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XII. Keynesian stabilization in an open economy

XII. Keynesian stabilization in an open economy. XII. 1 Aggregate demand in the short run. Net export and real ExR. In the short-run, export depends on foreign demand and real exchange rate , import depends on domestic AD and real exchange rate

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XII. Keynesian stabilization in an open economy

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  1. XII. Keynesian stabilization in an open economy

  2. XII. 1 Aggregate demand in the short run

  3. Net export and real ExR • In the short-run,export depends on foreign demand and real exchange rate, import depends on domestic AD and real exchange rate • Usual assumption: Marshall-Lerner condition, i.e. net export depends on real exchange rate only (see Krugman, Obstfeld) • Consequently, assume: • The lower the real exchange rate, the less competitive domestic goods and services are, the higher the current account deficit (NX drops) • And vice versa

  4. Aggregate demand and real ExR • Consideringrelation between demand for real output and real ExR, ceteris paribus, i.e. when all other variables (interest, taxes, etc.) unchanged • and standard assumption: economy at the potential output (full employment) equilibrium • AD = C + I + G + NX , but if only Y and real ExR allowed to vary, we might schematically write AD = AD(Y,e)

  5. Output determination in the short run • Short run : prices (and wages) assumed fixed, than real ExR depends of nominal ExR only • Closed economy in the short run: relation between output and interest (ISLM) • Open economy in the short run: relation between output and ExR (interest considered as given) • “ISLM-type” adjustment (see next slide): • Excess demand → inventories↓ → output↑ • Excess supply, vice versa • Combinations of output and ExR, keeping goods market in short run equilibrium: DD curve (see next slide again)

  6. AD E Y DD E2 E1 Y

  7. What shifts DD curve? • In general: any disturbance, raising AD, shifts DD to the right; disturbance, lowering AD, shifts DD to the left • In our framework, following factors might be relevant: • Expenditures G, taxes T, investment I, domestic price P, foreign price P*, changes in autonomous consumption, demand shifts between domestic and foreign goods • Checkyourself

  8. XII.2 Asset market in the short run

  9. Output and ExR on the asset market • Asset market: interest parity condition • Interest rate determined by equilibrium on domestic money market(see LXI): • Short run: expectations, foreign interest rate, price and money supply given • Infinite combinations of output and ExR, keeping asset market in equilibrium: AA curve (see next slide)

  10. E E AA Return on foreign deposits returns Y

  11. What shifts AA curve? • Change in domestic money supply MS • Change in price P • Change in expectations Ee • Change in foreign interest rate r* • Shifts in demand for money function

  12. XII.3 Short run equilibrium in an open economy

  13. Equilibrium and adjustment • Equilibrium both on goods and asset market: intersection of DD and AA curves • Adjustment speed: faster adjustment on assets market than on goods market E DD AA C ● ● B A Y

  14. XII.4 Policies

  15. XII.4.1 Temporary policies • Short term policies, expected to be reversed in the future, i.e. expections remain constant • Prices, wages, expectations fixed • Adjustment obvious – see above what changes DD and AA curves Monetary policy Fiscal policy E DD AA E Y Y

  16. Use (and many warnings) • Both expansionary monetary and fiscal policies • Increase output • Monetary → depreciation, fiscal → appreciation • Application: short term reaction to exogenous shocks • Many pitfalls • Inflation bias • Time lags • Unclear origins of disturbances, etc.

  17. XII.4.2 Permanent policies • Policies that are not reversed → change of expected ExR • Consideringlong term effects – after full adjustment of prices, wages and volumes • Starting point – potential output, natural values, ExR expectation equals actual ExR → domestic interest equals “foreign” interest

  18. Robert Mundell • 1932 – • Stanford University • International institutions (namely IMF) • International economics • Mundell-Fleming model • Nobel price in 1999

  19. Monetary policy • Money supply increase → shift of AA curve, but larger than in case of temporary case • Shift due to MS increase • Shift due Ee increase • Long term adjustment: price increase due to larger money supply(next slide: red color means final positions): • Real appreciation → domestic goods relatively more expensive → fall of foreign demand → shift of DD curve “up and left” • Real money supply falls → AA curve, after an initial shift „up“, shifts “down and left”

  20. DD2 E DD1 E2 2 3 E3 AA2 E1 AA3 1 AA1 Yf Y2 Y

  21. Monetary policy efficiency • Long term adjustment: • Return to potential output • Higher price level • Nominal depreciation • However – in the short term (within a concept of Keynesian policystimulation) monetary policy is efficient • Increase of output and employment • Remember ExR overshooting (see LXI)

  22. Fiscal policy • Permanent fiscal expansion • In reality usuallyaccompanied by permanent tax increase, otherwise unsustainable • Remember: balanced budget multiplier = 1 • Open economy • Short term shift of DD curve “up and right” • Permanent fiscal change → increase of Ee → shift of AA curve “down and left”

  23. E DD1 DD2 1 E1 X AA1 E2 2 AA2 Y Yf

  24. Fiscal policy efficiency • Adjustment on the currency market extremely fast → after initial DD shift, change in expectation moves the AA curve immediately„down“ • There is no increase of output (and employment) even in the short term (economy will never reach point X) • Long term adjustment in closed economy • Return to potential output, government spending crowds-out private investment, inflation • Open economy • Remains at potential output at appreciated currency • Aggregate demand for domestic product crowded-out by demand for foreign products (as they became cheaper) • Fiscal policy inefficient

  25. XII.5 Fixed exchange rate

  26. Notice • When ExR fixed, but market pressures against the fix, then Central Bank must intervene • Pressure towards appreciation → purchase of foreign assets • Pressure towards depreciation → sale of foreign assets • Link between Central Bank intervention and money supply • Purchase of (foreign) assets → increase in money supply • Sale of (foreign) assets → decrease in money supply

  27. Fixing the rate • Commitment of Central Bank to trade domestic currency at given rate • Why fix? • There is no ideal floating in reality • Arrangements for countries in a transitory stage of economies • Lessons from the past • Regional currency areas (e.g. Euro)

  28. Equilibrium under Fix • Fix – expected ExR equals actual one • Interest rate parity implies that domestic interest must equal foreign interest • Implications for domestic money market – e.g. in case of output increase: • Push towards increase of domestic interest rate → push towards appreciation • To keep currency fixed, Central Bank must intervene → purchase of foreign assets → increase of money supply → interest rate and ExR remain at original levels • Under fix – automatic accommodation of monetary policy

  29. E E1 r1 r L(Y1,r) L(Y2,r)

  30. Stabilization policies under fix (1) • Only short term effects, try to derive yourselves diagrammatically • Monetary policies, e.g. increase of money supply by purchasing domestic assets → pressure towards decrease of interest and depreciation (shift in AA) → Central Bank must intervene selling foreign assets → decrease of money supply • No effect on output and employment, but decrease in foreign reserves exactly equal to original purchase of domestic assets

  31. Stabilization policies under fix (2) • Fiscal expansion→ increase of AD, shift of DD → increase of output and pressure towards appreciation, at the same excess demand for money and pressure towards interest increase → Central Bank must intervene, buying foreign assets to increase money supply (and to keep fix) → shift of AA → further increase of output, ExR remains at fix • Fiscal policy has an impact on output (and employment)

  32. Stabilization policies under fix (3) • Changes in ExR, assume that Central Bank is credible, i.e. people accept new expected ExR immediately • Devaluation → increase of exports and AD (why?) → increase of output, excess demand for money, pressure towards interest increase → Central Bank intervention, buying foreign assets → expansion of money supply, shift of AA, new equilibrium

  33. XII.6Conclusions for stabilization policies Theefficiency of fiscal, monetary and trade policydiffersaccording the exchange rate regime • Flexible exchange rate (float) • Fiscal policy very little efficient • Monetary policy very efficient • Fixed exchange rate • Fiscal policy very efficient • Monetary policy very little efficient • Changes in ExR efficient

  34. Literature to Ch. XII • Krugman, Obstfeld, ch.15-17. Basic textand references there. • Dornbush, Fischer, ch. 6. Slightly different way of explanation, but it might seem more comprehensive to some

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