11

Open Economy Macro

2

Agenda for Open Economy Macro

A few slides on the Great Recession in the world economyShort reminder on the international monetary systemShort-run open-economy output determination (Mundell

Fleming model)Some important cases

3

Short run or long run?

(full adjustment of capital,

expectations, etc.)

Classical or non-classical?(sticky wages

and prices, rationalexpectations, etc.)

long-run

short-run

yes

Keynesian model (sticky wages

and prices, upward-sloping

AS

Tree of Macroeconomics

Closed economy

IS-LM, dynamic AS-AD

Open economy

Mundell-Flemingflexible ER;

small open economy and large open

economy)

no

4

The output decline in the Great Recession (industry)

Percent change from prior three months at annual rate

5

The employment drop during the Great Recession

Percent change from prior three months at annual rate

6

The sharp decline in world trade during the Great Recession

(Note that trade change is more than output change.)

Percent change from prior three months at annual rate

7

The growth in the public debt around the world

Debt/GDP ratio (%)

8

The risk premium on corporate securities in the US and Europe

9

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

10

Real exchange rate of $ against broad currency group

70

80

90

100

110

120

130

140

1975 1980 1985 1990 1995 2000 2005 2010

Do

llar

bu

bb

le w

ith

hig

h U

S i

nte

rest

ra

tes

Re

al

exc

ha

ng

e r

ate

ag

ain

st

bro

ad

co

un

try

gro

up

Inte

rne

t b

ub

ble

Flig

ht

to s

afe

ty

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

0%

20%

40%

60%

80%

100%

1960 1970 1980 1990 2000

Shar

e of

wor

ld G

DP b

y floa

ters

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The Mundell-Fleming Model

Mundell-Fleming (MF) model is short run Keynesian model (usually applies to small open economy but we will do large open economy)

Very similar to IS-LM model.It derives impact of policies and shocks in the short run

for an open economy.Usual stuff for domestic sectors:

- Price and wage stickiness, unemployment, no inflation- 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 determined by rd and rw

- Net exports a function of real exchange rate, NX = NX(R)

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Goods marketStart with usual expenditure-output equilibrium condition.New wrinkle is the NX function:

(1) Y = C(Y - T) + I(rd) + G + NX(R)

Financial marketsThen the monetary policy equation.

(2) r = L (Y)Important note: This can be interpreted as LM or as Taylor rule. π = 0

for this discussion.

Balance of PaymentsCapital flows are determined by domestic and foreign interest rates. But have BP balance:

(3) CF(rd, rw) = NX(R)

Substituting (3) into (1), we get equation in Y and rd:(IS ) Y = C(Y - T) + I(rd) + G + CF(rd, rw)

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rdLM

C+I(rd)+G+CF(rd) (IS$)

Y

CF=NX=0

C+I(rd)+G (IS)

Equilibrium

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Two little reminders added after lecture

1. Remember the difference between real investment and financial investment. Real investment (I) goes down as domestic interest rates rise. Financial investment (CF) goes up as domestic interest rates rise because financial investments are attracted from abroad.

2. We and Mankiw define CF as the capital outflow. This is the opposite of the financial account in the balance of payments, so CF = - Financial surplus. This is somewhat confusing, but that’s what he does and we follow that. Remember the picture on the next page.

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Financial capital outflow(CF +)

17

rd

CF (capital outflow) = - Financial surplus

CF(rd, rw)

rd *

CF*

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CF

CF(r)

rd

Y

LM

IS$

Real exchange rate, R

0NX

NX(R)

R*

NX*

r*

0

CF*

Mundell-Fleming for large open economy: the case of the US with a large financial surplus and current account deficit

rd

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Interesting polar case: very open

CF

CF(r)

Y

LM

IS$

Real exchange rate, R

0NX

NX(R)

R*

0

Effects of policy just like small open economy

rd rd

20

Interesting polar case: almost closed

CF

CF(r)

Y

LM

IS$

Real exchange rate, R

0NX

NX(R)

R*

0

Effects of policy just like closed economy

rd rd

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Special Case I. Stimulus plan

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)

22

CF

CF(r)

Y

LM

IS$

Real exchange rate, R

0NX

NX(R)

R*

0

Effect of fiscal stimulus

IS$’

rd rd

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Special Case II. Normal Monetary Expansion

How does openness change the impact of a monetary policy?

Effect is larger because lower i → depreciation → higher NX.- Double barreled effect of monetary policy

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CF

CF(r)

Y

LM

IS$

Real exchange rate, R

0NX

NX(R)

R*

0

Normal monetary expansion

rd rdLM’

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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, cannot repel foreign

investment and depreciate currency.

So open economy does not change the basic liquidity trap dilemma!

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rd

LM

Y

IS$

Equilibrium

LM’

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New Fed policy (QE2)

Use unconventional policies to reduce long-run interest rates:- verbal language that Fed funds rate will be low for long time.- Buy long-term securities (add to excess reserves)

This will lower rd, depreciating dollar.Source of criticism from foreign governments of

“competitive depreciation.” But this is what monetary policy is supposed to do

0

0.5

1

1.5

2

2.5

3

3.5

4

4.5

5

1 mo 3 mo 6 mo 1 yr 2 yr 3 yr 5 yr 7 yr 10 yr 20 yr 30 yr

Yiel

d on

Tre

asur

y se

curi

ties

(%

per

yea

r)

10/29/2010 6/2/2010

1/4/2008

6/2/2010

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Term structure of interest rates

0

0.5

1

1.5

2

2.5

3

3.5

4

4.5

5

1 mo 3 mo 6 mo 1 yr 2 yr 3 yr 5 yr 7 yr 10 yr 20 yr 30 yr

Yiel

d on

Tre

asur

y se

curi

ties

(%

per

yea

r)

10/29/2010 6/2/2010

1/4/2008

6/2/2010

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Other cases

Show that protectionism has no effect on net exports or output.

What about effect of China buying large quantities of US$ securities to appreciate its currency?