Slides for International Finance - American University value of any given amount of imports in terms...
Transcript of Slides for International Finance - American University value of any given amount of imports in terms...
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
Slides for International FinanceAggregate Demand and the SR (KOM Chapter 17)
Alan G. Isaac
American University
2012-10-22
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
AA CurveAggregate Demand
PREVIEW
AA Curvereview SR model of asset market equilibriumAA: ^Y � _E (to maintain asset mkt eq)
DD CurveSR model of output market equilibriumDD: ^E � ^Y (to maintain asset mkt eq)
SR ModelAA + DD: simultaneous output market and asset marketequilibriumtemporary v permanent changes in monetary and fiscal policiesliquidity trap (zero interest rates, deflation, stimulus)Adjustment of the current account over time.
IS-LM modelalternative perspective on the same results
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
AA CurveAggregate Demand
SR vs. LR Models
LR models
all prices of inputs and outputs have time to adjust.
predict future exchange rate tendencies
suggest ways of thinking about how market participants formexpectations
SR modelssome prices of inputs and outputs do not fully adjust
labor contractscosts of adjustmentimperfect information about market demand.
Goal
show how macroeconomic policies affect E, Y, and CA
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
AA CurveAggregate Demand
Short-Run Equilibrium in Asset Markets
Consider two related asset markets:
money market: M/P = L(R, Y)^Y � ^L � (M/P < L) � ^R
foreign exchange market: R = R* + (Ee - E)/E^R � _E
When income (production) increases:
the demand for real liquidity increases,driving up the domestic interest rate,causing an appreciation of the domestic currency.
Summary: ^Y � _E
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
AA CurveAggregate Demand
Output and the Exchange Rate in Asset Market Equilibrium
L(R,Y1) L(R,Y2)
R1 R2
E
E1
E2
M/P
R
Q
Compare KOM 9 Figure 17-6Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
AA CurveAggregate Demand
Short-Run Equilibrium in Asset Markets: AA Curve
AA Curve
equilibrium in financial markets (money market and foreignexchange market)
inverse relationship between output and exchange rates (asdervied above)
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
AA CurveAggregate Demand
The AA Schedule
E
Y
AA
E1
Y1
E2
Y2
Compare KOM 9 Figure 17-7Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
AA CurveAggregate Demand
Shifting the AA Curve
1 ^M � _R (in the short run) � ^E (for every Y): the AA curveshifts up
2 ^P � _M/P � ^R � _E (given Y): the AA curve shifts down3 ^L (exogenously) � ^R � _E (given Y): the AA curve shifts
down4 ^R* � foreign currency deposits more attractive � ^E (given Y):
the AA curve shifts up5 ^ Ee: if market participants expect the future domestic currency
to be depreciated, foreign currency deposits become moreattractive, � ^E (given Y): the AA curve shifts up
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
AA CurveAggregate Demand
^M � ^E in Assets Markets
L(R,Y1)
R1R2
E
E1
E2
M2/P
R
Q
M1/P
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
AA CurveAggregate Demand
^M � AA Shifts Up
E
YAA
E1
Y1
AA’
E2
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
AA CurveAggregate Demand
^M � AA Shifts Up
E1
Q
L(R,Y1)
Q2
R10 returns
R∗+ Ee1−EE
E2
E
E1
E2
E
YY1
AAAA’
R2
M1/P
M2/P
Q1
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
AA CurveAggregate Demand
^Ee � AA Shifts Up
E1
Q
L(R,Y1)
Q1
R10 returns
R∗+ Ee1−EE
R∗+ Ee2−EE
E2
E
E1
E2
E
YY1
AAAA’
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
AA CurveAggregate Demand
Determinants of Aggregate Demand
Aggregate demand the aggregate amount of goods and servicesthat individuals and institutions are willing and able to buy
C: consumption expenditure
I: investment expenditure
G: government expenditure (purchases of final goods andservices)
CA: net expenditure by foreigners (the current account)
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
AA CurveAggregate Demand
Determinants of Consumption Demand
disposable income (Yd = Y - T)^(Y-T) � ^C (mpc < 1)
real interest ratestheoretically indeterminate (conflicting income and substitutioneffects)empirically hard to detectwe will ignore
Wealthimportant theoretically and empiricallynevertheless, we assume that wealth is relatively constant andthus a relatively unimportant consideration
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
AA CurveAggregate Demand
Income Shocks and Consumption
Source: KOM 17A1-1
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
AA CurveAggregate Demand
Determinants of the Current Account
disposable income (Yd = Y - T)^(Y-T) � ^Im (mpm < 1)
real exchange rate (q = EP*/P)theoretically indeterminant, but we assume:^q � ^Ex, _Im � ^(Ex-Im)expenditure shifting: expenditure on domestic products rises, andexpenditure on foreign products falls.
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
AA CurveAggregate Demand
Real Depreciation and the Current Account: More Details
CA = EX - IM the value of exports relative to the value of imports
Real depreciation: a rise in q (i.e., ^ EP*/P) prices of foreignproducts rise relative to the prices of domestic products.
The volume of exports that are bought by foreigners rises.
The volume of imports that are bought by domestic residents falls.
The value of any given amount of imports in terms of domesticproducts rises (i.e., the relative price of imports rises, foreignproducts becomes relatively expensive)
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
AA CurveAggregate Demand
Marshall-Lerner Condition
Real current account:
CA = EX - IM = EX - q Immeasured in domestic goodsConflicting volume and valuation effects
Marshall-Lerner Condition
Condition for ^q � ^CAvolume effects outweigh value effectneed sum of export and import elasticities > 1
εX + εM > 1
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
AA CurveAggregate Demand
SR Effect of Depreciation: Value Effects and Volume Effects
SR volume effects
volume of imports and exports is relatively fixed in SR
value effects
sticky prices: P and P* relatively fixed in the short runpass through: ^E � ^EP* (imports cost more)^ (EP*/P)
SR net effect
domestic currency value of exports does not change.domestic currency value of imports rises_CA
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
AA CurveAggregate Demand
Depreciation and the Current Account: Elasticity Dynamics
SR net effect
Iniitally volumes of imports and exports do not change muchFor example, contract obligations to buy fixed amounts ofproducts may cause the volume effect to be small.� value effect may dominate the volume effect when thereal exchange rate changes.
Medium term net effect
volumes gradually respond � the volume effect overcomesthe value effect (eventually)evidence: in most countries, the volume effect dominatesthe value effect after one year or less.
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
AA CurveAggregate Demand
Depreciation and the Current Account: The J-Curve
time
CA0
CASR
CALR
t0 t1
CA
Compare KOM 9 Figure 17-18
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
AA CurveAggregate Demand
Exchange-Rate Pass Through
Exchange-rate pass through: the percentage by which import priceschange when the value of the domestic currency changes by 1%.pass through may be less than 100% due
price discrimination in different countries.price-setting firms may decide not to match changes in theexchange rate with changes in prices of foreign products
Pass through less than 100% dampens the effect of depreciationor appreciation on the current account.
smaller decline in CA (smaller J-curve)but also: smaller volume effects
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
AA CurveAggregate Demand
Table 17A2-1: Estimated Price Elasticities for InternationalTrade in Manufactured Goods
Source: KOM 17A2-1
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
AA CurveAggregate Demand
DD-AA model assumptions
pass through rate is 100%:import prices in domestic currency exactly match a depreciationof the domestic currency.prices fixed in domestic currency: nominal depreciation impliesreal depreciationML condition is satisfied:
the volume effect dominates the value effect.a real depreciation improves the current account
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
AA CurveAggregate Demand
Exchange Rates and Real Exchange Rates
Nov 10, 200759.92 Icelandic króna per USD
Nov 10, 2008128.78 Icelandic króna per USD
Depreciation over the period: 114.92%
Inflation over the period: 15.90%
HUGE real depreciation: 99.02%
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
AA CurveAggregate Demand
Depreciation in Iceland
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
AA CurveAggregate Demand
Determinants of Aggregate Demand
Determinants of the current account include:Real exchange rate: an increase in the real exchange rateincreases the current account.Disposable income: an increase in the disposable incomedecreases the current account.
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
AA CurveAggregate Demand
CA/GDP vs. EP*/P in the US
Compare KOM Figure p.451 (which inverts the real exchange rate).
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
AA CurveAggregate Demand
Determinants of Aggregate Demand (cont.)
I, G and T are exogenous
G and T determined by political factors we do not modelI is determined by exogenous business decisions (for now)
(later we let I depend on the interest rate (i.e., on the cost ofborrowing to finance investment)
Consumption = C(Y-T)Current account = CA(EP*/P, Y-T)Therefore aggregate demand = C(Y-T) + I + G + CA(EP*/P, Y-T)
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
AA CurveAggregate Demand
Determinants of Aggregate Demand (cont.)
Summarize the determinants of aggregate demand:
D = D(EP* /P, Y-T, I, G)^q � ^CA � ^D^(Y-T) � ^C � ^D (even though ^IM)mpm < mpc < 1
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
DD CurveSR EquilibriumPermanent Fiscal ExpansionPermanent ^M
Short-Run Equilibrium for Aggregate Demand and Output
Aggregate demand is a function of:
the real exchange rate (EP*/P)disposable income (Y-T)investment expenditure (I)government purchases of final goods and services (G)
Equilibrium: our aggregate output (Y) equals the aggregate demandfor our output (D)Y = D(EP*/P, Y- T, I, G)
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
DD CurveSR EquilibriumPermanent Fiscal ExpansionPermanent ^M
Aggregate Demand as a Function of Output
D
Y
D(EP*/P, Y-T, I, G)
D1
Y1 Y2
D1
45◦
Compare KOM 9 Figure 17-1
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
DD CurveSR EquilibriumPermanent Fiscal ExpansionPermanent ^M
The Determination of Output in the Short Run
D
Y
D(EP*/P, Y-T, I, G)
D1
Y1
D = Y
45◦
Compare KOM 9 Figure 17-2
AD > Y -> firms increase output; AD < Y -> firms decrease outputAlan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
DD CurveSR EquilibriumPermanent Fiscal ExpansionPermanent ^M
Short-Run Equilibrium and the Exchange Rate: DDSchedule
Q: How does E affect AD?
A depreciation makes foreign goods and services relativelyexpensive (given domestic and foreign prices).
Aggregate demand shifts toward domestic products.
In equilibrium, production will increase to match the higher aggregatedemand.
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
DD CurveSR EquilibriumPermanent Fiscal ExpansionPermanent ^M
Output Effect of ^E with Fixed Output Prices
D
Y
D(E1P ∗/P, . . .)
D1
Y1
D = YD(E2P ∗/P, . . .)
D2
Y2
Compare KOM 9 Figure 17-3
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
DD CurveSR EquilibriumPermanent Fiscal ExpansionPermanent ^M
Deriving the DD Schedule
D
EY
YY2Y1
Y1 Y2
E1
E2
DD
D|E1
D|E2
D=Y
Compare KOM 9 Figure 17-4Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
DD CurveSR EquilibriumPermanent Fiscal ExpansionPermanent ^M
Short-Run Equilibrium and the Exchange Rate: DDSchedule (cont.)
DD schedule
shows combinations of output and the exchange rate at which theoutput market is in short run equilibrium (such that aggregatedemand = aggregate output).
slopes upward because a rise in the exchange rate causesaggregate demand and aggregate output to rise.
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
DD CurveSR EquilibriumPermanent Fiscal ExpansionPermanent ^M
Shifting the DD Curve
Changes in the exchange rate cause movements along the DD curve.Other changes cause shifts of the DD curve.Exogenous ^D � DD shifts right:
^G � ^ AD � ^ Y.
^I � ^ AD � ^ Y.
^Cd (exog) � ^ AD � ^ Y. (expenditure increase or switching)
_T � ^ C � ^ AD � ^ Y.
_P � ^ q � ^ CA � ^ AD � ^ Y.
^ P* � ^ q � ^ CA � ^ AD � ^ Y.
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
DD CurveSR EquilibriumPermanent Fiscal ExpansionPermanent ^M
^G Shifts the DD Curve to the Right
D
EY
YY2Y1
Y1 Y2
E1
DD
D|G1
D|G2
D=Y
DD’
Compare KOM 9 Figure 17-5Output increases for every exchange rate: the DD curve shifts right.
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
DD CurveSR EquilibriumPermanent Fiscal ExpansionPermanent ^M
Putting the Pieces Together: the DD and AA Curves
Short-run equilibrium: a nominal exchange rate (E) and a level ofoutput (Y) such that we are on both the DD and AA curves
DD curve
output markets are in equilibrium on the DD curveD = Y (aggregate demand equals aggregate output;equilibrium in the output markets)
AA curve
asset markets are in equilibrium on the AA curveR-R*=(Ee-E)/E (interest parity; equilibrium in theforeign exchange markets)M/P=L (real money supply equals real money demand;equilibrium in the money market)
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
DD CurveSR EquilibriumPermanent Fiscal ExpansionPermanent ^M
Short-Run Equilibrium in the DD-AA Model
E
Y
DD
AA
E1
Y1
Compare KOM 9 Figure 17-8Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
DD CurveSR EquilibriumPermanent Fiscal ExpansionPermanent ^M
DD-AA Model: Very Short Run Disequilibrium Adjustment
E
Y
DD
AA
ESR
YSR
1
2
3
Compare KOM 9 Figure 17-9E adjusts immediately; asset markets are always in equilibrium.Y adjusts more slowly; commodity markets may be in temporary disequilibrium.
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
DD CurveSR EquilibriumPermanent Fiscal ExpansionPermanent ^M
Temporary Changes in Monetary and Fiscal Policy
Monetary policy: the monetary authority (e.g., central bank)influences conditions in the money markets (e.g., the supply ofmonetary assets)
Fiscal policy the fiscal authority (e.g., treasury) influences aggregatedemand via taxation and spending
Temporary policy changes:
expected to be reversed in the near futuredo not affect Ee
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
DD CurveSR EquilibriumPermanent Fiscal ExpansionPermanent ^M
Impact of Temporary ^M
AA shifts up: ^M � _R � ^E
Move along DD ^E � ^EP*/P � ^D � ^Y
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
DD CurveSR EquilibriumPermanent Fiscal ExpansionPermanent ^M
Temporary ^M: SR Effects
E
Y
DD
AA’
E2
Y1
AA
E1
Y2
Compare KOM 9 Figure 17-10Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
DD CurveSR EquilibriumPermanent Fiscal ExpansionPermanent ^M
Temporary Changes in Fiscal Policy
Exogenous changes in aggregate demand
may result from fiscal changes^G � ^AD or _Tx � ^AD^AD � equilibrium Y (at each E)i.e., the DD curve shifts right.
^Y�^L
increased demand of real monetary assets increasesequilibrium interest rates,� _E (domestic currency appreciation)we move along the AA curve
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
DD CurveSR EquilibriumPermanent Fiscal ExpansionPermanent ^M
Temporary Fiscal Expansion: SR Effects
E
Y
DD
AA
E1
Y1
DD’
E2
Y2
Compare KOM 9 Figure 17-11Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
DD CurveSR EquilibriumPermanent Fiscal ExpansionPermanent ^M
How Big (Small?) Are Fiscal Multipliers?
Robert Barro (WSJ, 2009): Peacetime multipliers are essentially zero
Christina Romer (2009): Multiplier is around 1.5
Difference: 3.7 million jobs by the end of 2010
Existing studies mainly confined to OECD countries: Blanchardand Perotti (2002), Perotti (2004), Uhlig and Mountford (2005),Ramey (2008), Barro and Redlik (2009)
Exception: Ilzetzki, Mendoza, and Vegh (2009):
45 country panel (19 high-income, 26 developing)quarterly data (1960Q1 - 2007Q4)focus on the factors/characteristics that affect the size of themultipliers
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
DD CurveSR EquilibriumPermanent Fiscal ExpansionPermanent ^M
Fiscal Multipliers
Question: What is the impact on GDP of a $1 increase in governmentexpenditure?
Impact Multiplier: ∆GDP0/∆G0
Cumulative Multiplier ∑t0 ∆GDPt/∑
t0 ∆Gt
Long-run multiplier: the cumulative multiplier once both impulseresponses have died down.
Ilzetzki, Mendoza, and Vegh (2009) find characteristics matter:
High income versus emerging/developing
Fixed (predetermined) versus flexible exchange rate regimes
Open versus closed
High-debt versus low debt
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
DD CurveSR EquilibriumPermanent Fiscal ExpansionPermanent ^M
Policy conclusion:
Size of fiscal multipliers depends on key country characteristics:
high income versus developing
fixed versus flex
closed versus open
high debt versus low debt
Worst combination: developing, open, exchange rate flexibility� Not much scope therefore for countercyclical fiscal policy
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
DD CurveSR EquilibriumPermanent Fiscal ExpansionPermanent ^M
Potential Output (Yf)
Potential output
resources are used effectively and sustainablyproduction is at the “potential” or “natural” level
Under utilization
resources not used effectively, orresources are underemployed (e.g., high unemployment,few hours worked, idle equipment)� lower than normal production of goods and services.
Over utilization
resources are not used sustainablyresources are over-employed (e.g., unusually lowunemployment, overtime hours, over-utilized equipment)� unsustainably high production of goods and services.
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
DD CurveSR EquilibriumPermanent Fiscal ExpansionPermanent ^M
Temporary Fall in Aggregate Demand: SR Effects
E
Y
DD’
AA
ESR
YSR
DD
E0
Yf
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
DD CurveSR EquilibriumPermanent Fiscal ExpansionPermanent ^M
Monthly Unemployment
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
DD CurveSR EquilibriumPermanent Fiscal ExpansionPermanent ^M
^G as Policy Response to Temporary _D
E
Y
AA
ESR
YSR
DD|G2
E0
Yf
DD|G1
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
DD CurveSR EquilibriumPermanent Fiscal ExpansionPermanent ^M
^M as Policy Response to Temporary _D
E
Y
DD
AA|M1
ESR
YSR
E0
Yf
AA|M2
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
DD CurveSR EquilibriumPermanent Fiscal ExpansionPermanent ^M
Fig. 16-12: Maintaining Full Employment After a TemporaryFall in World Demand for Domestic Products
Source: KOM Figure 17-12
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
DD CurveSR EquilibriumPermanent Fiscal ExpansionPermanent ^M
Temporary ^L: SR Effects
E
Y
DD
AA
E0
YSR
AA’
ESR
Yf
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
DD CurveSR EquilibriumPermanent Fiscal ExpansionPermanent ^M
Policies to Maintain Full Employment After ^L
Source: KOM Figure 17-13
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
DD CurveSR EquilibriumPermanent Fiscal ExpansionPermanent ^M
Policies to Maintain Full Employment: Difficulties
Our model suggests it is easy to maintain full employment.In practice, it is difficult.Expansionary fiscal and monetary policies may induce inflation andhigher inflation expectations, preventing high output and employment.(Ignoring this leads to inflationary bias.)
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
DD CurveSR EquilibriumPermanent Fiscal ExpansionPermanent ^M
Policies to Maintain Full Employment: Difficulties
Model assumptions:expectations given
but people may anticipate the effects of policy changes andmodify their behavior.
all prices stickyworkers may require higher wages if they expect overtimeand easy employmentproducers may raise prices if they expect higher wages andstrong demand
we know about the contractionary shock
but economic measurement is difficult and andeconomic data hard to understand.policy makers must guess the state of the assetmarkets and aggregate demand; they makemistakes.
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
DD CurveSR EquilibriumPermanent Fiscal ExpansionPermanent ^M
Policies to Maintain Full Employment: Difficulties
Model assumptions:
policy changes are implemented immediately and haveimmediate effects
but changes in policies take time to beimplemented and to affect the economy.expansionary policy may affect the economy afterthe the shock has dissipated.
policy choices not influenced by political or bureaucraticinterests
but policies may be influenced by political or bureaucraticinterests.
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
DD CurveSR EquilibriumPermanent Fiscal ExpansionPermanent ^M
US Economic Stimulus Act of 2008
Feb 13, 2008
Bush signs into law
Response to
2007 subprime mortgage crisis and credit crunchincreasing evidence of economic slowdown
Tax rebates and investment incentives
$152 B budget cost projected for 2008$124 B additional cost over 10 years
Evidence of substantial stimulus effect?
limited, but Broda and Parker (2008) find some evidence ofincreased household spending immediately following receiptof the rebate.
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
DD CurveSR EquilibriumPermanent Fiscal ExpansionPermanent ^M
China (PRC) Fiscal Stimulus 2008
November 2008
Announced $586 B over two years
Reaction to
global economic crisisgrowth slowdown (perhaps to 6%, vs. 10% p.a.)factory closing and mass layoffs in the south
Comment:
G/Y in China low relative to EU and US
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
DD CurveSR EquilibriumPermanent Fiscal ExpansionPermanent ^M
American Recovery and Reinvestment Act of 2009 (ARRA)
CBO and the staff of the Joint Committee on Taxation estimated ARRAwould increase budget deficits by $787 billion between fiscal years2009 and 2019.Current CBO estimates: $814 billion, about half in fiscal year 2010
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
DD CurveSR EquilibriumPermanent Fiscal ExpansionPermanent ^M
Effect of 2009 Stimulus on Employment and Output
CBO’s model-based estimates say ARRA:Raised the level of real (inflation-adjusted) gross domesticproduct (GDP) by between 1.7 percent and 4.5 percent,Lowered the unemployment rate by between 0.7 percentagepoints and 1.8 percentage points,Increased the number of people employed by between 1.4 millionand 3.3 million, andIncreased the number of full-time-equivalent (FTE) jobs by 2.0million to 4.8 million compared with what those amounts wouldhave been otherwise. (Increases in FTE jobs include shifts frompart-time to full-time work or overtime and are thus generallylarger than increases in the number of employed workers.)
The effects of ARRA on output and employment are expected to belargest during 2010.Source: http://cboblog.cbo.gov/?p=1326
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
DD CurveSR EquilibriumPermanent Fiscal ExpansionPermanent ^M
G/Y and G/Yf in the U.S.
Source: http://www.econbrowser.com/archives/2010/10/the_everexpandi_1.html
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
DD CurveSR EquilibriumPermanent Fiscal ExpansionPermanent ^M
Quantitative Easing
Quantitative Easing (QE):
policy to expand the high-powered money supply even whenSR interest rates are unresponsive (e.g., already near zero)especially: substantial expansion of bank reserves (and thusthe monetary authority’s balance sheet)goals: ease credit; lower long bond rates; affect expectationsterm often used to include “qualitative easing” or “crediteasing”
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
DD CurveSR EquilibriumPermanent Fiscal ExpansionPermanent ^M
Credit Easing
Credit easing:
monetary authority attempts to influence credit conditions bymanipulating the composition of its balance sheettargets non-traditional assets, especially less liquid andriskier securities (including mortgage-backed securities,longer term Treasury issue)does not just target bank reserves
QE 2:
popular name for a second round of credit easing, especiallyas initiated in the US in November 2010Federal Reserve committed to purchase an additional$600B in longer-term Treasuries by mid-2011, acquiringabout $75B per month
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
DD CurveSR EquilibriumPermanent Fiscal ExpansionPermanent ^M
Permanent Changes in Monetary and Fiscal Policy
“Permanent” shock: changes expectations about the futureexchange rate
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
DD CurveSR EquilibriumPermanent Fiscal ExpansionPermanent ^M
Permanent Fiscal Expansion
Permanent change in fiscal stanceincrease in G or decrease in TChanges aggregate demand
subject to usual qualifications
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
DD CurveSR EquilibriumPermanent Fiscal ExpansionPermanent ^M
Effects of a Permanent Fiscal Expansion
E
Y
DD|G1
AA|Ee=E1
E1
Yf
DD|G2
E2
AA|Ee=E2
The AA curve also shifts: a permanent fiscal expansion appreciates Emore.
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
DD CurveSR EquilibriumPermanent Fiscal ExpansionPermanent ^M
Fig. 16-16: Effects of a Permanent Fiscal Expansion
Source: KOM Figure 17-16
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
DD CurveSR EquilibriumPermanent Fiscal ExpansionPermanent ^M
Permanent Fiscal Expansion
SR effectsdoes up demand -> up Y?No: E appreciates -> real E appreciates
Ee appreciates (permanent shock)How much does E appreciate?
Enough to restore D=Yf(to see, think LR)
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
DD CurveSR EquilibriumPermanent Fiscal ExpansionPermanent ^M
Permanent Fiscal Expansion (LR)
LR outcomes and SR outcomes are the same!
M=M0, Y = Yf, R=R*so P is unchanged!But then D(EP*/P,Y-T,I,G)=Yf� ^G must “crowd out” private demand through CA!
Twin deficits once again
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
DD CurveSR EquilibriumPermanent Fiscal ExpansionPermanent ^M
Permanent Changes in Monetary Policy
Permanent ^M1 makes people expect future depreciation of the domestic
currency (increases the expected rate of return on foreigncurrency deposits at each E)
2 causes ^M/P and _R (in the short run)
Two forces for depreciation combine:
E rises more than when expectations are constant (see ourstatic expectations results).the AA curve shifts up more than the case whenexpectations are held constant.
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
DD CurveSR EquilibriumPermanent Fiscal ExpansionPermanent ^M
Permanent ^M � ^Ee and _R (in SR).
E
Y
DD
AA
E1
Yf
AA’
ESR
YSR
Compare: KOM Figure 17-14Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
DD CurveSR EquilibriumPermanent Fiscal ExpansionPermanent ^M
Effects of Permanent Changes in Monetary Policy in theLong Run
With employment and hours above their normal levels, there is atendency for wages to rise over time.
With strong demand of goods and services and with increasingwages, producers have an incentive to raise prices over time.
Both higher wages and higher output prices are reflected in ahigher level of average prices.
What are the effects of rising prices?
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
DD CurveSR EquilibriumPermanent Fiscal ExpansionPermanent ^M
Long-Run Adjustment to a Permanent Increase in the MoneySupply
Source: KOM Figure 17-15
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
Interest Rates, Exchange Rates and a Liquidity Trap
A liquidity trap occurs when nominal interest rates fall to zero andthe central bank cannot encourage people to hold more liquid(monetary) assets.
Nominal interest rates can not fall below zero, or else depositorswould have to pay to put their money in banks.When interest rates fall to zero, people are indifferent betweenholding monetary and interest-bearing assets, so that central bankcan not encourage them to spend or borrow more money.
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
Japan: Three-Month T-Bill Rates
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
US: Three-Month T-Bill Rates
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
Three-Month Interest Rates on Dollar and Yen Deposits
Source: KOM 9 Fig 14-2
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
Interest Rates, Exchange Rates and a Liquidity Trap
R = R∗+ (Ee−E)/E
1 + R−R∗ = Ee/E
E = Ee/(1 + R−R∗)
If the domestic interest rate is reduced to zero, then
E = Ee/(1−R∗)
With fixed expectations about the exchange rate (and inflation)and fixed foreign interest rates, the exchange rate is fixed.
A purchase of domestic assets by the central bank does not lowerthe interest rate, nor does it change the exchange rate.
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
Temporary ^M with a Liquidity Trap
E
Y
DD
AA
Ee
1−R∗
Y1
Compare KOM 9 Figure 17-19Compare: KOM 9 Figure 17-19If nominal interest rates are zero, a temporary monetary expansion will not lower interest rates and will not affect exchange ratesnor output: a liquidity trap.
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
Permanent ^M with a Liquidity Trap
E
Y
DD
AA
Ee
1−R∗
Y1
Ee
1−R∗
AA’
Y2
Ee
1+R−R∗
A permanent monetary expansion will raise expectations of inflationand cause markets to expect a depreciation of the domestic currency:inflationary money policy depreciates the currency and raises output.
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
Devaluation and a Liquidity Trap (cont.)
A devaluation of the currency could achieve the same goals if marketexpectations do not change: a devaluation raises output.
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
Interest Rates, Exchange Rates and a Liquidity Trap (cont.)
Prices and wages have fallen (deflation), allowing a realdepreciation of Japanese products.
Low output and employment has gradually risen as prices, wagesand the value of Japanese products have fallen.
In addition, Japan has maintained low interest rates, hasincreased the growth rate of its money supply and has tried todepreciate the yen by purchasing international reserves.
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
Interest Rates, Exchange Ratesand a Liquidity Trap
Liquidity trap nominal interest rates fall so low that the central bankcannot encourage people to hold more liquid assets (money).
At some low interest rate, people are indifferent between holdingmoney and interest bearing assets
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
Negative Interest Rates
Traditional wisdom: R < 0 impossiblePeople would just hold cash (� 0 rate of return )
Reality:holding cash is riskycompare: people pay for depositories for valuables
Reality (1970s):Switzerland paid negative interest on foreign deposits
response to speculative interest in owning Swiss Francs
traditionally considered a very special case
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
Negative Interest Rates: Japan
Reality (late 1998, early 1999):Western banks paid negative interest on yen interbank deposits
Note: Japanese banks chose Western over local institutionsbased on perceived risk
negative interest rates on short-term Japanese gvt bills
Reality (February 1999):BoJ adopts “zero interest rate policy”)Note arbitrage opportunity:
foreign banks increased their holdins at BoJ!
(BoJ imposes limits)Reality (January 2003):
Japanese interbank rate <0
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
Liquidity Trap and Monetary Policy
Temporary Monetary Expansionshifts out M/Pbut no effect on Rtherefore completely ineffective
Permanent Monetary Expansionhas effects by changing expectationspermanent M increase� increase expected E
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
Japan’s Policy Choices
Many observers urged monetary expansion or active devaluation.New BoJ governors (since March 2003)
increased the growth of the money supplypurchased international reserves
Did Japan court deflation (price adjustment policy)?prices and wages fall over time (deflation)produce a real depreciation of Japanese productsstimulate demand� expand economy
Fiscal Expansiona fiscal expansion could workhigh public debt made policy makers cautiousprimary deficit actually showed signs of tightening in early noughts
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
Another Option
Export expansion - Japan got lucky: 2002 export boomlargely due to China’s growth
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
Macro Policy and CA
XX curve:
(Y,E) combinations for a constant CAE.g., CA is constant at its desired level XTo keep CA constant, ^Y must be offset by ^E: the XX curveslopes upward.
As Y increases, the current account declines, cet. par.As E increases, the current account improves, cet. par.
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
Macroeconomic Policy and the Current Account
E
Y
CA = 0
E1
Y1
E2
Y2
CA < 0
CA > 0
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
AA, DD, and XX
E
Y
DD
XX
AA
E1
Y1
Note: compare KOM 9 Figure 17-7.Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
Why XX is Flatter than DD
To keep the current account constant, the domestic currencymust depreciate as income and output increase
the XX curve slopes upward.
To keep the goods market in equilibrium, domestic income mustrise as our currency depreciates
the DD curve slopes upward.
Which is flatter?Start with CA = XRaise E and Y so that CA=X (still on XX)No change in AD via CA, but up AD and AS due to up Y, -> excesssupply
so DD is above XX
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
Macroeconomic Policies and the Current Account (cont.)
Policies affect the current account through their influence on thevalue of the domestic currency.
An increase in the quantity of monetary assets supplieddepreciates the domestic currency and often increases the currentaccount in the short run.An increase in government purchases or decrease in taxesappreciates the domestic currency and often decreases thecurrent account in the short run.
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
Temporary Fiscal Expansion and the Current Account
E
Y
DD
XX
AA
E1
Yf
DD’
E2
Y2
temporary fiscal expansion � DD shifts right � _E � _CAAlan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
Permanent Fiscal Expansion and the Current Account
E
Y
DD
XX
AA
E1
Yf
DD’
E2
Y2
AA’
The AA curve also shifts: a permanent fiscal expansion decreases CAmore.
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
^M � ^CA
Increase in the money supply
shifts up the AA curvecauses a movement along the DD curve, which is steeperthan XX� depreciates the domestic currency� ^CA
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
Temporary Monetary Expansion and the Current Account
E
Y
DD
XX
AA
E1
Y1
AA’
E2
Y2
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
Permanent Monetary Expansion: the Short Run
E
Y
DD
XX
AA
E1
Y1
AA’
ESR
YSR
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
Summary: Macroeconomic Policy and the Current Account
Source: KOM Figure 17-17b
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
Bond yields (missing part of our story)
Source: IMF 2009, Global Financial Stability Report
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
US: Debt and Debt/GDP
Source: Wikipedia
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
Eurozone: Debt/GDP
Source: ECB 16-85
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
Developed Countries: Debt/GDP
Source: http://www.imf.org/external/pubs/ft/spn/2010/spn1013.pdf
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
Developed Countries: Debt/GDP
Source: http://www.imf.org/external/pubs/ft/spn/2010/spn1013.pdf
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
Developed Countries: Debt/GDP
Source: Global Financial Stability Report 2012
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
Interest Rates
Our DD-AA model assumed investment expenditure isexogenous.Some parts of investment clearly respond to interest rate
Residential fixed investment
Investment projects funded by saved or borrowed fundsinterest rate represents the (real) opportunity cost costA higher interest rate means less investment expenditure.
But see Chetty (2004 REStud)
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
Interest Rates
Other expenditure may depend on the interest rate.A higher interest rate makes saving more attractive andconsumption expenditure (on domestic and foreign products) lessattractive.
But there are conflicting income and substitution effects
And the effect of the interest rate appears to be much larger oninvestment expenditure than it is on consumption expenditure andimports.
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
Interest Rate Sensitive Aggregate Demand
Government purchases are exogenous.Investment is a function of the real interest rate.Current account is a function of the real exchange rate, disposableincome and the real interest rate.Consumption is a functionof disposable income and possibly the realinterest rate.
D = C(Y −T ,R−πe) + I(R−π
e) + G + CA(EP ∗/P,Y −T ,R−πe)
Or more simply:
D = D(EP ∗/P,Y −T ,R−πe,G)
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
Interest Rates
Treat expected inflation as exogenous for nowI = I(R) I’<0R = R* + Ee/E -1I = I(R* + Ee/E -1)
Now up E => down R => up I (extra stimulus)DD flatterAlso: R* and Ee become shift factors for DD curve
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
IS-LM Model
Instead of relating exchange rates and output, the IS-LM relatesinterest rates and output.
In equilibrium, aggregate output = aggregate demand
Y = D(EP ∗/P,Y −T ,R−πe,G)
In equilibrium, interest parity holdsR = R* + (Ee-E)/EE(1+R) = ER* + EeE(1+R- R*) = EeE = Ee/(1+R- R*)
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
IS Curve
Y = D(EeP ∗/P(1 + R−R∗),Y −T ,R−πe,G)
Exogenous: Ee, P∗, P, R∗, T , πe, and G.
Commodity markets are in equilibrium along the IS curve.
combinations of interest rates and output such thataggregate demand equals aggregate output._R � ^I (and possibly C and M) � ^AD -> ^Y.The IS curve slopes down.
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
IS Curve
R
Y
IS
R2
Y1 Y2
R1
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
LM Curve
The money market is in equilibrium along the LM curve.
Ms/P= L(R,Y)combinations of interest rates and output such that themoney market is in equilibrium, given exogenous P and M
The LM curve slopes up.
^Y � ^L � ^R (in equilibrium)
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
IS Curve
R
Y
LM
R1
Y1 Y2
R2
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
Equilibrium in the IS-LM Model
Commodity markets are in equilibrium along the IS curve.Money market is in equilibrium along the LM curve.Both markets are in equilibrium where the two curves intersect.
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
Equilibrium in the IS-LM Model
R
Y
LM
IS
R1
Y1
Commodity and money markets are in equilibrium at Y1, R1Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
Effects of Temporary Changes in the Money Supply
R
Y
LM’
IS
R2
Y2
LM
R1
Y1
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
Effects of Temporary Changes in the Money Supply
R
Y
LM’
IS
Y2
LM
Y1E1E2E
R2
R1
Compare: KOM Figure 17-ISLM01
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
SR Effects of Permanent ^M (IS-LM)
R
Y
LM’
IS|Ee1
R2
Y2
LM
R1
Y1
IS|Ee2
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
SR Effects of Permanent ^M (IS-LM)
R
Y
LM’
IS|E1
Y2
LM
Y1E1E2E
R2
R1
IS|Ee2
Compare: KOM Figure 17-ISLM02
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
Effects of Temporary Changes in Fiscal Policy
Source: KOM Figure 17-ISLM03
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
Effects of Permanent Changes in Fiscal Policy
Source: KOM Figure 17-ISLM04
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
Summary
Aggregate demand (D) responds to disposable income (Y-T) andthe real exchange rate (q=EP*/P).
The AA illustrates asset markets equilibrium: (Y,E) combinationssuch that M/P=L and interest parity holds.
The DD curve illustrates goods market equilibrium: (Y,E)combinations such that D=Y
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
Summary
In the DD-AA model, we assume the Marshall-Lerner condition issatisfied
so a depreciation of the domestic currency improves the currentaccount and increases aggregate demand)in reality we may have a J-curve, where CA initially deterioratesbecause the value effect initially dominates the volume effect.
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
Summary: Temporary Policy Shocks
Temporary ^M � temporary ^Y and temporary ^E
Temporary ^G � temporary ^Y and temporary _E
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
Summary: Permanent Policy Shocks
Permanent ^M � temporary ^Y and temporary overshooting,with permanent ^E
Permanent ^G � no change in Y but permanent _E
Alan G. Isaac Slides for International Finance
Introductory ConceptsShort-Run Model: DD and AA
Liquidity TrapMacro Policy and CA
Summary: IS-LM
The IS-LM model compares interest rates with output.
The IS curve illustrates (Y,R) combinations such that D=Y
The LM curve illustrates (Y,R) combinations such that M/P=L(R,Y)The IS-LM model gives basically the same results
tends to underplay Eecaptures interest rate effects on D, which our model ignored
Alan G. Isaac Slides for International Finance