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The Open Economy IS-LM Model
The Mundell-Fleming Model
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Learning Objectives Understand how what BOP equilibrium is and how it is represented by BP curve Understand how internal (IS-LM) and external equilibria interact to produce an unique over equilibrium Understand how the fiscal and monetary policy are affected by the exchange rate regime Understand how fiscal and monetary policy are affected by the SOE\LOE assumption Apply it to some real world cases
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Comment on Mankiw’s Presentation
Mankiw covers this in chapter 13 Different diagrams (more confusing) I prefer my way which I think is clearer You can use whichever appeals to you If you use mine, Mankiw’s text is still relevant
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Revision of some basics
BOP Exchange rates Fixed vs floating Real vs nominal Interest rates and capital flows
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BOP Record of a country’s economic transactions with the rest of the world. Rule: receipt = positive (+) , payment = negative (-) If receipts > payments = surplus. If receipts < payments = deficit. 2 main accounts: current and capital. Different implications for the economy. The current account directly affects AD It is possible to have a current a/c deficit as long as there is a capital a/c surplus. Example, USA.
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Exchange Rate What is $ price of domestic currency (€)?
Exchange rate: $ price of one € what we quote in paper €1=$1.12 Price of 1$ is 1/1.12=0.89 e=1.12 Depreciation of € Losses value Fewer $ per euro Or e falls This or the reciprocal? Follow the book I prefer the other way
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Fixed vs Floating In a certain trivial sense the BOP always balances
Supply equals demand For floating exchange rate this is achieved by the free market For fixed exchange rates the government makes up the difference Current account surplus is counteracted by cap deficit and/or changes in reserves US vs China Note a bit inconsistent to have e floating but P fixed As before our excuse is that’s what happens in reality
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Fixed Erates Governments may try to fix the exchange rate (why? See later) Requires supplying foreign currency to market when there is excess demand Requires buying foreign currency when there is excess supply Mechanism by which an currency crisis can occur
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Real Exchange Rate Compare price levels of different countries
In a common currency (usually US$) Related to the concept of purchasing power parity (PPP) Simple example is the Hamburger index What is the US$ price of a Big Mac in various countries What is the effect of an increase in R? our goods more expensive; their’s relatively cheaper Expect exports to rise and imports to fall “loss of compteitiveness”
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Do for all goods in a basket and calculate the ratio
What does this tell you? “competitiveness” Are one country’s goods cheaper than another’s? Do for all goods in a basket and calculate the ratio i.e. CPI or GDP or wages Look at R for Ireland over time Level doesn’t tell much Trend does
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Again note the inconsistent treatment of prices and exchange rates.
What causes R to change? e changes Prices change i.e. inflation can erode competitiveness Productivity These last two factors are “Long Run” and so will be ignored in this model Thus changes in the nominal exchange rate (e) will change the real exchange rate (R) in proportion We will just talk of “exchange rate” to mean both Again note the inconsistent treatment of prices and exchange rates.
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e affects the IS Curve NX rises following a depreciation (e down)
Price in $ of goods produced in Ireland falls Example: furry leprechaun €5 e=1.12 (the $ price of 1€) 1€ gets $1.12 leprechaun costs 5*1.12=$5.6 Depreciation e=0.5 implies €1 get $0.5 Cost is 5*0.5= $ 2.5 Sales rise Note this leads to a shift in IS curve Every r is associated with higher Y
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r IS2 IS1 Y
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Interest Rates Interest rates can be used to influence capital flows and therefore defend a currency. reuro > rus Capital inflow e reuro < rus Capital outflow e Usually used to prevent depreciation of the exchange rate. Sounds like it might affect the LM curve but we account for it separately
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Taking Stock We have from the last section a definition of equilibrium (IS-LM) We now call this “Internal Equilibrium” We have dealt with the prelimaries that enable us to talk about BP equilibrium We need to find the combinations of (r,Y) that lead to BOP equilibrium external equilibrium
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External Balance Define external balance to be where BP=0
Net flow of currency between countries is zero Current account could be in deficit if capital account in surplus Why is this an equlibrium? Plans consistent See later how BOP not balanced leads to changes For now think of exporters and importers plans Show this on IS-LM framework (r,Y) that give BP=0 Assume (for now) that e is fixed As with any curve we want to know The slope What causes it to shift?
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Start at initial point (A)
assume eqm, BP=0 Y up, Imports up (NX falls), flow out of $ Or increased supply of € Either way BP<0 : at B assume e fixed To restore equilibrium need to encourage capital inflows (perhaps borrowing) r up sufficiently to restore equilibrium, Connect all such points : BP=0 curve
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BP curve is the locus of External equilibrium i.e. the set of (r,Y) combinations which give BOP=0 r BP=0 C A B Y
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Shifts in BP=0 Points above BP=0 represent BP surplus
Think if r increases beyond C Points below BP=0 represent BP deficit Location of curve depends on e, world income (Y*) and world interest rates (r*) Change in any will shift BP=0 (see diagram) r* rises: BP shifts up, need higher r for all Y Y* rises: BP shifts right, NX rises, Y rises for all r e falls: depreciation, NX up, for all r Y up, BP shifts right
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r BP=0 Y
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Slope of BP=0 Slope depends on Marginal propensity to import
Capital mobility What portion of every increase in GDP is spent on imports If high increase in Y leads to a large deficit need large capital flows to restore equilibrium Large increase in r Steep BP curve
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Capital Mobility How sensitive are cap flows to interest differentials? How free is capital to flow? Flatter BP=0 curve Special Case : “Small Open Economy” r=r* BP=0 flat Perfect Capital mobility No influence on world Note what happens when BP=0 “shifts” if SOE e.g. changes in r* Changes in Y*
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Small Open Economy with Perfect Capital Mobility
BP=0 r* Y
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PCM & SOE This is crucial for the effectiveness of policy – as we will see You need the two assumptions to get the flat curve PCM implies your interest rate is the worlds SOE implies what you do has no effect on the world Think of examples PCM is relatively recent and was very controversial Note we also postpone risk until later
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Overall Equilibrium We put the three curves together
The intersection is the overall equilibium Internal balance External balance As usual we have to show it is stable (why?) We already know that internal eqm is stable So we concentrate on showing how economy adjusts to external disequilibrium
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Internal and External Balance
IS-LM give eqm in goods and money market Together they give “internal balance” Showed it was stable Add BP to give external balance Show stable r LM BP=0 IS Y
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External Imbalance Need to show that if not in external balance, will go there A is point of internal balance (what does this mean?) A is BP<0: deficit r is too low to attract the capital flows Plans not consistent What will happen? depends on whether e is free to adjust r BP=0 B LM A IS Y
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LM2 r Assume Fixed e BP deficit means net outflow of (foreign) currency Money supply falls LM curve shifts up Interest rate rises until sufficient to stem the outflow of funds New eqm at B Note Change in money supply is automatic – not policy Mechanism: CB buys € with $ from reserves LM1 B BP=0 A Y
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BP deficit means net outflow of (foreign) currency
Float Exchange rates BP deficit means net outflow of (foreign) currency Excess demand for $ and excess supply of € Price of € falls: e falls Depreciation Net exports rise IS shifts right: for every r now Y up Also BP shifts down depr until sufficient to restore balance New eqm at B r IS2 IS1 BP2 BP1 B A Y Note difference in behaviour of central bank in both cases Note different effect on output and interest rates
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Imbalance with PCM Perfect Capital Mobility provides an interesting special case Flat BP=0 curve Interest rate fixed at world levels No influence on world Ireland vs. US Assume internal equilibrium is BP surplus (point A) Fixed exchange rates Inflow of foreign currency Or domestic interest rate too high Money supply rises: LM shifts down Keeps going until r=r* Forex reserves rise
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r LM1 A LM2 r* C B BP IS1 IS2 Y
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Floating exchange rates
Inflow of foreign currency Excess supply of $ causes their price to fall Excess demand for € e rises: appreciation: more $ per € Exports fall & imports rise IS shifts left BP shifts right onto itself A B
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Fixed exchange rates Inflow of foreign currency Excess supply of $ has to be soaked up by CB CB buys $ with € to keep price constant Money supply up (more € in circulation) LM curve shifts down AC Note: Change in money supply is automatic – not policy
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Policy In an Open Economy
Can look at Monetary, Fiscal and Exchange Rate Policy If we think of the purpose of policy is to control Y then we get The reason is the automatic effects of BP Fixed e Float e Fiscal Effective Ineffective Monetary
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Method Now we will assume SOE & PCM as it makes things easier
Drop SOE later To analyse any policy First look at its effect on internal balance IS-LM Check what sort of BOP disequilibrium that generates (i.e. we will be off BP curve) Apply the rules for adjustment to external balance Remember: These are different depending on exchange rate regime Apply 1-4 in exam
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Fiscal Policy with Fixed e
G up: IS shifts to right (why?) Internal balance at B At B: BP>0, r>r* (why?) This BP>0 cannot be equilibrium as plans are changing (whose?) fixed e: CB must buy excess $ by printing € this leads to money supply up LM shifts down Interest rate falls Balance restored at C Note contrast with closed economy No change in r Larger change in Y
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Fiscal policy: Fixed e, SOE
r B C r* BP A LM0 IS1 LM1 IS0 Y
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Monetary Policy with Fixed e
Expand money supply LM shifts down Internal balance at B At B: BP<0, r<r* Net currency out flow CB must sell $ for € (why?) Money supply falls back LM Shifts up Return to A MP is ineffective Only change is in central banks balance sheet
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Monetary Policy: Fixed e, SOE
BP A B LM0 LM1 IS0 Y
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Fiscal Policy with Floating e
G up: IS shifts to right Internal balance at B BP>0, r>r* excess supply of $ and/or excess demand for € Under float e this leads to an appreciation of € $ price of € rises Exports fall IS curve shifts left Balance restored at A Note contrast with closed economy and fixed e No change in r No change Y Net exports are crowded out
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Fiscal policy: Float e, SOE
r B r* BP A LM0 IS1 IS0 Y
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Monetary Policy with Float e
Expand the Money supply LM shifts down Internal balance at B BP<0, r<r* net outflow of funds Excess demand for $ (or supply of €) Price of € falls: e falls; depreciation in the € Net exports rise IS curve shifts to the right Overall Balance at C Note contrast with closed economy and fixed e No change in r Larger change in Y Net exports are “crowded in”
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Monetary policy: Float e, SOE
BP A C LM0 B IS1 IS0 LM1 Y
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Policy In an Open Economy
Can look at Monetary, Fiscal and Exchange Rate Policy If we think of the purpose of policy is to control Y then we get The reason is the automatic effects of BP Fixed e Float e Fiscal Effective Ineffective Monetary
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