Learning objectives. Macroeconomics I International Group Course Topic 8: AGGREGATE DEMAND IN AN OPEN ECONOMY

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1 Learning objectives Macroeconomics I International Group Course Topic 8: AGGREGATE DEMAND IN AN OPEN ECONOMY Here we extend the study of aggregate demand to a small open economy. Unlike the previous topic, now we shall study the determinants of aggregate demand in open economies when prices are sticky. In other words, we focus on the short-run. We shall extend the IS-LM framework to the case of a small open economy. Thus, everything that we learnt for the closed economy is applicable here with two crucial modifications: Net exports is a component of aggregate demand that depends on the exchange rate: XN=XN(e) Since we assume that financial capital can freely move across countries and our economy is a small one, the real interest rate is given at its international level: r=r* 1 2

2 IS LM The Mundell-Fleming model Arbitrage condition Perfect capital mobility The full model Y = C( Y T) + I( r) + G+ XN( e) Exogenous variables: M, P, T, G, r* Three endogenous variables: Y, r, e (XN depends on the real exchange rate, ε, but since we assume fixed prices the real exchange rate only moves with the nominal one, e) M LY (, r ) P = r = r* IS* LM* The Mundell-Fleming model The reduced model Y = C( Y T) + I( r*) + G+ XN( e) Exogenous variables: M, P, T, G, r* Two endogenous variables: Y, e M LY (, r *) P = 3 4

3 The Mundell-Fleming model The study of the determinants of aggregate demand in the open economy proceeds along the same steps as in the closed economy case. The IS-LM framework in the open economy only differs from that in the closed economy in that the real interest rate is exogenous while there is a new endogenous variable: the real exchange rate (e). Thus, we modify the graphic representation of the IS-LM that are now drawn in the space {e,y}. This alters the shape and the way these curves shift in the space {e,y} with respect to what we saw in the closed economy. But the economics of the model is the same. The IS* curve in the space {e, Y} Y = C( Y T) + I( r*) + G+ XN( e) Net exports and the aggregate demand fall as the exchange rate rises. Thus the slope of the IS* is negative. The IS* shifts with autonomous changes in C, I, G, XN and r*. 5 6

4 The LM* curve in the space {e, Y} IS* LM* equilibrium in the space {e, Y} M LY (, r *) P = Equilibrium in the money market does not depend on the exchange rate. Thus, the LM* is vertical. {e 0, Y 0 } is the pair of values of income and exchange rate that clear both the money and the goods and services markets. The LM* shifts with autonomous changes in M, P, L(.) and r*. No other pair can clear both markets simultaneously. 7 8

5 Flexible or fixed exchange rates? Recall that the real exchange rate is the product of two relative prices: the price of domestic goods relative to that of foreign goods, and the price of the domestic currency relative to the foreign currency. These two relative prices are related but are different and are determined in different markets. In the short-run the relative price of goods is fixed, then the only variation in the real exchange rate comes from variations in the nominal exchange rate (e). Flexible or fixed exchange rates? Flexible nominal exchange rates respond to variations in the demand and supply of domestic and foreign currencies. But very often, countries prefer to avoid fluctuations in the nominal exchange rate. A regime of fixed exchange rates is one in which the monetary authority regulates the money supply to sustain a given value of the exchange rate. Only sporadic changes are allowed: devaluations or revaluations. Both regimes have coexisted in the international monetary system. The euro/dollar exchange rate is flexible. The peso/dollar was fixed during the dollarization in Argentina. The European Monetary Union is an extreme case of fixed exchange rate. In other cases the exchange rates are allowed to fluctuate within a narrow band (European Monetary System, before EMU). 9 10

6 Flexible or fixed exchange rates? IS-LM equilibrium differs from one regime to the other. Also, economic policies have different effects depending on whether the Central Bank lets the exchange rate fluctuate freely or not. Fiscal policy under flexible exchange rates G 2 >G 1 (or T 2 <T 1 ) Let us first analyze the IS-LM equilibrium and aggregate demand in a system of flexible rates. Example: when the world demand for euros increases relative to its supply or when the demand for dollars falls relative to its supply, then the euro appreciates. The euro depreciates in the opposite case

7 Fiscal policy under flexible exchange rates A fiscal stimulus has no effect on output under flexible exchange rates. Monetary policy under flexible exchange rates M 2 >M 1 In the figure we can see that since the LM* is vertical, changes in government spending or in taxes that shift the IS* affect the equilibrium exchange rate leaving aggregate demand unaffected. If G increases (or T falls) then aggregate demand increases (1 to 1 ). But as aggregate demand rises, so does the demand for money; this puts pressure on the domestic interest rate above the international one (r>r*). Since capital moves freely across countries, this interest rate gap induces a massive inflow of foreign capital, which leads to a rise in the demand for domestic currency (foreign investors purchasing domestic bonds). This appreciates the domestic currency, thus leading to a fall in net exports and in aggregate demand (1 to 2). The interest rate goes back to r*. The fiscal stimulus has worsened our trade balance, leaving aggregate demand unchanged

8 Monetary policy under flexible exchange rates Monetary policy has a strong effect under flexible exchange rates. We can see in the figure that the LM* shifts outwards as the money supply increases: this changes both the equilibrium exchange rate and aggregate demand. As M rises the domestic interest rate tends to fall below its international level, increasing aggregate demand (r<r*)(1 to 1 ). This negative interest rate differential induces a massive outflow of capital. Domestic and foreign investors demand foreign bonds, thus reducing the demand for domestic currency, which depreciates. As the currency depreciates, domestic goods become more competitive, so that net exports rise along with aggregate demand (1 to 2). This increases the domestic interest rate again back to the international level r*. The monetary stimulus does not operate through the same channel as in the closed economy. Since the domestic interest rate returns to its international level, the increase in demand is caused by a rise in net exports. Since we cannot bring future demand to the present, we attract a larger share of world demand for goods Fixed exchange rates If the exchange rate is the relative price of two currencies, how can it be held fixed at a given level? When two countries share the same currency (as in EMU, the states in the U.S., regions in the same country, etc.) it is straightforward, since the exchange rate is fixed at 1 by an administrative decision: exchange rate between the French Euro and the German Euro is 1. When a country decides to fix its exchange rate with respect to another country, the Central Bank of the former must commit itself to put into the market, or to withdraw from it, as much currency as is needed to maintain that value. In practice that means that the exchange rate becomes an exogenous (policy) variable, while the money supply becomes endogenous

9 IS* LM* Fixed exchange rates The model Y = C( Y T) + I( r*) + G+ XN( e) Exogenous variables: e, P, T, G, r* Two endogenous variables: Y, M M LY (, r *) P = IS*-LM* equilibrium under fixed exchange rates {M 0, Y 0 } is the pair of values of the money supply and income that clears the goods and money markets for a given exchange rate (e 0 ). For any other pair of values {M,Y} there would be equilibrium only in the goods market (if the pair is on the IS*) or only in the money market (if the pair is on the LM*) or in neither of them

10 Fiscal policy under fixed exchange rates G 2 >G 1 (or T 2 <T 1 ) Fiscal policy under flexible exchange rates In a fixed exchange rate regime the fiscal policy does have an effect on aggregate demand. As we can see in the figure, the only possible equilibrium is at e 1. After the outward shift of the IS*, the LM* must shift as well to maintain the desired exchange rate. The fiscal stimulus increases aggregate demand (1 to 1 ). Then, the demand for real balances rises and there is an upward pressure on the interest rate, above its international level (r>r*). Foreign capital will enter the country purchasing assets denominated in domestic currency, which appreciates. To prevent this appreciation, the Central Bank will increase the supply of domestic currency. This eases off the upward pressure on the interest rate and the LM* shifts to the right, inducing an increase in aggregate demand (1 to 2)

11 Monetary policy under fixed exchange rates M 2 >M 1 Monetary policy under fixed exchange rates If the exchange rate is held fixed, monetary policy has no effect whatsoever (in fact there is no independent job for monetary policy, other than keeping the exchange rate at its target level). In the figure we see that the only possible equilibrium after the rise in the money supply must be e 1. Thus, after the rightwards shift of the LM*, it must shift back to its previous position. As the Central Bank increases M, the domestic interest rate tends to fall below its international level (r<r*). Thus, investors will sell domestic assets to buy the more profitable foreign ones. This reduces the demand for domestic currency, which tends to depreciate (1 to 1 ). To avoid this depreciation, while keeping the exchange rate at its desired level, the domestic Central Bank must reduce the supply of domestic currency. Thus, the supply of money falls, the LM* shifts back and the downward pressure on the interest rate eases off. The domestic currency recovers its previous value (1 to 2)

12 (Fixed) exchange rate devaluation e 2 <e 1 (Fixed) exchange rate devaluation A currency devaluation increases aggregate demand. As the figure shows, if the Central Bank lowers the value of the exchange rate from e 1 to e 2, the LM* must shift to the right, thus leading to higher aggregate demand. To devaluate the currency the Central Bank issues more money, shifting the LM* to the right and inducing a fall in the domestic interest rate below its international level (r<r*) (1 to 1 ). This leads to a domestic capital outflow, the demand for domestic currency falls. This eliminates the downward pressure on the interest rate, which returns to its international value, but reduces the demand for domestic currency, which falls to the new desired level (1 to 2)

13 The aggregate demand curve in the open economy So far we have assumed that domestic prices were sticky. Thus, as in the closed economy, equilibrium aggregate demand (IS*- LM*) is defined for a given value of prices. If this value changes, so does aggregate demand. The aggregate demand curve in the open economy can be drawn by asking how the IS*-LM* equilibrium changes as P moves. The aggregated demand curve has some similitude and some differences with its closed economy counterpart: It is negatively sloped in the space {P, Y} It is affected by changes in some exogenous variables, but not in all of them. Those that affect output and those that do not depend on the exchange rate regime. To see this we shall go back to the general model in which net exports depend on the real exchange rate (ε). 25 The aggregate demand curve: flexible rates The full model under flexible exchange rates IS LM Real exchange rate Y = C( Y T) + I( r*) + G+ XN( ε ) Exogenous variables: M, P, T, G, r* Three endogenous variables: Y, ε, e M LY (, r *) P = P ε = e P * 26

14 The aggregate demand curve: flexible rates A rise in prices (P 1 to P 2 ) shifts the LM* to the left, the real exchange rate (ε) appreciates and aggregate demand falls. The aggregate demand curve: flexible rates Under flexible exchange rates, neither fiscal polices nor other shocks that shift the IS* have an effect on aggregate demand. IS*-LM* Aggregate demand IS*-LM* Aggregate demand 27 28

15 The aggregate demand curve: flexible rates Under flexible exchange rates, both monetary policy and any other shock that shifts the LM* shift the aggregate demand curve. IS*-LM* Aggregate demand The aggregate demand curve: fixed rates The full model under fixed exchange rates IS LM Y = C( Y T) + I( r*) + G+ XN( ε ) M LY (, r *) P = Real exchange rate P ε = e P * Exogenous variables: e, P, T, G, r* Three endogenous variables: Y, M, ε 29 30

16 The aggregate demand curve: fixed rates A rise in prices (P 1 to P 2 ) appreciates the currency in real terms (ε), shifts the LM* (due to the rise in P and the adjustment in M to keep the nominal rate, e, fixed), and aggregate demand falls. The aggregate demand curve: fixed rates Under fixed exchange rates, both fiscal policy as well as any other shock that shifts the IS* shift the aggregate demand curve. IS*-LM* Aggregate demand IS*-LM* Aggregate demand 31 32

17 The aggregate demand curve: fixed rates Under fixed exchange rates, neither monetary policy nor any other shock that shifts the LM* has an effect on aggregate demand. IS*-LM* Aggregate demand The aggregate demand curve: fixed rates Under fixed exchange rates, a nominal exchange rate (e) devaluation shifts the aggregate demand curve. Con tipos de cambio fijo una devaluación desplaza la curva de demanda agregada a la derecha Aggregate demand IS*-LM* 33 34

18 What have we learned? We study the determinants of aggregate demand in open economies when prices are sticky (short run). The IS-LM framework in the open economy only differs from that in the closed economy in that the real interest rate is exogenous while there is a new endogenous variable: the real exchange rate. One country may keep its exchange rate fixed or it may allow it to fluctuate vis-a-vis other currencies. What have we learned? A fiscal stimulus has no effect on output under flexible exchange rates whereas has a strong effect under fixed rates. A monetary stimulus has full effect on output under flexible exchange rates but has no effect under fixed rates. A currency devaluation rises output in the short run. The aggregate demand in a small open economy: slope and shifts