EC 205 Lecture 20 04/05/15

Transcription

1 EC 205 Lecture 20 04/05/15 Remaining material till the end of the semester: Finish Chp 14 (1 subsection left) Open economy version of IS-LM (Chp 6.1&6.3+13) Chp 16 OR Dynamic macro models (As time permits) 0

2 The natural rate hypothesis Our analysis of the costs of disinflation, and of economic fluctuations in the preceding chapters, is based on the natural rate hypothesis: Changes in aggregate demand affect output and employment only in the short run. In the long run, the economy returns to the levels of output, employment, and unemployment described by the classical model (Chaps. 3-8). 1

3 An alternative hypothesis: Hysteresis Hysteresis: the long-lasting influence of history on variables such as the natural rate of unemployment. Negative shocks may increase u n, so economy may not fully recover. 2

4 Hysteresis: Why negative shocks may increase the natural rate The skills of cyclically unemployed workers may deteriorate while unemployed, and they may not find a job when the recession ends. Cyclically unemployed workers may lose their influence on wage-setting; then, insiders (employed workers) may bargain for higher wages for themselves. Result: The cyclically unemployed outsiders may become structurally unemployed when the recession ends. 3

5 Next: Open economy macroeconomics (Chp and Chp. 13) Preliminaries (Chp 6) the Mundell-Fleming model (IS-LM for the small open economy) causes and effects of interest rate differentials arguments for fixed vs. floating exchange rates how to derive the aggregate demand curve for a small open economy We will start with some preliminaries from Chapter 5 4

6 Imports and exports of selected countries, Exports Imports Percent of GDP Australia China Germany Greece S. Korea Mexico United States 5

7 6

8 Turkish Current Account Balance and Foreign Trade,

9 In an open economy, spending need not equal output saving need not equal investment 8

10 Preliminaries d f C = C + C d f I = I + I d f G = G + G superscripts: d = spending on domestic goods f = spending on foreign goods EX = exports = foreign spending on domestic goods IM = imports = C f + I f + G f = spending on foreign goods NX = net exports (a.k.a. the trade balance ) = EX IM 9

11 GDP = expenditure on domestically produced g & s d d d Y = C + I + G + EX = ( C C f ) + ( I I f ) + ( G G f ) + EX f f f = C + I + G + EX ( C + I + G ) = C + I + G + EX IM = C + I + G + NX 10

12 The national income identity in an open economy Y = C + I + G + NX or, NX = Y (C + I + G ) net exports domestic spending output 11

13 Trade surpluses and deficits NX = EX IM = Y (C + I + G ) trade surplus: output > spending and exports > imports Size of the trade surplus = NX trade deficit: spending > output and imports > exports Size of the trade deficit = NX 12

14 International capital flows Net capital outflow = S I = net outflow of loanable funds = net purchases of foreign assets the country s purchases of foreign assets minus foreign purchases of domestic assets When S > I, country is a net lender When S < I, country is a net borrower 13

15 The link between trade & cap. flows NX = Y (C + I + G ) NX implies = (Y C G ) I = S I trade balance = net capital outflow Thus, a country with a trade deficit (NX < 0) is a net borrower (S < I ). 14

16 Saving, Investment (% of GDP) Saving, investment, and the trade balance , USA 30% 25% 20% 15% 10% 5% trade balance (right scale) saving 0% -10% investment 20% 15% 10% 5% 0% -5% Trade Balance (% of GDP)

17 Assumptions about capital flows in the model a. domestic & foreign bonds are perfect substitutes (same risk, maturity, etc.) b. perfect capital mobility: no restrictions on international trade in assets c. economy is small: cannot affect the world interest rate, denoted r* a & b imply r = r* c implies r* is exogenous 16

18 Investment: The demand for loanable funds r r * Investment is still a downward-sloping function of the interest rate, but the exogenous world interest rate determines the country s level of investment. I (r ) I (r* ) S, I 17

19 The nominal exchange rate e = nominal exchange rate, the relative price of domestic currency in terms of foreign currency (e.g. Yen per TL) NOTE: This is the opposite of the convention in Turkey! We use exchange rate as TL per Yen. 18

20 The nominal exchange rate Crucial: With textbook s convention, e increases when TL appreciates against the foreign currency. Ex: Suppose e=$1 per TL today, if it increases to e=$2 per TL tomorrow, Turkish Lira gains value: Let a US good X have a price of $100 per unit. With 100 TL you can buy 1 unit of X today. When e(tl/usd)=$2, you can buy 2 units of X with the same amount of TLs. Therefore, when e increases, we can buy more foreign goods with the same amount of TL TL gains value (appreciates) 19

21 The real exchange rate the lowercase Greek letter epsilon ε = real exchange rate, the relative price of domestic goods in terms of foreign goods (e.g. Japanese Big Macs per U.S. Big Mac) 20

22 Understanding the units of ε ε = = = = e P P * (Yen per $) ($ per unit U.S. goods) Yen per unit Japanese goods Yen per unit U.S. goods Yen per unit Japanese goods Units of Japanese goods per unit of U.S. goods 21

23 How NX depends on ε ε U.S. goods become more expensive relative to foreign goods EX, IM NX The net exports function reflects this inverse relationship between NX and ε : NX = NX(ε ) 22

24 NX (% of GDP) U.S. net exports and the real exchange rate, % 2% 0% -2% -4% -6% Trade-weighted real exchange rate index Net exports (left scale) Index (March 1973 = 100) -8%

25 How NX depends on e In M-F model, prices are fixed. So all changes in ε are due to changes in e : e (domestic currency appreciates) Domestic goods become more expensive relative to foreign goods EX, IM NX Therefore: NX = NX(e) such that: 24

26 The NX curve e When e is relatively low, domestic goods are relatively inexpensive e 1 So net exports will be high NX(e) 0 NX(e NX 1 ) 25

27 The Mundell-Fleming model Open economy version of the IS-LM model Key assumption: Small open economy with perfect capital mobility. r = r* Goods market equilibrium the IS* curve: Y = C ( Y T ) + I ( r *) + G + NX ( e) where e = nominal exchange rate = foreign currency per unit domestic currency 26

28 The IS* curve: Goods market eq m Y = C ( Y T ) + I ( r *) + G + NX ( e) The IS* curve is drawn for a given value of r*. e Intuition for the slope: e NX Y IS* Y 27

29 The LM* curve: Money market eq m M P = L( r *, Y ) The LM* curve: is drawn for a given e value of r*. is vertical because: given r*, there is only one value of Y that equates money demand with supply, regardless of e. LM* Q: What happens when M increases? Y 28

30 Equilibrium in the Mundell-Fleming model Y = C ( Y T ) + I ( r *) + G + NX ( e) M P = L( r *, Y ) e LM* equilibrium exchange rate equilibrium level of income IS* Y 29

31 Floating & fixed exchange rates In a system of floating exchange rates, e is allowed to fluctuate in response to changing economic conditions. In contrast, under fixed exchange rates, the central bank trades domestic for foreign currency at a predetermined price. Next, policy analysis first, in a floating exchange rate system then, in a fixed exchange rate system 30

32 Fiscal policy under floating exchange rates Y = C ( Y T ) + I ( r *) + G + NX ( e) M P = L( r *, Y ) At any given value of e, a fiscal expansion increases Y, shifting IS* to the right. Results: e > 0, Y = 0 e 2 e 1 e * LM 1 Y 1 * IS 2 * IS1 Y 31

33 Fiscal policy under floating exchange rates Intuition: a fiscal expansion puts upward pressure on the country s interest rate as the domestic interest rate rises even the tiniest bit above the world rate, tons of foreign (financial) capital will flow in to take advantage of the rate difference Demand for TL increases TL appreciates This appreciation makes exports more expensive to foreigners, and imports cheaper to people at home, and thus causes NX to fall. The fall in NX offsets the effect of the fiscal expansion. e 2 e 1 e * LM 1 Y 1 * IS 2 * IS1 Y 32

34 Lessons about fiscal policy In a small open economy with perfect capital mobility, fiscal policy cannot affect real GDP. Crowding out closed economy: Fiscal policy crowds out investment by causing the interest rate to rise. small open economy: Fiscal policy crowds out net exports by causing the exchange rate to appreciate. 33

35 Monetary policy under floating exchange rates Y = C ( Y T ) + I ( r *) + G + NX ( e) M P = L( r *, Y ) An increase in M shifts LM* right because Y must rise to restore eq m in the money market. Results: e < 0, Y > 0 e 1 e 2 e LM Y 1 * 1 LM Y 2 * 2 * IS1 Y 34

36 Monetary policy under floating exchange rates Intuition: An increase in M Downward pressure on interest rates Huge capital outflow Demand for domestic currency falls down e decreases NX increase Y increases e 1 e 2 e LM Y 1 * 1 LM Y 2 * 2 * IS1 Y 35

37 Lessons about monetary policy Monetary policy affects output by affecting the components of aggregate demand: closed economy: M r I Y small open economy: M e NX Y Expansionary mon. policy does not raise world agg. demand, it merely shifts demand from foreign to domestic products. So, the increases in domestic income and employment are at the expense of losses abroad. 36

38 Trade policy under floating exchange rates Y = C ( Y T ) + I ( r *) + G + NX ( e) M P = L( r *, Y ) At any given value of e, a tariff (tax on imports) or quota reduces imports, increases NX, and shifts IS* to the right. Results: e > 0, Y = 0 e 2 e 1 e * LM 1 Y 1 * IS 2 * IS1 Y 37