From the Mundell-Fleming model to the long run.

Assumptions:

• Prices are fixed in the short run, and flexible in the long run

• In the long run, output is equal to its potential (full employment) value, in the short run it adjusts to demand

The aggregate demand schedule

•The aggregate demand schedule consists of real income–price level combinations that achieve equality of real income and aggregate desired expenditures while at the same time maintaining equilibrium in the market for real money balances.

•Consequently, every point along an aggregate demand schedule corresponds to a point of IS–LM-BP equilibrium.

Factors that Determine the Position of the Aggregate Demand Schedule in an Open Economy

• The degree of capital mobility conditions the extent to which monetary and fiscal policy actions can affect equilibrium real income.

• In addition, the real income effects of monetary and fiscal policies depend on whether a nation adopts fixed or floating exchange rates.

• It follows that the extent to which aggregate demand responds to monetary or fiscal policy actions in an open economy depends on the degree of capital mobility and the system of exchange rates that is in place.

Monetary Policy and Aggregate Demand

• Consider a closed economy in which the issues of capital mobility and exchange rate-flexibility are irrelevant.

• In a closed economy, a rise in the nominal money stock causes an increase in aggregate demand, an increase in output and then – an increase in prices

• As prices increase, real interest rate changes crowd out the excess demand, and output returns to its potential level

The Effect of an Increase in the Money Stock on Aggregate Demand in a Closed Economy

Monetary Policy and Aggregate Demand in an Open Economy with a Fixed Exchange Rate

• If central bank foreign exchange interventions to maintain fixed exchange rates are unsterilized, then efforts to expand aggregate demand through increases in the money stock ultimately are ineffective.

• Output, prices and exchange rate remain constant (the only change is the change in foreign reserves of the Central Bank)

The Effect of an Increase in the Money Stock on Aggregate Demand in an Open Economy with a Fixed Exchange Rate

• Note however that Central Banks may choose to vary their exchange rate objectives as a means of bringing about shifts in the aggregate demand schedule.

• How can an exchange rate devaluation influence aggregate demand (under fixed exchange rate regime)?

• To devalue, the central bank would need to expand the money stock. This shifts the LM schedule rightward.

• The increase in the exchange rate would cause the IS and BP schedules to shift to the right.

Monetary Policy and Aggregate Demand in an Open Economy with a Fixed Exchange Rate

Exchange-Rate Policy and Aggregate Demand in an Open Economy

• In the short-run, an exchange-rate devaluation in a system of fixed exchange rates would cause aggregate demand to increase.

• Assuming the same increase in M, the amount of the expansion in aggregate demand would be greater with higher degrees of capital mobility

• However, over the long run, higher aggregate demand implies an increase in the price level and a real appreciation (with fixed exchange rate)

• Output returns to a long run level of output, real exchange rate returns to the old level.

Monetary Policy and Aggregate Demand in an Open Economy with a Floating Exchange Rate

• In a system of floating exchange rates, an expansionary monetary policy action raises aggregate demand over the short run.

• The size of the effect on aggregate demand becomes greater as the degree of capital mobility increases (for a given increase in M).

• Thus, under floating exchange rates, greater capital mobility enhances the potential strength of monetary policy over the short run

• Over the short run, exchange rate depreciates (real and nominal depreciation).

• Over the long run, prices increase, output comes back to its equilibrium value.

• Due to increased prices, the long run value of nominal exchange rate is higher (domestic currency has depreciated; but the real exchange rate has not changed (recall the PPP & classical model)

• Note that this implies that as prices increase, there must be a real appreciation (initially we observe a big depreciation, than the increase in prices implies an appreciation an at the end, the real exchange rate is unchanged)

Monetary Policy and Aggregate Demand in an Open Economy with a Floating Exchange Rate

The Effect of an Increase in the Money Stock on Aggregate Demand in an Open Economy with a Floating Exchange Rate

What factors determine the extent to which changes in the quantity of money can influence aggregate demand in an

open economy?

•Under fixed exchange rates, an unsterilized increase in the quantity of money does not influence aggregate demand.

•Exchange-rate devaluations, in contrast, induce an increase in aggregate demand, and the same effect arises from an increase in the amount of money in circulation under a floating exchange rate.

•Greater capital mobility enhances the amount of the increase in aggregate demand.

Monetary expansion and exchange rates in the long run .

• Over the long run, monetary expansion leads to an increase in prices and a constant output

• Hence, prices will increase and we know from PPP that the nominal exchange rate should depreciate proportionately over the long run. It also depreciates (devalues) over the short run.

• Note that the increase in P decreases the real money supply (and pushes LM back), hence some interesting medium-run dynamics will appear

The Short Run

• The M-F model shows us what happens to interest rate and output in the SR

• Monetary expansion – interest rate goes down.

• Exchange rate depreciates sharply (recall the Dornbush model [DM] – exchange rate overshoots)

• This causes a shift of the IS and BP lines and SR equilibrium in the MF model is reached – higher output

The medium run

• Prices start to increase

• This causes the LM to shift back

• As the interest rate (slightly) increases and ..

• ..over the medium run, according to the [DM] we observe a (relatively small) appreciation, what pushes IS back

• In the LR, we are back to the initial equilibrium point, overall the exchange rate is on a higher level (our currency has depreciated in nominal terms)

m

r

m - p

t t

p s

T t T t

The increase in money supply over the short

and long run

E

Fiscal Policy and Aggregate Demand

• The direct result of a rise in real government expenditures is a rightward shift in the IS schedule.

• The rise in real income causes the demand for real money balances to rise, thereby generating an increase in the equilibrium nominal interest rate. As a result, real investment spending declines, but not sufficiently to prevent a net rise in equilibrium real income.

• Thus, in a closed economy the increase in government spending causes an increase in aggregate demand.

The Effect of An Increase in Government Spending on Aggregate Demand in a Closed Economy

Fiscal Policy and Aggregate Demand in an Open Economy with a Fixed Exchange Rate

• In a system of fixed exchange rates, an expansionary fiscal policy action unambiguously raises aggregate demand.

• The size of the effect on aggregate demand becomes greater as the degree of capital mobility increases.

• Thus, under fixed exchange rates, greater capital mobility enhances the potential strength of fiscal policy in the short-run.

• Over the long run, prices start to rise, leading to real appreciation (recall the classical model!), and output returns to long run value.

• Full crowding out of net exports by fiscal policy changes.

The Effect of an Increase in Government Spending on Aggregate Demand in an Open Economy with a Fixed Exchange Rate

Fiscal Policy and Aggregate Demand in an Open Economy with a Floating Exchange Rate

• Under floating exchange rates, the size of the effect of a given fiscal policy action on aggregate demand declines as the degree of capital mobility increases.

• Under perfect capital mobility, fiscal policy cannot influence the position of the aggregate demand schedule.

Adopting a system of floating exchange rates tends to mute the effects that fiscal policy actions can exert on aggregate demand.

Remember, that as a result of fiscal policy, we observe an exchange rate change over the short run (an appreciation with big and perfect capital mobility).

Over the long run, the increase in prices and real appreciation makes output return to long run value.

The Effect of an Increase in Government Spending on Aggregate Demand in an Open Economy with a Floating Exchange Rate

What factors determine the extent to which fiscal policy actions can influence aggregate demand in an open

economy?

• The key factors influencing the aggregate demand effects of fiscal policy actions are capital mobility and the exchange rate system that is adopted.

Aggregate Supply: Output and Employment Determination

• Changes in the price of an individual good or service typically induce firms to alter the amount of inputs, such as labor, that they use in production and to vary the quantity of the good or service that they produce and offer for sale in the marketplace.

• A long-standing issue, however, is the extent to which changes in the overall price level affect the aggregate levels of employment and output.

• Resolving this issue is crucial to determining whether monetary or fiscal policies can influence aggregate employment and output levels in an open economy.

Aggregate Supply: Output and Employment Determination

• In the short run the factor of production that firms can vary is the quantity of labor that they employ.

• Given a sufficient span of time, labor contracts or other institutional wage arrangements should reflect such factors as the productivity of a nation’s workers, the size of its labor force, and general willingness of workers to supply their skills to firms.

• In a long-run equilibrium, therefore, the nominal wage should adjust equiproportionately to changes in the price level.

• Thus, the long-run aggregate supply schedule for an economy is vertical.

The Short-Run and Long-Run Aggregate Supply Schedules

The Effects of a Policy-Induced Increase in Aggregate Demand

P3

The Output and Price Level Effects of Economic Policies with Floating versus Fixed Exchange Rates

• An expansionary policy action IF it yields an increase in aggregate demand has the following key effects.

It produces inflation, because it pushes up the price level.

In the medium run, both prices and real output increase; total employment increases in conjunction with the rise in real output.

Over the long run, prices rise further and output returns to its long run value.

Economic Policies, Output, and Inflation with Floating versus Fixed Exchange Rates

• Floating rates enhance the potential for monetary policy actions to have significant short-run effects on output. Expansions in the money stock also tend to have more inflationary consequences under floating rates, as compared with expansionary fiscal policy actions.

• Changes in the quantity of money generally have muted effects on aggregate demand and, thus, on real output and the price level, under fixed exchange rates.

• Maintaining fixed exchange rates enhances the potential influence of fiscal policy actions on aggregate demand and, consequently, on equilibrium real output and prices.

Fiscal expansion Monetary expansion

Fixed Floating Fixed Floating

Y (short run)

+ 0 (or close to zero)

0 +

Y (long run) 0 0 0 0

P (long run) + 0 0 +

E nominal 0 Appreciation 0 Big depreciation, then small appreciation

E real Appreciation

Appreciation

0 0

Summary (for big & perfect capital mobility)

Conclusions

• In open economies, the consequences of macroeconomic policies might be different over the short run compared to closed economies (some policies loose the ability to influence output even in the short run)

• Over the long run, in both the closed and the open economies, policies cannot influence output

• In open economies, the economy returns to long run equilibrium also through real exchange rate changes.