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Open Economy Macro

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Open Economy Macro

A few slides on the Great Recession in the world economy

Short reminder on the international monetary system

Short-run open-economy output determination (Mundell Fleming model)

Some important cases

Tree of Macroeconomics

yes

IS-LM,

dynamic AS-AD

long-

run

Closed

economy

Short run or

long run?

(full adjustment

of capital,

expectations,

etc.)

Keynesian model

(sticky wages

and prices,

upward-sloping

AS

Classical

or non-classical?

(sticky wages

and prices, rational

expectations, etc.)

short-

run

no

Open

economy

Mundell-Fleming

flexible ER;

small open economy

and large open

economy)

The output decline in the Great Recession (industry)

Percent change from prior three months at annual rate

The employment drop during the Great Recession

Percent change from prior three months at annual rate

The sharp decline in world trade during the Great Recession

(Note that trade change is more than output change.)

Percent change from prior three months at annual rate

The growth in the public debt around the world

Debt/GDP ratio (%)

The risk premium on corporate securities in the US and Europe

Foreign-exchange rates are the relative prices of different national monies or currencies.

Nominal exchange rate

= e = foreign currency/$

Real exchange rate (R)

R = e × p d / p f

= domestic prices/foreign prices in a common currency

Real exchange rate of $ against broad currency group

Mundell-Fleming (MF) model is short run Keynesian model (usually applies to small open economy but we will do large open economy)

Very similar to IS-LM model.

It derives impact of policies and shocks in the short run for an open economy.

Usual stuff for domestic sectors:

- Price and wage stickiness, unemployment, no inflation
- Standard determinants for domestic industries (C, I, G, financial markets, etc.)
Open economy aspects:

- Small open economy would have rd = rw
- Large open economy financial flows determined by rd and rw
- Net exports a function of real exchange rate, NX = NX(R)

Goods market

Start with usual expenditure-output equilibrium condition.

New wrinkle is the NX function:

(1) Y = C(Y - T) + I(rd) + G + NX(R)

Financial markets

Then the monetary policy equation.

(2) r = L (Y)

Important note: This can be interpreted as LM or as Taylor rule. π= 0 for this discussion.

Balance of Payments

Capital flows are determined by domestic and foreign interest rates. But have BP balance:

(3) CF(rd, rw) = NX(R)

Substituting (3) into (1), we get equation in Y and rd:

(IS) Y = C(Y - T) + I(rd) + G + CF(rd, rw)

rd

LM

CF=NX=0

Equilibrium

C+I(rd)+G+CF(rd) (IS$)

C+I(rd)+G (IS)

Y

CF

CF

- Remember the difference between real investment and financial investment. Real investment (I) goes down as domestic interest rates rise. Financial investment (CF) goes up as domestic interest rates rise because financial investments are attracted from abroad.
- We and Mankiw define CF as the capital outflow. This is the opposite of the financial account in the balance of payments, so CF = - Financial surplus. This is somewhat confusing, but that’s what he does and we follow that. Remember the picture on the next page.

Financial capital outflow(CF +)

rd

rd *

CF(rd, rw)

CF*

CF

CF (capital outflow) = - Financial surplus

CF

rd

rd

LM

r*

IS$

CF(r)

CF*

CF

0

Y

Real exchange rate, R

Mundell-Fleming for large open economy: the case of the US with a large financial surplus and current account deficit

R*

NX(R)

NX

CF

NX*

0

CF

rd

rd

LM

CF(r)

IS$

CF

0

Y

Real exchange rate, R

Effects of policy just like small open economy

R*

NX(R)

NX

CF

0

CF

rd

rd

LM

CF(r)

IS$

CF

0

Y

Real exchange rate, R

Effects of policy just like closed economy

R*

NX(R)

NX

CF

0

CF

How does openness change the impact of a stimulus plan?

Multiplier is reduced because some of the stimulus spills into imports and stimulates other countries

Note that financial crisis and high risk premium is the opposite (IS$ shift to the left)

rd

rd

LM

IS$’

IS$

CF(r)

CF

0

Y

Real exchange rate, R

Effect of fiscal stimulus

R*

NX(R)

NX

CF

0

CF

How does openness change the impact of a monetary policy?

Effect is larger because lower i → depreciation → higher NX.

- Double barreled effect of monetary policy

rd

rd

LM’

LM

IS$

CF(r)

CF

0

Y

Real exchange rate, R

Normal monetary expansion

R*

NX(R)

NX

CF

0

CF

What about a liquidity trap?

Note that monetary policy cannot work on either of the two mechanisms in a liquidity trap.

- Interest rates stuck and cannot stimulate domestic investment.
- With no change in interest rates, cannot repel foreign investment and depreciate currency.
So open economy does not change the basic liquidity trap dilemma!

rd

IS$

LM

LM’

Equilibrium

Y

CF

CF

Use unconventional policies to reduce long-run interest rates:

- verbal language that Fed funds rate will be low for long time.
- Buy long-term securities (add to excess reserves)
This will lower rd, depreciating dollar.

Source of criticism from foreign governments of “competitive depreciation.”

But this is what monetary policy is supposed to do

Show that protectionism has no effect on net exports or output.

What about effect of China buying large quantities of US$ securities to appreciate its currency?