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OPEN ECONOMY MACROECONOMICS Week 9: Lecture-2 Mr. Rup Singh School of Economics The University of the South Pacific Suva (Fiji) Lecture 1. Objectives: Extend the closed economy IS-LM model to include the external sector.
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Week 9: Lecture-2
Mr. Rup Singh
School of Economics
The University of the South Pacific
The international conditions sometimes give us (domestic economy) opportunities and sometimes, pose threats to us also.
Economies are linked through trade flows and changes in interest (exchange) rate. [The first affects trade accounts and external debt and the second affects capital account flows.]
We will look at the implications of different international macroeconomic conditions on our economic fundamentals.
Solving the balance of payments problems generally means getting out of a deficit situation, in the trade account, the current account, the balance of payments account, or in all three accounts simultaneously.
But, first of all let’s discuss what is Exchange Rate - the first link to the ROW. Exchange rate is the price one country’s currency expressed in terms of some other country’s currency.
E.g, if we we relate FJD to the USD as “how much it takes to get 1 USD, in terms of FJD,” the exchange rate is:
This gives the definition of the nominal exchange rate that we will be using now onwards:
E = FJ/USD
It tell us that the price of 1USD = $2.2FJ.
Fiji’s, currency is tied down to our trading partners’ currencies (Aust, NZ, Euro, Japan, and USA).
Our exchange rate is close to fixed, but we operate under the so called a Pegged Exchange Rate system.
Now, given the definition of the nominal exchange rate, we can define the real exchange rate.
Like any other variable, Real = Nominal /Prices
Therefore the real Exchange rate is Nominal exchange rate adjusted for relative prices (or inflation differentials).
θ = [F/USD]/[Pd/Pf]
θ = E /Pd/Pf
θ = E*Pf/Pd
If θ [for e.g. if Pd increases] -appreciation of the FJD – loss in international competitiveness
θ = Depreciation of FJD – gain in the international competitiveness [ for e.g. if pf increases]
BOP is external equilibrium.
It shows whether we have gained or lost from our net exports of goods and services (current account) and whether we are net exporters of importers of investment funds (capital account).
BOP = CA + KA
If we have current account surplus as well as capital account surplus, we will have BOP Surplus.
[if CA is in surplus, but KA is in deficit, (or other combinations), BOP depends on the relative magnitudes of surplus or deficit]
Under fixed exchange rate system, a BOP surplus meansaccumulation of foreign exchange reserves.
On the other hand, a BOP deficit implies a decline in foreign exchange reserves or de-accumulation of forex. reserves.
Note the change in the foreign reserves is the basis for market intervention by the C/Bank under the fixed exchange rate system.
Money supply becomes endogenous in the model. It is no longer under the full control of the C/B.
Capital flow - movement of international speculative investment. One of the determinants of capital flows is the Interest rate.
If interest rate is higher in Fiji, more capital inflow into the economy and v-v – in search for higher RR. Investors look at the differences in returns to investment, which is called the Interest Rate Differentials.
If there are interest differential which favors us (i > if), capital will inflow into Fiji. If interest rate differentials do not favor us, investors will hesitantly invest here, and we say there is imperfect capital mobility.
In special cases, there are no difference between the interest offered here and that abroad.
In other words, there are no interests rate differentials between the two economies. We call this situation, “perfect capital mobility” - a scenario where our economy is as competitive as any one else’s. (i = if)
So investors are indifferent whether they invest here or anywhere around the globe. Capital flows without hesitation - Perfect Capital Mobility
So given these briefings, we can extend our simple IS-LM model to IS-LM-BP model.
The following slides define the three markets - goods, money and forex markets, from where we derive the IS, LM and the BP equations.
In our analysis of IS-LM-BP Model we will discuss the Mundell-Fleming Model as we proceed.
Mundell and Fleming is an interesting extension to the IS-LM-BP Model, which assumes perfect capital mobility
Part 5: Flexible Exchange Rate Regime with (2) Perfect Capital Mobility
IS-LM and BP Models
L = kY- hi
Ms/P = M0 /P +ΔRES/P
L = Ms/P
Ms = M0/P +ΔRES/P
The supply of money is determined in part by the C/Bank and partly by the BOP situation. If BOP is in deficit, we say that the C/Bank de-accumulates the foreign exch. reserves, thus MS will fall, and v-v.
The money supply is no longer exogenous ( but it is endogenous) and is not under the full control of the C/Bank.
Ms/P = M0/P +ΔRES/P
L = kY- hi
LM (M0, P, ΔRES)
BP (NX0, CF0, θ, if, Yf )
IS (C0, TR0, T0, I0, G0, X0, Imo, θ, Yf )
Only under the fixed exchange rate system, there is accumulation or de-accumulation of foreign exchange reserve, which changes Money Supply (Ms), LM curve shifts to restore final equilibrium.
Money supply becomes endogenous – is not under full control of the Central bank. It is made up of domestic base money supply + foreign exchange reserves (BOP surplus) .
Thus C/Bank cannot carry out independent monetary policy under fixed exchange rate.