Open economy macroeconomics

1. Open economy macroeconomics • Short-run open-economy output determination (Mundell -Fleming model) • International financial system • The rise, crisis, and (fall?) of the Euro Open Economy Macro

2. Tree of Macroeconomics Classical IS-MP, dynamic AS-AD long- run Closed economy Short run or long run? (full adjustment of capital, expectations, etc.) Keynesian model (sticky wages and prices, upward-sloping AS Classical or non-classical? (sticky wages and prices, rational expectations, etc.) short- run Open economy Non-classical Mundell-Fleming; small open economy and large open economy

3. The output decline in the Great Recession (real GDP) Percent change from prior year Good reading: IMF, World Economic Outlook

4. Unemployment during the Great Recession Percent of labor force

5. The sharp decline in world trade during the Great Recession (Note that trade change is > output change.) Percent change from prior three months at annual rate

6. The growth in the public debt around the world Debt/GDP ratio (%)

7. The risk premium on corporate securities in the US and Europe

8. Housing bubble: The Old and the New world

9. The Mundell-Fleming Model for Open Economy Mundell-Fleming (MF) model is short run Keynesian model for open economy. Hybrid of IS-MP and open-economy classical model. It derives the impacts of policies and shocks in the short run for an open economy. Usual stuff for domestic sectors: • Price and wage stickiness, unemployment • Standard determinants for domestic industries (C, I, G, financial markets, etc.) Open economy aspects: • Small open economy would have rd = rw • Large open economy financial flows (CF) determined by rd and rw • Net exports a function of real exchange rate, NX = NX(R) • We consider primarily a flexible exchange rate.

10. Goods market Start with usual expenditure-output equilibrium condition. New wrinkle is the NX function: (Exp) Y = C(Y - T) + I(rd) + G + NX(R) Financial markets Then the monetary policy equation. (MP$) r = L (Y) Mankiw has LM, but there is no difference in the analysis except for monetary policy. Balance of Payments Capital flows are determined by domestic and foreign interest rates. This leads to balance of payments: (BP) CF(rd, rw) = NX(R) Substituting (BP) into (Exp), we get IS$ equation in Y and rd: (IS $) Y = C(Y - T) + I(rd) + G + CF(rd, rw)

11. Reminder on Exchange rates Foreign-exchange rates are the relative prices of different national monies or currencies. Nominal exchange rate = e = foreign currency/$ Real exchange rate (R) R = e × p d / p f = domestic prices/foreign prices in a common currency

12. Real exchange rate of $ relative to major currencies (R) Appreciation Dollar bubble with high interest rates Dot.com stock bubble Flight to $ safety Depreciation

13. CLOSED ECONOMY rd MP C+I(rd)+G (IS) Y CF CF

14. OPEN ECONOMY rd MP$ CF=NX=0 Equilibrium C+I(rd)+G+CF(rd) (IS$) C+I(rd)+G (IS) Y CF CF

15. (IS$) rd MP$ Tiny open economy Closed economy Y CF CF

16. Special Case I. Fiscal Stimulus How does openness change the impact of a stimulus plan? Multiplier is reduced because some of the stimulus spills into imports and stimulates other countries Note that financial crisis and high risk premium is the opposite (IS$ shift to the left)

17. rd Fiscal Expansion MP$ IS$’ IS$ Y CF CF

18. rd Fiscal Expansion MP$ IS’ IS IS$’ IS$ Open economy Y CF Closed economy CF

19. Special Case II. Normal Monetary Expansion How does openness change the impact of a monetary policy? Double barreled effect of monetary policy • Lower r → higher I (domestic investment) • Lower r → higher CF → depreciates exchange rate (R) → raises NX (foreign investment)

20. rd Monetary Expansion MP$ MP$’ IS$ Y CF CF

21. rd Monetary Expansion MP$ MP$’ IS$ IS Open economy Y CF Closed economy CF

22. Special Case III What about a liquidity trap? Note that monetary policy cannot work on either of the two mechanisms in a liquidity trap. • Interest rates stuck and cannot stimulate domestic investment. • With no change in interest rates, no change in CF (financial flows), no change exchange rate, no change NX So open economy does not change the basic liquidity trap dilemma! - Fiscal policy super-effective - Monetary policy super-ineffective

23. rd Monetary Expansion in Liquidity Trap IS$ MP$’ MP$ Equilibrium Y CF CF

24. rd You do fiscal expansion IS$ MP$ Equilibrium Y CF CF

25. The International Monetary System

26. What is the international monetary system? International monetary system denotes the institutions under which payments are made for transactions that cross national boundaries and are made in different currencies. In particular, the international monetary system determines how foreign exchange rates are set and how governments can affect exchange rates.

27. Exchange rate regimes I. . Fixed exchange rate A. Currency union: currencies irrevocably fixed - US states (1789 - ) - Eurozone (2001- ?) B. Other fixed exchange rate regimes: • Gold standard (1717 - 1933) • Bretton Woods (1945 - 1971) • Hard and soft fixed rates of different varieties (China) II. Flexible exchange rates (US, Eurozone, UK pound, BOJ) • Currencies are market determined • Governments use monetary policies to affect exchange rates

28. What are desirable characteristics of an international financial system? • Stability of exchange rates to lower risk and promote trade and capital flows. • Openness of financial markets to promote efficient allocation and diffusion of best-practice technologies • Adjustment to macroeconomic shocks through monetary policy But we will see that these three goals are not compatible in the “fundamental trilemma”

29. Evolution of Exchange Rate Regimes (% of countries) The Evolution of Exchange Rate Systems: # countries

30. The share of floating has increased sharply (% of world GDP)