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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)

slide4

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

slide7

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

slide8

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

slide12

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

slide15

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.
slide17

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.
slide19

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