Notes_ECO202_04 - Macroeconomics Theory and Policy Open...

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Unformatted text preview: Macroeconomics Theory and Policy Open Economy in Short Run Chapters 6, 7, and 8 Masoud Anjomshoa 1 Goods Market in Open Economies: . We assume that we have two goods, domestic made good, Y, with price P, and foreign made good, Y*, with price P*. Consumers should decide how much of each, they can consume. Nominal Exchange Rate, E: E = 1.4205 $/ € E = 1.6208 $/ £ E = 0.0127 $/¥ Nominal Depreciation: If foreign currency becomes stronger, or domestic currency becomes weaker, or if Nominal Appreciation: If foreign currency becomes weaker, or domestic currency becomes stronger, or if Masoud Anjomshoa Masoud Anjomshoa 2 1 Macroeconomics Theory and Policy Goods Market in Open Economies: European Car = €47,000 Canadian Car = $60,000 E = 1.4205 $/ € Which product is cheaper? Pr ice ratio . 47,000 1.4205 1.1127 60,000 Real Exchange Rate, ε: Real Depreciation: If foreign goods become relatively more expensive, or domestic goods become relatively cheaper, or if Real Appreciation: If foreign goods become relatively cheaper, or domestic goods become relatively more expensive, or if Masoud Anjomshoa 3 Goods Market in Open Economies: Real Exchange Rate: EP * Example: ΔE/E= 2% . P E P * P E P* P E * E π = 6% π* = 3% Δε/ε= -1% Real appreciation domestic goods become relatively more expensive. Masoud Anjomshoa Masoud Anjomshoa 4 2 Macroeconomics Theory and Policy Financial Market in Open Economies: . We assume that we have 4 assets, foreign and domestic bonds, B, and B*, and foreign and domestic money. People do not normally keep foreign currency. Because it is neither good for transactions nor return. Maybe only for: - M B B* W ealth Domestic interest rate, i Foreign interest rate, i* Masoud Anjomshoa 5 Financial Market in Open Economies: . People should decide between foreign and domestic bonds. Year t $1 Investing in domestic bonds Year t+1 it ? Et Eet+1 i*t Investing in foreign bonds Masoud Anjomshoa Masoud Anjomshoa 6 3 Macroeconomics Theory and Policy Financial Market in Open Economies: . Assumptions: - Same risk for both bonds - No transaction costs If E e1 (1 i t ) t (1 i* ) t Et E e1 (1 i t ) t (1 i* ) t Et If Buy domestic assets Buy foreign assets By arbitrage, in equilibrium: E e1 Ee t 1 1 t 1 (1 i* ) (1 i* ) (1 i t ) t t Et Et E e1 E t E e1 E t * * t (1 i t ) i t i t t (1 i t ) 1 Et Et Uncovered Interest Parity Condition (1 i t ) Masoud Anjomshoa 7 Financial Market in Open Economies: Expected exchange rate . Nominal exchange rate E e1 E t i t i* t t Et UIP Condition: Rate of return on domestic assets Expected rate of return on foreign assets Masoud Anjomshoa Masoud Anjomshoa Expected depreciation rate 8 4 Macroeconomics Theory and Policy Goods Market in Open Economies: . Z= C+I+G – ε Q +X DD Import Export Domestic demand Including demand for goods Demand for domestic goods for foreign goods Z = co +c1 (Y-T) + I(Y , i) + G + – – ε Q( ε , Y) + X( ε , Y*) – + + + Masoud Anjomshoa 9 DD = co + c1 (Y-T) + I(Y, i) + G Z ZZ AA X ( , Y *) O AA DD Q( , Y ) Q( , Y ) Given i , ε X( , Y *) NX Yo Y + 0 Yo Y Masoud Anjomshoa Masoud Anjomshoa NX X Q 10 5 Macroeconomics Theory and Policy ZZ =Y Z DD = co + c1 (Y-T) + I(Y, i) + G ZZ A X ( , Y *) O E Given i , ε 45o Y Yo NX Y + Yo 0 Y Y NX X Q - Z ZZ =Y Given i , ε 11 DD1 = co + c1 (Y-T) + I(Y, i) + G1 DD = co + c1 (Y-T) + I(Y, i) + G ZZ 1 DD 1 X ( , Y *) Q ( , Y ) O1 E1 ZZ DD X ( , Y *) Q ( , Y ) E O - Masoud Anjomshoa Yo Y Y Y=Yo Y1 + 0 Impact of expansionary fiscal policy: G ↑ 45o NX Y1 Trade Deficit NX X Q 12 6 Macroeconomics Theory and Policy Z ZZ =Y Given i , ε DD = co + c1 (Y-T) + I(Y, i) + G O1 ZZ 1 DD X ( , Y1* ) Q ( , Y ) E1 ZZ DD X ( , Y ) Q ( , Y ) * O 45o Y=Yo Yo1 Y1 Y + 0 - Y Y=Yo Y1 Impact of increase in foreigners’ income: Y*↑ E NX Yo1 NX 1 X 1 Q NX X Q Trade Surplus 13 Marshall-Lerner Condition: . NX= X(ε , Y*) – ε Q(ε , Y) NX (Y , Y*, ε ) – + + + If ε ↑ Q(ε , Y) ↓ – + ε Q(ε , Y) – + Marshall and Lerner showed if export and NX= X(ε , Y*) – ε Q(ε , Y) import are elastic enough, then a real ↑ ↓ depreciation improves the trade balance: ↑ Q X Marshall-Lerner X Q 1 NX (Y , Y*, ε ) Condition: – + + Masoud Anjomshoa Masoud Anjomshoa 14 7 Macroeconomics Theory and Policy Z ZZ =Y Given i DD = co + c1 (Y-T) + I(Y, i) + G O1 ZZ 1 DD NX ( Y , Y *, 1 ) E1 ZZ DD NX ( Y , Y ) E 45o Y=Yo Yo1 Y1 Y + Y Y=Yo - Impact of a real depreciation: ε ↑ O 0 * NX Y1 Yo1 Trade Surplus NX 1 NX 15 J-curve, Dynamics of Real Depreciation: Net Exports, NX + 0 Real depreciation (ε ↑) t Time – Marshall-Lerner condition fails right after the policy: NX= X(ε , Y*) – ε Q(ε , Y) ↓ √ Domestic buyers gradually substitute domestic goods for foreign goods, and buyers abroad realize that domestic goods are cheaper. This leads to a gradual decrease in imports, as exports increase, which leads to improvement of trade balance. So Marshall-Lerner condition may finally work. ↑√ Masoud Anjomshoa Masoud Anjomshoa 16 8 Macroeconomics Theory and Policy Financial Market in Open Economies: Demand and supply of money in open economies are still the same as closed economy. So the LM curve in open economies is the same as close economies: M B B* M Y L(i ) P The right combination of E e1 E t domestic and foreign assets i i* t (B and B*) is depending on Et UIP relation: Capital outflow: i i* E . W ealth Capital inflow: Et Et E e1 E t i i* t Et e t 1 Masoud Anjomshoa Financial Market in Open Economies Uncovered Interest Parity Condition: 17 . Suppose expected E e 1 E t UIP : i i * t E e1 E e t Et exchange rate is fixed i i* Ee 1 E i Given i*, E e Ee E 1 i i* If i = i* Then E = E e O i* Ee Masoud Anjomshoa Masoud Anjomshoa E 18 9 Macroeconomics Theory and Policy Financial Market in Open Economies Uncovered Interest Parity Condition: 1- Suppose domestic interest rate, i, increases: . If i increases: i1 i * i Ee E E i1 A O i=i* UIP E1 i1 i * E E Ee E e E1 E1 Masoud Anjomshoa 19 Financial Market in Open Economies Uncovered Interest Parity Condition: 2- Suppose foreign interest rate, i*, increases: . If i* increases: * i i1 i Ee E E i1* i=i* O1 O A UIP E Ee E1 * i i1 E Masoud Anjomshoa Masoud Anjomshoa Higher demand for foreign currency E e E1 E1 20 10 Macroeconomics Theory and Policy Financial Market in Open Economies Uncovered Interest Parity Condition: 3- Suppose market expects nominal depreciation: Ēe↑ . If Ēe increases: i i* i E 1e E E i=i* O A O1 UIP EE e Higher demand for foreign currency i i* E e 1 E =E1 E 1e E 1 E1 Masoud Anjomshoa 21 IS/LM Curves in Open Economies: . IS : Y c o c1 (Y T) I(Y, i ) G NX(Y, Y *, ) ML M Y L( i ) P e E UIP : E 1 i i * RER : EP * / P Short Run : P, P * are fixed E LM : IS : Y c o c1 (Y T) I(Y, i ) G NX(Y, Y *, Ee ) 1 i i * ML LM : M Y L( i ) P Masoud Anjomshoa Masoud Anjomshoa 22 11 Macroeconomics Theory and Policy IS/LM Curves in Open Economies: IS : Y c o c1 (Y T) I(Y, i ) G NX(Y, Y *, The IS curve for open economies is flatter than the closed economy one. Closed economy: If E ) 1 i i * ML i i1 Open economy: 1)- If O i 2)- If Capital inflow . e ISopen ISclosed Yopen Yclosed Y Y Masoud Anjomshoa 23 Open Economy with Flexible Exchange Regime: i i1 i LM Y A O Impact of an Expansionary Fiscal policy: G↑ i A i1 i=i* O A: Short Run Equilibrium IS1 IS NX Y Y1 Y E1 E Ee - Masoud Anjomshoa E IS: Y C I(Y, i) G NX(Y, Y*,E) + 0 UIP Y1 Y Y Trade Deficit A NX 1 LM: ML M Y L (i) P NX 24 12 Macroeconomics Theory and Policy Open Economy with Flexible Exchange Regime: IS : Y co c1 (Y T) I(Y, i ) G NX(Y, Y *, E) LM : ML M YL(i ) P Impact of an Expansionary Fiscal policy: G↑ (subject to ML) E e E1 In equilibrium: i1 i * E 1 Ee E ii i * E Masoud Anjomshoa 25 Open Economy with Flexible Exchange Regime: i i i1 LM LM i 1 Y O Impact of an Expansionary Monetary policy: M↑ O i=i* i1 A A: Short Run Equilibrium A IS1 IS NX Y Y1 UIP Y E Ee E1 IS: Y C I(Y, i) G NX(Y, Y*,E) + A 0 - Masoud Anjomshoa E Y Trade Surplus ML M i Y LM: P Y L () Y1 NX Masoud Anjomshoa 26 13 Macroeconomics Theory and Policy Open Economy with Flexible Exchange Regime: IS : Y co c1 (Y T) I(Y, i ) G NX(Y, Y *, E) LM : ML M YL(i ) P Impact of an Expansionary Monetary policy: M↑ e In equilibrium: Also: i i i * E E E i1 i * E e E1 E1 Masoud Anjomshoa 27 Open Economy with Flexible Exchange Regime: i i1 i LM Y A i A i1 i=i* A: Short Run Equilibrium O O UIP1 IS NX Y Y1 + 0 - Masoud Anjomshoa Y e E E E1 E 1 e Y Trade surplus Y1 UIP E IS: Y C I(Y, i) G NX(Y, Y*,E) A Y Impact of an expected depreciation: Ēe ↑ NX 1 NX LM: ML M Y L (i) P 28 14 Macroeconomics Theory and Policy Open Economy with Flexible Exchange Regime: IS : Y co c1 (Y T) I(Y, i ) G NX(Y, Y *, E) ML M YL(i ) P Impact of an Expected Depreciation: Ēe ↑ i i * E 1e E E In equilibrium: E e E1 i1 i * 1 E1 LM : Masoud Anjomshoa 29 Masoud Anjomshoa 30 Fixed Exchange Rate Regime Masoud Anjomshoa 15 Macroeconomics Theory and Policy (Credible) Pegged (Fixed) Exchange Regime: In pegged system, the Central Bank sets the exchange rate: E = Ē In order to keep the system credible, the Central Bank must defend the rate Ē, by buying/selling foreign exchange. If the system is credible, then: Ēe= Ē E S€ Ē1 E Ē2 Devaluation Policy: If the Central Bank increases Ē, making domestic currency weaker. Revaluation Policy: If the Central Bank decreases Ē, making domestic currency stronger. D€ Quantity of Exchange Masoud Anjomshoa 31 (Credible) Pegged (Fixed) Exchange Regime: Ee E UIP : i i * E Pegged : EE Credibilit y : E e E IS : Y co c1 (Y T) I(Y, i *) G NX(Y, Y *, E) ML LM : M Y L(i *) P Flexible Exchange Regime: Market determines exchange rate, E. The Central Bank sets money supply, M (expansionary/contractionary). Pegged (fixed) Exchange Regime: Market determine money supply, M. The Central Bank sets exchange rate, E (devaluation/revaluation). Masoud Anjomshoa 32 Masoud Anjomshoa 16 Macroeconomics Theory and Policy (Credible) Pegged (Fixed) Exchange Regime: i i LM Y Impact of an Expansionary Monetary policy: M↑ i LM1 O i=i* O IS NX Y Y E Ee E IS: Y C I(Y, i *) G NX Y, Y*,E) ( + 0 UIP M i Y LM: P Y L (*) Y - ML E Ee NX Masoud Anjomshoa 33 (Credible) Pegged (Fixed) Exchange Regime: IS : Y co c1 (Y T) I(Y, i *) G NX(Y, Y *, E) ML M YL(i *) E Ee P Impact of an Expansionary Monetary policy: M↑ LM : Money supply, M, decreases So the initial increase in money supply will be neutralized. e Also: i i * E E E The only change will be the difference in the Central Bank assets. The central bank now has less foreign assets, and more government bonds. Masoud Anjomshoa Masoud Anjomshoa 34 17 Macroeconomics Theory and Policy (Credible) Pegged (Fixed) Exchange Regime: i i LM Y A O Impact of an Expansionary Fiscal policy: G↑ i O i=i* A: Short Run Equilibrium A IS1 IS NX Y Y1 Y - E Ee E IS: Y C I(Y, i *) G NX(Y, Y*,E) + 0 UIP Y A Y1 Y LM: M Y L (i *) P ML E Ee NX Trade Deficit Masoud Anjomshoa 35 (Credible) Pegged (Fixed) Exchange Regime: ) G NX( (Y, Y *, ) IS : Y co c1 (Y T) I(Y, i *) G NXY, Y *, EE) o 1 ML ML M YL(i ) *) E Ee P Impact of an Expansionary Fiscal policy: G↑ Because output/income rises: Ee E i i* E LM : Masoud Anjomshoa Masoud Anjomshoa 36 18 Macroeconomics Theory and Policy (Credible) Pegged (Fixed) Exchange Regime: i i LM Y A Impact of a (credible) devaluation policy: Ē ↑ i i=i* A A: Short Run Equilibrium O O IS NX Y + 0 - Y1 Y EE Y Y E 1 E e 1 UIP E IS: Y C I(Y, i *) G NX(Y, Y*,E) A Y1 e LM: M Y L (i *) P ML E Ee NX Trade surplus Masoud Anjomshoa 37 (Credible) Pegged (Fixed) Exchange Regime: ) G NX( (Y, Y *, ) IS : Y co c1 (Y T) I(Y, i *) G NXY, Y *, EE) o 1 ML ML M YL(i ) *) E Ee P Impact of a Devaluation Policy: Ē ↑ E e E1 i i* 1 E1 Because output/income rises: LM : Masoud Anjomshoa Masoud Anjomshoa 38 19 Macroeconomics Theory and Policy Non-credible Pegged Exchange Regime: i i1 A Y LM i i1 A Financial or exchange crisis LM1 i=i* i O O IS NX Y1 Y Y EE 0 - Y1 Y Y UIP E A: Short Run Equilibrium NX Trade surplus E e 1 Impact of an expected depreciation, and exchange crisis: Ēe ↑ + A e Masoud Anjomshoa 39 Non-credible Pegged Exchange Regime: IS : Y co c1 (Y T) I(Y,, i *) G NXY, Y *, EE) IS : Y co c1 (Y T) I(Y ) G NX( (Y, Y *, i ) ML ML M LM : M YL(i ) E Ee YL( *) i LM : P P Impact of an Expected Depreciation: Ēe ↑ E 1e E i i* E In new equilibrium: Ee E i1 i * 1 E How can financial crisis be fixed? Anjomshoa Masoud Devaluation Masoud Anjomshoa 40 20 Macroeconomics Theory and Policy Balance of Payments Accounting: Current Account (CA): Keeps track of flow of goods, services, transfers, and factor payments. Balance of Payments Accounts are parts of System of National Accounts (SNA), which record a country’s international transactions. Capital and Financial Accounts (KA): Keeps track of flow of assets. Any transaction that involves a flow of funds into the country is a credit item, and is entered to the account with a plus sign. Any transaction that involves a flow of funds out of the country is a debit item, and is entered to the account with a negative sign. If CA > 0 If CA < 0 If a country runs trade deficit (current account deficit), it should run capital account surplus, i.e. selling its assets to foreigners. Balance of Payments = CA + KA = 0: Masoud Anjomshoa 41 Balance of Payments Accounting: Canada’s Balance of Payments, 2003 (Billions of Dollars) Debit Credit Balance . 1)- Export of merchandise 2)- Import of merchandise 3)- Merchandise trade balance (1+2) 4)- Export of services 5)- Import of services 6)- Services trade balance (4+5) 7)- Net export (3+6) 8)- Income receipts on investment 9)- Income payments on investment 10)- Net income from assets (8+9) 11)- Net receipts of wages and salaries 12)- Net current transfers 400.0 -341.8 58.2 59.9 -70.9 -11.0 47.2 32.7 -56.4 13)- Current account (CA) (7+10+11+12) Masoud Anjomshoa Masoud Anjomshoa -23.7 0.1 0.2 23.8 42 21 Macroeconomics Theory and Policy Balance of Payments Accounting: Canada’s Balance of Payments, 2003 (Billions of Dollars) Debit Credit Balance . 14)- Canadian direct investment abroad -35.0 15)- Canadian portfolio investment abroad -37.8 16)- Purchases of foreign assets by Canadians (14+15) 17)- Foreign direct investment in Canada 28.0 18)- Foreign portfolio investment in Canada 15.4 19)- Sales of Canadian assets to foreigners (17+18) 20)- Canadian Official reserves assets 21)- Financial account (16+19+20) 22)- Capital account 23)- Capital and financial accounts (KA) (21+22) 24)- Statistical discrepancy (-23-13) 25)- Balance of Payments (24+23+13) 26)- Official settlement balance (Balance of Payments) (-20) Masoud Anjomshoa Masoud Anjomshoa -72.8 43.4 4.7 -24.7 4.0 -20.7 -3.1 0 -4.7 43 22 ...
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