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Chapter 13. Aggregate Demand in the Open Economy
We will not cover the Appendix.
Homework: pp. 388-89 # 1, 2 or 3
macromodel mundell_fleming # 1, 4, 10
Link to syllabus
Preview of Coming Attractions!
Fig. 13-3, p. 361. The Mundell-Fleming Model
More, even better Previews! Table 13-1, p. 372
Mundell and Dornbusch
Robert Mundell, 1932Nobel prize 1999
Rudiger Dornbusch
1942-2002.
Mundell taught at U. of Chicago for many years, where Dornbusch
was his student. Dornbusch taught at MIT.
Fig. 13-1, p. 359.
The IS* Curve
Fig. 13-2, p. 360.
The LM* Curve
With a vertical LM*,
all the fun is over before
we even start.
Fig. 13-3 p. 361. Equilibrium in the Mundell Fleming Model
Depreciation
of US $
Appreciation
of US $
Fig. 13-3 p. 361. Equilibrium in the Mundell Fleming Model
Fond, old memories.
When the textbook expanded from the closed economy loanable funds
model of Chapter 3 to the open economy loanable funds model of
Chapter 6, it kept the same general framework, but we ended up with two
graphs; one with r on the vertical axis [where r always equaled r*],
and the other with the exchange rate on the vertical axis.
Now, from chapter 12 to13, we go from closed economy IS-LM to open
economy IS-LM. This time, however, we don’t bother with the graph
that has r on the vertical axis, but jump right into the graph with the
exchange rate on the vertical axis.
Fig. 13-4, p. 362. Fiscal Expansion Under
Floating Exchange Rates
No change in output without even assuming a vertical AS curve.
That implies that the AD curve does not move, either.
mt’s attempt at explaining result of fiscal expansion
(assuming small open economy, flexible x-rates)
An increase in government expenditures
→ would raise interest rates,
→ leading to an inflow of foreign capital (loans),
→ appreciating the currency (higher Y/$),
→ lowering net exports,
→ which cancels out the expansionary effect of higher Gov’t spending
→ leaving the economy at the same level of output.
Another part of the story is that these effects are so strong that the
domestic interest rate never really rises above the world interest rate.
Fig. 13-5, p. 364. Monetary Expansion under
Floating Exchange Rates
mt‘s attempt at explaining this result of monetary expansion
The increase in the money supply would initially
→ lower domestic interest rates, and so
→ cause capital outflows and depreciate the currency
→ raise net exports, increasing real output
All this happens real quickly, so the graph (Fig. 13-5) just shows
the shift of the LM and the lower – depreciated – exchange rate.
Fig. 13-6, p. 365.
Trade Restriction
under Floating
Exchange Rates
Because of vertical LM*,
There is no change in Y.
Thus, AD doesn’t move.
However, there is a
change in the composition
of production of tradeable
goods.
Fixed Exchange Rates vs. Flexible Exchange
Rates in a Small Open Economy.
The key to the coming analysis is that in a s.o.e., with perfect capital
mobility, a shift of the return to assets will give rise to a very large
surge of capital flows which cannot be neutralized by the central bank.
It took macroeconomists a few decades to realize fully the impact of that
fact, on their macroeconomic models. The results are, initially,
quite surprising.
Fig. 13-7, p. 367. How a Fixed Exchange Rate
Governs the Money Supply
Market forces push the LM* to where it intersects the IS* at the
predetermined, fixed exchange rate (see next slide).
Fig. 13-7, p. 367 (again). How a Fixed
Exchange Rate Governs the Money Supply
180
A
150
150
120
At point A, agents borrow$ and convert them
to yen at 180Y/$ overseas, then bring the Yen
for exchange into the US, buying $ at 150
for an automatic profit. The Fed, in
selling $, raises US money supply.
H
At H, agents will buy $ at 120
and sell them to the Fed at
150Y/$, making 25 % profit. This
reduces the supply of $, pushing
the LM* to the left.
Fig. 13-8, p. 369. Fiscal Expansion under
Fixed Exchange Rates
Fig. 13-9, p. 369. Monetary Expansion under
Fixed Exchange Rates
Monetary policy has no effect with fixed exchange rates, for a s.o.e.
Fig. 13-10, p. 371. Trade Restriction under
Fixed Exchange Rates
Table 13-1, p. 372
Fig. 13-11, p. 374. An Increase in the Risk Premium
Fig. 13-12, p. 381. The Impossible Trinity
Fig. 13-13, p. 384. Mundell-Fleming in AD
Fig. 13-14 p. 385 Short Run and Long Run in an SOE
Putting it all together (Chapter 14 appendix, p. 424)
Appendix
The large open economy is an average of the closed economy and the
small open economy. To find how any policy will affect any variable,
find the answer in the extreme cases for the closed and SOE, and
take the ‘average’.
(page 394)
Figure 13.15 p. 391 (appendix). A Short-Run
Model of a Large Open Economy
Figure 13.16 p. 392. A Fiscal Expansion in a Large
Open Economy
An increase in Gov’t spending raises
real GDP and the real interest rate,
lowers capital outflows, raises the
exchange rate, and reduces net
exports. The decline in net exports
lowers the increase of real GDP.
In the SOE, there is no change in
GDP because the ∆ G = - ∆ NX.
Figure 13.17 p. 393. A Monetary Expansion in a
Large Open Economy
An increase in M moves LM right,
lowering r. This increase capital
outflow, which lowers the exchange
rate, ultimately increasing net exports.
In a SOE, an increase in M increases
real output in the short run.

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