The open economy

The Mundell-Fleming Model -Perfect capital mobility -Static expectations for ε Consequently: In floating exchange rate:

ε Y LM* IS* An increase in G Monetary policy only can effect Y

In a fixed exchange rate, the LM curve (and monetary policy) disappears IS* ε Y Money supply is endogenous

Rational exchange rate expectation and overshooting Dornbusch (1976) When expectations are not static, PKM does not implies that i=i* The (uncovered see fn 10) interest rate parity Consider the effect of an ↑M which implies in the LR ↑P,ε In the short run, i↓, from 5.19, we see that: How is that possible?

t Log ε ε0ε0 ε1ε1 jump The macroeconomic world is full of overshooting

i Y LM IS Overshooting of i in the IS-LM model

Imperfect capital mobility is an intermediate case between the Mundell-Fleming model and the close economy model. Do it yourself. Section 5.4 on the Output-inflation tradeoffs is fundamental.

Output-inflation tradeoffs, the Phillips curve, and the natural rate A permanent output-inflation trade-off in a simple Keynesian model Consider the following modelling of the supply side: And consider an ↑ in AD (fiscal or monetary policy)

P Y AD0 AS0 AS1 Y0Y0 P0P0 AD1 Y1Y1 P1P1 AS2 AD2

Y 0 might be viewed as in figure 5.18 P Y Permanent output-inflation trade-off? (Phillips, 1958) A theory of inflation (the natural rate, Friedman 1968) LRAS AD

The Phillips curve π u φ

Okun’s law and Phillips curve Putting the two together lead to the following aggregate supply curve (figure 5.19) And the expectations-Augmented Phillips Curve (Friedman-Phelps)

π Ln Y0 LRAS(π e =π) AS(π e =0) AS(π e =π 1 )

When inflationary expectations adjust no permanent output (unemployment) trade-off Example: adaptative expectations But more generally (see Romer section 5.4), modern Keynesians tend to support the following AS curve: Where π* is the core or underlying inflation and it is not necessarily equal to the expected inflation rate. As an example:

Canonical New Keynesian Model Three ingredients in this model: New Keynesian IS curve, New Keynesian Phillips curve, interest rate rule With uncertainty Phillips curve is based on infrequent adjustment of nominal prices Bank adjusts interest rates in response to changes in expected future inflation and output

The model

The Taylor Rule and the modelling of Monetary policy Controlling money supply or the interest rate Reaction to a demand shock versus supply shock In 2009, the i by the FED shoul have been negative according to Taylor

Case of white noise disturbance The general model is usually solved with calibration and simulation (read page ) With white noise disturbances (the rhos in 7.87 to 7.89) there is no force causing agents to expect the economy to depart from its steady state in the future. The E(y and π) in 7.84 to 7.86 = 0

Contractionary (increase ump) monetary policy raises interest rate and lower output and inflation Positive aggregate demand shock (increase uis) increases output and inflation but does not affect the interest rate (money policy is forward looking and does not respond to the shock). As the basic RBC model, no internal propagation mechanism (only with the rhos) Read 7.9