1

Finish savings experimentThoughts on sources of technological changeReal business cycles: A sketchOpen economy macroeconomics• International financial system• Short-run open-economy output determination (Mundell -

Fleming model)• The rise, crisis, and (fall?) of the Euro

Open-economy macroeconomics

2

Bottom line this week

• Exports and imports affect aggregate demand, particularly for very open economies.

• Openness is growing in trade and finance.• Exchange rates are the monetary link among

countries.• In the open economy, the tail wags the dog

(tail = financial flows; dog = trade balance).• US has a chronic trade surplus because people

love to put their money here (central banks and investors).

• Countries face a trilemma among fixed exchange rates, domestic monetary policy, and open financial markets.

• Europe has made a fateful choice in the trilemma that is devastating the continent with no end in sight.

3

New elements in open-economy macro

1. Trade flows:- Exports and imports depend on relative prices (domestic

to foreign)- These depend critically on exchange rate:

NX(R) = EX(R) – IM(R); NX’(R) < 0.

2. Financial capital increasingly “mobile”– Free flow of finance among countries– Investors compare domestic and foreign interest rates

(rd, rw )– Capital outflow (CF) = lending abroad = CF(rd, rw).– In small economy, rd = rw = world interest rate (riskless)

4

Measuring international flows

5

Essential balancing property of Balance of Payments

Current Account (≈NX) AFinancial Balance (≈-CF) -

A

Net Balance 0

For macro purposes:Net exports = capital outflowNX = CF

6

Balance of Payments v. Real Goods and Services

1. Macro:NX =

Net Exports = exports goods and services – imports g&s

2. Current account:Current account = NX + locational adjustments (domestic v. national product)+ unilateral transfers (not current goods/services)

Difference = locational stuff + transfers

7

Balance of Payments, 2011

Goods and services -560Exports 2,103Imports -2,663

Net income of foreign investments 227Unilateral transfers, net -133

Balance on Current Account -466

Net change in assets 555Central banks 212Other 343

Statistical discrepancy -89

Balance on Financial Account 466

Net exports -569

* I have omitted "capital account," which is trivial in $ terms.

8

.02

.04

.06

.08

.10

.12

.14

.16

.18

.20

1950 1960 1970 1980 1990 2000 2010

Imports/GDPExports/GDP

Globalization in trade of goods and services, US

Rising trend

9

Open Economy Macro:The transmission mechanism

through the real exchange rate

10

Exchange rates

Foreign-exchange rates are the relative prices of different national monies or currencies.

Convention in Econ 122 and Jones: Nominal exchange rate • Exchange rates = amount of foreign currency per

unit of domestic currency.• Think Japanese Yen: 100 yen to $.

11

Terminology

For market-determined exchange rates:• An appreciation of a currency is when the value of

the currency rises– e or R rises

• A depreciation of a currency is when the value of the currency falls– e or R falls

For fixed exchange rates:• Price set by government is the “parity.”• A revaluation is an increase in the official parity.• A devaluation is a decrease in the parity.

12

Index of US nominal exchange rate (e)

Appreciation

Depreciation

20

40

60

80

100

120

140

1970 1975 1980 1985 1990 1995 2000 2005 2010

13

Real exchange rates

Real exchange rate, R [Jones uses RER) R = nominal exchange rate corrected for relative

prices

R = e × (p d / p f )= p d / (p f / e)

= domestic prices/foreign prices in a common currency

Note: If you calculate the rate of growth of R, you get

Example of car exchange rate: 100 Yen/$; Toyota = 2,000,000Y; Ford = $20,000; R = 100 * 20000/2000000 = 1 Toyota/Ford

rate of real rate of nominal domestic foreign

appreciation appreciation inflation rate inflation rate

14

Big Mac Real Exchange Rate

R = p d / (p f / e)

Example of Big MacPrice in Beijing: 15.4YuanPrice in New York: $4.20Real exchange rate: $4.20/(Y15.4/6.32) = $4.07/( $3.67) = 1.72

People use this to argue that Yuan is 72% “undervalued.”Anything wrong with this argument?

15

Real exchange rate of $ relative to major currencies (R)

Appreciation

Depreciation

16

Dol

lar

bubb

le:

hig

h $

inte

rest

rat

es

Inte

rnet

bub

ble

Flig

ht to

saf

ety

in $

Real exchange rate of $ relative to major currencies (R)

Appreciation

Depreciation

17

Short run or long run?

(full adjustment of capital,

expectations, etc.)

Classical or non-classical?(sticky wages

and prices, rationalexpectations, etc.)

long-run

short-run

yes

Keynesian model (sticky wages

and prices, upward-sloping

AS

Tree of Macroeconomics

Closed economy

IS-MP, dynamic AS-AD

Open economy

Mundell-Flemingmodel

no

18

The Mundell-Fleming Model for Open Economy

Mundell-Fleming (MF) model is short run Keynesian model for open economy.

Very similar to IS-MP model.It derives impact of policies and shocks in the short run

for an open economy.Usual stuff for domestic sectors:

- Price and wage stickiness, unemployment, no inflation- Standard determinants for domestic industries (C, I, G,

financial markets, etc.)

Open economy aspects:- Small open economy would have rd = rw

- Large open economy financial flows (CF) determined by rd and rw

- Net exports a function of real exchange rate, NX = NX(R)

19

Goods marketStart with usual expenditure-output equilibrium condition.New wrinkle is the NX function:

(1) Y = C(Y - T) + I(rd) + G + NX(R)

Financial marketsThen the monetary policy equation.

(2) r = L (Y)

Balance of PaymentsCapital flows are determined by domestic and foreign interest rates. But have BP balance:

(3) CF(rd, rw) = NX(R)

Substituting (3) into (1), we get equation in Y and rd which is IS$ curve.(IS$ ) Y = C(Y - T) + I(rd) + G + CF(rd, rw)

20

Dollars out = debit - I buy VW - Yale buys Greek debt.CF > 0 (outflow)

Dollars in = credit - Marco comes to Yale. - Worry warts buy T bills.CF < 0 (capital inflow

21

A picture album of the world economy,

2012

22

The output decline in the Great RecessionPercent change from prior year

All from the IMF, World Economic Outlook, Sept 2012.

23

Unemployment during the Great Recession

Percent of labor force

24

25

26

27

The growth in the public debt around the world

Debt/GDP ratio (%)

28

CF

rdMP$

C+I(rd)+G+CF(rd) (IS$)

Y

CF=NX=0

C+I(rd)+G (IS)

Equilibrium

Open Economy

29

Special Case I. Stimulus plan

How does openness change the impact of a stimulus plan?

Multiplier is reduced because some of the stimulus spills into imports and stimulates other countries

Note that financial crisis and high risk premium is the opposite (IS$ shift to the left)

30

CF

rd MP$

IS$

Y

(S$’

Open economy

Closed economy

IS

IS’

Fiscal Expansion

31

Special Case II. Normal Monetary Expansion

How does openness change the impact of a monetary policy?

Double barreled effect of monetary policy- Lower r → higher I (domestic investment)

- Lower r → higher CF → depreciates exchange rate (R) → raises NX (foreign investment)

32

CF

rd MP$

IS$

Y

MP$’

IS

Monetary Expansion

Open economy

Closed economy

33

Special Case III

What about a liquidity trap?Note that monetary policy cannot work on either of

the two mechanisms in a liquidity trap.- Interest rates stuck and cannot stimulate domestic

investment.- With no change in interest rates, no change in CF

(financial flows), no change exchange rate, no change NX

So open economy does not change the basic liquidity trap dilemma!

34

CF

rd

MP$

Y

IS$

Equilibrium

MP$’

Monetary Expansion in Liquidity Trap

35

CF

rd

MP$

Y

IS$

Equilibrium

You do fiscal expansion

36

The International Monetary System

37

What is the international monetary system?

International monetary system denotes the institutions under which payments are made for transactions that cross national boundaries and are made in different currencies.

In particular, the international monetary system determines how foreign exchange rates are set and how governments can affect exchange rates.

38

I. . Fixed exchange rateA. Currency union: currencies irrevocably fixed

- US states (1789 - )- Eurozone (2001- ?)

B. Other fixed exchange rate regimes:– Gold standard (1717 - 1933)– Bretton Woods (1945 - 1971)

II. Flexible exchange rates- Currencies are market determined- Governments use monetary policies to affect exchange

rates

Exchange rate regimes

39

What are desirable characteristics of an international financial system?

1. Stability of exchange rates to lower risk and promote trade and capital flows.

2. Openness of financial markets to promote efficient allocation and diffusion of best-practice technologies

3. Adjustment to macroeconomic shocks through monetary policy

But we will see that these three goals are not compatible in the “fundamental trilemma”

40

The share of floating has increased sharply (% of world GDP)

0%

20%

40%

60%

80%

100%

1960 1970 1980 1990 2000

Shar

e of

wor

ld G

DP b

y floa

ters

41

The Fundamental Trilemma

Country can choose only two the three objectives: fixed exchange rate, open financial markets, or monetary independence: 1. Country can have fixed exchange rate and retain

monetary policy. But this would require maintaining controls on financial flows.- China today and early Bretton Woods;

2. Country can leave financial movements free and retain monetary autonomy, but only by letting the exchange rate fluctuate.- Euro countries and US

3. Country can have open financial markets and stabilize the currency, but only by abandoning monetary policy as countercyclical tool.- Argentina yesteryear, individual countries of Euroland, Hong Kong

42

History of Eurozone- Gold standard through 1914, suspended WW I, reinstates

1920s.- Long war (1914 – 1945) followed by political union after

1945.- Gold standard deepened the Great Depression- Reconstruction with Bretton Woods system (1945- 1971)- Common Market and European Community (1958 – 1993)- European Monetary System (1978 - 1988): fixed rates of

major countries- Delors plan for monetary union (1989)- Irrevocable fixing of rates for Eurozone (2001)- Full establishment (1999) and adopted by 17 countries as of

2012- Growing imbalances after 2001- World financial crisis 2008 weakened public finances- Eurozone crisis begins in Ireland, spreads to Greece, then to

Italy- According to Euroskeptics, the end of the Eurozone is nigh…

43

Eurozone 2012

44

Major “flow” problem: no way to adjust to imbalances which lead to changes in real

exchange rate (R)

0.7

0.8

0.9

1

1.1

1.2

1.3

1.4

1.5

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Greece Spain Italy

France Germany Austria

45

rEuro

IS$(2000)

Y2000

IS$(2010)

Y2010Y2012

rEuro + risk premium

Greece, Spain, Italy: The Sweet Life Turns Sour

46

Options according to Nouriel Roubini*

1. Rapid Growth of Eurozone– ECB lowers rates, Euro depreciates, Germany expands– Problem: No way Germany will allow

2. Long Recession to Restore Periphery Competitiveness. - Austerity in periphery - Problem: No way citizens of Greece, Italy, etc. will put up

with

3. The Core Permanently Subsidizes the Periphery (“transfer union”)- Problem: No way Germany will subsidize Greece and Italy

4. Widespread Debt Restructurings and EZ breakup- Default?- Problem: will lead to world financial meltdown.

* Former Yale Department of Economics Professor.