Aggregate Demand in the Open Economy CHAPTER TWELVE Aggregate Demand in the Open Economy

This chapter: 1. The Mundell-Fleming model 2. The small open economy under floating exchange rates 3. The small open economy under fixed exchange rates

Building the Mundell-Fleming Model Start with these two equations: IS*: Y = C(Y-T) + I(r*) + G + NX(e) LM*: M/P = L (r*,Y) Assumption 1: The domestic interest rate is equal to the world interest rate (r = r*). Assumption 2: The price level is exogenously fixed since the model is used to analyze the short run (P). This implies that the nominal exchange rate is proportional to the real exchange rate. Assumption 3: The money supply is also set exogenously by the central bank (M). Assumption 4: Our LM* curve will be vertical because the exchange rate does not enter into our LM* equation.

Deriving the Mundell-Fleming IS* Curve The Keynesian Cross An increase in the exchange rate, lowers net exports, which shifts planned expenditure downward and lowers income. The IS* curve summarizes these changes in the goods market equilibrium. (c) E Y=E Planned Expenditure, E = C + I + G + NX Income, Output, Y (a) (b) e The NX Schedule e The IS* Curve NX(e) IS* Net Exports, NX Income, Output, Y

Deriving the Mundell-Fleming LM* Curve The LM Curve r LM The LM curve and the world interest rate together determine the level of income. r = r* Income, Output, Y The LM* Curve e LM* Income, Output, Y

The Mundell-Fleming Model LM* Equilibrium exchange rate IS* Income, Output, Y Equilibrium Income

Exchange Rates Regimes in Europe, 2004 1. European Monetary Union (fixed exchange rates among themselves, by the adoption of a common currency, the euro): Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain 2. Members of the Exchange Rate Mechanism of the European Monetary System: Cyprus, Czech Republic, Denmark, Hungary, Latvia, Malta, Poland, Slovak Republic, Slovenia

3. Managed floaters (follow the euro closely, they actively limit the fluctuations of their exchange rates, usually vis-a-vis the euro): Croatia, Macedonia, Norway, Romania, Russia, Sweden, Ukraine 4. Free floaters (largely allow the market to determine their exchange rate): Albania, Iceland, Switzerland, United Kingdom 5. Currency board (they peg to the euro): Estonia, Lithuania, Bosnia-Herzegovina, Bulgaria

The Mundell-Fleming Model Under Floating Exchange Rates Expansionary Monetary Policy Expansionary Fiscal Policy e LM* LM*' e LM* +DG, or –DT  +De, no DY +DM  -De, +DY IS*' IS* IS* Income, Output, Y Income, Output, Y When income rises in a small open economy, due to the fiscal expansion, the interest rate tries to rise but capital inflows from abroad put downward pressure on the interest rate.This inflow causes an increase in the demand for the currency pushing up its value and thus making domestic goods more expensive to foreigners (causing a –DNX). The –DNX offsets the expansionary fiscal policy and the effect on Y. When the increase in the money supply puts downward pressure on the domestic interest rate, capital flows out as investors seek a higher return elsewhere. The capital outflow prevents the interest rate from falling. The outflow also causes the exchange rate to depreciate making domestic goods less expensive relative to foreign goods, and stimulates NX. Hence, monetary policy influences the e rather than r.

The Mundell-Fleming Model Under Fixed Exchange Rates The goal of the monetary policy of the Central Bank: keep the exchange rate at the announced level. The essence of a fixed-exchange rate system: the commitment of the Central Bank to allow the money supply to adjust to whatever level will ensure that the equilibrium exchange rate equals the announced exchange rate. Let’s see how fixing the exchange rate determines the money supply! ARBITRAGE: the process of buying something such as a commodity or a currency in one place and sell it in another place at the same time.

The Central Bank must increase the money supply (a) The Equilibrium Exchange Rate is Greater Than the Fixed Exchange Rate LM1* LM2* Exchange rate, e Equilibrium exchange rate Fixed exchange rate IS* Income, output, Y The Central Bank must increase the money supply

(b) The Equilibrium Exchange Rate is Less Than the Fixed Exchange Rate LM2* LM1* Exchange rate, e Fixed exchange rate Equilibrium exchange rate IS* Income, output, Y The Central Bank must decrease the money supply

The Mundell-Fleming Model Under Fixed Exchange Rates Expansionary Monetary Policy Expansionary Fiscal Policy +DG, or –DT + DY +DM  no DY e LM* e LM* LM*' IS*' IS* IS* Income, Output, Y Income, Output, Y A fiscal expansion shifts IS* to the right. To maintain the fixed exchange rate, the Fed must increase the money supply, thus increasing LM* to the right. Unlike the case with flexible exchange rates, there is no crowding out effect on NX due to a higher exchange rate. If the Fed tried to increase the money supply by buying bonds from the public, that would put down- ward pressure on the interest rate. Arbitragers respond by selling the domestic currency to the central bank, causing the money supply and the LM curve to contract to their initial positions.

Policy in the Mundell-Fleming Model: A Summary The Mundell-Fleming model shows that the effect of almost any economic policy on a small open economy depends on whether the exchange rate is floating or fixed. The Mundell-Fleming model shows that the power of monetary and fiscal policy to influence aggregate demand depends on the exchange rate regime.

Exchange Rate Conclusions Fixed vs. Floating Exchange Rate Conclusions

Exchange Rate Conclusions Floating Exchange Rates Fixed vs. Floating Exchange Rate Conclusions Floating Exchange Rates Fixed Exchange Rates Fiscal Policy is Powerless. Monetary Policy is Powerful. Fiscal Policy is Powerful. Monetary Policy is Powerless. Hint: (Think of floating money.) Hint: (Fixed and Fiscal sound alike). The Mundell-Fleming model shows that fiscal policy does not influence aggregate income under floating exchange rates. A fiscal expansion causes the currency to appreciate, reducing net exports and offsetting the usual expansionary impact on aggregate demand. The Mundell –Fleming model shows that monetary policy does not influence aggregate income under fixed exchange rates. Any attempt to expand the money supply is futile, because the money supply must adjust to ensure that the exchange rate stays at its announced level.

Should Exchange Rates Be Floating or Fixed? Historically - most economists have favoured a system of floating exchange rates In recent years - some advice the return to fixed exchange rates Arguments for floating exchange rate: - it allows monetary policy to be used for other purposes (stabilizing employment or prices) Arguments for fixed exchange rates: - exchange rate uncertainty makes international trade more difficult (after Bretton Woods, real and nominal exchange rates became much more volatile than anyone expected) - a commitment to a fixed exchange rate is a way to discipline a nation’s monetary authority and prevent excessive growth in the money supply

The choice between floating and fixed exchange rate is more flexible than it may seem at first: - during periods of fixed exchange rates, countries can change the value of their currency if they notice that maintaining the exchange rate is in conflict with other goals - during periods of floating exchange rates, countries may use formal or informal targets for the exchange rates when deciding whether to expand or contract the money supply We rarely observe exchange rates that are completely fixed or completely floating. The main objective of the central bank: stability of the exchange rate.

Interest Rate Differentials What if the domestic interest rate were above the world interest rate? The higher return will attract funds from the rest of the world, driving the US interest rate back down. And, if the interest rate were below the world interest rate, domestic residents would lend abroad to earn a higher return, driving the domestic interest rate back up. In the end, the domestic interest rate would equal the world interest rate.

Country Risk and Exchange Rate Expectations Why doesn’t this logic always apply? There are two reasons why interest rates differ across countries: 1) Country Risk: when investors buy US government bonds, or make loans to US corporations, they are fairly confident that they will be repaid with interest. By contrast, in some less developed countries, it is plausible to fear that political upheaval may lead to a default on loan repayments. Borrowers in such countries often have to pay higher interest rates to compensate lenders for this risk. 2) Exchange Rate Expectations: suppose that people expect the French franc to fall in value relative to the US dollar. Then loans made in francs will be repaid in a less valuable currency than loans made in dollars. To compensate for the expected fall in the French currency, the interest rate in France will be higher than the interest rate in the US.

Differentials in the Mundell-Fleming Model To incorporate interest-rate differentials into the Mundell-Fleming model, we assume that the interest rate in our small open economy is determined by the world interest rate plus a risk premium q. r = r* + q The risk premium is determined by the perceived political risk of making loans in a country and the expected change in the real interest rate. We’ll take the risk premium q as exogenously determined. For any given fiscal policy, monetary policy, price level, and risk premium, these two equations determine the level of income and exchange rate that equilibrate the goods market and the money market. IS*: Y = C(Y-T) + I(r* + q) + G + NX(e) LM*: M/P = L (r* + q,Y)

Now suppose that political turmoil causes the country’s risk premium q to rise. The most direct effect is that the domestic interest rate r rises. The higher interest rate has two effects: 1) IS* curve shifts to the left, because the higher interest rate reduces investment. 2) LM* shifts to the right, because the higher interest rate reduces the demand for money, and this allows a higher level of income for any given money supply. These two shifts cause income to rise and thus push down the equilibrium exchange rate on world markets. The important implication: expectations of the exchange rate are partially self-fulfilling. For example, suppose that people come to believe that the French franc will not be valuable in the future. Investors will place a larger risk premium on French assets: q will rise in France. This expectation will drive up French interest rates and will drive down the value of the French franc. Thus, the expectation that a currency will lose value in the future causes it to lose value today. The next slide will demonstrate the mechanics.

An Increase in the Risk Premium Is this really is where the economy ends up? In the next slide, we’ll see that increases in country risk are not desirable. e LM* LM*' IS* IS*' Income, Output, Y An increase in the risk premium associated with a country drives up its interest rate. Because the higher interest rate reduces investment, the IS* curve shifts to the left. Because it also reduces money demand, the LM* curve shifts to the right. Income rises, and the exchange rate depreciates.

There are three reasons why, in practice, such a boom in income does not occur. 1. First, the central bank might want to avoid the large depreciation of the domestic currency and, therefore, may respond by decreasing the money supply M. 2. Second, the depreciation of the domestic currency may suddenly increase the price of domestic goods, causing an increase in the overall price level P. 3. Third, when some event increase the country risk premium, residents of the country might respond to the same event by increasing their demand for money (for any given income and interest rate), because money is often the safest asset available. All three of these changes would tend to shift the LM* curve toward the left, which mitigates the fall in the exchange rate but also tends to depress income.

The Mundell-Fleming Model with a Changing Price Level Recall the two equations of the Mundell-Fleming model: IS*: Y=C(Y-T) + I(r*) + G + NX(e) e LM* LM*' LM*: M/P=L (r*,Y) When the price level falls the LM* curve shifts to the right. The equilibrium level of income rises. The second graph displays the negative relationship between P and Y, which is summarized by the aggregate demand curve. IS* Income, Output,Y P AD Income, Output,Y

International Financial Crisis: Mexico 1994-1995 August 1994: a Mexican peso=30 cents August 1995: a Mexican peso=16cents What can explain this large fall? COUNTRY RISK is a large part of the story. Some facts: - beginning of 1994: NAFTA (North American Free Trade Agreement) reduced trade barriers among USA, Canada and Mexico - increasing confidence in the Mexican economy

- Political changes: a violent uprising in the Chiapas region of Mexico, Luis Donaldo Colosio (the leading presidential candidate) was assasinated investors started to place a larger risk premium on Mexican assets Mexico had a fixed exchange rate system at the beginning, the value of peso was not affected (the Mexican Central Bank bought pesos and sold dollars) But……Mexico’s reserves of foreign currency were too small the government announced a devaluation of the peso at the end of 1994

This increased even more the country risk premium (investors became even more distrustful of Mexican policymakers). Mexican government was unable to pay its debts that were coming due Mexico became in a few months a risky economy with a government on the edge of bankruptcy. Indebted local firms and banks which had borrowed in foreign currency, mostly dollars, saw their debts double overnight, making them effectively bankrupt.

Then……. USA enters. Why? For 3 reasons: 1. To help its neighbor on the south 2. To prevent massive illegal immigration 3. To prevent the investor pessimism regarding Mexico from spreading to other developing countries

USA provided loan guarantees for Mexican government debt some of the confidence in the Mexican economy was restored. Anyway, this was a painful experience for Mexican people, because the country experienced a deep recession as well. The lesson from this: changes in perceived country risk (political instability) are an important determinant of interest rates and exchange rates in small open economies.

Key Concepts of Ch. 12 Mundell-Fleming Model Floating exchange rates Fixed exchange rates