xii. keynesian stabilization in an open economy
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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 - PowerPoint PPT PresentationTRANSCRIPT
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
• 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
0NX , eNXNX e
Aggregate demand and real ExR
• Considering relation 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)
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)
AD
Y
45o
1EAD
AD E2
ondepreciati - EE 12
1Y 2Y
Y
E
1Y 2Y
E1
E2
DD
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
– Check yourself
XII.2 Asset market in the short run
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)
r r* Ee -E E
rY,LPMS
E
P
M
returns
Return on foreign deposits
P
MS
1r
r),L(Y1
1E
r),L(Y2
2r
2E
12 YY
E
Y2Y1Y
1E
2E
AA
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
XII.3 Short run equilibrium in an open economy
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
Y
DDAA
A
●C
●B
XII.4 Policies
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
Y
DD
1AA
2AA
Y
E AA1DD
2DD
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.
XII.4.2 Permanent policies
• Policies that are not reversed → change of expected ExR
• Considering long 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
Robert Mundell
• 1932 –• Stanford University• International
institutions (namely IMF)
• International economics
• Mundell-Fleming model
• Nobel price in 1999
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”
E
Y
AA1
DD1
Yf
E1
AA2
Y2
E2
DD2
AA3
E3
1
23
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 policy stimulation) monetary policy is efficient– Increase of output and employment
• Remember ExR overshooting (see LXI)
Fiscal policy
• Permanent fiscal expansion– In reality usually accompanied 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”
E
Y
DD1
AA1
Yf
E1
DD2
AA2
1
X
2E2
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
XII.5 Fixed exchange rate
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
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)
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
P
M
r
E
EE-Er e*
L(Y1,r)
P
M1
r1
E1
L(Y2,r)
P
M2
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
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)
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
XII.6 Conclusions for stabilization policies
The efficiency of fiscal, monetary and trade policy differs according 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
Literature to Ch. XII
• Krugman, Obstfeld, ch.15-17. Basic text and references there.
• Dornbush, Fischer, ch. 6. Slightly different way of explanation, but it might seem more comprehensive to some