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AGGREGATE DEMAND IN THE OPEN ECONOMY(Continued…):Fixed exchange rates

<< AGGREGATE DEMAND IN THE OPEN ECONOMY:Lessons about fiscal policy
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LESSON 31
AGGREGATE DEMAND IN THE OPEN ECONOMY(Continued...)
Equilibrium in the Mundell-Fleming model
Y = C (Y - T ) + I (r *) + G + NX (e )
M P = L (r *,Y )
LM*
e
equilibrium
exchange
rate
IS*
equilibrium
Y
level of
income
Fiscal policy under floating exchange rates
At any given value of e, a fiscal expansion increases Y, shifting IS* to the right. Results: Δe >
0, ΔY = 0
LM*1
e
e2
e1
IS*2
IS*1
Y
Y1
Results: Δe > 0, ΔY = 0
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Monetary policy under floating exchange rates
An increase in M shifts LM* right because Y must rise to restore equilibrium in the money
market.
e
LM*1
LM*2
e1
e2
IS*1
Y
Y1
Y2
Results: Δe < 0, ΔY > 0
Trade policy under floating exchange rates
At any given value of e, a tariff or quota reduces imports, increases NX, and shifts IS* to the
right.
LM*1
e
e2
e1
IS*2
IS*1
Y
Y1
Lessons about trade policy
·
Import restrictions cannot reduce a trade deficit.
·
Even though NX is unchanged, there is less trade:
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­  The trade restriction reduces imports
­  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, but destroy jobs in export-producing sectors.
Hence, import restrictions fail to increase total employment.
Worse yet, import restrictions create "sectoral shifts," which cause frictional
unemployment.
Fixed exchange rates
·
Under a system of fixed exchange rates, the 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 its pre-announced rate.
·
This system fixes the nominal exchange rate.
In the long run, when prices are flexible, the real exchange rate can move even if the
nominal rate is fixed.
a. The Equilibrium exchange rate is Greater than the fixed exchange rate
LM1   LM2
e
Equilibrium
exchange rate
>
>
>
Fixed exchange rate
IS*
Income, Output, Y
b. The Equilibrium exchange rate is less than the fixed exchange rate
LM2   LM1
e
Fixed exchange rate
>
>>
IS*
Equilibrium exchange rate
Income, Output, Y
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Fiscal policy under fixed exchange rates
Under fixed exchange rates, a fiscal expansion would raise e. To keep e from rising,
the central bank must sell domestic currency, which increases M and shifts LM* right.
LM*1
LM*2
e
e1
IS*2
IS*1
Y
Y1
Y2
Results: Δe = 0, ΔY > 0
Under floating rates, fiscal policy ineffective at changing output. Under fixed rates, fiscal policy
is very effective at changing output. LM shifts out!
Monetary policy under fixed exchange rates
An increase in M would shift LM* right and reduce e. To prevent the fall in e, the central bank
must buy domestic currency, which reduces M and shifts LM* back left.
LM*1
LM*2
e
e1
IS*1
Y
Y1
Y2
Results: Δe = 0, ΔY = 0
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Under floating rates, monetary policy is very effective at changing output. Under fixed rates,
monetary policy cannot be used to affect output.
Trade policy under fixed exchange rates
A restriction on imports puts upward pressure on e. To keep e from rising, the central bank
must sell domestic currency, which increases M and shifts LM* right.
LM*1
LM*2
e
e1
IS*2
IS*1
Y
Y1
Y2
Results: Δe = 0, ΔY > 0
Under floating rates, import restrictions do not affect Y or NX. Under fixed rates, import
restrictions increase Y and NX. But, these gains come at the expense of other countries, as
the policy merely shifts demand from foreign to domestic goods
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
Monetary Expansion
0
0
0
Import Restriction
0
0
0
Interest-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.
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·
Expected exchange rate changes:
If a country's exchange rate is expected to fall, then its borrowers must pay a higher
interest rate to compensate lenders for the expected currency depreciation.
Differentials in the M-F model
r = r *+ θ
Where θ is a risk premium.
Substitute the expression for r into the IS* and LM* equations:
Y = C (Y - T ) + I (r * + θ ) + G + NX (e )
M P = L (r * + θ ,Y )
The effects of an increase in θ
IS* shifts left, because ↑ θ ⇒ ↑r ⇒ ↓I
LM* shifts right, because ↑ θ ⇒ ↑r ⇒ ↓(M/P) d,
So Y must rise to restore money market equilibrium.
LM*1
LM*2
e1
e2
IS*1
IS*2
Y1
Y2
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 the rise in r).
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Table of Contents:
  1. INTRODUCTION:COURSE DESCRIPTION, TEN PRINCIPLES OF ECONOMICS
  2. PRINCIPLE OF MACROECONOMICS:People Face Tradeoffs
  3. IMPORTANCE OF MACROECONOMICS:Interest rates and rental payments
  4. THE DATA OF MACROECONOMICS:Rules for computing GDP
  5. THE DATA OF MACROECONOMICS (Continued…):Components of Expenditures
  6. THE DATA OF MACROECONOMICS (Continued…):How to construct the CPI
  7. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES
  8. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  9. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  10. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  11. MONEY AND INFLATION:The Quantity Equation, Inflation and interest rates
  12. MONEY AND INFLATION (Continued…):Money demand and the nominal interest rate
  13. MONEY AND INFLATION (Continued…):Costs of expected inflation:
  14. MONEY AND INFLATION (Continued…):The Classical Dichotomy
  15. OPEN ECONOMY:Three experiments, The nominal exchange rate
  16. OPEN ECONOMY (Continued…):The Determinants of the Nominal Exchange Rate
  17. OPEN ECONOMY (Continued…):A first model of the natural rate
  18. ISSUES IN UNEMPLOYMENT:Public Policy and Job Search
  19. ECONOMIC GROWTH:THE SOLOW MODEL, Saving and investment
  20. ECONOMIC GROWTH (Continued…):The Steady State
  21. ECONOMIC GROWTH (Continued…):The Golden Rule Capital Stock
  22. ECONOMIC GROWTH (Continued…):The Golden Rule, Policies to promote growth
  23. ECONOMIC GROWTH (Continued…):Possible problems with industrial policy
  24. AGGREGATE DEMAND AND AGGREGATE SUPPLY:When prices are sticky
  25. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…):
  26. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…):
  27. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  28. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  29. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  30. AGGREGATE DEMAND IN THE OPEN ECONOMY:Lessons about fiscal policy
  31. AGGREGATE DEMAND IN THE OPEN ECONOMY(Continued…):Fixed exchange rates
  32. AGGREGATE DEMAND IN THE OPEN ECONOMY (Continued…):Why income might not rise
  33. AGGREGATE SUPPLY:The sticky-price model
  34. AGGREGATE SUPPLY (Continued…):Deriving the Phillips Curve from SRAS
  35. GOVERNMENT DEBT:Permanent Debt, Floating Debt, Unfunded Debts
  36. GOVERNMENT DEBT (Continued…):Starting with too little capital,
  37. CONSUMPTION:Secular Stagnation and Simon Kuznets
  38. CONSUMPTION (Continued…):Consumer Preferences, Constraints on Borrowings
  39. CONSUMPTION (Continued…):The Life-cycle Consumption Function
  40. INVESTMENT:The Rental Price of Capital, The Cost of Capital
  41. INVESTMENT (Continued…):The Determinants of Investment
  42. INVESTMENT (Continued…):Financing Constraints, Residential Investment
  43. INVESTMENT (Continued…):Inventories and the Real Interest Rate
  44. MONEY:Money Supply, Fractional Reserve Banking,
  45. MONEY (Continued…):Three Instruments of Money Supply, Money Demand