Transcript International Dimensions

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
XS is the world supply of
capital.
iw
XD is the domestic net
demand for capital from
the rest of the world.
i1
XS
i0
XD=I+D-S*
-X1
0
X0
Capital demanded from and supplied
by the world market in domestic currency
XD = I + D – S*.
At i1, the domestic economy
is a net supplier of capital.
At i0, the domestic economy
is a net demander of capital
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:
• Pd = Pf/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 = Pf/e.
• Consequently:
M = M = Me
P
Pf/e
Pf
IS/LM: Small Open Economy
LM1
i
LM*
At Y1, the economy is
operating above full
employment.
iw
0
IS
Y*
Y1
Y
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
Flexible Exchange Rates:
LM1
i
LM*
iw
0
IS
Y*
Y1
Y
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 = Pf /e, so as
e falls, Me falls, and the real
money supply falls.
LM* shifts left.
IS/LM: Small Open Economy
Fixed Exchange Rates:
LM1
i
LM* When P rises, net exports fall
as they become more expensive
relative to foreign goods.
iw
IS
The demand for the domestic
currency falls, putting
downward pressure on e.
The central bank intervenes,
and buys domestic currency,
decreasing the money supply.
0
Y*
Y1
Y
LM* shifts left
Policy Efficacy: Flexible Exchange
Rates
LM1 LM2
iw
Fiscal policy in a small open
economy is completely ineffective
as a way to stimulate the economy.
LM3
IS
0
Y1
Y2
Y3 Y
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.
Policy Efficacy: Fixed Exchange
Rates
LM1
iw
LM3
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
IS causes the price level to rise and the
exchange rate to fall.
0
Y1
Y2 Y
But, fixed exchange rates require
the central bank to intervene
and buy domestic currency, thereby,
decreasing the money supply.
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.