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Macroeconomics

Macroeconomics. Short Run Open Economy Macroeconomics. Principles of Macroeconomics by N. Gregory Mankiw Large Open Economy IS-LM Model. Instructor: Prof. John M. Veitch. Interest Rate Differentials. Assumed for small open economy that r = r * …but not always true because:

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Macroeconomics

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  1. Macroeconomics Short Run Open Economy Macroeconomics

  2. Principles of Macroeconomicsby N. Gregory MankiwLarge Open Economy IS-LM Model Instructor: Prof. John M. Veitch

  3. Interest Rate Differentials • Assumed for small open economy that r = r*…but not always true because: • Country Risk leads investors to demand risk premium. • Expected Changes in EXR lead investors to demand premium (or discount) to compensate for change. • Assume r = r* + q, where q = Country premium determined exogenously by investor perceptions. • Small Open Economy IS-LM Model given by: (IS) Y = C(Y-T) + I(r* + q) + G + NX(e) (LM) M/P = L(r* + q, Y)

  4. 1. Increase in Country Risk - increases risk premium . LM*2 - higher domestic interest rate. 2. I falls, shifts IS Curve inward. 2. 3. 3. Money Demand decreases. - shifts LM Curve outwards. 4. Results: - EXR depreciates. - Real GDP rises. 4. e2 IS*2 Y2 Increase in the Risk Premium LM*1 Exchange Rate e1 IS*1 Y1 Income, Output

  5. Int’l IS-LM and AD Curve • Look at Price Changes in Open Economy IS-LM. • Recall NX depends on e = e(P/P*), so IS-LM is: (IS) Y = C(Y-T) + I(r*) + G + NX(e) (LM) M/P = L(r*, Y) • Assume Domestic Price Level rises; • Real Money supply falls, shifts LM inwards. • Real exchange rate rises, NX falls, lower Real GDP. • This is the AD Curve for small open economy. • Any other variables that shift IS or LM will shift AD Curve correspondingly.

  6. LM*(M/P2) e2 3. 2. Y2 4. P2 1. AD(G,T,M,r*) Y2 Open Economy AD Curve e LM*(M/P1) Begin at Price Level P1 with IS1 and LM*1. 1. Increase Price level to P2. - LM* shifts to LM*2. 2. Increases exchange rate, e2. 3. Lower level of real GDP, Y2, at higher Price level P2. 4. AD Curve summarizes relationship of P and Y. Anything that shifts IS or LM Curve (with Price level fixed) will shift AD Curve. e1 IS1 Y Price Y1 Level P P1 Y1 Y

  7. 2. YSR < YLR so Unemployed resources lead to fall in input prices. 3. SRAS shifts down, Price level falls, LM* shifts out as M/P increases. 4. New LR equilibrium at YLR, lower Price level P2 and exchange rate, e2. LM*2 3. 2. P2 4. e2 SRAS2 4. YLR IS-LM & AD Curve in SR & LR 1. Begin below LR equilibrium at point 1 as result of shock to economy. LRAS LM*1 AD* e P SRAS1 P1 eSR 1. 1. IS* YSR YLR YSR Y Y

  8. Principles of Macroeconomicsby N. Gregory MankiwChapter 11 Appendix: Large Open Economy in the Short Run Instructor: Prof. John M. Veitch

  9. Large Open Economy Solution • Large open economy sets own interest rate. • IS-LM Model with Price Levels fixed • (IS) Y = C(Y-T) + I(r) + G + NX(e) • (LM) M/P = L(r,Y) • Solve for equilibrium levels of r1 and Y1. • Net Foreign Investment • Solve for NFI(r1) at Domestic real interest rate. • Market for Foreign Exchange • Take NFI(r1) as “Supply” of domestic currency. • Draw NX(e) as “Demand” for domestic currency. • Find exchange rate, e0, where NFI(r0) =NX(e0).

  10. Large Open Economy IS-LM • Combine 3 equations of Large Open Economy into 2 equations for IS-LM. • Modified IS-LM Model • substitute Currency Mkt Equilib. (NX = NFI) into IS. • (IS*) Y = C(Y-T) + I(r) + G + NFI(r) • (LM) M/P = L(r,Y) • Solve for equilibrium levels of r1 and Y1. • Adding NFI(r) makes Large Open Economy IS Curve flatter than Closed Economy IS Curve. • Flatter is NFI(r) Curve, flatter is the IS* Curve.

  11. IS-LM for Large Open Economy Real LM Interest Rate r r1 IS* Y1 Income, Output

  12. Net Foreign Investment Real Interest Rate NFI 0 NFI NFI negative NFI positive

  13. Market for Foreign Exchange • Market for foreign currency exchange. • “Supply” of Dollars: Net Foreign Investment, NFI(r1). • “Demand” for Dollars: Net Exports, NX(e). • Higher real exchange rate reduces Net Exports. • Equilibrium: NFI(r1) = NX(e) • determines the real exchange rate and the quantity of dollars exchanged for foreign currency. • NFI determined by IS-LM diagram but determines “Supply” in Market for Foreign Exchange.

  14. Market for Foreign Exchange NFI(r1) Exchange Rate (Supply of $) e1 NX(e) (Demand for $) $1 # of $ Exchanged

  15. r1 Y1 NFI(r1) e1 Net Foreign Investment r LM r NFI IS* Income, Ouput NFI IS-LM Diagram Exchange Rate NX(e) Large Open Economy # of $ Market for Foreign Exchange

  16. Fiscal Policy • Effects of Expansionary Fiscal Policy in Large Open Economy. • Increase in Gov’t Purchases shifts IS* outwards. • Results: • Output and Real Interest Rate Increase. • Lowers Domestic Investment and NFI. • Fall in NFI reduces Supply of Foreign Exchange. • Real Exchange Rate Appreciates. • Gov’t fiscal policies thus affect output, domestic real interest rate, investment, and exchange rate.

  17. r2 2. IS*2 1. DG Y2 NFI2 3. e2 4. Net Foreign Investment r r LM r1 NFI IS*1 Y1 Y NFI IS-LM Diagram NFI1 Exchange Rate NX Fiscal Policy: Increase in G e1 # of $ Market for Foreign Exchange

  18. Monetary Policy • Effects of Expansionary Monetary policy in a Large Open Economy. • Increase in Nominal Ms shifts LM Curve outwards. • Results: • Real Interest Rate falls, Output and NFI increase. • Increase in NFI increases Supply of Foreign Currency • Exchange rate depreciates, Net Exports increase. • Monetary policy affects Output, domestic real interest rate, NFI, Net Exports, and exchange rate.

  19. LM2 1. DM 2. r2 Y2 NFI2 3. 4. e2 Net Foreign Investment r LM1 r r1 NFI IS* Y Y1 NFI IS-LM Diagram NFI1 Exchange Rate NX Monetary Policy: e1 Increase MS # of $ Market for Foreign Exchange

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