Chapter 13. Aggregate Demand in the Open Economy

We will not cover the Appendix.

Homework: pp. 388-89 # 1, 2 or 3 macromodel mundell_fleming # 1, 4, 10

Link to syllabus

Preview of Coming Attractions!Fig. 13-3, p. 361. The Mundell-Fleming Model

More, even better Previews! Table 13-1, p. 372

Mundell and Dornbusch

Robert Mundell, 1932-Nobel prize 1999

Rudiger Dornbusch1942-2002.

Mundell taught at U. of Chicago for many years, where Dornbusch was his student. Dornbusch taught at MIT.

Fig. 13-1, p. 359. The IS* Curve

Fig. 13-2, p. 360. The LM* Curve

With a vertical LM*,all the fun is over beforewe even start.

Fig. 13-3 p. 361. Equilibrium in the Mundell Fleming Model

Fig. 13-3 p. 361. Equilibrium in the Mundell Fleming Model

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Fond, old memories.

When the textbook expanded from the closed economy loanable funds model of Chapter 3 to the open economy loanable funds model of Chapter 6, it kept the same general framework, but we ended up with twographs; one with r on the vertical axis [where r always equaled r*],and the other with the exchange rate on the vertical axis.

Now, from chapter 12 to13, we go from closed economy IS-LM to openeconomy IS-LM. This time, however, we don’t bother with the graphthat has r on the vertical axis, but jump right into the graph with theexchange rate on the vertical axis.

Fig. 13-4, p. 362. Fiscal Expansion Under Floating Exchange Rates

No change in output without even assuming a vertical AS curve.That implies that the AD curve does not move, either.

mt’s attempt at explaining result of fiscal expansion(assuming small open economy, flexible x-rates)

An increase in government expenditures → would raise interest rates, → leading to an inflow of foreign capital (loans),→ appreciating the currency (higher Y/$), → lowering net exports, → which cancels out the expansionary effect of higher Gov’t spending → leaving the economy at the same level of output.

Another part of the story is that these effects are so strong that thedomestic interest rate never really rises above the world interest rate.

Fig. 13-5, p. 364. Monetary Expansion under Floating Exchange Rates

mt‘s attempt at explaining this result of monetary expansion

The increase in the money supply would initially→ lower domestic interest rates, and so→ cause capital outflows and depreciate the currency→ raise net exports, increasing real output

All this happens real quickly, so the graph (Fig. 13-5) just shows the shift of the LM and the lower – depreciated – exchange rate.

Fig. 13-6, p. 365. Trade Restriction

under Floating Exchange Rates

Because of vertical LM*,There is no change in Y.Thus, AD doesn’t move.

However, there is a change in the compositionof production of tradeablegoods.

Fixed Exchange Rates vs. Flexible Exchange Rates in a Small Open Economy.

The key to the coming analysis is that in a s.o.e., with perfect capitalmobility, a shift of the return to assets will give rise to a very largesurge of capital flows which cannot be neutralized by the central bank.

It took macroeconomists a few decades to realize fully the impact of that fact, on their macroeconomic models. The results are, initially,quite surprising.

Fig. 13-7, p. 367. How a Fixed Exchange Rate Governs the Money Supply

Market forces push the LM* to where it intersects the IS* at thepredetermined, fixed exchange rate (see next slide).

Fig. 13-7, p. 367 (again). How a Fixed Exchange Rate Governs the Money Supply

A

At point A, agents borrow$ and convert themto yen at 180Y/$ overseas, then bring the Yenfor exchange into the US, buying $ at 150for an automatic profit. The Fed, in

selling $, raises US money supply.

H

At H, agents will buy $ at 120and sell them to the Fed at150Y/$, making 25 % profit. Thisreduces the supply of $, pushingthe LM* to the left.

150

180150

120

Fig. 13-8, p. 369. Fiscal Expansion under Fixed Exchange Rates

Fig. 13-9, p. 369. Monetary Expansion under Fixed Exchange Rates

Monetary policy has no effect with fixed exchange rates, for a s.o.e.

Fig. 13-10, p. 371. Trade Restriction under Fixed Exchange Rates

Table 13-1, p. 372

Fig. 13-11, p. 374. An Increase in the Risk Premium

Fig. 13-12, p. 381. The Impossible Trinity

Fig. 13-13, p. 384. Mundell-Fleming in AD

Fig. 13-14 p. 385 Short Run and Long Run in an SOE

Putting it all together (Chapter 14 appendix, p. 424)

Appendix

The large open economy is an average of the closed economy and the small open economy. To find how any policy will affect any variable, find the answer in the extreme cases for the closed and SOE, and take the ‘average’.

(page 394)

Figure 13.15 p. 391 (appendix). A Short-Run Model of a Large Open Economy

Figure 13.16 p. 392. A Fiscal Expansion in a Large Open Economy

An increase in Gov’t spending raises real GDP and the real interest rate, lowers capital outflows, raises the exchange rate, and reduces net exports. The decline in net exports lowers the increase of real GDP. In the SOE, there is no change in GDP because the ∆ G = - ∆ NX.

Figure 13.17 p. 393. A Monetary Expansion in a Large Open Economy

An increase in M moves LM right, lowering r. This increase capital outflow, which lowers the exchange rate, ultimately increasing net exports.In a SOE, an increase in M increases real output in the short run.