The Open Economy IS-LM Model

1. The Open Economy IS-LM Model The Mundell-Fleming Model

2. Learning Objectives • Understand how what BOP equilibrium is and how it is represented by BP curve • Understand how internal (IS-LM) and external equilibria interact to produce an unique over equilibrium • Understand how the fiscal and monetary policy are affected by the exchange rate regime • Understand how fiscal and monetary policy are affected by the SOE\LOE assumption • Apply it to some real world cases

3. Comment on Mankiw’s Presentation • Mankiw covers this in chapter 13 • Different diagrams (more confusing) • I prefer my way which I think is clearer • You can use whichever appeals to you • If you use mine, Mankiw’s text is still relevant

4. Revision of some basics • BOP • Exchange rates • Fixed vs floating • Real vs nominal • Interest rates and capital flows

5. BOP • Record of a country’s economic transactions with the rest of the world. • Rule: receipt = positive (+) , payment = negative (-) • If receipts > payments = surplus. • If receipts < payments = deficit. • 2 main accounts: current and capital. • Different implications for the economy. The current account directly affects AD • It is possible to have a current a/c deficit as long as there is a capital a/c surplus. Example, USA.

7. Exchange Rate • What is $ price of domestic currency (€)? • Exchange rate: $ price of one € • what we quote in paper • €1=$1.12 • Price of 1$ is 1/1.12=0.89 • e=1.12 • Depreciation of € • Losses value • Fewer $ per euro • Or e falls • This or the reciprocal? • Follow the book • I prefer the other way

8. Fixed vs Floating • In a certain trivial sense the BOP always balances • Supply equals demand • For floating exchange rate this is achieved by the free market • For fixed exchange rates the government makes up the difference • Current account surplus is counteracted by cap deficit and/or changes in reserves • US vsChina • Note a bit inconsistent to have e floating but P fixed • As before our excuse is that’s what happens in reality

9. Fixed Erates • Governments may try to fix the exchange rate (why? See later) • Requires supplying foreign currency to market when there is excess demand • Requires buying foreign currency when there is excess supply • Mechanism by which an currency crisis can occur

10. Real Exchange Rate • Compare price levels of different countries • In a common currency (usually US$) • Related to the concept of purchasing power parity (PPP) • Simple example is the Hamburger index • What is the US$ price of a Big Mac in various countries • What is the effect of an increase in R? • our goods more expensive; their’srelatively cheaper • Expect exports to fall and imports to rise • “loss of competitiveness”

12. What does this tell you? • “competitiveness” • Are one country’s goods cheaper than another’s? • Do for all goods in a basket and calculate the ratio • i.e. CPI or GDP or wages • Look at R for Ireland over time • Level doesn’t tell much • Trend does

14. What causes R to change? • e changes • Prices change i.e. inflation can erode competitiveness • Productivity • These last two factors are “Long Run” and so will be ignored in this model • Thus changes in the nominal exchange rate (e) will change the real exchange rate (R) in proportion • We will just talk of “exchange rate” to mean both • Again note the inconsistent treatment of prices and exchange rates.

15. e affects the IS Curve • NX rises following a depreciation (e down) • Price in $ of goods produced in Ireland falls • Example: furry leprechaun €5 • e=1.12 (the $ price of 1€) • 1€ gets $1.12 • leprechaun costs 5*1.12=$5.6 • Depreciation e=0.5 implies €1 get $0.5 • Cost is 5*0.5= $ 2.5 • Sales rise • Note this leads to a shift in IS curve • Every r is associated with higher Y

16. r IS2 IS1 Y

17. Interest Rates • Interest rates can be used to influence capital flows and therefore defend a currency. • reuro> rusCapital inflow e • reuro< rusCapital outflow  e • Usually used to prevent depreciation of the exchange rate. • Sounds like it might affect the LM curve but we account for it separately

18. Taking Stock • We have from the last section a definition of equilibrium (IS-LM) • We now call this “Internal Equilibrium” • We have dealt with the prelimaries that enable us to talk about BP equilibrium • We need to find the combinations of (r,Y) that lead to BOP equilibrium • external equilibrium

19. External Balance • Define external balance to be where BP=0 • Net flow of currency between countries is zero • Current account could be in deficit if capital account in surplus • Why is this an equlibrium? • Plans consistent • See later how BOP not balanced leads to changes • For now think of exporters and importers plans • Show this on IS-LM framework • (r,Y) that give BP=0 • Assume (for now) that e is fixed • As with any curve we want to know • The slope • What causes it to shift?

20. Start at initial point (A) • assume eqm, BP=0 • Y up, • Imports up (NX falls), • flow out of $ • Or increased supply of € • Either way BP<0 : at B • assume e fixed • To restore equilibrium need to encourage capital inflows (perhaps borrowing) • r up sufficiently to restore equilibrium, • Connect all such points : BP=0 curve

21. BP curve is the locus of External equilibrium i.e. the set of (r,Y) combinations which give BOP=0 r BP=0 C A B Y

22. Shifts in BP=0 • Points above BP=0 represent BP surplus • Think if r increases beyond C • Points below BP=0 represent BP deficit • Location of curve depends on e, world income (Y*) and world interest rates (r*) • Change in any will shift BP=0 (see diagram) • r* rises: BP shifts up, need higher r for all Y • Y* rises: BP shifts right, NX rises, Y rises for all r • e falls: depreciation, NX up, for all r Y up, BP shifts right

23. r BP=0 Y

24. Slope of BP=0 • Slope depends on • Marginal propensity to import • Capital mobility • Marginal propensity to import • What portion of every increase in GDP is spent on imports • If high increase in Y leads to a large deficit • need large capital flows to restore equilibrium • Large increase in r • Steep BP curve

25. Capital Mobility • How sensitive are cap flows to interest differentials? • How free is capital to flow? • Flatter BP=0 curve • Special Case : “Small Open Economy” • r=r* • BP=0 flat • Perfect Capital mobility • No influence on world • Note what happens when BP=0 “shifts” if SOE • e.g. changes in r* • Changes in Y*

26. Small Open Economy with Perfect Capital Mobility r BP=0 r* Y

27. PCM & SOE • This is crucial for the effectiveness of policy – as we will see • You need the two assumptions to get the flat curve • PCM implies your interest rate is the worlds • SOE implies what you do has no effect on the world • Think of examples • PCM is relatively recent and was very controversial • Note we also postpone risk until later

28. Overall Equilibrium • We put the three curves together • The intersection is the overall equilibium • Internal balance • External balance • As usual we have to show it is stable (why?) • We already know that internal eqm is stable • So we concentrate on showing how economy adjusts to external disequilibrium

29. Internal and External Balance • IS-LM give eqm in goods and money market • Together they give “internal balance” • Showed it was stable • Add BP to give external balance • Show stable r LM BP=0 IS Y

30. External Imbalance • Need to show that if not in external balance, will go there • A is point of internal balance (what does this mean?) • A is BP<0: deficit • r is too low to attract the capital flows • Plans not consistent • What will happen? • depends on whether e is free to adjust r BP=0 B LM A IS Y

31. LM2 r LM1 B • Assume Fixed e • BP deficit means net outflow of (foreign) currency • Money supply falls • LM curve shifts up • Interest rate rises until sufficient to stem the outflow of funds • New eqm at B • Note Change in money supply is automatic – not policy • Mechanism: CB buys € with $ from reserves BP=0 A Y

32. r IS2 IS1 • Float Exchange rates • BP deficit means net outflow of (foreign) currency • Excess demand for $ and excess supply of € • Price of € falls: e falls • Depreciation • Net exports rise • IS shifts right: for every r now Y up • Also BP shifts down • depr until sufficient to restore balance • New eqm at B BP2 BP1 B A Y • Note difference in behaviour of central bank in both cases • Note different effect on output and interest rates

33. Imbalance with PCM • Perfect Capital Mobility provides an interesting special case • Flat BP=0 curve • Interest rate fixed at world levels • No influence on world • Ireland vs. US • Assume internal equilibrium is BP surplus (point A) • Fixed exchange rates • Inflow of foreign currency • Or domestic interest rate too high • Money supply rises: LM shifts down • Keeps going until r=r* • Forex reserves rise

34. r LM1 A LM2 C r* BP B IS1 IS2 Y

35. Floating exchange rates • Inflow of foreign currency • Excess supply of $ causes their price to fall • Excess demand for € • e rises: appreciation: more $ per € • Exports fall & imports rise • IS shifts left • BP shifts right onto itself • A  B

36. Fixed exchange rates • Inflow of foreign currency • Excess supply of $ has to be soaked up by CB • CB buys $ with € to keep price constant • Money supply up (more € in circulation) • LM curve shifts down • AC • Note: Change in money supply is automatic – not policy

37. Policy In an Open Economy • Can look at Monetary, Fiscal and Exchange Rate Policy • If we think of the purpose of policy is to control Y then we get • The reason is the automatic effects of BP

38. Method • Now we will assume SOE & PCM as it makes things easier • Drop SOE later • To analyse any policy • First look at its effect on internal balance IS-LM • Check what sort of BOP disequilibrium that generates (i.e. we will be off BP curve) • Apply the rules for adjustment to external balance • Remember: These are different depending on exchange rate regime • Apply 1-4 in exam

39. Fiscal Policy with Fixed e • G up: IS shifts to right (why?) • Internal balance at B • At B: BP>0, r>r* (why?) • This BP>0 cannot be equilibrium as plans are changing (whose?) • fixed e: CB must buy excess $ by printing € • this leads to money supply up • LM shifts down • Interest rate falls • Balance restored at C • Note contrast with closed economy • No change in r • Larger change in Y

40. Fiscal policy: Fixed e, SOE r B C r* BP A LM0 IS1 LM1 IS0 Y

41. Monetary Policy with Fixed e • Expand money supply • LM shifts down • Internal balance at B • At B: BP<0, r<r* • Net currency out flow • CB must sell $ for €(why?) • Money supply falls back • LM Shifts up • Return to A • MP is ineffective • Only change is in central banks balance sheet

42. Monetary Policy: Fixed e, SOE r r* BP A B LM0 LM1 IS0 Y

43. Fiscal Policy with Floating e • G up: IS shifts to right • Internal balance at B • BP>0, r>r* • excess supply of $ and/or excess demand for € • Under float e this leads to an appreciation of € • $ price of € rises • Exports fall • IS curve shifts left • Balance restored at A • Note contrast with closed economy and fixed e • No change in r • No change Y • Net exports are crowded out

44. Fiscal policy: Float e, SOE r B r* BP A LM0 IS1 IS0 Y

45. Monetary Policy with Float e • Expand the Money supply • LM shifts down • Internal balance at B • BP<0, r<r* • net outflow of funds • Excess demand for $ (or supply of €) • Price of € falls: e falls; depreciation in the € • Net exports rise • IS curve shifts to the right • Overall Balance at C • Note contrast with closed economy and fixed e • No change in r • Larger change in Y • Net exports are “crowded in”

46. Monetary policy: Float e, SOE r BP A C B LM0 IS1 IS0 LM1 Y

47. Policy In an Open Economy • Can look at Monetary, Fiscal and Exchange Rate Policy • If we think of the purpose of policy is to control Y then we get • The reason is the automatic effects of BP