#### Transcript Chapter # 6

```Macroeconomic Theory
Chapter 6
The Open Economy in the Short run
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 So far we assumed that economies are completely closed.
 In many economies exports amount high as a percentage of GDP.
 Financial markets of advanced and emerging economies are
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1.
2.
3.
4.
integrated.
This chapter is about open economy in the short run, when prices
and wages are given. The following issues are addressed:
How is output determination in the short run affected by trade
and financial openness?
What determines the trade balance and why does it matter?
What is the real exchange rate and how does it affect output and
How do fixed and flexible exchange rate regimes work?
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Opening the Goods Market
 Both m and x influence the level of output in the economy in the
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short run (lower GDP or increase GDP), equilibrium condition of
output is modified to account of this.
Also, in the short run there may be a trade deficit, balance or
surplus.
Surplus is used to buy foreign assets or increase official foreign
exchange reserves in the CB (wealth is rising).
Deficit is financed either by running down foreign exchange
reserves or borrowing from abroad (wealth is declining).
Monitoring the trade balance is therefore important.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Goods Market Equilibrium
 Goods market eq. condition is:
 yD=y
 yD in the closed economy depends on planned expenditure on C, I
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and g, i.e.:
yD ≡ c(y,t,r,wealth) + I(r,A) + g
Trade in goods has two effects:
The demand for home output is boasted in the form of x.
The demand is dampened by m (a substitute for domestic
output).
Domestic absorption Abs is the spending by home agents on c, I
and g irrespective of the origin of the goods or services
Abs ≡ c + I + g
To calculate domestic absorption on home produced goods
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
yD ≡ (c + I + g) – m + x
≡ Abs + (x-m)
≡ Abs + BT
BT ≡ x – m
 We turn now to the determinants of x and m (and hence BT).
Assume that:
x = xpar
m = myy
my=mpm
BT ≡ x – m
≡ xpar - myy
 The level of income at BT= 0, yBT is:
 yBT = (1/my).xpar
 Where yBT is the level of output at which BT is zero.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 There are four ways of expressing the goods market eq. condition.
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To simplify let c be a linear function to disposable income, I and g
are exogenous. t is also linear t=tyy. We have c=c0+cy(y-tyy). The
market eq. condition becomes:
y = Abs+BT
(goods market eq. 1)
=c0+cy(y-tyy) + I + g + xpar - myy
Collecting terms on y on the LHS and rearranging gives:
y = (1/sy+cyty+my).(c0+I+g+xpar) (goods market eq. 2)
Note that the open economy multiplier is lower than the closed
economy multiplier.
If we multiply by the denominator of the multiplier we have
(sy+cyty+my).y = c0+I+g+xpar
(goods market eq. 3)
Planned leakages
Macroeconomic Theory
planned injections
Prof. M. El-Sakka
CBA. Kuwait University
 We can also rearrange the trade balance equation as:
myy = xpar
and show both the goods market eq and BT eq in the same
diagram, in fig 9.1. at A planned leakages and injections are equal
and y=y0. at this level of BT is in deficit.
 BT balance requires a reduction of y to yBT. This is either
achieved by lowering the size of the multiplier (raise t where
planned leakages line will be steeper) or by a fall in one of the
exogenous components of domestic demand, which leads to a
downward shift of planned injections line.
 Now let us examine the implications for output and the trade level
balance of an exogenous change in x.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Fig 9.1
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 In fig 9.2 an exogenous increase in x, yBT rises by more than actual
output, there is a trade surplus, when additional leakages (s and t
and m) are generated by a rise in income. A rise in x to xpar1,
leakages will equal injections at point B. at y1, x > m and B
therefore is a position of trade surplus. Note the rightward shift of
yBT.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Fig 9.2
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Sector financial balances
 Another useful way of manipulating the goods market eq
condition is to write it in terms of sectoral savings and investment
balances.
 Private sector financial balance is s-I,
 Government sector financial balance is net tax
 We arrange leakages and injections equations to separate out
taxation and show the sector financial balances
(Syydisp - c0 - I) +
(tyy - g)
= xpar - myy
Private sector balance
govt sector balance
where ydisp = (1-ty)y
 This expression highlights the flow eq in the economy. One sector
(e.g., private sector) can run a financial deficit if another sector
(government or foreign sector) runs a surplus.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 The goods market will be in eq the private sector s-I (financial
balance) plus the govt B surplus (financial balance) is equal to
 Real and nominal exchange rates
 What affects our demand for foreign goods and services and the
demand of foreign residents for our tradable products? One
obvious determinant of the demand for tradables is relative
prices, in order to compare prices across countries we need to
convert them to a common currency, (this is a measure of price
competitiveness)
θ ≡ (p. of foreign goods expressed in home currency)/(p of home goods)
≡ P*.e/P (price competitiveness, real exchange rate)
P* is the foreign price level, e is the nominal exchange rate measured
in number of home currency per unit of foreign currency
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
e ≡ (no. of units of home currency)/(one unit of foreign currency)
(nominal exchange rate)
 Another name of θ is the real exchange rate because it measures
the rate at which domestic and foreign goods exchange for each
other. If a Mars bar = ₤.3 in the UK and = €.5 in Germany if the
₤/€=.6 then θ = (.5x.6)/.3 = 1.
 Suppose that the price increase in Germany to €.55 and no change
in ₤/€ rate, the new θ = (.55x.6)/.3=1.1, i.e. UK real exchange rate
increases (depreciated), i.e. price competitiveness of UK increased.
 Note that e may be domestic currency units for a foreign currency
unit, or foreign currency units for a domestic currency unit.
 Note that the rise in e has different implications depending on the
definition.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Price setting in the open economy
 Two alternative pricing rules are suggested:
1. home cost pricing (based on domestic costs)
2. world pricing (based on similar products produced abroad)
 If there is an increase in costs in the home country not abroad:
 Under the first rule, price of home exports will go up relative to
abroad. Home country competitiveness will be reduced.
 Under the second rule, price of home exports will not change, and
no change in price competitiveness of exports. But profit margins
of home firms are squeezed, and will be at a relative disadvantage
future investment , marketing, R & D will be limited. Therefore,
non price competitiveness is reduced. Competitiveness and real
exchange rate based on relative costs is more appropriate.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 One commonly used measure is “relative unit labor costs RULC”
RULC ≡(foreign unit labor cost expressed in home currency/home unit labor cost.
RULC≡ULC*e/ULC
(cost competitiveness; real exchange rate)
 A rise in RULC is a real depreciation and improvement in
competitiveness and vice versa.
 Evidence on international integration of goods markets
 The two pricing rules can be compared to the LOP and PPP.
 According to LOP the price of a traded good j is identical in different countries.
Pj = Pj*e
(LOP)
 For all goods j in a basket of goods to common consumes in both countries,
Pj = Pj*.e
P = P*.e
=== θ = 1
Macroeconomic Theory
for all goods j
(absolute PPP)
Prof. M. El-Sakka
CBA. Kuwait University
 The PPP hypothesis of absolute PPP implies that θ is always equal
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to one. Under perfect competition where P=MC, MC will be the
same, hence in a world of absolute PPP and perfect competition,
neither price nor cost competitiveness can vary.
Empirical evidence show that neither LOP nor absolute PPP are
true.
Transportation cost and trade barriers will interfere with LOP
Nontradables and differences in tastes will prevent absolute PPP
from holding.
Obstfeld argues that tradable markets are segmented
internationally as the markets of nontradables.
Part of the explanation rests on the fact the international markets
are imperfect. Most tradables are differentiated products and
producers engage in pricing strategies to maximize their profits.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Opening the financial markets
 Trade in international financial markets dominates the foreign
exchange market. To understand the essential aspects of
international financial market it is useful to make some
simplifying assumptions:
 F1: there is perfect international capital mobility
 F2: the home country is small, it cant affect world interest rate
 F3: there is a perfect substitutability between foreign and
home bonds, i.e., no risk premium on foreign bonds, the only
difference between home and foreign bonds is the expected
rate of return.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Uncovered interest parity condition
 If home residents have the opportunity to hold foreign bonds,
what will influence their choice. Assuming that there is no
difference in risk between bonds issued by two different govts,
there are two factors affect the expected return on home as
compared with foreign bonds:
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Any differences in interest rates
The likely development of the exchange rate
 If iUK=6.5%, iUS=4%, holding UK bonds entails an additional
2.5% return. But in order to buy UK bonds we need ₤. This
pushes the demand for ₤ and an immediate appreciation of the ₤.
 What about the expectations of exchange rates. If the ₤ is
expected to depreciate by 2.5%, the 2.5% interest differentials
will be wiped out. For the expected return on \$ and ₤ bonds to
equal, expected loss due to depreciation should equal expected
gain due to interest differentials.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 This condition is called uncovered interest parity UIP.
i - i*
Interest gain
=
(eEt+1 – et)/et
(UIP).
expected depreciation
 Interest rate gain from holding a foreign bond must be offset by
expected loss from the depreciation of the ₤ over the period for
which interest differentials prevail.
 Consider an identical interest rates in UK and USA at 4%, and
exchange rate is ₤ .65/\$. If UK interest is raised to 6.5% for one
year. There is a 2.5% gain of holding UK bonds. The ₤ is expected
to depreciate by 2.5% for expected return on \$ and ₤ bonds to
equalize.
 Announcement of a rise in the UK interest rate, the ₤ immediately
appreciate from a rate of 0.65 to 0.635, over the course of time
from t1 to t2, the pound depreciates back to the original level of
0.65. The paths of the nominal exchange rate an interest
differentials is presented in figure 9.4.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Fig 9.4
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Using UIP condition
 The UIP condition is very useful because it provides a direct link
from a change in monetary policy to changes in exchange rate. Fig
9.5 shows the UIP condition. At point A, i=i* and e0=eE. If i rises
to i1, and eE is eE0. Since i>i*, there must be a change in the actual
exchange rate. According to UIP e should increase to e1.
 The key features of UIP diagram are:
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Each UIP must go through the point (eE, i*)
Given i*, any change in eE shifts the UIP curve
Given e, any change in i* shifts the UIP curve
 Suppose i* falls, given i, the UIP shifts to UIP1, as shown in fig 9.6.
the economy is initially at A on UIP0, a fall in i* will lead to an
immediate appreciation of the home currency. If the CB shifts i
down to equal i*, the economy then shifts to C.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Fig 9.5
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Fig 9.6
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 If traders suddenly change their view about eE, the UIP will shift.
If a depreciated exchange rate is expected, the UIP curve will shift
to RHS. With i=i* will lead to an immediate depreciation of the
exchange rate to the new eE. If the govt is to prevent an immediate
depreciation, it must raise i as shown in the new UIP condition to
compensate holders of domestic bonds for expected depreciation.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Fixed and flexible exchange rate regimes
 At one extreme is the case for freely floating. The exchange rate is
determined by supply and demand for the currency relative to
other currencies.
 At the other extreme is the case of fixed exchange rate, where the
govt sets a rate (peg) at which it will buy or sell foreign exchange
in order to keep the price fixed. These are called official
intervention (ΔR), in case of a purchase ΔR>0 and in the sale
ΔR<0.
 Fig 9.7 shows the foreign exchange market.
 A rightward shift in the supply, e.g., if home bonds are now more
attractive than foreign bonds, under floating exchange rate the
exchange rate would appreciate. Under a fixed rate, (e=e0), the CB
will have to intervene to absorb the excess supply of foreign
exchange to keep the exchange rate fixed i.e., ΔR>0.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Fig 9.7
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Under flexible exchange rate the UIP condition shows how
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arbitrage in international financial market will lead to changes in
e in response to changes in:
Home’s interest rate assuming eE and i* unchanged
i* assuming eE and i remain unchanged
eE assuming i and i* remain unchanged
In a fixed e the CB actively intervenes in the foreign exchange
market to keep the exchange rate constant. The interest parity
condition makes clear, if expected depreciation or appreciation is
zero, then i and i* must always be equal.
Fig 9.8 shows the comparison between flexible and fixed exchange
rate regime where there is an exogenous fall in MD. In the upper
panel (flexible e) the fall in MD lowers i the UIP condition in the
LHS shows that this leads to an immediate depreciation of e.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Fig 9.8
flexible
fixed
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 In the fixed exchange rate system the MD falls puts downward
pressure on the interest rate. The CB must intervene to buy
domestic currency ΔR<0 to lower MS to match the new MD. i
remain unchanged as the economy is affected by domestic or
foreign shocks, the domestic MS moves around in order to keep
e=eE=epeg and i=i*.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 The Mundell-Fleming model for the short run
 Now we can show the impact of policy and domestic and foreign
shocks on y and BT in the short run.
 Assumptions:
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MF1. prices and wages are fixed. π and πe are zero and i=r.
MF2. the home economy is small. i.e., it can not affect i* or y*.
MF3. perfect capital mobility and perfect asset substitutability. No
difference in risk between the bonds and UIP holds.
 The MF model consists of four elements:
1. The open economy goods market eq condition summarized by ISXM
2. The money market eq condition summarized by LM curve
3. The UIP condition summarized by UIP curve
4. Financial integration condition summarized by i=i* line
 In the short run the economy must lie on the i=i* line as eE=e.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 The MF model can be used to analyze policy choices by home govt
and the implications for a change in economic conditions
originated from the rest of the world, e.g., a change in i* or a
change in yD*, or from the home economy, e.g., consumption
boom or a slum in investment.
 The MF model and monetary policy
 Fixed exchange rates:
 Under pegged e the home economy loses control over MS and
monetary policy will be ineffective. If the CB engages in OMO
purchase of home bonds for newly printed money. The LM shifts
to RHS. Eq is summarized by the UIP where i=i* the new eq must
be at A, monetary policy have no effect. As P increases pushes i
downwards, but the CB is committed to maintaining e it must use
foreign reserves to purchase domestic currency and prevent e
from depreciation. The LM shifts back to initial position.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Fig 9.9
fixed
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Flexible exchange rates
 The e can adjust any discrepancy between i and i* by a change in
monetary policy. Monetary policy can affect y and BT. An
expansionary monetary policy shifts the LM and new eq is at Z in
fig 9.10. the ISXM must shift to RHS to intersect LM’ at i=i* line.
The shift of ISXM is brought about by exchange rate
depreciation, which shifts the yBT line to RHS, there will be a
trade surplus which will increase y by more than the increase in
Abs.
 Now what is the role played by UIP condition? In fig 9.11 the
initial UIP condition is in the left panel. The process of
adjustment depends on how eE are formed. Assume that agents
update their eE using adaptive expectations to that e depreciates
from e0 to e1, we shall assume that the new eE=e1.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Step1. the LM shift to RHS leads to a fall in i and y rises from
A to B.
 Step2. the fall in i leads to exchange rate depreciation to e1 in
order that expected appreciation from B’ to A’ would offset
the expected interest loss from holding domestic currency
rather than foreign bonds.
 Step3. depreciation shifts ISXM to ISXMe1 which raises y
further (B to C) in the RHS panel, i<i*.
 Step4. because of depreciation, eE changes according to the
adaptive expectations rule. The new UIP curve crosses the i=i*
where e=e1. given eE is now e1, exchange rate will depreciate to
e2 and the economy move to c’ in the UIP diagram
 Step5. is simply a repetition of step 3, the depreciation shifts
ISXM further to RHS
 Once i=i* there will be no further adjustment and the economy is
at a new stable short run eq at Z.

Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Now consider what happens if we assume rational
expectations instead. Assume that all agents understand the
model of the economy and can figure out the e that is consistent
with the new eq Z. to do this they must figure out the extent of the
depreciation required to shift ISXM far to the right that it
intersects with LM’ at i=i*, i.e., they expect e to be eE=ez as soon
as the new monetary policy is announced. UIP jumps from UIP0
to UIPz immediately. In the goods market the ISXM jumps
immediately to ISXMez and the economy moves straight to Z. with
rational expectations and rapid adjustment in the goods market,
we observe the shift from A to Z.
 Note that the new e (ez) is not the same as e1. the move along UIP
from A’ to B’ is a consequence of the arbitrage condition in the
financial market given a fall in i. the shift from UIP(eE=e0) to
UIP(eE=ez) reflects the change in e required in the goods market to
increase ISXMe0 to ISXMez.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
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