OPEN ECONOMY MACROECONOMICS Week 9: Lecture-2 Mr. Rup Singh School of Economics

1. OPEN ECONOMY MACROECONOMICS Week 9: Lecture-2 Mr. Rup Singh School of Economics The University of the South Pacific Suva (Fiji) Lecture 1

2. Objectives: • Extend the closed economy IS-LM model to include the external sector. • Evaluate the relevance of fiscal and monetary policies at the disposal of policy makers. • Analyze how the domestic economy performs, given the international macroeconomic conditions. • Carry out quantitative analysis of various polices/shocks to the economy vis-a-vis the extended IS-LM model.

3. The international conditions sometimes give us (domestic economy) opportunities and sometimes, pose threats to us also. • Therefore, the more an economy is integrated into the global village (through globalisation), the more severe these impacts will be. [Being totally closed is not a viable option for various reasons] • Growing international interdependence implies booms and recessions in one country spills over to other country.[When America sneezes, the world catches cold!]

4. Economies are linked through trade flows and changes in interest (exchange) rate. [The first affects trade accounts and external debt and the second affects capital account flows.] • For example, the Asian Crisis of 1997-99 was limited to few countries initially but spread to other countries, affecting global economic growth. We call this “The Contagion effect” • In this chapter (11-12), basic facts (empirical evidence) and models of international economic linkages are introduced and discussed.

5. We will look at the implications of different international macroeconomic conditions on our economic fundamentals. • You should read the text: Donbusch et al. (chap. 11-12) and also read the revised edition (by the same authors) from the reserve section of the library. (see chap.13-15). • There are 4 copies. • You should analyse various discussions/arguments presented on these chapters, as my presentation will be largely based on them.

6. A word of advise: • There is no substitute for lectures, so attendance in lectures will pay dividends in exams, starting from the third test coming next week. • If you have been missing lectures, (cut it out and) attend any session (consistently) if something’s discomforting you. You must attempt the set tut. exercises assigned to you, each week.

7. Coming back to business: • When we think of open economy the first set of questions we ask: How a country with a fixed exchange rate adjusts to balance of payments problems (e.g., persistent deficit in the trade/overall balance; loss of reserves; rising level of debt; pressure on the exchange rate)? • [Note that all the major countries have switched to the floating exchange rate system after 1973 (when the US de-linked the dollar from gold), but many countries, most of them small open economies, continue to maintain a fixed exchange rate system.]

8. Solving the balance of payments problems generally means getting out of a deficit situation, in the trade account, the current account, the balance of payments account, or in all three accounts simultaneously. • Balance of payments problems are solved through automatic adjustment mechanisms or through changes in economic policy. • Let us see what policy options are there, available to policy makers

9. But, first of all let’s discuss what is Exchange Rate - the first link to the ROW. Exchange rate is the price one country’s currency expressed in terms of some other country’s currency. E.g, if we we relate FJD to the USD as “how much it takes to get 1 USD, in terms of FJD,” the exchange rate is: $2.2FJ:$1US This gives the definition of the nominal exchange rate that we will be using now onwards: E = FJ/USD It tell us that the price of 1USD = $2.2FJ.

10. Fiji’s, currency is tied down to our trading partners’ currencies (Aust, NZ, Euro, Japan, and USA). Our exchange rate is close to fixed, but we operate under the so called a Pegged Exchange Rate system. Now, given the definition of the nominal exchange rate, we can define the real exchange rate. Like any other variable, Real = Nominal /Prices Therefore the real Exchange rate is Nominal exchange rate adjusted for relative prices (or inflation differentials).

11. We denote θ as the real exchange rate θ = [F/USD]/[Pd/Pf] θ = E /Pd/Pf θ = E*Pf/Pd Note: If θ [for e.g. if Pd increases] -appreciation of the FJD – loss in international competitiveness θ = Depreciation of FJD – gain in the international competitiveness [ for e.g. if pf increases]

12. Then we need to know what is BOP. BOP is external equilibrium. It shows whether we have gained or lost from our net exports of goods and services (current account) and whether we are net exporters of importers of investment funds (capital account). BOP = CA + KA If we have current account surplus as well as capital account surplus, we will have BOP Surplus. [if CA is in surplus, but KA is in deficit, (or other combinations), BOP depends on the relative magnitudes of surplus or deficit]

13. Under fixed exchange rate system, a BOP surplus meansaccumulation of foreign exchange reserves. On the other hand, a BOP deficit implies a decline in foreign exchange reserves or de-accumulation of forex. reserves. Note the change in the foreign reserves is the basis for market intervention by the C/Bank under the fixed exchange rate system. Money supply becomes endogenous in the model. It is no longer under the full control of the C/B.

14. Capital flow - movement of international speculative investment. One of the determinants of capital flows is the Interest rate. If interest rate is higher in Fiji, more capital inflow into the economy and v-v – in search for higher RR. Investors look at the differences in returns to investment, which is called the Interest Rate Differentials. If there are interest differential which favors us (i > if), capital will inflow into Fiji. If interest rate differentials do not favor us, investors will hesitantly invest here, and we say there is imperfect capital mobility.

15. Other factors that determine capital mobility are: • Substitutability of investments • Tax structure • Capital controls • Political/macroeconomic conditions (in search of safe heavens)

16. In special cases, there are no difference between the interest offered here and that abroad. In other words, there are no interests rate differentials between the two economies. We call this situation, “perfect capital mobility” - a scenario where our economy is as competitive as any one else’s. (i = if) So investors are indifferent whether they invest here or anywhere around the globe. Capital flows without hesitation - Perfect Capital Mobility

17. So given these briefings, we can extend our simple IS-LM model to IS-LM-BP model. The following slides define the three markets - goods, money and forex markets, from where we derive the IS, LM and the BP equations. In our analysis of IS-LM-BP Model we will discuss the Mundell-Fleming Model as we proceed. Mundell and Fleming is an interesting extension to the IS-LM-BP Model, which assumes perfect capital mobility

18. Outline of the following discussions • Part 1: • Extension of the IS-LM Model, exposition and explanation of the IS-LM-BP model • Part 2: Fixed Exchange Rate • 1. Fixed Exchange Rate Regime with (1) Imperfect Capital Mobility • Fiscal Policy • Monetary Policy • Exchange Rate Policy (devaluation)

19. Part 3: • Fixed Exchange Rate Regime with(2) Perfect Capital Mobility • Fiscal Policy • Monetary Policy • External shock (increase in foreign interest rate) • Part 4: Flexible Exchange rate • Flexible Exchange Rate Regime with (1) Imperfect Capital Mobility • Fiscal Policy • Monetary Policy • External shock (Increase in foreign income)

20. Part 5: Flexible Exchange Rate Regime with (2) Perfect Capital Mobility • Fiscal Policy • Monetary Policy • Conclusion on policy options • Part 6:Other policy options to cure persistent BOP problems • The J-Curve effect (A J-curve for Fiji using recent time series data) • IMF and its role to solve BOP crisis – monetary approach to BOP.

21. Open Economy IS-LM Analysis IS-LM and BP Models

22. GOODS MARKET • C = C0 + cYD • YD = Y- T +TR • T = T0 + tY • I = I0 - bi • G = G0, TR = TR0 • X= X0 + λθ + γYf • M = M0 + mY – ψθ • Y = C + I + G + NX • FOREIGN EXCHANGE MARKET • NX = NX0 – mY + vθ + γYf • CF = CF0 + f(i-if) • NX + CF = ΔRES/P MONEY MARKET L = kY- hi Ms/P = M0 /P +ΔRES/P L = Ms/P

23. GOODS MARKET • X= X0 + λθ + γYf • Exports are determined by foreign income (demand for export) and real exchange rate. If θreal exports will increase as increase in θ implies a depreciation of the domestic currency. Cheaper domestic currency will make it easier for foreigners to purchase our goods. • IM = IM0 + mY – ψθ • Along similar lines of argument, θ will lower imports into the country. We will find it difficult to purchase outside goods/services once exchange rate appreciates. Imports also depend on domestic income.

24. MONEY MARKET Ms = M0/P +ΔRES/P The supply of money is determined in part by the C/Bank and partly by the BOP situation. If BOP is in deficit, we say that the C/Bank de-accumulates the foreign exch. reserves, thus MS will fall, and v-v. The money supply is no longer exogenous ( but it is endogenous) and is not under the full control of the C/Bank.

25. FOREIGN EXCHANGE MARKET • NX = NX0 – mY + vθ + γYf • CF = CF0 + f(i-if) • ΔRES/P = NX + CF • The above explains the external equilibrium. BOP is the sum of current account and capital account. Current account is the net trade of goods and services (NX). Technically, NX is X-IM. • Capital flows are of two types. Foreign direct investments (exogenous) and speculative investments - determined by interest rate differentials. The f measures how responsive is the capital flows to interest rate differentials. If f is large, a slight change in interest rate differential will cause massive capital flows, and v-v. So f measures the degree of capital mobility. • If f is large and (i-if) is small (say = 0), perfect capital mobility is implied. • If f is very small, no matter how large is (i-if), imperfect capital mobility is implied.

26. GOODS MARKET • C = C0 + cYD • YD = Y- T +TR • T = T0 + tY • I = I0 - bi • G = G0, TR = TR0 • X= X0 + λθ + γYf • M = M0 + mY – ψθ • Y = C + I + G + NX • FOREIGN EXCHANGE MARKET • NX = NX0 – mY + vθ + γYf • CF = CF0 + f(i-if) • ΔRES/P = NX + CF • Solving for the Y in each of these markets will give us the IS, LM and BP equations. MONEY MARKET Ms/P = M0/P +ΔRES/P L = kY- hi

27. Graphical re-presentation of three equations • Y0 Y • IS = -αG/b < 0, negative slope • LM = k/h > 0, positive slope • BP = m/f > 0, positive, but less then h/k. LM is more stepper than BP (u find out why!). LM (M0, P, ΔRES) i BP (NX0, CF0, θ, if, Yf ) i0 IS (C0, TR0, T0, I0, G0, X0, Imo, θ, Yf )

28. Only under the fixed exchange rate system, there is accumulation or de-accumulation of foreign exchange reserve, which changes Money Supply (Ms), LM curve shifts to restore final equilibrium. Money supply becomes endogenous – is not under full control of the Central bank. It is made up of domestic base money supply + foreign exchange reserves (BOP surplus) . Thus C/Bank cannot carry out independent monetary policy under fixed exchange rate.

29. End of Lecture 12.1