LECTURE 6: MACROECONOMIC INTERDEPENDENCE (I) Interdependence: Y depends on Y*.

LECTURE 6: • MACROECONOMIC INTERDEPENDENCE • (I) Interdependence: Y depends on Y*. • (II) The two-country model, to be used for a country big enough to affect world income Y*. • Simultaneous determination of Y & Y*. • Implication of repercussion effects for the multiplier. • (III) International transmission under fixed vs. floating exchange rates • of a disturbance originating domestically. • of a disturbance originating abroad .

Re-endogenizing Exports }=> where I.e., Y depends on Y*. “When the US sneezes, Canada catches cold.” ITF-220 Prof.J.Frankel, HKS

Y depends on Y*. For every $1 of foreign income, how much is spent on our goods? For every $1 of demand for our exports, how much does our income rise? ITF-220 Prof.J.Frankel, HKS

The other equation of the two-country model: Y* depends on Y Instead of deriving the equation for Y* from scratch, use equation for Y, For every $1 of domestic income, how much is spent on foreign goods? and substitute foreign for domestic and domestic for foreign: For every $1 of demand for foreign goods, how much does foreign income rise? ITF-220 Prof.J.Frankel, HKS

FIGURE 17.A.1 2-COUNTRY MODEL Combine two simul-taneous relationships: => equilibrium at B . Fiscal expansion shifts Y to D in small-country Keynesian model (too small to affect Y*), • • • but further, to D´, in large-country model. ITF-220 Prof.J.Frankel, HKS

• In two-country model, multiplier is increased by subtraction from denominator of m*m /(s*+m* ), • • of which m is leakage abroad through imports, m/(s*+m* ) is the multiplier effect of our imports on Y* , and m* [m /(s*+m* )] is the repercussion effect: how much comes back as demand for our goods. ITF-220 Prof.J.Frankel, HKS

BIG-COUNTRY VS. SMALL-COUNTRY MODEL FIGURE 17.5 The same result -- fiscal expansion raises Y to Din small-country Keynesian model, but further, to D´, in large-country model -- can be shown in our traditional graph. • The X-M line is flatter now, because it captures the repercussion effect on TB: Beyond Y↑ => IM↑, also X*↑ =>Y*↑ => X↑ • ● D’’ • ITF-220 Prof.J.Frankel, HKS

Ifbothcountriesexpand: FIG.17.A.1 adverse trend in TB (D´´ lies above TB=0 line, which is deficit territory) can result if either: • is rising faster than , • or m>m*(TB=0 line is flat). But this model may not work in the long run, when growth is supply-driven rather than demand-driven. ITF-220 Prof.J.Frankel, HKS

International Transmission ↓ ↓ Fix Float => depreciation Float Fix => appreciation • • • • • • Floating decreases effect on Y Floating increases effect on Y = “bottling up”of disturbance. = “insulation.”

Conclusions regarding transmission(with no capital mobility) • (i) Trade makes economies interdependent (at a given exchange rate). • TB can act as a safety valve, releasing pressure from expansion: . • Disturbances are transmittedfrom one country to another: . ITF-220 Prof.J.Frankel, HKS

Conclusions regarding transmission(with no capital mobility), continued • (ii) Floating exchange rates work to isolate effects of demand disturbances within the country where they originate: • Effects of a domestic disturbance tendto be “bottled up” within the country. In the extreme, floating reproduces the closed economy multiplier: . . • The floating rate tends to insulate the domestic economy from effects of foreign disturbances. In the extreme, floating reproduces a closed economy: . . ITF-220 Prof.J.Frankel, HKS

End of Lecture 6: International Transmission ITF-220 Prof.J.Frankel, HKS

LECTURE 6: MACROECONOMIC INTERDEPENDENCE (I) Interdependence: Y depends on Y*.