Macroeconomics for Development Week 4 Class

Transcription

1 MSc in Economics fo Development Macoeconomics fo Development Week 4 Class Sam Wills Depatment of Economics, Univesity of Oxfod samuel.wills@economics.ox.ac.uk Consultation hous: Fiday, 2-3pm, Weeks 1,3-8 (MT) 01 Novembe 2011 Maco fo Development Class 4 1

2 Week 3 Review CES utility function limits CES utility function: Limit as σ 1: Cobb Douglas Limit as σ : Pefect substitutes Limit as σ 0: Pefect complements (Leontief) Maco fo Development Class 4 2

3 Week 4 Refeences Heijda, B. J., Van de Ploeg, F., 2002, Foundations of Moden Macoeconomics, OUP, Ch 11.1 Bief late undegad/gaduate level look at IS-LM model Donbusch, R., Fische, S., Statz, R., 2008, Macoeconomics, McGaw Hill, Ch 12 and 20 Ealy undegad look at IS-LM with plenty of diagams and intuitive link to national accounts Also ty any othe undegad text Maco fo Development Class 4 3

4 Oveview: The Mundell-Fleming Model The Mundell-Fleming model is a simple gaphical model of geneal equilibium in an open economy The ole of the Mundell-Fleming model is to simply model changes in the national accounts We now intoduce the cental bank to the analysis of the balance of payments in wk 1 The Mundell-Fleming model consists of fou components: a. Goods maket b. Asset maket c. Balance of payments d. Foeign cuency maket We conside the effects of monetay and fiscal policy unde thee diffeent sets of assumptions: 1. Immobile capital, fixed exchange ates 2. Pefectly mobile capital, fixed exchange ates 3. Pefectly mobile capital, flexible exchange ates Howeve, the Mundell-Fleming model emains a simple model, and should only be used fo back-of-the-envelope calculations Next week s class Maco fo Development Class 4 4

5 The Mundell-Fleming model is a simple gaphical model of geneal equilibium in an open economy Gaphical Oveview LM BP=0 Simple This model makes a numbe of simplifying assumptions including: fixed pices single domestic good ignoes expectations Gaphical E LL IS The geat benefit of the model is the use of simple gaphs to explain complex inteactions. As a esult we ll ty to stee clea of too many equations this week Geneal Equilibium It succinctly descibes equilibium in good, asset and cuency makets, poviding an undestanding of how they inteact Maco fo Development Class 4 5

6 The ole of the Mundell-Fleming model is to simply model changes in the national accounts Consistency accounting matix Souce: Week 1 class, Ageno. Maco fo Development Class 4 6

7 We now intoduce the cental bank to the analysis of the balance of payments in week 1 Balance of Payments Cuent Account - Capital Account (Δ Net Foeign Assets) Δ Cental Bank Foeign Assets Δ Pivate and Govt Foeign Assets Detail Cental Bank Balance Sheet Assets Net Foeign Assets (NFA CB ) Domestic Cedit (DC) Liabilities High Poweed Money (H) Cental bank tansactions in foeign assets and domestic cedit also affect the money stock. Maco fo Development Class 4 7

8 The Mundell-Fleming model consists of fou components a.goods Maket IS Cuve: = A(,) + G + NX(,E) A(,) = C() + I(,) Gaphical Oveview of the Mundell- Fleming Model LM b.asset Maket LM Cuve: M/P = L(,) BP=0 IS c.balance of Payments BP Cuve BP = NX(,E) + KA(-*) E LL d. Foeign Cuency Maket Fixed: E=E* LL: M = L(,) : = A(,) + G + NX(,E) Maco fo Development Class 4 8

9 a. Goods Maket The IS Cuve IS: = A(,) + G + NX(,e) Absoption: A(,) = C() + I(,) Real exchange ate: e = EP*/P Pices: P=P*=1 IS Details The IS cuve descibes the Investment and Saving Equilibium All points whee total investment equals total savings no unplanned inventoy Descibes the eal economy in this model Fom Week 1 this is equivalent to the points whee aggegate output is: = C + I + G + NX The IS cuve descibes how this behaves The IS cuve has the following popeties: A <0 Defe C and I 0<A <1 Keynesian multiplie NX <0 Impots NX e >0 Mashall - Lene Maco fo Development Class 4 9

10 b. Money Maket The LM Cuve Details M S M D M/P Money Demand: Money Supply: LM(M/P) M D /P = L(,) M S = μ[nfa CB + DC] The LM cuve descibes the Liquidity Pefeence and Money Supply Equilibium At each point the demand and supply fo money is in equilibium fo a given level of output Money demand L(,) has the following popeties: L < 0 Speculative L >0 Tansactions In this analysis we allow money supply to potentially be endogenous to actions of the cental bank in FX makets To close the model we assume P=P*=1 Maco fo Development Class 4 10

11 c. Balance of Payments The Balance of Payments Details * i) NX (,e) = 0 NX>0 NX<0 iii) BP=0 ii) BP=0 Balance of Payments: BP = NX(,E) + KA(-*) = ΔNFA CB Capital mobility: i) Immobile KA(-*) =0 ii) Pefectly mobile =* iii) Impefectly mobile 0<KA < ifty The Balance of Payments descibes all the tansactions with the est of the wold. It is compised of: Cuent Account - assume CA=NX Capital Account - KA(-*). When KA>0, selling bonds to wold (boowing) When E is fixed, ΔNFA CB must set BP=0 When E is flexible, BP = 0 automatically: If NX<0, excess demand fo foeign cuency This depeciates the domestic cuency Capital flows in to buy cheap bonds, supplying foeign cuency E adjusts until NX(,E) = - KA(-*) Maco fo Development Class 4 11

12 d. Foeign Cuency Maket The Mundell-Fleming Model LM Details Fixed exchange ates We ignoe the second diagam as E=E* The cental bank must adjust the money supply, shifting LM, to ensue BP=0. E* E LL BP=0 IS E=E* Floating exchange ates We intoduce the second diagam as output and exchange ates ae linked via NX(,E). We only do this with mobile capital: With immobile capital E adjusts so NX=0 With mobile capital, changes in E automatically ensue that BP=0: BP = NX(,E) + KA(-*) = ΔNFA CB = 0 The model is now a system of 3 equations in 3 vaiables:,, E. These can be plotted as simultaneous equilibia. In (E,) space, high E stimulates X and thus. LL: M = L(,) : = A(,) + G + NX(,E) : =* Maco fo Development Class 4 12

13 We conside the effects of monetay and fiscal policy unde thee diffeent sets of assumptions: Capital Mobility Immobile Pefectly mobile Fixed Case 1 Case 2 Exchange Rates Floating Skipped Case 3 Maco fo Development Class 4 13

14 Case 1: Immobile capital, fixed exchange ates Monetay Expansion BP=0 X>0 X<0 e 0 e1 LM(M 0 ) LM(M 1 ) IS Stat at e 0 CB inceases domestic cedit: ΔM S = μ ΔDC >0 M 0 M 1 At e, NX<0, imbalance in the maket fo foeign cuency. The cental bank must ΔNFA CB <0 to decease the money supply and keep E fixed. Incease in DC exactly offset by loss of NFA CB. Only composition of CB potfolio changes. Fiscal Expansion BP=0 X>0 X<0 e 1 e 0 e LM(M 2 ) LM(M 0 ) IS(G 1 ) Stat at e 0 Govenment inceases spending G 0 G 1 At e, NX<0, imbalance in the maket fo foeign cuency. CB must ΔNFA CB <0 to educe money supply M 0 M 2 to keep E fixed IS(G 0 ) Monetay and Fiscal policy cannot pemanently aise income with fixed e and immobile capital Maco fo Development Class 4 14

15 Case 2: Pefectly mobile capital, fixed exchange ates Monetay Expansion e 0 e 1 LM(M 0 ) LM(M 1 ) BP=0 IS Stat at e 0 CB inceases domestic cedit: ΔM S = μ ΔDC >0 M 0 M 1 At e, <*, causing mobile capital to flow out, meaning less demand fo domestic cuency. CB must sell foeign assets to educe supply of domestic cuency (ΔNFA CB <0 ). Fiscal Expansion e 0 e e 1 LM(M 0 ) LM(M 1 ) BP=0 IS(G 1 ) Stat at e 0 Govenment inceases spending G 0 G 1 At e,, >*, causing mobile capital to flow in, meaning moe demand fo domestic cuency. CB must buy foeign assets ΔNFA CB >0 to incease money supply M 0 M 1 to keep E fixed IS(G 0 ) When exchange ates ae fixed, monetay policy is ineffective but fiscal policy is effective Maco fo Development Class 4 15

16 Case 3: Pefectly mobile capital, flexible exchange ates Monetay Expansion Stat at e 0 CB inceases domestic cedit: ΔM S = μ ΔDC >0 M 0 M 1 fo both LM and LL At e, <* and capital flows out The cuency must depeciate fom E 0 E 1 to stimulate net expots so that the maket fo foeign cuency is in equilibium This shifts the IS cuve until =* Monetay policy effective Maco fo Development Class 4 16

17 Case 3: Pefectly mobile capital, flexible exchange ates Fiscal Expansion Stat at e 0 Govenment inceases spending fom G 0 G 1 This shifts the IS cuve to the ight (moe demand fo goods at each ), and the cuve to the ight to e At e, >* so capital flows in, poviding supply of foeign cuency E appeciates fom E 0 E 1, causing expots to fall and impots to ise This offsets the incease in G so eveything etuns to e 0 Fiscal policy ineffective Maco fo Development Class 4 17

18 Howeve, the Mundell-Fleming model emains a simple model, and should only be used fo back-of-the-envelope calculations Limitation Fixed pices Extension Endogenise aggegate supply: See Heijda and Van de Ploeg (2002), Ch Ignoes expectations Focuses on money makets Intoduce ational expectations and uncoveed inteest paity: Donbusch (1976) Changes = * to = * + E[Δe] Consides flexible e and sticky P Intoduce simple, explicit monetay policy ules instead of the LM cuve: Taylo Rule (1993) Rome (2000) Single good Disaggegation of taded and non-taded sectos: see lectue notes No micofoundations New Keynesian open economy maco: Obstfeld and Rogoff (1996): Textbook Goodfiend and King (1997): New neoclassical synthesis Lane (2001): Suvey Maco fo Development Class 4 18

19 Next week s class Hand back poblem sets Extended consultation session bing questions! Maco fo Development Class 4 19