1. MACRO REVIEW THE KEYNESIAN MODEL
Part 1: Introduction to Keynesian Model:
Derivation, and National Saving Identity.
Part 2: Multipliers for spending & exports
Part 3: International transmission under fixed vs. floating exchange rates
Part 4: Adjustment of a CA deficit via expenditure-reducing vs. expenditure-switching policies
Part 5: Monetary factors
API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Copyright 2007 Jeffrey Frankel, unless otherwise noted

2. Imports & exports depend on income:
assuming E & Y* fixed, for now. Y TB + -
…and rises in contractions
where slope = -m ≡
- marginal propensity
to import
TB falls in expansions…
as does consumption: Keynesian consumption function

3. Determination of equilibrium income in open-economy Keynesian model
Now solve:
where
and

4. Derivation of National Saving Identity
Income ≡ Output (assuming no transfers)
Y ≡ GDP
/ /
C + S + T ≡ C + I + G + X -M
S + (T-G) ≡ I + X – M
NS ≡ S + BS ≡ I + TB
National
Saving
Identity
API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Copyright 2007 Jeffrey Frankel, unless otherwise noted

5. API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Copyright 2007 Jeffrey Frankel, unless otherwise noted

6. US National Saving, Investment, & Current Account as Shares of GDP, 1949-2010
Gap widened,
as NS fell relative to I
API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Copyright 2007 Jeffrey Frankel, unless otherwise noted

7. } Keynesian Consumption Function: or, expressed as a saving function:
where s ≡ 1 – c }
API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Copyright 2007 Jeffrey Frankel, unless otherwise noted

8. Closed economy: NS – I = 0 Fiscal Expansion
1 < Closed-economy multiplier 1/s < ∞
API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Copyright 2007 Jeffrey Frankel, unless otherwise noted

9. Open economy: NS – I = TB = X – M
Imports: for simplicity
Exports: for simplicity

10. Open economy Fiscal Expansion
slope = s
API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Copyright 2007 Jeffrey Frankel, unless otherwise noted

11. Part 2: KEYNESIAN MULTIPLIERS AND THE TRANSFER PROBLEM
The multiplier for an increase in , e.g., due to a fiscal expansion .
The multiplier for an increase in , e.g., due to a devaluation .
The Transfer Problem
API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Copyright 2007 Jeffrey Frankel, unless otherwise noted

14. SUMMARY OF MULTIPLIERS
+ Keynesian model of S + M =>
Fiscal Expansion
Devaluation
open-ec. multiplier = 1/(s+m)<1/s
Equation (17.11). Note misprint in 10th ed. of WTP.)

15. MACROECONOMIC INTERDEPENDENCE
Part 3:
MACROECONOMIC INTERDEPENDENCE
International transmission under fixed vs. floating exchange rates
of a disturbance originating domestically.
of a disturbance originating abroad .
API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University

16. International Transmission↓
Fix
Float ↓
Float
Fix
=>
depreciation
=> appreciation
Floating increases effect on Y
Floating decreases effect on Y
= “insulation”

17. Conclusions regarding transmission (with no capital mobility)
Trade makes economies interdependent (at a given exchange rate).
TB can act as a safety valve, releasing pressure from expansion: .
Disturbances are transmitted from one country to another:
API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University

18. Conclusions regarding transmission (with no capital mobility), continued
Floating exchange rates work to isolate effects of demand disturbances within the country where they originate:
Effects of a domestic disturbance tend to be “bottled up” within the country In the extreme, floating reproduces the closed economy multiplier:
The floating rate tends to insulate the domestic economy from effects of foreign disturbances. In the extreme, floating reproduces a closed economy:
API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University

19. Parts 4 & 5: POLICY INSTRUMENTS
Goals and Instruments
Policy goals: Internal balance & External balance
Policy instruments
The Swan Diagram
The principle of goals & instruments
Introduction of monetary policy
The role of interest rates
Monetary expansion
Fiscal expansion & crowding out

20. Goals and instruments Policy Goals Policy Instruments
Internal balance:
e.g., Y = ≡ potential output
Y < ≡ ES ≡ “output gap” => unemployment >
Y > ≡ ED => “overheating” => inflation and/or asset bubbles
External balance:
e.g., BP=0 or CA=0
Policy Instruments
Expenditure-reduction,
e.g., G ↓
Expenditure-switching,
e.g., E ↑
API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Copyright 2007 Jeffrey Frankel, unless otherwise noted

21. Internal balance Output gap, as percentage of GDP, 2009 Jpn IrUS
Jpn
France UK Ir
In 2009, after the global financial crisis, most countries suffered much larger output gaps than in preceding recessions: Y << .
API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Source: IMF, via Economicshelp, 2009
Copyright 2007 Jeffrey Frankel, unless otherwise noted

22. Output gap in eurozone periphery Source: IMF Economic Outlook, September 2011 (note: data for 2012 are predictions)
Greece & Ireland overheated by 2007: Y >>
and crashed in : Y <<
Like Italy, Spain & Portugal in 1992,
but the devaluation option is now gone.

23. THE PRINCIPLE OF TARGETS AND INSTRUMENTS
Can’t normally hit 2 birds with 1 stone
Have n targets?
=> Need n instruments,
and they must be targeted independently.
Have 2 targets: CA = 0 and Y = ?
=> Need 2 independent instruments:
expenditure-reduction &
expenditure-switching.
API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Copyright 2007 Jeffrey Frankel, unless otherwise noted

24. vs. Financing Adjustment RESPONSES TO CURRENT ACCOUNT DEFICIT
By borrowing
or running down reserves.
vs.
Adjustment
Expenditure-reduction (“belt-tightening”)
e.g., fiscal or monetary contraction
or Expenditure-switching
e.g., devaluation.

25. current account deficit at point N, policy-makers can adjust either by
Starting from
current account deficit
at point N,
policy-makers can
adjust either by
cutting spending, ● ● or
(b) devaluing. ● ●
API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Copyright 2007 Jeffrey Frankel, unless otherwise noted

26. CA deficit is eliminated at X; but Y falls below potential output .
If they
cut spending,
CA deficit is eliminated at X;
but Y falls below
potential output . ● ●
=> recession
API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Copyright 2007 Jeffrey Frankel, unless otherwise noted

27. is again eliminated, at B, but with the effect of pushing Y above
(b) If they devalue,
CA deficit
is again eliminated, at B,
but with
the effect of pushing Y above
potential output. ● ●
=> overheating
API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Copyright 2007 Jeffrey Frankel, unless otherwise noted

28. Only by using both sorts of policies simultaneously
DERIVATION OF SWAN DIAGRAM
Only by using both sorts of policies simultaneously
can both internal & external balance be attained, at point A. ● ●
Experiment: increase in Ă
(e.g. G↑) ●
Expansion moves economy rightward to point F.
Some of higher demand falls on imports. => TB<0 .
What would have to happen to reduce trade deficit? ● ● ●
Devaluation

29. Again,
At F, TB<0 .
What would have to happen to eliminate trade deficit?
E ↑ . ● ●
If depreciation is big enough, restores TB=0
at point B. ●

30. ● ● ● To repeat, at F, some of higher demand falls on imports.
What would have to happen to eliminate trade deficit? ●
E ↑ . If depreciation is big enough, restores TB=0
at point B. ● ●
We have just derived upward-sloping external balance line, BB.
API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Copyright 2007 Jeffrey Frankel, unless otherwise noted

31. ● ● Now consider internal balance. Return to point A.
Experiment: increase
Expansion moves economy rightward to point F. ● ●
Some of higher demand falls on domestic goods
=> Excess Demand. Y >
What would have to happen to eliminate excess demand? ● ●
E ↓ . ●

32. Experiment:
Fiscal expansion, cont.
At F, Y > .
What would have to happen to eliminate excess demand? ● ●
E ↓ . ●
If appreciation is big enough,
restores Y=
at point C.

33. ● ● ● At F, some of higher demand falls on domestic goods.
What would have to happen to eliminate excess demand? ● ●
E ↓.
If appreciation is big enough, restores at C. ●
We have just derived downward-sloping internal balance line, YY.

34. Swan Diagram has 4 zones:
ED & TD
ES & TD
ES & TB>0
ED & TB>0 ●

35. Summary:
combination
of policy instruments
to hit one goal
slopes up,
to hit the other
slopes down.

36. Example: Emerging markets in 1990s
Classic response to a balance of payments crisis:
Devalue and cut spending
Excgange rate E
YY:
Internal balance
Y=Potential
ED & TD
ED & TB>0
ES & TD
ES & TB>0
Mexico 1994
or Korea 1997
Mexico 1995
or Korea 1998
BB:
External balance
CA=0 ●
Spending A
API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Copyright 2007 Jeffrey Frankel, unless otherwise noted

37. Example: China in the past decade
Excgange rate E
YY:
Internal balance
Y = Potential
ED & TD
ES & TD
ES & TB>0
China
2010
BB:
External balance
CA=0
2002
ED & TB>0 ●
By 2007, rapid growth had pushed China into ED.
But by 2010, a strong recovery, due in part to G stimulus,
shifted China again into ES.
Spending A
At the end of 2008, an abrupt loss of X, due to the US crisis, shifted China into ES.
API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Copyright 2007 Jeffrey Frankel, unless otherwise noted

38. Part 5: Monetary policy
is another instrument to affect the level of spending.
It can be defined in terms of the interest rate i, which in turn affects i-sensitive components such as I & consumer durables.
Or it can be defined in terms of money supply M.
In which case an expansion is a rightward shift of the LM curve
Which itself slopes up (because money demand depends negatively in i and positively on Y).
E.g., Taylor Rule sets i. LM
E.g., Quantitative Easing sets MB. i Y
API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Copyright 2007 Jeffrey Frankel, unless otherwise noted

39. Monetary expansion lowers i, stimulates demand, shifts NS-I down/out.
New equilibrium at point M.
In lower diagram, which shows i explicitly on the vertical axis,
We’ve just derived IS curve.
If monetary policy is defined by the level of money supply,
then the same result is viewed
as resulting from a rightward shift of the LM curve.

40. Fiscal expansion shifts IS out.
New equilibrium: At point D if monetary policy is accommodating. .
At point F, if the money supply is unchanged, so we get crowding out: i↑ => I↓
Rise in Y < full
Keynesian multiplier. D