Only an outline of the Dornbusch analysis, along with some

Transcription

1 Sahoko KAJI --- Open Economy Macoeconomics Lectue Notes IV The M-F Result unde Fixed Exchange Rates In showing how the M-F esults come about, the logic that we used stated with detemining, both unde flexible and fixed exchange ates. With pefect capital substitutability and static expectations egading exchange ate depeciation, is effectively fixed fo this small county. This is in fact the key to the M-F esults. is no longe fixed but endogenous, the M-F esults beak down. assumptions that make endogenous. Once Thee ae seveal Chapte 10 of Donbusch ( Open Economy Macoeconomics, Basic Books, 1980) shows two of them; the two-county assumption and the impefect capital substitutability assumption. This pat of the lectue essentially follows Chapte 10 of Donbusch (1980), and is not epoduced in detail hee. additional explanations and comments ae given. Only an outline of the Donbusch analysis, along with some In the fist pat of Chapte 10, Pofesso Donbusch explains the M-F esult unde the oiginal assumptions of small county, pefect capital substitutability and static expectations egading exchange ate depeciation. When the small county attempts a monetay expansion though an open maket puchasing opeation (buying domestic bonds in exchange fo money), thee is downwad pessue on the domestic ate of inteest. This leads to a massive and immediate outflow of capital, and the IRPC is maintained. a esult, does not divege fom. As In the pocess of this capital outflow, the domestic cuency is sold and the foeign cuency is bought, which puts pessue on the exchange ate to depeciate. The exchange ate must be kept constant, so the monetay authoity intevenes in the foeign exchange maket. It buys the domestic cuency and sells the foeign cuency. The supply of domestic cuency in the maket declines. At the same time, foeign exchange eseves ae lost, and this bings down domestic money supply (ecall the balance sheet of the cental bank). Money supply is bought down to the oiginal level and the attempt at money supply expansion fails. In shot, the money supply is not contollable as an exogenous policy vaiable in this economy. mentioned, this is a estatement of the Inconsistent Tiangle.) (As aleady As fo fiscal policy, its effectiveness is enhanced by the fact that the ate of inteest emains constant. Fiscal expansion puts upwad pessue on the ate of inteest, capital inflow ensues, and the exchange ate comes unde pessue to appeciate. The monetay authoities counte this pessue with intevention, selling the domestic cuency and buying the foeign cuency.. investment. Money supply inceases and stays at the level equal to This enables fiscal expansion to occu without cowding-out pivate secto IV-7

2 Sahoko KAJI --- Open Economy Macoeconomics Lectue Notes IV Altenative assumptions: Two-County assumption Pofesso Donbusch changes the small county assumption into a two-county assumption in the second pat of the chapte. The IRPC holds, expectations on exchange ate changes ae static, so the domestic ate of inteest is still equal to the foeign ate of inteest. But the foeign ate of inteest is now endogenous in this two-county setting, so the domestic and foeign inteest ates ae jointly endogenous (o the wold inteest ate is endogenous). This means that when the domestic monetay authoity attempts to incease money supply, the incease does indeed take place, because the wold inteest ate falls in esponse. This esponse of the inteest ate is cucial, because it inceases money demand. Unde the small county assumption, money supply could not incease because money demand emained constant, because the ate of inteest emained constant. It was like pouing wate into a containe of fixed size. If we add wate to a containe that is aleady full to the bim, the excess wate will simply spill out and be lost. The amount of wate in the containe emains the same. In the same way, if we ty to add money supply when money demand is equal to money supply and money demand emains constant, the additional money supplied will spill and be lost in the fom of losses in foeign exchange eseves. The amount of domestic money supply and demand emains the same. In contast, in the two-county setting, the wold inteest ate declines in esponse to monetay expansion, making monetay policy effective in boosting income. The inteest ate declines because it inceases money demand which makes it possible fo money supply to expand. And the decline in inteest ate (o the expansion in money supply) inceases spending, which stimulates income. In fact, the monetay expansion could take place in eithe county and it would incease income in both counties. This is because this two-county model is not much diffeent fom a closed-economy small county model. The only diffeence is that the vaiables ae supeficially divided into two. The adjective supeficially is used hee, because the two counties goods, money and bonds ae pefect substitutes. Thee is effectively only one IS, one LM and one bond maket equilibium condition. In economics, the only chaacteistic that distinguishes a good (in the boad sense of the wod) is the pice. Diffeences in colou, size, shape o any othe chaacteistic do not count. If the pice (o cost) is the same, it is the same good and belongs to the same equilibium condition. The IRPC states that the pice of holding domestic bonds is equal to the pice of holding foeign bonds. They ae pefect substitutes, o effectively the same bonds, and thee is only one equation that shows the equilibium condition fo these bonds. On the supply side, thee is the sum of the supply of domestic and foeign bonds, and on the demand side, thee is the sum of the demand fo domestic and foeign bonds. IV-8

3 Sahoko KAJI --- Open Economy Macoeconomics Lectue Notes IV In addition, because of fixed exchange ates, the domestic cuency can be changed into the foeign cuency at a fixed exchange ate at all times. Hence the two cuencies ae also pefect substitutes. Thee is only one LM equation in the wold, with the sum of domestic and foeign money supply on one side and the sum of domestic and foeign money demand on the othe. Futhemoe, pices of goods ae assumed to be fixed in this model and P=eP* is also assumed, so with the exchange ate fixed, the domestic poduct can also be changed into the foeign poduct at a fixed pice at all times. Hence the two goods ae also pefect substitutes. Thee is only one IS equation in this model, with the sum of domestic and foeign aggegate poduction on one side and the sum of domestic and foeign aggegate demand on the othe. Thus, in this two-county model thee is only one IS, one LM and one bond maket equilibium condition. It is analytically simila to a closed economy model; the diffeence is that each of the endogenous and exogenous vaiables compises two pats. Thee is not much wonde if monetay policy woked even unde fixed exchange ates, pefect capital substitutability and static expectations. The expansion of wold money supply leads to inceases in the sum of the two incomes. Thee ae two outes fom monetay expansion to income expansion in this two-county setting, one though the decline in inteest ate and the othe though the incease in income. Pofesso Donbusch shows foeign income as a function of domestic income and the wold ate of inteest : ( ) = Φ, whee Φ > 0, Φ < 0. An incease in and a decease in both lead to an incease in as a esult of monetay expansion. policy in this model.. Both take place The intenational tansmission is positive fo monetay The allocation of the income incease between home and aboad is not discussed in Chapte 10, but would depend on the patial deivatives Φ and Φ which ae functions of patial deivatives E, E, T, T, as well as E and E (whee E is aggegate expenditue and T is tade). With egad to the question of allocation between the two counties, Pofesso Donbusch discusses the allocation of the loss of foeign exchange eseves. When eithe monetay authoity conducts an open maket opeation to incease money supply, supply exceeds demand in the wold money maket. The wold ate of inteest declines and both domestic and foeign demand fo money incease. Pofesso Donbusch shows IV-9

4 Sahoko KAJI --- Open Economy Macoeconomics Lectue Notes IV mathematically how the allocation of this incease in money demand depends on the elative size of the two counties ( and ) as well as the esponse of money demand to inteest ate changes (patial deivatives L and L ). Money demand will incease moe domestically, the lage is elative to and the lage L is elative to L. And the lage the incease in money demand at home, the smalle the loss of foeign exchange eseves at home, because the size of the containe expands that much moe to hold the additional supply of money. Fiscal policy could have a negative tansmission in this two-county model. If domestic income inceases that would have a positive effect on foeign income, but an incease in the wold inteest ate has a negative effect on foeign income. When the domestic fiscal authoity inceases govenment spending, the sum of the two incomes and the wold ate of inteest both incease. The incease in the ate of inteest is due to the inceased demand fo funds. Since domestic and foeign poducts ae pefect substitutes in this model, a domestic fiscal expansion could just as easily incease foeign income as domestic income. An incease in foeign income would have a positive effect on domestic income, but thee is the incease in the wold inteest ate to contend with. Although not explicitly stated in Chapte 10, this suggests a possibility that domestic fiscal policy would be ineffective in inceasing domestic income. In fact, it could even lead to a decline in domestic income, in the exteme case whee the incease in domestic govenment spending is spent entiely on buying foeign poducts and only the effect of highe inteest ate emains domestically. We need to emembe, howeve, that this esult depends on the assumption that domestic and foeign poduct pices ae constant. Without this assumption, domestic and foeign poducts can not emain pefect substitutes unde fixed exchange ates. Altenative assumptions: Impefect Capital Substitution In the thid pat of Chapte 10, Pofesso Donbusch evives the small county assumption and intoduces the new assumption of impefect capital mobility. Domestic and foeign bonds ae not the same in the eyes of investos and thee ae two sepaate equilibium conditions fo each. Pofesso Donbusch expesses the degee of capital substitutability in an extemely intuitive way, as a function of the patial deivatives that show the esponse of demand fo bonds to changes in domestic and foeign inteest ates ( σ and σ, whee σ is the IV-10

5 Sahoko KAJI --- Open Economy Macoeconomics Lectue Notes IV demand function fo domestic bonds). Pefect capital substitutability is a state in which the sum of these patial deivatives goes to infinity, i.e. when investos espond to inteest ate changes with immediate and massive capital flows. In contast, if capital substitutability is impefect, the sum of these patial deivatives stays within the ange of lage than zeo but smalle than infinity. The loss of foeign exchange eseves esulting fom monetay expansion is deived as a function of the sum of these patial deivatives: dr dd L = 1 σ + σ * whee R is the stock of foeign exchange eseves and D is the stock of domestic bonds held by the cental bank. An incease in D means the cental bank has conducted an open maket puchase opeation, expanding money supply. Unde pefect capital substitutability, the denominato of the second tem on the ight-hand side goes to infinity, endeing the left-hand side equal to -1. The expansion in money supply (by expansion in cental bank holding of domestic bonds) is completely offset by the loss in foeign exchange eseves; they ae exactly the same in amount and opposite in sign. But if capital is only impefectly substitutable, this expession is lage than -1 and smalle than zeo, indicating that thee is oom fo monetay expansion. Money supply is contollable, at least to an extent. In esponse to monetay expansion, the ate of inteest declines and income inceases. Pofesso Donbusch also shows that fiscal policy is effective, and its effectiveness inceases with the substitutability of domestic and foeign capital. When capital substitutability is pefect, thee is no cowding-out. IV-11