eco 209y macroeconomic theory and policy 14 - eco... · 2015. 3. 31. · but the bank of canada...
TRANSCRIPT
© Gustavo Indart Slide 1
ECO 209YMacroeconomic
Theory and Policy
Lecture 14:The AS and AD in an
Open Economy
© Gustavo Indart Slide 2
Trade Balance and the Price Level In a closed economy, an increase in the price level (P) reduces
the real supply of money (M/P) In the IS-LM model, the increase in P only affects the
position of the LM curve
In an open economy, the increase in P not only affects the real supply of money (M/P) but also the real exchange rate (ePf/P) In the IS-LM model, the increase in P affects the position
of both the LM and the IS curves
Recall the expression for the IS curve: i = AE/b − (1/bαAE)Y, where
AE = C + cTR − cT + I + G + X – Q + (x + s) (ePf/P)
© Gustavo Indart Slide 3
The Effect of an Increase in P on the IS and LM Curves
IS: i = AE/b − (1/bαAE) YLM: i = − (M/P)/h + (k/h) Y
i
Y
IS
IS’
LM
LM’
Y1Y2Y3
In a closed economy, the real money supply would decrease and Y would fall to Y2.
In an open economy, the real exchange rate would also decrease and Y would fall further to Y3.
© Gustavo Indart Slide 4
The Effect of an Increase in P on Exports and Imports
X = X + x(ePf/P) Q = Q − s(ePf/P) + mY
XQ
Y
X
X’
Q
Q’
Y1
Initially, NX = 0 at Y = Y1.
The increase in P causes exports to decrease and imports to increase. Therefore, now NX < 0 at Y = Y1.
Therefore, there is a deterioration in the current account and now NX = 0 at Y = Y2.
Y2
© Gustavo Indart Slide 5
Fixed Exchange Rate and No Capital Mobility In the absence of capital mobility, the balance of
payments (BP) is equal to the balance in the current account (NX)
Under fixed exchange rates, the external sector doesn’t need to be in equilibrium in the short run (i.e., BP ≠ 0) But the Bank of Canada will have to buy or sell foreign
currency to keep the exchange rate unchanged
However, the external sector could also be in equilibrium, and thus NX = 0
What we will do now is to derive a relationship between P and Y for which NX = 0
© Gustavo Indart Slide 6
The Relationship between P and Y when NX = 0
XQ
Y
X(P1)
X(P2)
Q(P1)
Q(P2)
Y1 YY2
P
Y1
P1
Y2
P2
NX
We will assume that the NX curve is steeper than the AD curve.
P2 > P1
© Gustavo Indart Slide 7
Point Off the NX Curve
XQ
Y
X(P1)
X(P2)
Q(P1)
Q(P2)
Y1 YY2
P
Y1
P1
Y2
P2
NX
A
AB
B
C
C1
C2
Trade Surplus
D
D1
D2Trade Deficit
© Gustavo Indart Slide 8
The AS-AD-NX DiagramP
YY1 Y*
AD
AS
NX
The economy could be in equilibrium without achieving internal balance.
Under fixed exchange rates, the economy could be in equilibrium without achieving external balance either.
Trade Surplus
P1
© Gustavo Indart Slide 9
Policy Options to Achieve Internal and External Balance
P
YY*
AD
AS
NX
Suppose that the economy is initially in a situation of internal balance, but with a deficit in the external sector.
What can the government do to move the economy to a situation of both internal and external balance?
Trade Deficit
P1
We will look at two possible policy options the government could follow to move the economy to a situation of both internal and external balance.
© Gustavo Indart Slide 10
Option 1: Classical Adjustment Process
P
YY2 Y*
AD0’
AS2
NX
One option would be to do nothing and let the market achieve both internal and external balance.
Under fixed exchange rates, the Bank of Canada must sell foreign currency to eliminate the deficit in the external sector. Therefore, the money supply decreases and the AD curve shifts down.P1
The decrease in the price level causes the AS curve to shift down the following period.P0’
AD1
AS0’
AD2
P2
Y1
AD0
AS0
P0
AS: P = P-1 [1 + λ(Y – Y*)]
A trade deficit arises again and the Bank of Canada sells foreign currency. The money supply decreases and the AD curve shifts down once again.
This approach is called Internal Devaluation.
© Gustavo Indart Slide 11
Option 2: DevaluationP
YY1 Y*
AD
AS
NX
Another policy option is to devalue the Canadian dollar to improve the balance of payment at each level of income.
A devaluation of the currency (i.e., a revaluation of the exchange rate) will shift the NX curve up.Trade Deficit
P1
NX’Let’s look at the impact of a devaluation on NX.
© Gustavo Indart Slide 12
The Impact of a Devaluation on Net Exports
XQ
Y
X(P1, e1)
X(P1, e2)
Q(P1, e1)
Q(P1, e2)
Y1 YY*
P
Y1
P1
Y*
NX(e1)
When e = e1 and P = P1, NX = 0 at Y = Y1.
B
A A B
NX(e2)
When e = e2 and P = P1, NX = 0 at Y = Y*.
A devaluation of the Canadian dollar (e2 > e1) increases X and decreases Q at all levels of P, including P1.
© Gustavo Indart Slide 13
Option 2: Devaluation and Contractionary Policy
P
YY*
NX
The devaluation of the domestic currency (i.e., revaluation of the exchange rate) shifts the NX curve to the right.
In turn, the increase in NX causes the AD curve to shift to the right.
P1
To maintain internal balance, the government must implement contractionary fiscal or monetary policy at the same time that the Bank of Canada devalues the currency.
AD’
Y1
AD
AS
NX’
© Gustavo Indart Slide 14
Trade Surplus – China Classical Adjustment Process
P
YY2Y*
AS2
NX
P1
The increase in the price level causes the AS curve to shift up until external balance is achieved.
P0’
AD1
AS0’
AD2
P2
Y1
AD0
AS0
P0
AS: P = P-1 [1 + λ(Y – Y*)]
●
AD0’
Trade Surplus
© Gustavo Indart Slide 15
Trade Surplus – China Revaluation
P
YY0Y*
AD
AS
NX
A revaluation of the currency (i.e., a devaluation of the exchange rate) will shift the NX curve down.Trade Surplus
P1
NX’
AS: P = P-1 [1 + λ(Y – Y*)]
To maintain internal balance, the government must implement expansionary fiscal or monetary policy at the same time that the central bank revalues the currency.
AD’
© Gustavo Indart Slide 16
Expansionary Fiscal Policy with Fixed Exchange Rates and Perfect Capital Mobility
Pi
Y
AS0
BP
LM’(P0)
IS(P0)
LM(P0)
IS’(P0)
i*
Y* Y*
BA
A
Y
AD’
AD
Y0 Y0Y1Y1
P1
P0
C
CLM’(P1)
IS’(P1)
AS2
P2
D
D
Y2Y2
AS0’= LM’(P0’)
= IS’(P0’)
B
E
E
P0’LM’(P2)
IS’(P2)
Under fixed exchange rates and perfect capital mobility, fiscal policy is effective with respect to income in the short-run.AS: P = P-1 [1 + λ(Y – Y*)]
© Gustavo Indart Slide 17
Expansionary Monetary Policy with Fixed Exchange Rates and Perfect Capital Mobility
Pi
Y
AS0
BP
LM’(P0)
IS(P0)
LM(P0)
i*
Y* Y*
A
A
Y
AD
P0
Under fixed exchange rates and perfect capital mobility, monetary policy is completely ineffective with respect to income.
© Gustavo Indart Slide 18
Expansionary Fiscal Policy with Flexible Exchange Rates and Perfect Capital Mobility
Pi
Y
AS0
BP
IS’(P0)
IS(P0)
LM(P0)
i*
Y* Y*
A
A
Y
AD
P0
Under flexible exchange rates and perfect capital mobility, fiscal policy is completely ineffective with respect to income: the increase in G completely crowds-out NX.
© Gustavo Indart Slide 19
Expansionary Monetary Policy with Flexible Exchange Rates and Perfect Capital Mobility
Pi
Y
AS0
BP
LM’(P0)
IS(P0)
LM(P0)
IS’(P0)
i*
Y* Y*
BA
A
Y
AD’
AD
Y0 Y0Y1Y1
P1
P0
C
CLM’(P1)
IS’(P1)
AS2
P2
D
D
Y2Y2
AS0’= LM’(P0’)
= IS’(P0’)
B
E
E
P0’LM’(P2)
IS’(P2)
Under flexible exchange rates and perfect capital mobility, monetary policy is effective with respect to income in the short-run.AS: P = P-1 [1 + λ(Y – Y*)]