Lecture notes - open2

Lecture notes - open2 - Open Economy Macroeconomics(part 2...

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Open Economy Macroeconomics (part 2) I. The IS-LM Model for an Open Economy (Mundell-Fleming model) A. Only the IS curve is affected by having an open economy instead of a closed economy: the LM curve and FE line are the same 1. The IS curve is affected because net exports are part of the demand for goods 2. The IS curve remains downward sloping 3. Any factor that shifts the closed-economy IS curve shifts the open-economy IS curve in the same way 4. Factors that change net exports (given domestic output and the domestic real interest rate) shift the IS curve a. Factors that increase net exports shift the IS curve up b. Factors that decrease net exports shift the IS curve down S d – I d , NX Domestic real interest rate, r S d - I d 0 NX B. The open-economy IS curve 1. The goods-market equilibrium condition is S d – I d = NX (assume NFP = 0) 2. Plotting S d – I d and NX illustrates goods-market equilibrium a. Net exports can be positive or negative b. The net export curve slopes downward, because a rise in the real interest rate increases the real exchange rate and thus reduces net exports
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c. The S – I curve slopes upward, because a rise in the real interest rate increases desired national saving and reduces desired investment d. Equilibrium occurs where the curves intersect Domestic real interest rate, r Domestic real interest rate, r S d – I d , NX Output, Y (S – I) 1 (S – I) 2 Y1 Y2 r 1 r 2 NX1 IS 0 NX2 3. To get the open-economy IS curve, we need to see what happens when domestic output changes a. Higher output increases saving, so the S – I curve shifts to the right b. Higher output reduces net exports, so the NX curve shifts to the left c. The new equilibrium occurs at a lower real interest rate, so the IS curve is downward sloping C. Factors that shift the open-economy IS curve 1. Any factor that raises the real interest rate that clears the goods market at a constant level of output shifts the IS curve up a. An example is a temporary increase in government purchases b. The rise in government purchases reduces desired national saving, shifting the S – I curve to the left, shifting the IS curve up c. Anything that reduces desired national saving relative to investment shifts the IS curve up
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Domestic real interest rate, r Domestic real interest rate, r S d – I d , NX Output, Y (S – I) 2 (S – I) 1 Y r 2 r 1 NX IS2 IS1 0 2. Anything that raises a country’s net exports, given domestic output and the domestic real interest rate, will shift the open-economy IS curve up a. The increase in net exports is shown as a shift to the right in the NX curve b. This raises the real interest rate for a fixed level of output, shifting the IS curve up c. Three things could increase net exports for a given level of output and real interest rate An increase in foreign output, which increases foreigners’ demand for domestic exports An increase in the foreign real interest rate, which makes people want to buy foreign assets, causing the exchange rate to depreciate, which in turn causes net exports to rise
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