Transcript Macroeconomics In The Global Economy

Macroeconomics In The Global
Economy
Wei wei
Shool of Economics and Finance
Jiaotong University
CHINA - GDP (% real change pa)
from 1980 to 2009
CHINA - Nominal GDP (US$ at
PPP) from 1980 to 2009
CHINA - Real GDP from 1980 to
2009
CHINA - Real private
consumption from 1980 to
2009
CHINA - Real government
consumption from 1980 to
2009
CHINA - Real gross fixed
investment from 1980 to 2009
Chapter 5 Investment


The goal of study investment
1. Enrich our understanding of how the output in a given period is
allocated between consumption and investment.


2. Fluctuations in firms’ investments play a role in determining the
level of output and unemployment in a economy.
3. Investment spending contributes in significant ways to long-term
growth of the economy.

Assumptions

1. Labor is always fully employed and that output is therefore at its
full-employment level as well.
2. Fluctuations in output is come solely from shifts in the capital
stock, or from other supply-side shocks to the production function, but
not from shifts in aggregate demand.


Investment and Output Growth in the U.S,
1948-1990
20
15
Investment (%
GDP)
GDP growth
rate
10
5
0
1948
-5
1954
1960
1973
1982
1990










Main topics in this chapter
1. Types of capital and investment
2. The basic of theory of investment
3. Extensions to the basic theory
4. Inventory Accumulation
5. Empirical investigations of investment expenditures
We will mainly discuss on the topics as follows:
1.The basic of theory of investment
2. Extensions to the basic theory
3. Inventory Accumulation
The basic of theory of investment

The framework of analysis
 1. The optimal investment rule for households simply carries



over to the more realistic setting in which business firms make the
investment decisions and households own the business firms.
2. The decision of whether or not to invest is to recognize that
purchases of capital goods are another way to allocate
consumption over time.
3. Investment spending should be increased whenever there is a
higher rate of return in saving for the future via purchases of
investment goods rather than through the purchase of financial
assets.
The production function
 The household’s investment decisions




Families now have two different ways to transfer purchasing
power across time: they can either lend money in financial
markets at the interest rate r or they can invest to increase future
output.
Q1 - C1 = S1= B1 + I1
C2 = Q2 + ( 1 + r ) B1

C1 + C2 / ( 1 + r ) = (Q1 － I1) + Q2 /( 1 + r ) = W1

It must decide not only how much to consume and save, but also
how to divide saving between investment and bonds.
1. Choosing investment I1 so as to maximize total wealth.




△W = －1 + MPK2 /( 1 + r )
MPK2 = ( 1 + r )
2.Choosing optimal consumption path
The household’s consumption decision given
an optimal investment choice
Period
1
A
C2
F
UL1
C1
W 1
Period
1

The separation of optimal investment and consumption
decisions.
 The investment demand schedule
 The case of many periods
 MPK:
MPK+1 = (r + d )

Net present value
NPV = － △I + △I (MPK +1)/( 1 + r ) + △I (1 － d)/( 1 + r )

The wealth-maximizing level of capital

I = K *+1 － K + dK
 The role of expectations


Investments depend on judgments about the future marginal
productivity of capital. So they are fraught with uncertainty.
Part of the volatility of investment, and thus of the uncertainty that
surrounds it, stems from shifts in expectations about the future.
Inventory Accumulation
1. Inventory stocks
1) Changes in inventory holdings represent an
important and highly volatile type of investment
spending.
2) Three basic kinds of inventory stocks:
a. Primary inputs to production
b. Semi-finished goods in the course of
production.
c. Finished goods ready for sale to final users.
Inventory Stocks as a % of Total inventory in
U.S Manufacturing, 1990
31%
32%
37%
Primary
mterial
work-inprocess
Finished
goods
Inventory Stocks As a % of Annual Shipments in U.S
Manufacturing, 1990
60
40
20
As a % of
annual
0
Primary
materials
Primary
materials
Work-inprocess
Finished
goods
2. Firms need inventories of primary materials to
economize on the costs of producing final output.
3. Most formal theories of inventory management
focus on final goods inventories.
1) Production smoothing
2) Avoidance of stockouts
The firm must balance the costs of inventory
holdings against the costs of involuntary stockouts.
So, it is important to derive a mathematics rule for
optimal inventory management.
Empirical Investigations on
Investment Expenditure
1. Even armed with these theories of investment,
however, it is quite difficult to explain—much less
to predict—patterns of investment spending.
2. Several econometric models have been developed
to explain actual investment behavior.
1) The accelerator Model of investment
2) The adjustment-cost approach
3) The q theory
4) Theories based on credit rationing
Chapter 6 Saving, Investment,
and the Current Account

Traditionally, I = S always appears in a closed
economy. However, it is no longer true in an open
economy.
 In this chapter, we study the determinants of
national lending and borrowing from the rest of
world.
 Main topics in this chapter
1. A Formal analysis of saving, investment, and
the current account
2. The current account and international trade
3. The determinant of the current account
4. A country’s intertemporal budget constraint
5. Limitations on foreign borrowing and lending

We will emphasis on
1. A Formal analysis of saving, investment, and
the current account
2. The determinant of the current account
3. A country’s intertemporal budget constraint
A Formal analysis of saving,
investment, and the current account

Assumptions
1. Classical, fully employed economy
2. A stable price level for goods (P = 1)
 Saving, investment, and the interest rate in a
closed economy
 Effects of Economic shocks on Saving and
investment, and interest rate in a closed economy
– Supply shock
– anticipated future increase in income

Lend or borrow from the rest of world and current

Claims or liabilities vs the rest of world and
current account
– current account (CA): the change in its net financial
asset position with respect to the rest world:


CA = B* － B* －1
Bi* = B 0 * + CA1 + CA2 + … + CAi
The Current Account and The Net International
Investment in The U.S., 1970-1989
(Billion of Current Dollars)
200
100
0
-100
-200
-300
-400
1988
1986
1984
1982
1980
1978
1976
1974
1972
-600
1970
-500
Net
Interna
tional
Investm
ent
Current
Account
Balance

The relationship among current account,
saving, and investment
1. Budget constrain of an individual household
Bi － Bi －1 = Qi + r Bi －1 － Ci － Ii
Bi － Bi －1 = Yi － Ci － Ii
Bi － Bi －1 = Si － Ii
2. Budget constrain of over all household
B* － B* －1 = S － I
CA = S － I

The determination of current account
schedule
Saving, Investment, and the Current Account
r
CA
S
I
S,I
CA
0
The Current Account and International Trade
The Determination of the Current Account

Assumption
– Given world interest rate
– Small country

The effect of different shocks on CA
1. Wold interest rate
There is a positive relationship between CA for small open
economy and the world interest rate at which its residents
borrow and lend
2. Investment shocks
The domestic interest rate is given by the world rate.
An investment surge has a deteriorating effect on CA.
3. Output shocks


The CA deficit after the temporary shock
Saving should not fall significantly in response to the
permanent shock.
4. Term-of-Trade shocks


A transitory rise in the TT induces AS tend to rise.
A permanent rise in the TT, saving rate does not
necessarily rise, so does the CA.
A Country’s Intertemporal Budget
Constraint

The level of S, I, and CA influence the future
path of consumption and income for the
economy as a whole.
 The Intetemporal Budget constraint in the twoperiod model
– Intetemporal Budget constraint on the household
level
B1* = Q1 － C1 － I1 = CA
B2* － B1* = Q2 + r B1* － C2 － I2
B2* = Q2 + (1 + r) B1* － C2 － I2
C1 + C2/(1 + r) = (Q1 － I1) + Q2 /(1 + r)
– Intetemporal budget constraint on the national
level
Countries too are bound by a national
intetemporal budget constraint
– Three fundamental conclusions

Trade balance
– ∵ TB1 = Q1 － C1 － I1, TB2 = Q2 － C2
– ∴ TB1 + TB2/(1 + r) = 0

The Intertemporal Budget constraint with many
periods
C1 + C2/(1 + r) + … =
(1 + r) B0* + (Q1 － I1) + ( Q2 － I2) /(1 + r) + …
(1 + r) D0* = TB1 + TB2/(1 + r) + …
– Net resource transfer (NRT)
NRT = (D* － D* -1 ) －r D* -1
NRT = － TB
(1 + r) D0* = NRT1 + NRT2/(1 + r) + …
The Country’s Budget Constraint and CA
Period 2
C2 ,Q2
CA surplus
CA Balance
C
Q
2
Q
Q1
CA deficit
C1 ,Q1
Period 1
Chapter 7 The Government
Sector
 The objective in this chapter
– The governmental behavior has important and
sometimes subtle effects on overall national S, I, and
CA.
– Economic effects of fiscal policy

Assumption
– Output is determined by supply and that shifts in AD
do not affect aggregate output.
– Price level is constant and equal to 1.

The main topics
– Government revenues and expenditures
– Government saving, investment, and borrowing
– The government budget and the CA
– The interaction of the private and public sectors
– Ricardian Equivalence
– Some reasons why governments overspend
– Other interactions between the public and private sectors

We will mainly discuss on the following topics:
– The interaction of the private and public sectors
– Ricardian Equivalence
– Some reasons why governments overspend
Government revenues and expenditures

Government revenues
– Taxes
– Profits of state enterprises and agencies that sell
goods and services

Government expenditures
–G
– Ig
– Tr
– r Dg
Government saving, investment, and
borrowing
 When its spending and income differ, the
government borrows or lends, just as the private
sector does.
Bg = Bg-1 + r Bg-1 + T － (G + Ig )
∵ Dg = － Bg
∴ Dg = Dg-1 + r Dg-1 + G + Ig － T
Dg － Dg-1 = G + r Dg-1 + Ig － T
Sg = (T － r Dg-1 ) －G
DEF = Dg － Dg-1 = Ig － Sg
The government Budget and Current
Account
 Integrate the public sector into analysis of CA
CA = (Sp + Sg) －( Ip + Ig )
= (Sp － Ip) + (Sg － Ig )
= (Sp － Ip) + DEF

Total national saving
Yd = Q + r Bp-1 － T
Sp = Yd －C = (Q + r Bp-1 － T ) －C
S = S p + Sg
= [ (Q + r Bp-1 － T ) －C] + [(T － r Dg-1) －G]
= Q + r B*-1 －C －G
= Y－(C + G)
CA = S － I = Y － ( C + G + I )
TB = Q － ( C + G + I )
Sp
r
S = Sp + Sg
Sg
S,I
The Interaction of the Private and Public
Sectors

Government fiscal policy decisions affect household
actions most directly through the effects of taxes on
the household’s intertemporal budget constraint
C1 + C2/(1 + r) = (Q1 － T1) + ( Q2 － T2) /(1 + r)
 A temporary tax-financed increase in Government
Spending
– Assume G1and T1 rise by an equal amount, while
Sg1, as well as G2 and T2 remain unchanged.
– Thus, private saving will fall with a temporary rise
in taxes, while government saving remains
unchanged. So the overall level of national saving
declines.
– For a small country facing a given world
interest rate, the decline in saving for a given
investment reduces its CA balance
– For a large Country, this decline in S not only
deteriorates CA, but also causes a rise in world
interest rate.
 A permanent increase in government spending
– The permanent rise in spending and taxes will
have no effect on the CA
 Fiscal “Crowding Out”
– Net exports might also get crowded out when G
rises
– Temporary tax-financed increase

A small country with free capital mobility

A large country with open capital mobility
– A permanent expansion in spending

Ricardian Equivalence
– Theoretical proposition
Under certain circumstances a change in the
path of taxes over time—lower taxes in the
present, higher taxes in the future, say—
does not affect national saving, investment,
or CA
– A statement of RE theorem
C1 + C2/(1 + r)
= Q1 + Q2 /(1 + r) － [T1 + T2/(1 + r) ]

T1 + △ T2/(1 + r) = －△ T + (1 + r) △ T /(1 + r)
=0
– The theoretical importance of considering a current
tax cut that leaves unchanged the present value of
taxes
– Limitations of Ricardian Equivalence
 Public sectors may have a longer borrowing
horizon than households
– Barro- Ricardian Equivalence
 liquidity-constraint households
 Uncertinty
 Empirical studies
△
Some Reasons Why Governments
Overspend

Political-economic model
– How the political environment a government faces
relates to the budgetary decisions it actually makes.
What is called fiscal “policy” is not generally one
policy after all, but the sum of the effects of
decisions made by myriad separate decision
makers
 Fiscal policy is the result of a complex political
bargaining process, and not the outcome of some
optimizing decision taken by a single agent

Other Interactions Between the Public
and Private Sector

Deadweight losses of taxes
 The case of tax smoothing
 Tax rate and Tax Revenues
 The cyclical pattern of budget deficits
Chapter 8 Money Demand

The objective
Up to this point, we have ignored the fundamental role
of money in our analysis, so we start to integrate
money into our analytical framework.

Main topics in this chapter
What is money?
Towards a theory of money demand
The demand for money
Empirical studies of money demand
The doctrine of Monetarism
What is money

The fundamental role of money
Medium of exchange: mutual coincidence of wants
A unit of account
A store of value: Gresham’s law—Bad money drives
good money out of the market

The definition of money
Mh
M1
M2
M3
Towards a theory of money demand

Interest rates and prices in a monetary economy
1.The current real interest rate is (approximately) equal
to the current nominal interest rate minus the rate of
inflation between this period and the next.

Money and the household budget constraint
PYd = PQ + i-1B -1 － PT
PSp = PYd － PC
PSp = PI + (B － B -1 ) + (M － M -1 )
P2C2 = P2（Q2 － T2）+ (1 + i) B 1 + M 1
P2C2 = P2（Q2 － T2）+ (1 + i) (B 1 + M1) － i M -1
P1C1 = P1（Q1 － T1) － P1I1－ (B 1 + M1)
C1 + C2/(1 + r) = (Q1 － T1 －I1) + (Q2 － T2 ) /(1 + r)
－i [ (M1 /P2) /(1 + r) ]
The Demand For Money
 The Baumol-Tobin Model
By holding a lot of wealth in the form of money, the
household loses the interest that it would have earned
by holding interest-bearing assets instead.
Thus, the household must balance the opportunity cost
of holding money against the transactions costs of
frequently converting other assets into money.
Household Money Balances Through Time
M
M*
M*/2
1/3
2/3
1
Time
The Cost of Holding Money and the Optimal
Money
Cost
TC
i(PQ/2)
OC = i(M* /2)
Pb
CW = Pb(PQ/ M*)
M0
*
PQ
M*
The function of money demand
 Income
 The interest rate
 The fixed cost
The modification by Merton Miller and Daniel Orr
MD = f ( i , Q )

Demand for Money as a Store of Wealth
Dominated assets and function of medium of exchange
and a unit of account
Reasons for money as a store of wealth
 Anonymity of it holder
 Currency substitution
Speculative demand for money

The velocity of money
The effects of economic factors on V
P
I
Q
b

Empirical Studies of Money Demand
 The Doctrine of Monetarism
Chapter 9 The Money Supply
Process

Main topics in this chapter
The money supply and the central bank: an
overview
Central bank operations and the monetary base
The money multiplier and the money supply
The money supply and the government budget
constraint
Equilibrium in the money market
The money supply and the central bank:
an overview

High-powered money(Mh)
 The amount of Ms(M1, M2, M3) are determined
by a combination of how much high-powered
money the CB issues,regulations governing the
banking system, and the financial instruments
people choose for their investment portfolios.
Central bank operations and the monetary
base
 The fundamental way of changing the amount of
Mh
Open market operations
The discount window
Rediscounting the paper of nonfinancial firms
Foreign-Exchange Operations
A fundamental equation for changes in the money
stock
(Mh － Mh-1) = (Dgc － Dgc-1) + E(B*c － B*c-1)
+ (Lc － Lc-1)
(Mh － Mh-1) = (Dgc － Dgc-1) + E( TB ) + (Lc － Lc-1)
The money multiplier and the money
supply

M1
Mh = CU + R R = Dc + VC
The reserve-to-deposit ratio: rd = (R/D)
M1 = CU + D
The rate of currency to deposits: cd = (CU/D)
M1/Mh = (CU + D) /(CU + R ) = (cd + 1)/(cd + rd )
M1 = [ (cd + 1)/(cd + rd ) ]Mh

The CB Control over the money supply
The CB can influence the Ms in important ways, but it
can not fully control it.

The CB does determine reserve requirements and
the discount rate, both of which influence the
level of reserves that banks actually hold. It can
not directly determine the rd, however, and it has
even less control over the cd that public holds..
 Different countries take different approaches to
monetary control, of course, there has been a long
debate over which monetary variable the CB
should attempt to control.
The Money Supply and the Government
Budget Constraint
 The monetization of the budget deficit.
– When the government budget is in deficit, the CB is the
most important purchaser of treasury bonds.
– The CB purchase of Treasury bonds essentially allows the
Government to buy goods and services simply by printing
money. So, the government finances its purchases of goods
and services by an inflation tax.
Dg － Dg-1 = P(G + Ig －T) + i Dg-1
Dgc － Dgc-1 = (Dg － Dg-1 ) － (Dgp － Dgp-1)
Mh － Mh-1 = (Dgc － Dgc-1) + E(B*c － B*c-1)
Dg － Dg-1 = (Mh － Mh-1) + (Dgp － Dgp-1) －E(B*c － B*c-1)
(Mh － Mh-1) + (Dgp － Dgp-1) －E(B*c － B*c-1) =
P(G + Ig －T) + i Dg-1
(Mh － Mh-1) + (Dgp － Dgp-1) －E(B*c － B*c-1) =
P(G + Ig －T) + i Dgp-1 －E(i * B*c-1)
Equilibrium in the Money Market
– In equilibrium, the supply of money has to be equal to
the demand for money.
MD = Pf(i, Y) = ø Mh = MS
A presentation of Equilibrium in Money market
P
MS
M S1
MD
MS’
P0
A
M
0
M1
M

The CB makes an open market purchase of bonds,
which, in turn, increases the monetary base.
– Case 1: A rise in prices, which would raise money
demand to equal the higher money supply

A presentation of Equilibrium in Money market
– Case 2: A fall in interest rates, which would also raise
money demand by decreasing the velocity of money.
– Case 3: A rise in income ,which would raise the
demand for money.
– Case 4: An endogenous fall in the money supply,
which would bring the money supply back down in
line with money demand.
Chapter 10 Money, Exchange Rates,
and Prices

The objective
– Examine the repercussions of monetary policy
throughout the economy under the framework of
general equilibrium analysis.

Assumptions
– Simple classical model: full-employment
– Capital is perfectly mobile between the domestic and
international markets: domestic and foreign interest
rates are equal.
– Only one type of good is produced and consumed in
the economy and that it can be imported or exported
at fixed international price.
 The
topics in this chapter
– Exchange rate arrangements
– The building blocks of a general equilibrium model
– General equilibrium of price, the exchange rate,
and money
– Monetary policy under fixed and floating
exchange rates
– Global fixed exchange-rate arrangements
– the effects of devaluation
– The case of capital controls
– Other kinds of exchange rate regimes
Exchange rate arrangements

The operation of a fixed exchange-rate regime
– fixed exchange rate
– Pegged exchange rate
– Adjustable peg
– The establishment of a particular exchange rate


One side peg
The operation of a fixed exchange-rate regime
– Clean float
– Dirty float
– The debate on the benefits of having a fixed or a
flexible exchange-regime.
The building blocks of a general
equilibrium model

Assumptions
– Output and income are always exogenous, and at full-employed
level.
– only a single good exists

PPP
– The law of one price: any commodity in a unified market has a
single price.
P = EP*
– The doctrine of PPP attempts to extend the law of one price
from individual commodities to the basket of commodities that
determines the average price level in an economy.
–
Because the law of one price should apply for each
commodity in international trade, it should apply generally for
the home price index(P), which is a weighted average of the
individual commodity price. P = EP*






If these barriers are stable over time, percentage changes in P should
approximately equal percentage changes in EP*.
The relationship that it states holds true only under several unrealistic
conditions: (1) that there are no natural barriers to trade, such as
transport and insurance costs; (2) that there are no artificial barriers,
such as tariffs or quotas; (3) that all goods are internationally traded;
and (4) that domestic and foreign price indexes have the same
commodities. In practice, these conditions never hold exactly.
(P － P-1)/ P-1 = (EP* － E -1 P* -1 )/ E -1 P* -1
The percentage change in EP* can be approximated as the sum of the
percentage changes in E and P*.
(P － P-1)/ P-1 = (E － E –1)/ E –1 + (P* － P* -1 )/ P* -1
Yet even this less restrictive version of PPP is unlikely to hold
precisely since many goods are not (easily) traded.









Why does the law of once price break down? Very simply,
transportation costs are too high for arbitrage to operate.
One measure of a country’s overall competitive in international
markets is the price of that country’s goods relative to the price of the
goods of the competitive countries. The term “real exchange rate” is
sometimes applied to the ratio e = EP* /P. When e rises, foreign goods
become more expensive that domestic goods, and we speak of a real
exchange-rate depreciation.
International Interest Arbitrage
The wealth held by households and firms is allocated among a
portfolio of financial assets according to the characteristics of those
assets, principally their risk and return, and the preferences of agents.
Assumption:
There is a single type of domestic money, M, and a single type of
domestic interest-bearing asset, a default-free bond, B.
Domestic agents hold only one type of interest-bearing asset
denominated in the foreign currency, a bond, which we denote by B*.
Nominal value of wealth: W = M + B + EB*
Real value of wealth: W/P = M/P + B/P + EB*/P






W/P = M/P + B/P + B*/P*
If capital moves freely between the home and foreign
capital markets,arbitrage will operate to equate the returns
on the two assets.
(1 + i) = (E +1/E ) (1 + i*)
This express can be rewritten as the following
approximation:
i = i* + (E +1 － E ) /E
Interest arbitrage: domestic interest rate must equal the
foreign interest rate plus the rate of exchange-rate
depreciation.

General Equilibrium of Price, the Exchange Rate,
and Money

Now we put together the three basic relationships that we
have analyzed to see how equilibrium in this economy is
achieved.
MD = PQ/V(i) = M
 Assumption: prices, the exchange rate, and other variables
held constant
 So, E = E +1 , i = i* + (E +1 － E ) /E can be rewritten as
 i = i*
 We now put together all these pieces to find a simple
relationship between the money supply and exchange rate.
 M V(i*) = EP*Q
 If the exchange rate is fixed by the central bank, we can
describe M as a function of the level of E chosen by the
central bank:
 M = (EP*Q )/ V(i*)
 If the exchange rate is flexible, the level of E should be
consist with the level of M chosen by the central bank:
 E = [MV(i*)] /(P*Q )


MD
E
α = V(i*)/P*Q


M
MD



P
P1



P0
α = V(i*)/Q


M
M0
M1



If the exchange rate is fixed by the central bank, then E
becomes an exogenous variable; M is an endogenous one,
that is determined by the equilibrium conditions of
economy.
If the exchange rate floats, then E is an endogenous
variable and M becomes an exogenous variable.
For given output and the external interest rate, there is a
positive linear relationship between money and prices, just
as there is between money and the exchange rate.
Chapter 11 Macroeconomic
Policies in the Open Economy

We take an important step toward realism by adapting
our approach for an open economy. To make things as
straightforward as possible, two parts are devoted to the
open-economy analysis of macroeconomic policies, one
focusing on the case of a fixed exchange-rate system,
and the other focusing on a floating-rate system.
Macroeconomic Policies in the open Economy: the case of
Fixed Exchange Rates

A Model of Internationally Differentiated Products
Assumption:
The home country produces a single output, but one that
is differentiated from the output produced by the rest of
world.

The domestic economy produces a single good that is
consumed both by domestic and foreign agents. Total
production of that good is Q, with a price P.
Whatever is produced but not purchased domestically is
exported. The local currency price of imported good is PM.
PM = EP*
The foreign currency price of the domestic good
P*X = P/E
The Determination of Aggregate Demand
Households consume both the domestic and the foreign
good. The total nominal value of consumption
PCd + PMCM = PcC
The CPI can be generally constructed as
Pc = λP + (1 －λ)PM
The real value of consumption
C
= (PCd + PMCM) / Pc
The total nominal value of investment expenditures as the
sum of spending on the domestic goods and on imports:
PcC = PId + PMIM
Assume for simplicity that all government spending falls on
the domestic good, that is PGG = PGd
So, the total nominal demand for domestic goods is
PQD = (PCd + PMCM) + (PId + PMIM) + PGd + PX
－(PMCM + PMIM)
the nominal value of imports PMIM is equal to PMCM +
PMIM, thus
PQD = (PCC + (PII + PGG) + (PX－PMIM)
= A + PTB
QD = A/P + TB
PTB = PX－PMIM
TB = X－(PM / P)IM
The reduced-form equation for absorption
A/P = a (G, T, [Q －T]F, MPKE , i)
The reduced-form equation for trade balance
TB = TB (A/P, A*/P*M , e)
A single equation for AD
QD = a (G, T, [Q －T]F, MPKE , i) + TB (A/P, A*/P*M , e)
TB is written as a function of A/P, so
QD = QD(G, T, [Q －T]F, MPKE , i, A*/P*M , e)
 The IS—LM Model for the open economy
Assumptions
The exchange rate E is fixed by the monetary authorities.
The levels of G, T, [Q －T]F, MPKE , A*/P* , and P are
given.
On this basis, we can draw a negative relationship between
the interest rate i and the level of domestic demand, QD ,
that is IS curve for the open-economy model.
Properties of the IS Curve
The LM Curve
Capital Mobility (CM Curve)
If capital flows freely across borders, i = i* (P574)
In the closed economy, the level of M is a policy choice.
The Monetary authorities set M, and that determines the
position of the LM curve. In a regime of fixed exchange
rates and capital mobility, however, the monetary
authorities are not able to choose both the money supply
and the exchange rate. When the monetary authorities fix E,
households may convert their domestic money into foreign
assets as they see fit.
The money demand by households is then given by M/P =
L (i*, QD ), and the money supply will adjust endogenously.
Equilibrium in the IS-LM-CM Framework
The monetary authorities undertake an open-market
purchase of bonds, the temporarily increasing the money
supply. The LM curve would shift down and to the right.
In the closed economy, point B would mark the new
equilibrium, i would be less than i*. (P575)
In open economy, domestic residents would try to sell their
domestic bonds to buy foreign bonds at point B. The
domestic interest rate would quickly rise back to i*. The
economy would remain on the IS curve at point A. In the
process, the increase in the money supply would be
reversed and the LM curve would shift back to the original
position, the central bank is suffering a decline in its
international reserves. (P575)
The IS curve shifts to the right. The new equilibrium is
therefore at point C, there is an excess demand for money
at the initial level of M. It is eliminated as households
convert some of their wealth into domestic money. The
central bank would sell M and buy foreign exchange. The
result would be an endogenous increase in the money
supply so that the interest rate remains at i = i*. (P577)
Under fixed exchange rates and perfect capital mobility,
the equilibrium point occurs at the intersection of the IS
curve and the CM line. The LM curve adjusts
endogenously to intersect the IS curve at that point.

The Determination of Output and the Price Level
Now we can use our modified IS-LM analysis to study the
effects of fiscal and monetary policies on output and prices.
To Derive the AD schedule
Suppose now that the price level rises to P1, a higher
domestic price causes the real exchange rate to appreciate
(e falls), hurting the country’s exports and increasing its
imports, and thereby deteriorating the trade balance.
At every interest rate, then AD will decline, shifting the IS
curve down and to left. The new equilibrium is then at
point B, at the section of the new IS curve and the CM line.
The LM curve now has to adjust endogenously to insect
with the IS curve at point B.
Effects of a Fiscal Expansion (P580)
Suppose that the government increases in expenditures.
This shifts the IS curve to the right. The equilibrium must
be at point C, along the CM line. The money supply will
rise endogenously as households convert foreign assets
into domestic money. Therefore, the LM curve shifts to
Intersect the IS curve and the CM line at point C.
The fiscal expansion is highly effective in raising AD,
because there is no rise in the interest rates to crowd out
investment or consumption when G rises. As a result of the
fiscal expansion, AD increases, the shift in the AD
schedule up and to the right. What happens to the
equilibrium level of output and prices depends on the
nature of the AS schedule.
The same diagram would of course describe the effects of
several other shocks to the economy, such as a devaluation
of the domestic currency, a tax cut, an increase in foreign
absorption, or a rise in expected future income.
Changes in the fiscal policy of a large economy do have an
effect on world interest rates, leading to a smaller
multiplier.
Effects of a Monetary Expansion (P583)
Suppose that central bank undertakes an operation that
increases the quantity of money in circulation. This excess
supply of money leads households to purchase foreign
assets, the exchange rate tending to depreciate. When
central bank therefore intervenes by selling foreign
exchange and absorbing the domestic currency, the LM
curve shifts back to the left as M fall, and the central bank
loses reserves.
Under fixed exchange rates and perfect capital mobility,
fiscal policy is highly effective in shifting AD, but
monetary policy is completely ineffective.
Effects of Devaluation (P584)
Under a fixed exchange-rate regime, the exchange rate
itself is a policy variable by the authorities. Suppose that
the authorities decide to devalue the domestic currency.
Because domestic prices do not respond to the devaluation,
the real exchange rate depreciates together with the
nominal rate. As a result, the trade balance improves and
therefore AD increases at every level of the interest rate. In
this framework a devaluation has an effect similar to that
of an increase in government spending.
 Capital Controls
In a world of capital controls, i need no longer equal i*,
Nor can households convert foreign assets to domestic
money rapidly. The central bank of an economy with
capital controls stands ready to buy and sell foreign
exchange at a given exchange rate, but only for current
account transactions. Therefore the domestic interest rate
can differ from the world interest rate, and the authorities
can determine the position of the LM curve, at least in the
short run.
Even in the case of capital controls, however, the
position of LM curve is still endogenous, but now the LM
curve shifts more gradually than with free capital mobility.
With capital controls, the monetary expansion is not
immediately reversed. Rather, the money expansion causes
the trade balance to change. In turn, the shift in the trade
balance causes the money supply to change, and the LM
curve shift endogenously.
The Case of a Monetary Expansion (P589)
Suppose that the authorities expand the money supply,
shifting the LM curve to the right. The immediate result is
a fall in interest rates and a rise in AD. A/P has risen,
thereby causing total imports to rise, the economy
therefore will move into a trade deficit.
The trade deficit implies a drop in money supply.
Eventually, the accumulated trade deficits match the initial
increase in the money supply, the entire increase in M will
have been offset. The LM curve is back at its initial level.
As a result of the initial money expansion, there is a
permanent loss of foreign exchange reserves equal to the
sum of the trade deficit.
The Case of a Fiscal Expansion (P590)
With the fiscal expansion, say, a rise in G, IS curve shifts
to the right, increasing AD. Absorption rises, and as a
result, the trade balance goes into deficit. The trade deficit


provokes a decline in the money supply. As M declines, the
LM schedule shifts upward and to the left until the trade
deficit is eliminated. The interest rate rises sharply in the
long-run.
Fiscal policy is effective only in the short run. When the
money supply adjusts to the fiscal shock, AD goes back to
its original position.
The increase in government spending crowds out private
spending partially in the short run, and this crowding out
is distributed between reduced private consumption and
reduced investment in response to higher interest rates.
Over the long term, however, the crowding out is total: the
increase interest rates (provoked both by the original
increase in government spending and by the reduction in
money supply that comes from the accumulated trade
deficits) fully crowds out private consumption and
investment.

Therefore, government spending has increased at the expense of
private investment and consumption.
Macroeconomic Policies in the Open Economy: The Case
of Flexible Exchange Rate
 The IS-LM-CM Framework with Flexible Exchange Rate
The characteristics of IS-LM-CM framework with flexible
exchange rate are the same as the case of fixed exchange
rate.
Under flexible exchange rates, of course, the exchange rate is
no longer a policy variable. E moves endogenously to the
forces of supply and demand. And because the position of
the IS curve depends on E through its effects on trade
flows, the IS curve also move endogenously. In particular,
it moves to the right when the exchange rate depreciates
and moves to the left when E appreciates.
When E floats, the monetary authorities lose control over E,
but they regain control over the money supply. The CB can
determine the level of money supply, and thus the position
of the LM curve. Clearly, the LM curve no longer adjusts
endogenously as it did in the case of fixed exchange rates.
The endogenous shift in the IS curve (P605)
If monetary authority decreases the money supply by
selling bonds to the public, the LM curve will shift up and
intersect the IS schedule at point B. But in an open
economy with high capital flow, the domestic interest rate
cannot remain higher than i*. Therefore, domestic and
foreign wealthholders would shift out of foreign bonds into
domestic bonds, prompting a capital inflow. It prompts an
appreciation of domestic currency, which, in turn, reduces
net exports. When this happens, the IS curve shifts to the
left. The final equilibrium is reached at the point along LM
line, with Flexible Exchange Rate with Flexible Exchange
Rate with Flexible Exchange Rate where the interest rate
has gone back to the world level and AD has declined.
The shape of aggregate demand schedule under flexible
exchange rate (P606)
A higher price level reduces real money balance, and this
causes the LM curve to shift to the left. The new equilibria
will be at point B, the intersection of LM’ curve and the CM
line. The IS curve must move endogenously to this new
intersection. AD falls when the price level rises.
 Macroeconomic Policies in a Small Country under Free
Mobility
Effects of fiscal Expansion (P608)
An increase in government expenditure shift the IS curve to
the right. Domestic interest rates are higher than world
interest rates, prompting capital inflow and an appreciation
of the currency. The appreciation of E causes a
deterioration of the TB, and IS curve starts to shift back to
the left. The final equilibrium is reached at point A. AD
remains unchanged.
Under fixed E, fiscal expansion provoked an endogenously
increase in money supply. By contrast, the fiscal expansion
prompts an appreciation of the home currency, which
exactly offsets the expansionary demand effect of higher
government spending. Fiscal policy, therefore, is totally
crowded out by a decline in net exports.
In closed economy, a fiscal expansion raises interest rates and
crowds out interest-sensitive consumption and investment
spending by the same amount as the fiscal expansion. But
in the open economy with flexible exchange rates and
capital mobility, the interest rate cannot rise; the crowding
out occurs with net exports rather than with investment.
Expansionary Monetary Policy (P610)
The CB increases the money supply through an openmarket purchase of domestic bonds. This action shifts the
LM curve downward. The incipient decline in the interest
rate provokes a capital outflow. This capital outflow causes
the exchange rate to depreciate and improves the trade
balance, thereby inducing an endogenous right-ward shift
of IS curve. The IS curve has moved endogenously to this
intersection from the original intersection, via currency
depreciation.
For a small open economy with high capital mobility and
flexible exchange rates, money policy works through its
effect on the E, then on TB rather than through its effect on
interest rate, then on C + I, as it would in a closed economy.
Since the IS and LM schedules are drawn for a given price
level, this implies that the AD schedule shifts to right.
 Exchange-Rate Dynamics
Exchange-rate overshooting (P613)
With an increase in the money supply, the E depreciates in
the same proportion as the rise in money, wages, and prices
in the long run. In this way, M/P is unchanged in the new
equilibrium,as is EP*M/P.
In the short run, when the money supply rises, the LM
curve shifts to LM’. Assuming i = i* because of capital
mobility, the new equilibrium is at point B. The IS curve
adjusts to point B endogenously, through a depreciate of E .
How big is the depreciation in the E needed to shift the IS
curve so that it goes through point B? The short-run
change can be larger or smaller than the long-run change,
depending on how responsive output is to change in the
real exchange-rate depreciation. If AD is not very
responsive to a real exchange-rate depreciation, the
depreciation of E in the short run is greater than the
depreciation of E in the long run. In technical terms, the
depreciation of E can overshoot its long-run value.
When ‘exchange-rate overshooting’ occurs, at the time of
the monetary expansion, the E depreciates sharply, by
more than in proportion to the money change. Over time,
as the economy is adjusting to long-run equilibrium, the E
gradually appreciates to its long-run value.
Expectations and Floating Exchange Rate (P617)
Suppose that it becomes widely expected that money
supply will be expanded in the next period, but not in the
current period. In the future, the exchange rate will
depreciate. Investors will come to expect a depreciation of
the E between now and the time that the money supply is
increased. The investors will begin to sell domestic assets
and buy foreign assets, and the domestic interest rate must
exceed the foreign interest rate by the amount of
anticipated depreciation.
 Macroeconomic Policies Under Free Capital Mobility:
Large-Country Case
A Fiscal Expansion (P619)
When a large country undertakes a fiscal expansion, the
overall saving-investment balance in the world economy
shifts, causing the world interest rate and domestic interest
rate to rise. This induces the IS curve shift to the right, and
CM line also shifts up. A new equilibrium is reached at
point C, an equilibrium characterized by higher AD, a
higher interest rate.
In the large-country case, the fiscal expansion is not fully
offset. The foreign interest rate rises, and the flow of
capital into the home country is somewhat less, so that the E
appreciation is smaller. In essence, there is less crowding
out of net exports in the large- country case.
An Increase in the Money Supply (P621)
A money expansion reduces the domestic interest rate.
Thus, in response, capital begins to fly abroad. Under
floating rates, the E will depreciate, thereby improving the
TB. Once that happens, the IS curve will shift to the right.
At the same time, in the large-country case, the domestic
monetary expansion reduces the world interest rate slightly.
Capital Controls and Floating Exchange
There are relatively few cases in the world of capital
controls and floating rates.
The implications of this policy regime is that for fiscal
policy an expansion in G raises output, but provoking a
currency depreciation rather than appreciation. A money
supply increase also raises output and causes a currency
depreciation. In the case of a fiscal expansion, interest rate
rise; with a monetary expansion, interest rates decline.
 The Policy Mix
In practice, policymakers often aim to achieve many targets,
in which case they may want to change many policy
variables at the same time. In that case, not all goals can be
achieved, and various trade-offs must be made.
A government with two policy instruments and two targets
Suppose that a government wants to keep output
unchanged while at the same time reducing the current
account deficit and that it has monetary and fiscal policy at
its disposal.
A fiscal contraction by itself would improve the trade
balance, but would reduce output. A monetary expansion
by itself would improve the trade TB but would raise
output. Therefore, a policy mix of fiscal contraction and
monetary expansion would improve the TB while having
little effect on output.
 Empirical Evidence