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## Macroeconomics

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### Macroeconomics

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

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

Short Run Open Economy Macroeconomics

Instructor: Prof. John M. Veitch

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)

- 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

- 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.

e2

3.

2.

Y2

4.

P2

1.

AD(G,T,M,r*)

Y2

Open Economy AD Curvee

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

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

Instructor: Prof. John M. Veitch

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

- 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.

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.

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

- 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.

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

- 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.

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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