Lecture12 - Aggregate Demand in the Open Economy Road map...

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Unformatted text preview: Aggregate Demand in the Open Economy Road map to the lecture Demand in an open economy: – Net exports – The exchange rate Stabilization policy in an open economy The Mundell-Fleming, IS-LM model for an open economy Deriving AD in an open economy ECN 101 - MACROECONOMICS slide 1 Imports and Exports as a percentage of output: 2003 g 50% 45% Pe rcentage of GDP o 40% 35% 30% 25% 20% 15% 10% 5% 0% Canada Imports France Germany Italy Exports ECN 101 - MACROECONOMICS Japan Mexico U.K. USA source: OECD slide 2 Fluctuations of Nominal Components of Demand 40 40 30 30 20 20 10 10 0 0 -10 -10 -20 -20 20 -30 1965 1970 1975 1980 1985 1990 1995 2000 2005 -30 1965 1970 1975 1980 1985 1990 1995 2000 2005 CGROWTH IGROWTH 40 30 20 10 0 -10 -20 -30 1965 1970 1975 1980 1985 1990 1995 2000 2005 MGROWTH ECN 101 - MACROECONOMICS XGROWTH slide 3 Share of Demand Components .72 .15 .70 .14 .68 .13 .66 .12 .64 .11 .62 62 .10 10 .60 1965 1970 1975 1980 1985 1990 1995 2000 2005 .09 1965 1970 1975 1980 1985 1990 1995 2000 2005 CY IY .05 .04 .03 .02 .01 1965 1970 1975 1980 1985 1990 1995 2000 2005 XY ECN 101 - MACROECONOMICS MY slide 4 In an open economy, spending need not equal output saving need not equal investment i d li ECN 101 - MACROECONOMICS slide 5 The national income identity in an open economy Y = C + I + G + NX or, NX = Y – (C + I + G ) domestic spending net exports output ECN 101 - MACROECONOMICS slide 6 Trade surpluses and deficits NX = EX – IM = Y – (C + I + G ) trade surplus: output > spending and exports > imports Size of the trade surplus = NX trade deficit: spending > output and imports > exports Size f the trade deficit Si of th t d d fi it = –NX ECN 101 - MACROECONOMICS slide 7 U.S. net exports (% of GDP), 1975-2003 19752% 1% 0% -1% 1% -2% -3% -4% -5% 1975 1980 1985 ECN 101 - MACROECONOMICS 1990 1995 2000 slide 8 The link between trade & cap. flows NX = Y – (C + I + G ) implies i li NX = (Y – C – G ) – I = S – I p trade balance = net capital outflows Thus, a country with a trade deficit (NX < 0) is a net borrower (S < I ). ECN 101 - MACROECONOMICS slide 9 The world’s largest debtor nation U.S. has had large trade deficits, been a net borrower each year since the early 1980s 1980s. As of 12/31/2003: U.S. U S residents owned $7.9 trillion worth of id t d $7 9 t illi th f foreign assets Foreigners owned $10 5 trillion worth of U.S. $10.5 US assets U.S. net indebtedness to rest of the world: $2.6 trillion---higher than any other country, hence U.S. is “world’s largest debtor nation” ECN 101 - MACROECONOMICS slide 10 Saving and Investment in a Small Open Economy An open-economy version of the loanable funds model includes many of the same elements: production function: consumption function: investment function: Y = Y = F (K , L ) C = C ( −T ) Y I = I (r ) exogenous policy variables: G = G , T = T ECN 101 - MACROECONOMICS slide 11 National Saving: pp y The Supply of Loanable Funds r S = Y − C (Y − T ) − G As before, assume , national saving does not depend on the interest rate S ECN 101 - MACROECONOMICS S, I slide 12 Assumptions re: capital flows a. domestic & foreign bonds are perfect substitutes (same risk, maturity, etc.) b. perfect capital mobility: no restrictions on international trade in assets c. economy is small: cannot affect the world interest rate, denoted r* a & b imply r = r* py c implies r* is exogenous ECN 101 - MACROECONOMICS slide 13 Investment: The Demand for Loanable Funds r Investment is still a downward-sloping function d d l i f ti of the interest rate, but the exogenous world interest rate… r* …determines the determines country’s level of investment. I (r ) I (r* ) r ECN 101 - MACROECONOMICS S, I slide 14 If the economy were closed… r …the i t th interest t rate would adjust to equate investment and saving: d i S rc I (r ) I (rc ) =S ECN 101 - MACROECONOMICS S, I slide 15 But in a small open economy… the exogenous world interest rate determines investment… r r* …and the difference between saving rc and investment determines net capital outflows and net exports ECN 101 - MACROECONOMICS S NX I (r ) I1 S, I slide 16 Fiscal policy at home r An increase in G or decrease in T reduces saving. r * 1 S 2 S1 NX2 NX1 Results: ΔI = 0 I (r ) ΔNX = ΔS < 0 I1 ECN 101 - MACROECONOMICS S, I slide 17 4 3 Budget deficit (right scale) 8 6 2 4 1 2 0 0 -1 -2 -2 2 -4 4 -3 Percen of GDP nt Percen of GDP nt NX and the Government Budget Deficit -6 Net exports (left scale) -4 -8 -5 1950 -10 1960 1970 ECN 101 - MACROECONOMICS 1980 1990 2000 slide 18 The nominal exchange rate g e = nominal exchange rate, i l h t the relative price of domestic currency in terms of foreign currency (e.g. Yen per D ll ) ( Y Dollar) ECN 101 - MACROECONOMICS slide 19 The real exchange rate rate, ε = real exchange rate the lowercase Greek letter epsilon the relative price of domestic goods in terms of foreign goods (e.g. (e g Japanese Big Macs per U.S. Big Mac) ECN 101 - MACROECONOMICS slide 20 Understanding the units of ε ε = e ×P P * (Yen per $) × ($ per unit U.S. goods) = Yen Y per unit J it Japanese goods d = Yen per unit U.S. goods Yen per unit Japanese goods = Units of Japanese goods per unit of U.S. goods ECN 101 - MACROECONOMICS slide 21 ~ McZample ~ p one good: Big Mac price in Japan: P* = 200 Yen p price in USA: P = $2.50 nominal exchange rate e = 120 Yen/$ Y /$ ε To buy a U.S. Big Mac, someone from Japan would have to pay an amount that could buy 1.5 Japanese Bi M 15J Big Macs. e ×P = P * 120 × $2.50 = = 1 .5 200 Yen Yen ECN 101 - MACROECONOMICS slide 22 Latest Big Mac Index from The Economist ECN 101 - MACROECONOMICS slide 23 ε in the real world & our model In the real world: We can think of ε as the relative price of a basket of domestic goods in terms of a basket of foreign goods In our macro model: There’s j Th ’ just one good, “output.” d “ ” So ε is the relative price of one country’s output in terms of the other country’s output ECN 101 - MACROECONOMICS slide 24 How NX depends on ε ↑ε ⇒ U.S. goods become more expensive relative to foreign goods ⇒ ↓EX, ↑IM ⇒ ↓NX ECN 101 - MACROECONOMICS slide 25 2% 140 1% 120 0% 100 -1% 80 -2% 60 -3% 40 -4% 20 -5% 1973 :1 = 100 Percent of GDP t U.S. Net Exports and the Real Exchange Rate, 1975-2003 g , 1975- 0 1975 1980 1985 1990 1995 2000 Net exports (left scale) Real exchange rate index (right scale) ECN 101 - MACROECONOMICS slide 26 The net exports function The net exports function reflects this inverse relationship between NX and ε: NX = NX (ε ) ECN 101 - MACROECONOMICS slide 27 Is dollar depreciation a separate policy channel for trade balance adjustment? Econbrowser, May 16, 2006 ECN 101 - MACROECONOMICS slide 28 Cont. …But it's important to remember that dollar p depreciation is in and of itself not sufficient to achieve a substantial reduction on the trade deficit. To the extent that the dollar decline reflects accelerating growth abroad the dollar's value abroad, dollar s merely reflects expectations of growth trends and monetary policy in the future. In other words, the dollar's l i d ll ' value is endogenous with respect to d ith tt monetary and fiscal policies, and it doesn't make sense to talk about movements in it in addition to those policies. ECN 101 - MACROECONOMICS slide 29 Exchange rate pass through and dollar decline Econbrowser, May 23, 2006 Is there a direct relationship running from a change p g g in the dollar's value and import and export prices and thence to consumer prices? Numerous commentators have suggested (e.g., here) that the declining dollar could lead to increased inflationary pressures. So a declining dollar, in this perspective, could confront the Fed with a particularly unpleasant set of choices. In ith ti l l l t t f h i I particular, it might be forced to react to the dollar's decline in order to squelch imported inflationary pressures at exactly the same time that it has already raised interest rates to cool domestic demand. ECN 101 - MACROECONOMICS slide 30 PassPass-Through Estimates ECN 101 - MACROECONOMICS slide 31 ECN 101 - MACROECONOMICS slide 32 ECN 101 - MACROECONOMICS slide 33 … ECN 101 - MACROECONOMICS slide 34 The NX curve for the U.S. ε so U.S. net US exports will be high When ε is relatively low, low U.S. goods are relatively y inexpensive ε1 NX(ε) 0 ECN 101 - MACROECONOMICS NX(ε1) NX slide 35 The NX curve for the U.S. ε ε2 At high enough values of ε, U.S. goods become so expensive that we export less than we import NX(ε) NX(ε2) 0 ECN 101 - MACROECONOMICS NX slide 36 How ε is determined The accounting identity says NX = S − I We W saw earlier how S − I i determined: li h is d i d • S depends on domestic factors (output, fiscal policy variables etc) variables, • I is determined by the world interest rate r * So, ε must adjust to ensure NX (ε ) = S − I (r *) ECN 101 - MACROECONOMICS slide 37 How ε is determined Neither S nor I depend on ε, d d so the net capital outflow curve is vertical. ε adjusts to equate NX ε S 1 − I (r *) ) ε1 with net capital outflow, S − I. ECN 101 - MACROECONOMICS NX(ε ) NX 1 NX slide 38 Interpretation: supply and demand in the foreign exchange market demand: Foreigners need dollars to buy U.S. U S net exports exports. supply: The net capital outflow (S − I ) is the supply of dollars to be invested abroad. abroad ε S 1 − I (r *) ) ε1 ECN 101 - MACROECONOMICS NX(ε ) NX 1 NX slide 39 Fiscal policy at home A fiscal expansion reduces national saving, net capital outflows, and the supply of dollars in the foreign exchange market… ε S 2 − I (r *) S 1 − I (r *) ε2 ε1 …causing the real exchange rate to rise and NX to fall. fall ECN 101 - MACROECONOMICS NX(ε ) NX 2 NX 1 NX slide 40 Purchasing Power Parity (PPP) Two definitions: – a doctrine that states that goods must sell at the same (currency-adjusted) price in all countries. – the nominal exchange rate adjusts to equalize the cost of a basket of goods across countries. Reasoning: easo g – arbitrage, the law of one price ECN 101 - MACROECONOMICS slide 41 Purchasing Power Parity (PPP) PPP: e ×P = P* Cost of a basket of domestic goods, in foreign currency. Solve for e : Cost of a basket of foreign goods, in goods foreign currency. Cost of a basket of C f b k f domestic goods, in domestic currency. e = P*/P PPP implies that the nominal exchange rate between two countries equals the ratio of the th countries’ price levels. ti ’ i l l ECN 101 - MACROECONOMICS slide 42 Does PPP hold in the real world? No, for three reasons: 1. International arbitrage not possible. g p nontraded goods transportation costs 2. 2 Goods of different countries not perfect substitutes substitutes. 3. Financial flows dwarf transactions in goods, hence differences in the returns of domestic and foreign assets also matter (uncovered interest rate parity) Nonetheless, PPP is a useful theory: • It’s simple & intuitive It s • In the real world, nominal exchange rates have a tendency toward their PPP values over the long run. ECN 101 - MACROECONOMICS slide 43 A fiscal expansion in three models A fiscal expansion causes national saving to fall. The effects of this depend on the degree of openness: p g p closed economy y large open economy y small open economy y rises rises, but not as much as in closed economy y no change g I falls falls, but not as much as in closed economy y no change g NX no change g falls, but not as much as in small open economy p y falls r ECN 101 - MACROECONOMICS slide 44 Uncovered Interest Rate Parity Condition UIP is also an arbitrage condition that states that I should be indifferent (adjusting for risk and everything else) between investing $ $1 domestically or internationally, i.e., y y, , Domestic return: (1 + r) Foreign return (in dollars): (1+r*)e Hence: e = (1+r)/(1+r*) or (i - π)/(i* - π *) = ln(e) ECN 101 - MACROECONOMICS slide 45 The Mundell-Fleming Model MundellKey assumption: Small open economy with perfect capital mobility. r = r* r Goods market equilibrium – the IS* curve: Y = C (Y − T ) + I (r *) + G + NX (e ) where e = nominal exchange rate = foreign currency per unit of domestic currency ECN 101 - MACROECONOMICS slide 46 The IS* curve: Goods Market Eq’m Y = C (Y − T ) + I (r *) + G + NX (e ) The IS* curve is drawn for a given value of r*. r e Intuition for the slope: ↓ e ⇒ ↑ NX ⇒ ↑ Y IS* Y ECN 101 - MACROECONOMICS slide 47 The LM* curve: Money Market Eq’m M P = L (r *,Y ) The LM* curve is drawn for a given value of r* l f * is vertical because: given r*, there is only one value of Y that equates money demand with supply, g regardless of e. ECN 101 - MACROECONOMICS e LM* Y slide 48 Equilibrium in the Mundell-Fleming model MundellY = C (Y − T ) + I (r *) + G + NX (e ) M P = L (r *,Y ) e LM* equilibrium exchange rate equilibrium level of income ECN 101 - MACROECONOMICS IS* Y slide 49 Floating & fixed exchange rates In a system of floating exchange rates, e is allowed to fluctuate in response to changing economic conditions. In contrast, under fixed exchange rates contrast rates, the central bank trades domestic for foreign currency at a p y predetermined price. p We now consider fiscal, monetary, and trade policy: first in a floating exchange rate system, then in a fixed exchange rate system. ECN 101 - MACROECONOMICS slide 50 Fiscal policy under floating exchange rates Y = C (Y − T ) + I (r *) + G + NX (e ) M P = L (r *,Y ) At any given value of e, a fiscal expansion increases Y, shifting IS* to the right. e LM 1* e2 e1 IS 2* Results: Δe > 0, ΔY = 0 ECN 101 - MACROECONOMICS IS 1* Y1 Y slide 51 Lessons about fiscal policy In a small open economy with perfect capital mobility, fiscal policy cannot affect real GDP. “Crowding out” • closed economy: Fiscal policy crowds out investment by causing the interest rate to rise. g • small open economy: Fiscal policy crowds out net exports by causing the exchange rate to appreciate. ECN 101 - MACROECONOMICS slide 52 Mon. policy under floating exchange rates Y = C (Y − T ) + I (r *) + G + NX (e ) M P = L (r *,Y ) e An increase in M shifts LM* right because Y must rise to restore eq’m eq m in the money market. Results: Δe < 0, ΔY > 0 ECN 101 - MACROECONOMICS LM 1*LM 2* e1 e2 IS 1* Y1 Y2 Y slide 53 Lessons about monetary policy Monetary policy affects output by affecting one (or more) of the components of aggregate demand: closed economy: ↑M ⇒ ↓r ⇒ ↑I ⇒ ↑Y small open economy: ↑M ⇒ ↓e ⇒ ↑NX ⇒ ↑Y Expansionary mon. policy does not raise world mon aggregate demand, it shifts demand from foreign to domestic products. p Thus, the increases in income and employment at home come at the expense of losses abroad. ECN 101 - MACROECONOMICS slide 54 Trade policy under floating exchange rates Y = C (Y − T ) + I (r *) + G + NX (e ) M P = L (r *,Y ) At any given value of e, a tariff or quota reduces imports, increases NX, and shifts IS* to the right. e LM 1* e2 e1 IS 2* Results: R lt Δe > 0, ΔY = 0 ECN 101 - MACROECONOMICS IS 1* Y1 Y slide 55 Lessons about trade policy Import restrictions cannot reduce a trade deficit. Even though NX is unchanged, there is less trade: – the trade restriction reduces imports – the exchange rate appreciation reduces exports Less trade means fewer ‘gains from trade.’ Import restrictions on specific products save jobs in the domestic industries that produce those products, th d ti i d t i th t d th d t but destroy jobs in export-producing sectors. Hence, import restrictions fail to increase total employment. Worse yet, import restrictions create “sectoral shifts,” which cause f i ti hift ” hi h frictional unemployment. l l t ECN 101 - MACROECONOMICS slide 56 Fixed exchange rates Under a system of fixed exchange rates, the country s country’s central bank stands ready to buy or sell the domestic currency for foreign currency at a predetermined rate. In the context of the Mundell-Fleming model, the central bank shifts the LM* curve as required to keep e at it preannounced rate. i dt k t its d t This system fixes the nominal exchange rate. In the long run, when prices are flexible, I th l h i fl ibl the real exchange rate can move even if the nominal rate is fixed. ECN 101 - MACROECONOMICS slide 57 Fiscal policy under fixed exchange rates Under floating rates, a fiscal expansion would policy ineffective at changing output. raise e. To keep e from rising, Under fixed rates, rates the central bank must fiscal policy is very sell domestic currency, effective at changing output. which increases M and shifts LM* right. e LM 1*LM 2* e1 IS 2* IS 1* Results: Δe = 0, ΔY > 0 ECN 101 - MACROECONOMICS Y1 Y2 Y slide 58 Mon. policy under fixed exchange rates An increase in M would shift Under floating rates, LM* right policy is very . i h monetary and reduce e ld d effective at changing e To prevent the fall in e, output. output the central bank must Under fixed rates, buy domestic currency, monetary policy cannot be which reduces M and hi h d d e1 used to affect output. shifts LM* back left. LM 1*LM 2* Results: Δe = 0, ΔY = 0 ECN 101 - MACROECONOMICS IS 1* Y1 Y slide 59 Trade policy under fixed exchange rates Under floating rates, A restriction on imports import restrictions do not puts upward pressure affecte. or NX. on Y Under fixed rates, rising To keep e from, rising, importcentral bank must the restrictions increase Y and NX. sell domestic currency, y, But, these gains come at which increases M the expense LM* right. and shifts of other countries, countries as the policy Results: merely shifts demand from foreign to = 0, ΔY goods. Δe domestic > 0 ECN 101 - MACROECONOMICS e LM 1*LM 2* e1 IS 2* IS 1* Y1 Y2 Y slide 60 M-F: summary of policy effects type of exchange rate regime: floating fixed impact on: Policy Y e NX Y e NX fiscal expansion 0 ↑ ↓ ↑ 0 0 mon. mon expansion ↑ ↓ ↑ 0 0 0 import restriction 0 ↑ 0 ↑ 0 ↑ ECN 101 - MACROECONOMICS slide 61 InterestInterest-rate differentials Two reasons why r may differ from r* country risk: The risk that the country’s borrowers will default on their loan repayments because of political or economic turmoil. Lenders require a higher interest rate to compensate them for this risk risk. expected exchange rate changes: If a country’s exchange rate is expected to fall, country s then its borrowers must pay a higher interest rate to compensate lenders for the expected currency depreciation. ECN 101 - MACROECONOMICS slide 62 Differentials in the M-F model Mr = r *+ θ where θ is a d h domestic risk premium. k Substitute the expression for r into the IS* and LM* equations: d ti Y = C (Y − T ) + I (r * + θ ) + G + NX (e ) M P = L (r * + θ ,Y ) ECN 101 - MACROECONOMICS slide 63 The effects of an increase in θ IS* shifts left, because ↑ θ ⇒ ↑r ⇒ ↓I LM LM* shifts right, because ↑ θ ⇒ ↑r ⇒ ↓(M/P )d, so Y must rise to restore e LM 1*LM 2* e1 money market eq’m. Results: R lt Δe < 0, ΔY > 0 ECN 101 - MACROECONOMICS e2 Y1 Y2 IS 1* IS 2* Y slide 64 The effects of an increase in θ The fall in e is intuitive: An increase in country risk or an expected depreciation makes holding the country’s currency less attractive. Note: an expected depreciation is a self-fulfilling prophecy. The increase in Y occurs because the boost in NX (from the depreciation) is even greater than the fall in I (from th rise in r ) (f the i i ). ECN 101 - MACROECONOMICS slide 65 Why income might not rise The central bank may try to prevent the depreciation by reducing the money supply The depreciation might boost the price of imports enough to increase the price level (which would reduce the real money supply) Consumers might respond to the increased risk by holding more money. Each f th b E h of the above would shift LM* l ft ld hift leftward. d ECN 101 - MACROECONOMICS slide 66 CASE STUDY: The Mexican Peso Crisis U.S Cents per Mexi S. ican Peso o 35 30 25 20 15 10 7/10/94 8/29/94 10/18/94 ECN 101 - MACROECONOMICS 12/7/94 1/26/95 3/17/95 5/6/95 slide 67 CASE STUDY: The Mexican Peso Crisis U.S Cents per Mexi S. ican Peso o 35 30 25 20 15 10 7/10/94 8/29/94 10/18/94 ECN 101 - MACROECONOMICS 12/7/94 1/26/95 3/17/95 5/6/95 slide 68 The Peso Crisis didn’t just hurt Mexico U.S. goods more expensive to Mexicans – U S firms lost revenue U.S. – Hundreds of bankruptcies along U.S. Mex U S -Mex border Mexican assets worth less in dollars – Affected retirement savings of millions of U.S. citizens ECN 101 - MACROECONOMICS slide 69 Understanding the crisis In the early 1990s, Mexico was an attractive place for foreign investment. investment During 1994, political developments caused an increase in Mexico s risk premium (θ ): Mexico’s • peasant uprising in Chiapas • assassination of leading presidential gp candidate Another factor: The Federal Reserve raised U.S. interest rates several times during 1994 to prevent U.S. inflation. (So inflation (So, Δr* > 0) ECN 101 - MACROECONOMICS slide 70 Understanding the crisis These events put downward pressure on the peso. peso Mexico’s central bank had repeatedly promised foreign investors that it would not allow the peso’s value to fall, so it bought pesos and sold dollars to “prop up” the peso exchange rate. Doing this requires that Mexico s central Mexico’s bank have adequate reserves of dollars. Did it? ECN 101 - MACROECONOMICS slide 71 Dollar reserves of Mexico’s central bank Mexico s December 1993 ……………… $28 billion August 17, 1994 ……………… $17 billion December 1, 1994 …………… $ 9 billion December 15 1994 ………… $ 7 billion 15, During 1994, Mexico’s central bank hid the fact that its reserves were being depleted. ECN 101 - MACROECONOMICS slide 72 the disaster Dec. 20: Mexico devalues the peso by 13% (fixes e at 25 cents instead of 29 cents) Investors are shocked ! ! ! …and realize the central bank must be running and out of reserves… ↑θ, Investors dump their Mexican assets and pull their capital out of Mexico. Dec. Dec 22: central bank’s reserves nearly gone bank s gone. It abandons the fixed rate and lets e float. In a week, e falls another 30%. week 30% ECN 101 - MACROECONOMICS slide 73 The rescue package 1995: U.S. & IMF set up $50b line of credit to provide loan guarantees to Mexico’s govt Mexico s govt. This helped restore confidence in Mexico, reduced the risk premium premium. After a hard recession in 1995, Mexico began a strong recovery from the crisis crisis. ECN 101 - MACROECONOMICS slide 74 The S.E. Asian Crisis exchange rate stock market % nominal GDP % change from change from % change 7/97 to 1/98 7/97 to 1/98 1997-98 1997 98 Indonesia -59.4% -32.6% -16.2% Japan -12.0% -18.2% -4.3% Malaysia -36.4% -43.8% -6.8% Singapore -15.6% -36.0% -0.1% S. Korea -47.5% -21.9% -7.3% Taiwan -14.6% -19.7% n.a. Thailand -48.3% -25.6% U.S. n.a. 2.7% ECN 101 - MACROECONOMICS -1.2% (1996-97) 2.3% slide 75 Floating vs. Fixed Exchange Rates Argument for floating rates: allows monetary policy to be used to pursue ll li b d other goals (stable growth, low inflation) Arguments for fixed rates: avoids uncertainty and volatility, making international transactions easier disciplines monetary policy to prevent p yp y p excessive money growth & hyperinflation ECN 101 - MACROECONOMICS slide 76 MundellMundell-Fleming and the AD curve So far in M-F model, P has been fixed. Next: to derive the N t t d i th AD curve, consider the id th impact of a change in P in the M-F model. We now write the M-F equations as: MF (IS* ) (LM* ) Y = C (Y − T ) + I (r *) + G + NX (ε ) M P = L (r *,Y ) (Earlier in this chapter, P was fixed, so we could write NX as a function of e instead of ε.) ECN 101 - MACROECONOMICS slide 77 Deriving the AD curve Why AD curve has y negative slope: ( ↑P ⇒ ↓(M/P ) ε ε2 ε1 IS* ⇒ LM shifts left ⇒ ↑ε ⇒ ↓NX ⇒ ↓Y LM*(P2) LM*(P1) P Y2 Y P2 P1 AD Y2 ECN 101 - MACROECONOMICS Y1 Y1 Y slide 78 From the short run to the long run If Y1 < Y , then there is downward pressure on prices. Over time, P will move down, causing (M/P )↑ ↑ ε↓ NX ↑ ε LM*(P1) LM*(P2) ε1 ε2 IS* P Y1 Y LRAS P1 SRAS1 P2 SRAS2 Y↑ AD Y1 ECN 101 - MACROECONOMICS Y Y Y slide 79 Large: between small and closed Many countries - including the U.S. - are neither closed nor small open economies. A large open economy is in between the polar cases of closed & small open. open Consider a monetary expansion: • Like in a closed economy, economy ΔM > 0 ⇒ ↓r ⇒ ↑I (though not as much) • Like in a small open economy, economy ΔM > 0 ⇒ ↓ε ⇒ ↑NX (though not as much) ECN 101 - MACROECONOMICS slide 80 ...
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