3. OPEN ECONOMY MACROECONOMICS

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1 3. OEN ECONOMY MACROECONOMICS The overall context within which open economy relationships operate to determine the exchange rates will be considered in this chapter. It is simply an extension of the closed economy aggregate supply and demand framework found in most modern undergraduate textbooks. Nonetheless, an understanding of this apparatus is essential to what follows in exchange rate determination theories like Mundell Fleming, Dornbush and Monetary models. 3.1 A Brief Look At a Closed Economy NOT ADDED YET!!!

2 3.2 Open Economy Macroeconomics The IS LM Model of Aggregate Demand (AD) The IS (Investment Savings) Curve (The Goods and The Services Market) The national income identity can be written as follows in an open economy: Y = C + I + G + NX Where; Y C I G NX = real national income = expenditure on consumption = expenditure on investment = net government purchases of goods and services = net exports (exports minus imports) If we subtract C, I, and NX from both sides, we get: S I NX = G There is a direct relationship between Savings (S = Y C) and income, other things being equal. As income rises, savings of the household sector will tend to increase. And a rise in the level of interest rates in the economy will stimulate Savings (meaning a direct relationship). On the other hand, investment spending by the corporate sector will depend on a comparison of the cost of funds for the purchase of equipment and so on with the profits to be expected from the investment. Other things being equal, the higher interest rates in the economy, the greater the cost of capital, and hence the less likely it is that any given prospective investment will appear profitable to the decision maker. In general, therefore, aggregate investment will vary inversely with the interest rates. Since savings increase as interest rates rise, while investment falls, the difference (S I) will be positively related to interest rates. Government spending will be taken as exogenously given determined outside the model by factors (political, social, technological and so on) beyond the scope of mere economist. The reasons behind fiscal expenditure changes will not be considered here. For the subject aim, the most important factor in the equation is the current account of balance of payments (NX). What are likely to be the main influences in NX? Among the many factors which affect NX of countries, there is almost certain to be one overriding consideration, this is the competitiveness of domestic relative to foreign output.

3 What this implies for price levels in general is that it is relative competitiveness, that is, the real exchange rate: Q S * which determines the state of a country s current account. Q is the price of foreign produced goods, measured in domestic currency. The greater is Q, therefore, the more competitive is domestic output. It follows that, at higher levels of Q, the current account surplus is likely to be greater (or the deficit smaller) than at low levels. There is one other macroeconomic factor affecting current account. Just as consumption of domestically produced goods and services rises with national income, the same is bound to be true of expenditure on imports, at a rate determined by the country s Marginal ropensity to Import (MI). The higher the income, the smaller is likely to be the surplus (or greater the deficit) on external trade, other things being equal in other words, at any given real exchange rate. Now let s look back at S I NX = G and incorporate our conclusions about how the components of aggregate demand are determined by a simple form: by + zr hq = G where b, z, and h are behavioral parameters. The first term on the left hand side summarizes the dependence of savings and imports on the level of economic activity, the second incorporates the positive relationship between interest rates and the private sector s saving net of its investment and the third represents the current account as a function of the real exchange rate. On the right hand side is the exogenous policy variable, G, fixed initially at the level G. Now the above equation represents the equilibrium condition in the goods and services market. It shows the relationship that must hold between y, r and Q, for there to be no excess demand for goods and services. If we rewrite the equation, by + zr = G + hq which reduces it to a relationship between y and r for the given values of G and Q on the right hand side. Obviously, there are infinite number of possible combinations of y and r that satisfy the above equation. Then the equation take the following form: by + zr = G + hq and the IS curve and equilibrium condition in the goods and services market will be plotted below:

4 The graph is plotted by asking this question: At any level of interest rate (r), what would have to be the level of national income (y)? The answer is given by the above equation. r1 is smaller than r and zr1 will be also smaller. So, at the previous value of y (that is y), the left side of equation given above will be smaller than before, and hence smaller the right hand side. In terms of economics, at lower r, the volume of saving will be smaller and the volume of investment spending greater than at A. Therefore, since A was an equilibrium, with saving net of investment just sufficient to finance the given deficits in the public and external trade sectors of the economy, net saving must be inadequate at the point C. There must be excess demand for goods and services at point C. The additional savings will only be forthcoming if national income is greater than y. At the point B, interest rates and net saving will be reduced, and income will be increased. The following equation gives the equilibrium at point B: by1 + zr1 = G + hq So, IS curve will be a downward sloping curve always associating lower levels of the interest rate with higher levels of y. Any increase in G or Q would make the left hand side of the equation larger. A rise in Q means a rise in real exchange rates (that is, a real devaluation) and more competitive prices of domestic country relative to foreign countries, which would cause a larger surplus (or smaller deficit) in current account. An increase in G or Q, would shift in IS curve to the right meaning an expansion in y. When interest rates are r, the level of national income would be y3. The lower level of r (r1) would mean a y4 level of national income.

5 The right hand side of the equation is the sum of the public sector deficit and the foreign sector surplus, which represents the total finance required out of net saving by the domestic private sector. This is satisfied by a change in y and/or r that serves to increase net savings in the economy. A rise in y and r stimulates greater saving by households but a rise in r would also cause a fall in investment by the corporate sector The LM Curve (The Money Market) Money refers to the asset or assets, which are commonly used as a means of payment. In the Medieval Europe for example, gold and silver were the only widely accepted means of payment. Nowadays, coins and banknotes and etc.. are commonly used as a means of payment. Operational definitions of money are given below: M1 = currency in circulation + checkable deposits M2 = M1 + noncheckable savings deposits + MMDA + small time deposits + MMMFs M3 = M2 + large time deposits MMDA = money market deposit accounts MMMF = money market mutual funds Near monies: M2 and M3 Small time deposits: less than 1, US$ in USA Large time deposits: 1, US$ or more in USA The Demand for Money Money is the most liquid asset, and there is an opportunity cost of holding money. The opportunity cost of holding money is the return that could have been earned by holding a less liquid asset than money. The demand for money will be greater the larger is the volume of transactions and will be smaller the higher is the return on non-money assets. The relationship between the demand for money and national income can be summarized as: M d = ky k > Where M d is the demand for money and Y is national income, both measured in nominal terms and k is a positive parameter. The reason why M d and Y are both defined in nominal terms should be obvious. Other things being equal, one would expect, say, a 1% increase in the real volume of transactions to have the same effect on the demand for

6 money as a 1% increase in the price level at which the transactions are conducted. In fact, if we define: Y = y Which just says nominal income, Y, is by definition the product of real income, y, times the price level,, at which it is traded, so we can rewrite the previous equation as: M d = k y Which is known as Cambridge quantity equation. If we divide both sides by : M d ky The left hand side is the demand for real money balances (the quantity of purchasing power the agents in the economy wish to hold in the form of money), the right hand side is the constant, k, times the real income generated in the economy. Equilibrium in the money market involves a situation where demand for money is equal to the supply of money. The demand for real balances will only be constant if the 1% rise in the demand for nominal money, M d, is offset by an increase of equal proportions in the price level,, thereby keeping the ratio M d / constant. In other words, each increase in the money supply generates an equiproportionate rise in the price index. M d ky lr k,1 > The equation now expresses our contention that the demand for real balances will increase with the volume of transactions, but decrease with the opportunity cost of holding money, as measured by the interest rate, r. If over some period the price level can be regarded as constant, an increase in the nominal money supply must amount to a rise in the value of real balances in the economy, and this in turn must cause an increase on the right hand side of the above equation. Again, if changes in real income are ruled out this must imply a fall in r, so as to reduce the damping effect of the opportunity cost on the demand for real balances. Summary of demand for money equation: It states that the impact of an increase (decrease) of x% if the interest rate is unchanged, or to push the interest rate down (up), if the price level is constant, or some combination of the two, that is, a price change of less than x% in addition to an interest rate change.

7 The Government Budget Constraint and The Money Supply Before considering money supply, it is better to understand the mechanics of government budget finance. When government expenditures are greater than its revenues, this deficit will be financed through some borrowings. We can summarize the fact as in the following identity: G T = the budget deficit = total government spending where G = government expenditures T = government tax revenue The government s borrowing could be short or long term, secured or unsecured, indexed or unindexed, in negotiable or unnegotiable instruments and so on.. But here, it is assumed to issue via the agency of the central bank, a kind of security which the public is willing to accept as money. The above equation can be written as the following identity: G T = MB + B S Where MB is the quantity of currency in existence, and B S is the quantity of nonmonetary government debt in existence (bonds). The government budget constraint is the identity that expresses the fact that all government spending over any given period must be financed either by taxation, by issuing currency or by issuing non-money securities (LT debt, bonds). The Supply of Money in an Open Economy What is meant by money supply is nothing more than the quantity of money in existence in the economy at a particular point in time. The money supply is identically equal to the sum of the domestic credit generated by the banking system plus the value of the country s reserves of gold and foreign currency held at central bank. FX + DC = (MB MB b ) + D FX + DC = MB p + D FX + DC = M S Where: FX = gold and foreign currency reserves DC = domestic credit (L + LG)

8 L: loans advanced to personal and corporate sector by commercial banks LG: lending to government by central bank MB = currency issued (monetary base) MB b = currency plus deposits with central bank MB p = currency in circulation D = deposits by public M S = money supply FX + DC = M S A (pure) floating exchange rate regime is one such that the balance of payments for official financing is identically zero, because the monetary authority either holds no foreign currency reserves or never uses them to intervene in currency markets. Under a floating exchange rate, the domestic money stock only changes as a result of changes in the lending behavior of the domestic banking system. Since the volume of lending can be controlled by the authorities, so can the money stock. In this sense, the money supply is a policy instrument at the disposal of the home country s monetary authority. So money supply is an exogenous variable leaving the exchange rate to be determined endogenously by market forces. The balance of payments, the change in the reserves and in the money supply are all endogenous. Only the change in exchange rate is exogenously fixed at zero. A fixed exchange rate regime (including managed float or dirty float) is one such that the balance of payments for official financing is not identically zero, the surplus or deficit being covered by the domestic monetary authority s use of the foreign currency reserves to intervene in currency markets. Under fixed rate system, money supply cannot be regarded as a policy variable but instead will be endogenous variable determined by whatever factors influence the balance of payments. The LM (Liquidity - Money) Curve Equilibrium in the money market equals when demand is equal to supply. Combinations of income and the interest rate consistent with equilibrium are plotted along the LM curve. The equilibrium equation will be as follows again: M S d M ky kr k,l >

9 If the money stock (money supply) is fixed initially at M S and at a given price level,, then: S M ky lr k,l > At r, the equilibrium level of y for money market to clear will be y. So it is the combination of r and y at point A that demand for money is equal to money supply. Let s assume that interest rates fell to r1: Then money holdings will be lower and demand for money will tend to increase. At r1, demand for money will be greater than money supply; therefore, equilibrium condition requires the lower interest rate to be associated by a lower level of activity, lower y, so as to damp down the demand for money for transactions purposes. So there will be a lower level of economic activity at y1. Any change in money supply or price level would cause LM curve to shift rightwards. But a identical change both in money supply and price level would not have any effect on LM curve since the ratio on the right hand side of equation would be unchanged. The new equilibrium production will be y2 and higher money supply will lower the interest rates also. Then equilibrium of y and r comes to y3 and r1. Aggregate Demand

10 The figure below combines IS and LM curves so as to generate a solution to the following equations: IS curve : by + zr = G + hq LM curve : S M ky lr k,l > oint A is the initial equilibrium level of income (y), government fiscal spending (G), money supply (M S ), the price level () and the real exchange rate (Q). Y is the equilibrium output in the IS-LM model and it is also referred as aggregate demand (AD) in the economy denoted by y d. If aggregate demand is greater than the economy s productive potential, then the price level will rise. And a rise in the price level will adversely affect AD. When the price level is 1, the value of money stock will be reduced (M S /1). So; M S 1 M S This will shift LM curve to the left indicating a higher r and lower y. The only effect of a rise in the price level on IS curve arises via the international price term, Q. Other things being equal, assuming neither the nominal exchange rate nor the foreign price level change, the higher domestic price level reduces the competitiveness (real exchange rate) of domestic production, pushing the IS curve downward and to the left. The new equilibrium level after a rise in the price level will be point B in IS-LM model and b in AD curve.

11 3.2.2 Aggregate Supply (AS) The classical theory under flexible prices and the Keynesian model in fixed prices are holding up in order to derive AS curve, indicating that AS curve is vertical under flexible prices and positively sloping in fixed prices Flexible rices A profit-maximizing firm will demand labor up to the point at which the value of its marginal product is just equal to the money wage, that is, up to the point where the last man-hour adds just as much to revenue as it does to costs. The demand for labor will be a decreasing function of the nominal wage at any given price level. At the price level, the demand for labor will be given by a downward sloping line labeled n d () in the figure below. If, for example, the price level increases by 2%, firms would seek to employ the same amount of labor at a money wage 2% greater than previously, because, other things

12 being equal, marginal man-hour would result in a proportionately greater addition to revenue than previously. Hence, demand curve shifts upwards. On the other hand, households are presumed to be intent on choosing a utilitymaximizing combination of work and leisure. They will offer their services up to the point at which the monetary benefit (in terms of consumption) they derive from the last man-hour supplied, as measured by the wage rate, is equal to their subjective assessment of its leisure value. The supply of man-hour will be an increasing function of the nominal wage as in n S (). At 1, any given money wage buys 2% less consumption. The household will therefore be in equilibrium supplying any given number of man-hours at a money wage 2% higher than before. The initial equilibrium level was at point A, now new level will be at point B. This indicates a 2% higher money wage and both the real wage and the level of employment are unchanged. The output (y) and employment of labor force will also be unchanged at point C. At a S constant output level of y, the price level will rise to 1 = 1.2 moving from point D to point E deriving AS curve in the classical approach. The classical or flexible price AS curve is vertical at the long run capacity output, because as the price level changes, the money wage adjusts to keep the real wage constant. Hence, employment and output never vary, and the price level itself is determined by AD.

13 Fixed rices Now consider what would happen if money wages are fixed. It could be regarded as the very short run reaction to a sudden change in the rice level after all, money wages can hardly respond overnight. In fact, wages might be fixed over a longer horizon by the existence of employment contracts. The supply curve is horizontal at the current fixed money wage, W. Assuming firms continue to react to the price changes in the way described in section , it follows that employment and output are no longer constant.

14 A rise in the price level is associated with a fall in the real wage and a consequent S S increase in employment from n to n 1 and output from y to y 1. The result will be the upward sloping AS curve under fixed prices of Keynesian Approach. The Keynesian or fixed price AS curve is flat at the currently given price level, reflecting the fact that demand fluctuations are associated with the equal and opposite variation in the real wage. Hence, with fixed prices, employment and output are demand-determined.

15 A Compromise: Sticky rices If the flexible wage model seems an implausible description of the very short run reaction of labor markets, while the fixed wage alternative is equally unrealistic as a description of long run behavior, consider a compromise between the two extremes. Suppose the assumptions underlying the Keynesian model apply to the short run, while wages and prices are completely flexible in the long run, as in the classical model. In other words, suppose, AS curve is flat in the immediate impact phase, but get steeper as time elapses, ultimately becoming vertical in the steady state equilibrium. The initial equilibrium is at point E. When AD shifts to the right, the equilibrium will be firstly at point A in the short run AS curve. As time passes, the equilibrium will move to point B in the medium term of AS curve. In the very long run, the long-term equilibrium will move from B to C in the long run AS curve. This model follows that reaction to an increase in AD involves initially an expansion in output with no inflation. As time passes, the price level rises and output falls back toward its long run level.