Managing an Open Economy Small Open Economy

Learning Objectives Introduce the concept of the small open economy. Develop the IS and LM models for a small open economy. Understand how the economy adjusts under a fixed exchange rate system and a flexible exchange rate system. Consider the efficacy of stabilization policies in a small open economy.

Small Open Economy A country is considered to be a small open economy when its actions in world markets are not large enough to affect the prices other market participants pay. –For example, a small open economy can lend and/or borrow in world capital markets without having any effect on the world interest rate.

Small Open Economy Model Assumptions: –Zero expected inflation –Static exchange rate expectations Market participants do not expect the exchange rate to move systematically either up or down.

Capital Market: Small Open Economy 0 i1i1 XSXS X D =I+D-S* -X 1 Capital demanded from and supplied by the world market in domestic currency X S is the world supply of capital. X D is the domestic net demand for capital from the rest of the world. X D = I + D – S*. At i 1, the domestic economy is a net supplier of capital. At i 0, the domestic economy is a net demander of capital iwiw i0i0 X0X0

IS: Small Open Economy In a small open economy, the IS curve is horizontal at the world interest rate. –Households still save more as income increases, and less as income decreases, but these actions are too small relative to the world capital market to change the world interest rate. –The IS is horizontal because every level of Y is associated with a constant world interest rate.

LM: Small Open Economy Assumptions: –Purchasing power parity holds: P d = P f /e and the exchange rate is 1.

LM: Small Open Economy In a small open economy, the LM curve is still upward sloping, but now changes in the exchange rate as well as changes in the real money supply can cause the curve to shift. –Decreases in the exchange rate shift the LM curve to the left. –Increases in the exchange rate shift the LM curve to the right.

LM: Small Open Economy Every LM curve represents a specific real money supply or M/P. In the small open economy model, P = P f /e. Consequently: M = M = Me P P f /e P f

IS/LM: Small Open Economy Y* Y 1 Y i IS LM 1 LM* 0 iwiw At Y 1, the economy is operating above full employment. In a small open economy, the adjustment to Y* will depend on whether the exchange rate is fixed or flexible.

IS/LM: Small Open Economy Y* Y 1 Y i IS LM 1 LM* 0 iwiw Flexible Exchange Rates: When P rises, net exports fall as they become more expensive relative to foreign goods. The demand for the domestic currency falls, causing e to fall. PPP dictates P = P f /e, so as e falls, Me falls, and the real money supply falls. LM* shifts left.

IS/LM: Small Open Economy Y* Y 1 Y i IS LM 1 LM* 0 iwiw Fixed Exchange Rates: When P rises, net exports fall as they become more expensive relative to foreign goods. The demand for the domestic currency falls, putting downward pressure on e. The central bank intervenes, and buys domestic currency, decreasing the money supply. LM* shifts left

Policy Efficacy: Flexible Exchange Rates Y 0 iwiw IS LM 3 LM 2 LM 1 Fiscal policy in a small open economy is completely ineffective as a way to stimulate the economy. Monetary policy, however, is an effective way to stimulate the economy, if the exchange rate is flexible. An increase in the nominal money supply causes a rise in the price level and a corresponding decrease in the exchange rate. As e falls, net exports and Y rise. Y 1 Y 2 Y 3

Policy Efficacy: Fixed Exchange Rates Y 0 iwiw IS LM 3 LM 1 Both fiscal policy and monetary policy are ineffective as a way to stimulate the economy in this case. With fixed exchange rates, an increase in the nominal money supply causes the price level to rise and the exchange rate to fall. But, fixed exchange rates require the central bank to intervene and buy domestic currency, thereby, decreasing the money supply. Y 1 Y 2

Lessons Learned: Small Open Economy The central bank cannot control the domestic interest rate, if it wishes to maintain a fixed exchange rate. –Fixed exchange rates mean interest rates are the same in all countries. –If not, investors would shift their funds to the country with the higher rates; thereby, bidding down the high rate and bidding up the low rate.

Lessons Learned: Small Open Economy In a fixed exchange rate system, the central bank cannot use changes in the money supply to influence domestic economic conditions. –It is required to use monetary policy to maintain stable exchange rates, buying the currency when the exchange rate falls, and selling the currency when the exchange rate rises.

Lessons Learned: Small Open Economy In the long run, the central bank cannot control inflation in a fixed exchange rate system. –In the long run, inflation equals the rate of growth of the money supply. –In a fixed rate system, the monetary policies of countries are closely tied together. –Therefore, inflation rates are equalized across countries.