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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 (YT) + I(Y , i) + G
+ –
– ε Q( ε , Y) + X( ε , Y*)
– +
+ +
Masoud Anjomshoa 9 DD = co + c1 (YT) + 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 (YT) + 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 (YT) + I(Y, i) + G1
DD = co + c1 (YT) + 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 (YT) + 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 MarshallLerner 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
MarshallLerner 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 (YT) + 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 Jcurve, Dynamics of Real Depreciation:
Net Exports, NX + 0 Real depreciation (ε ↑)
t
Time – MarshallLerner 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 MarshallLerner
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 Noncredible 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 Noncredible 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 (2313)
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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 Fall '08
 ANJOMSHOA
 Macroeconomics

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