Economy

# of $

Market for Foreign Exchange


Fiscal policy

Fiscal Policy

  • Effects of Expansionary Fiscal Policy in Large Open Economy.

    • Increase in Gov’t Purchases shifts IS* outwards.

    • Results:

      • Output and Real Interest Rate Increase.

      • Lowers Domestic Investment and NFI.

      • Fall in NFI reduces Supply of Foreign Exchange.

      • Real Exchange Rate Appreciates.

  • Gov’t fiscal policies thus affect output, domestic real interest rate, investment, and exchange rate.


Large open economy is lm model

r2

2.

IS*2

1. DG

Y2

NFI2

3.

e2

4.

Net Foreign Investment

r

r

LM

r1

NFI

IS*1

Y1

Y

NFI

IS-LM Diagram

NFI1

Exchange

Rate

NX

Fiscal Policy:

Increase in G

e1

# of $

Market for Foreign Exchange


Monetary policy

Monetary Policy

  • Effects of Expansionary Monetary policy in a Large Open Economy.

    • Increase in Nominal Ms shifts LM Curve outwards.

    • Results:

      • Real Interest Rate falls, Output and NFI increase.

      • Increase in NFI increases Supply of Foreign Currency

      • Exchange rate depreciates, Net Exports increase.

  • Monetary policy affects Output, domestic real interest rate, NFI, Net Exports, and exchange rate.


Large open economy is lm model

LM2

1. DM

2.

r2

Y2

NFI2

3.

4.

e2

Net Foreign Investment

r

LM1

r

r1

NFI

IS*

Y

Y1

NFI

IS-LM Diagram

NFI1

Exchange

Rate

NX

Monetary Policy:

e1

Increase MS

# of $

Market for Foreign Exchange


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