Model for Open Economy in Macroeconomics
The openness of the economy has three distinct dimensions:
1. Openness in the goods market: Free trade restrictions include tariffs and quotas.
2. Openness in the financial market: Capital controls place restrictions on the ownership of foreign assets
3. Openness in factor markets: The ability of firms to choose where to locate production, and workers to choose where to work. The EU is the biggest ever common market among sovereign countries, with 27 member states.
We will concentrate on the implications for the control of the macroeconomy of free trade in goods and financial markets.
OPENNESS IN GOODS MARKETS
By this, we mean the exports and imports of goods and services. The rising share of exports and imports in GDP is a sign of openness.
Domestic consumers must decide not only how much to consume and save but also whether to buy domestic or foreign goods. Their decision depends on,
(a) Their level of income, imports are correlated with domestic income and,
(b) It also depends on the price of domestic goods relative to foreign goods, which is known as the real exchange rate.
The nominal exchange rate (E) between the two countries is taken as the price of the domestic currency in terms of the foreign currency (dollars per pound e.g. 1 pound = 1.6 dollars). So, an appreciation of the domestic currency is an increase in the price of the domestic currency in terms of the foreign currency, which corresponds to an increase in the exchange rate (dollar per pound increase from 1 pound = 1.6 dollar to 1.8 dollars)
The real exchange rates (epsilon) are defined as the relative price of domestic goods in terms of foreign goods. So, if P is the price of UK goods in pounds (home country) and P* is the price of European goods in euros (foreign country) then the real exchange rate would be,
Like the nominal exchange rates, an increase in the relative price of domestic goods in terms of foreign goods is called a real appreciation, which corresponds to an increase in the real exchange rate (epsilon).
Bilateral exchange rates are exchange rates between two countries. Multilateral exchange rates are exchange rates between several countries. It is this multilateral exchange rate that we use in this model. Equivalent names for the relative price of foreign goods vis-a-vis UK goods are the real multilateral UK exchange rate, the UK trade-weighted real exchange rate or the UK effective real exchange rate.
OPENNESS IN FINANCIAL MARKETS
The purchase and sale of foreign assets imply buying or selling foreign currency - sometimes called foreign exchange. Openness in financial markets allows the financial investors to diversity, that is, to hold both domestic and foreign assets and speculate on foreign interest rate movements. In this way it allows countries to run a trade surplus and deficits. A country that buys more than it sells must pay for the difference by borrowing from the rest of the world.
BALANCE OF PAYMENTS
Balance of Payments (BOP) = Current Account (CA) + Capital Account + Official Reserves
The balance of payments account summarises a country's transactions with the rest of the world. Transactions above the line are current account transactions. Transactions below the line are capital account transactions. The current account balance and the capital account balance should be equal, but because of data gathering errors, they aren't. For this reason, the account shows a statistical discrepancy.
The current account: The transactions above the line record payments to and from the rest of the world are called current account transactions. The current account records the exports and imports of goods and services.
CA = Trade balance + net investment income + net transfers
The sum of net payments in the current account balance can be positive, in which case the country has a current account surplus, or negative means a current account deficit. For the UK, the trade balance is negative since the UK is a net importer. The investment income is positive since UK residents on net receive on their holdings of foreign assets. The net transfer is negative since the UK is the net giver of foreign aid.
The capital account: Transactions below the line are called capital account transactions.
Capital Account = net decrease in foreign assets
The capital account balance, also known as net capital flows, is positive if foreign holdings of home country assets are greater than home country's holdings of foreign assets, in which case there is a capital account surplus or money is flowing out of the home country (net).
Domestics or Foreign assets: The decision or whether to invest abroad or at home depends not only on today's nominal and real exchange rates but also the interest rate differences and the expectations of what will happen to the nominal exchange rate. The interest parity condition shows the same,
The UIP relation is an arbitrage condition stating that the expected rates of return in terms of domestic currency on domestic and foreign bonds must be equal. The assumptions that financial investors will hold only the bonds with the highest expected rate of return is obviously too strong because (a) It ignores transactions costs (b) It ignores the risk. The relation can be approximated as,
Arbitrage implies that the domestic interest rate must be equal to the foreign interest rate plus the expected depreciation rate of the domestic currency. Later on, we will see that under fixed exchange rates the interest rates of the two countries cannot differ. If the exchange rate is not fixed then they can.
GOODS MARKET IN AN OPEN ECONOMY
Assume prices to be fixed. So, the changes in nominal rates equal the changes in the real rates. The domestic demand for goods in an open economy is given by,
Applying the goods market equilibrium condition, Y=Z we get,
If G increases or T decreases then Y (output) would increase. Now, if Y increases, then IM (imports) would increase, which implies that NX (net exports) would decrease or the net trade balance would deteriorate. This happens because part of domestic demand falls on foreign goods. Therefore, change in Y (multiplier) is smaller than under a closed economy.
If Y* increases (foreign demand), then this would increase Y and also NX. Thus, higher foreign output implies improvements in the trade balance.
If epsilon decreases or the real exchange rates depreciate, then its effect on NX (net exports) and Y (output) is ambiguous. epsilon affects NX through 3 channels:
Channel 1 - epsilon decrement increases X (exports), domestic goods become relatively less expensive abroad.
Channel 2 - epsilon decrement decreases IM (imports), domestic goods become relatively less expensive abroad.
Channel 3 - epsilon decrement decreases IM/epsilon (imports in the home currency), import bill increases.
If 1 and 2 are larger than 3, a real depreciation leads to an improvement in the trade balance. This condition is called as the Marshall-Lerner condition.
A real depreciation leads initially to deterioration, then to an improvement of the trade balance. This dynamic behaviour is called the J-curve dynamics. This happens because quantity adjustment takes some-time. The immediate effect is that of price, so when depreciation occurs, imports become expensive and import bill rises, thereby worsening the trade deficit. Then over time, the quantities of import and export adjust to improve the trade balance.
MONEY MARKET IN AN OPEN ECONOMY
In an open economy, the demand for money is given by M/P = YL(i). The demand for money mostly comes from the domestic residents (so ignore foreigners), but the exchange rate and interest rates are connected through UIP condition. So, a higher domestic interest rate would lead to an increase in E or an appreciation.
EQUILIBRIUM
An increase in interest rate reduces output both directly (downward sloping IS curve) and indirectly (through the exchange rate). Also, given the real money stock, an increase in output increases the interest rate (upward sloping LM curve).
OPEN ECONOMY IN THE IS-LM SHORT RUN
Increases in demand: Suppose we have an increase in government expenditure in an open economy. This would lead to an increase in output and an increased trade deficit.
This increase in domestic demand (Y) has different effects on the open and closed economy. We see that there is an effect on the trade balance. The increase in output from Y to Y' leads to a trade deficit equal to BC. Imports (a function of Y and epsilon) go up and exports (a function of Y* and epsilon) do not change. So, the government spending on output is smaller than it would be in a closed economy. This means the multiplier is smaller in the open economy.
Increases in foreign demand: The direct effect of the increase in foreign output is an increase in the home country's exports. Dometic demand of goods do not change (C+I+G same as before, DD) but demand for domestic goods rise due to a rise in exports (ZZ to ZZ') So, an increase in foreign demand leads to an increase in output and to a trade surplus.
Consider a world of two countries, namely Home and Foreign, The multiplier of Home's fiscal policy would be,
So we see that in an open economy, the fiscal multiplier is lower than in a closed economy, (1/(1-c1)). Also, countries with higher import propensities will have lower fiscal multipliers. This might be because since the import penetrations are high, so the effect of domestic fiscal expansion, which would increase purchasing powers of domestic citizens, would boost imports since they prefer imported goods (since import penetration is high)
1. Openness in the goods market: Free trade restrictions include tariffs and quotas.
2. Openness in the financial market: Capital controls place restrictions on the ownership of foreign assets
3. Openness in factor markets: The ability of firms to choose where to locate production, and workers to choose where to work. The EU is the biggest ever common market among sovereign countries, with 27 member states.
We will concentrate on the implications for the control of the macroeconomy of free trade in goods and financial markets.
OPENNESS IN GOODS MARKETS
By this, we mean the exports and imports of goods and services. The rising share of exports and imports in GDP is a sign of openness.
Domestic consumers must decide not only how much to consume and save but also whether to buy domestic or foreign goods. Their decision depends on,
(a) Their level of income, imports are correlated with domestic income and,
(b) It also depends on the price of domestic goods relative to foreign goods, which is known as the real exchange rate.
The nominal exchange rate (E) between the two countries is taken as the price of the domestic currency in terms of the foreign currency (dollars per pound e.g. 1 pound = 1.6 dollars). So, an appreciation of the domestic currency is an increase in the price of the domestic currency in terms of the foreign currency, which corresponds to an increase in the exchange rate (dollar per pound increase from 1 pound = 1.6 dollar to 1.8 dollars)
The real exchange rates (epsilon) are defined as the relative price of domestic goods in terms of foreign goods. So, if P is the price of UK goods in pounds (home country) and P* is the price of European goods in euros (foreign country) then the real exchange rate would be,
Like the nominal exchange rates, an increase in the relative price of domestic goods in terms of foreign goods is called a real appreciation, which corresponds to an increase in the real exchange rate (epsilon).
Bilateral exchange rates are exchange rates between two countries. Multilateral exchange rates are exchange rates between several countries. It is this multilateral exchange rate that we use in this model. Equivalent names for the relative price of foreign goods vis-a-vis UK goods are the real multilateral UK exchange rate, the UK trade-weighted real exchange rate or the UK effective real exchange rate.
OPENNESS IN FINANCIAL MARKETS
The purchase and sale of foreign assets imply buying or selling foreign currency - sometimes called foreign exchange. Openness in financial markets allows the financial investors to diversity, that is, to hold both domestic and foreign assets and speculate on foreign interest rate movements. In this way it allows countries to run a trade surplus and deficits. A country that buys more than it sells must pay for the difference by borrowing from the rest of the world.
BALANCE OF PAYMENTS
Balance of Payments (BOP) = Current Account (CA) + Capital Account + Official Reserves
The balance of payments account summarises a country's transactions with the rest of the world. Transactions above the line are current account transactions. Transactions below the line are capital account transactions. The current account balance and the capital account balance should be equal, but because of data gathering errors, they aren't. For this reason, the account shows a statistical discrepancy.
The current account: The transactions above the line record payments to and from the rest of the world are called current account transactions. The current account records the exports and imports of goods and services.
CA = Trade balance + net investment income + net transfers
The sum of net payments in the current account balance can be positive, in which case the country has a current account surplus, or negative means a current account deficit. For the UK, the trade balance is negative since the UK is a net importer. The investment income is positive since UK residents on net receive on their holdings of foreign assets. The net transfer is negative since the UK is the net giver of foreign aid.
The capital account: Transactions below the line are called capital account transactions.
Capital Account = net decrease in foreign assets
The capital account balance, also known as net capital flows, is positive if foreign holdings of home country assets are greater than home country's holdings of foreign assets, in which case there is a capital account surplus or money is flowing out of the home country (net).
Domestics or Foreign assets: The decision or whether to invest abroad or at home depends not only on today's nominal and real exchange rates but also the interest rate differences and the expectations of what will happen to the nominal exchange rate. The interest parity condition shows the same,
The UIP relation is an arbitrage condition stating that the expected rates of return in terms of domestic currency on domestic and foreign bonds must be equal. The assumptions that financial investors will hold only the bonds with the highest expected rate of return is obviously too strong because (a) It ignores transactions costs (b) It ignores the risk. The relation can be approximated as,
Arbitrage implies that the domestic interest rate must be equal to the foreign interest rate plus the expected depreciation rate of the domestic currency. Later on, we will see that under fixed exchange rates the interest rates of the two countries cannot differ. If the exchange rate is not fixed then they can.
GOODS MARKET IN AN OPEN ECONOMY
Assume prices to be fixed. So, the changes in nominal rates equal the changes in the real rates. The domestic demand for goods in an open economy is given by,
Applying the goods market equilibrium condition, Y=Z we get,
If G increases or T decreases then Y (output) would increase. Now, if Y increases, then IM (imports) would increase, which implies that NX (net exports) would decrease or the net trade balance would deteriorate. This happens because part of domestic demand falls on foreign goods. Therefore, change in Y (multiplier) is smaller than under a closed economy.
If Y* increases (foreign demand), then this would increase Y and also NX. Thus, higher foreign output implies improvements in the trade balance.
If epsilon decreases or the real exchange rates depreciate, then its effect on NX (net exports) and Y (output) is ambiguous. epsilon affects NX through 3 channels:
Channel 1 - epsilon decrement increases X (exports), domestic goods become relatively less expensive abroad.
Channel 2 - epsilon decrement decreases IM (imports), domestic goods become relatively less expensive abroad.
Channel 3 - epsilon decrement decreases IM/epsilon (imports in the home currency), import bill increases.
If 1 and 2 are larger than 3, a real depreciation leads to an improvement in the trade balance. This condition is called as the Marshall-Lerner condition.
A real depreciation leads initially to deterioration, then to an improvement of the trade balance. This dynamic behaviour is called the J-curve dynamics. This happens because quantity adjustment takes some-time. The immediate effect is that of price, so when depreciation occurs, imports become expensive and import bill rises, thereby worsening the trade deficit. Then over time, the quantities of import and export adjust to improve the trade balance.
In an open economy, the demand for money is given by M/P = YL(i). The demand for money mostly comes from the domestic residents (so ignore foreigners), but the exchange rate and interest rates are connected through UIP condition. So, a higher domestic interest rate would lead to an increase in E or an appreciation.
EQUILIBRIUM
An increase in interest rate reduces output both directly (downward sloping IS curve) and indirectly (through the exchange rate). Also, given the real money stock, an increase in output increases the interest rate (upward sloping LM curve).
OPEN ECONOMY IN THE IS-LM SHORT RUN
Assumptions:
1. IS
a. Consumption - Depends on disposable income
b. Investment - Depends on income and interest rate
c. Government Expenditure - Exogenous
d. Taxation - Exogenous
e. Net exports - Determined by domestic (imports) and foreign (exports) income and real exchange rate
f. Exchange rate - Determined by uncovered interest parity condition with perfect capital mobility
2. LM
a. Money demand - Choice between money and bonds
b. Money supply - Exogenous, growth rate of money supply is zero in the medium run
3. Production function - One type of output and technological change. Depends on labour only, with constant returns to scale. Labour force is constant.
4. Labout market - Labour supply is perfectly elastic
5. Technological change - Equal to zero
Increases in demand: Suppose we have an increase in government expenditure in an open economy. This would lead to an increase in output and an increased trade deficit.
Increases in foreign demand: The direct effect of the increase in foreign output is an increase in the home country's exports. Dometic demand of goods do not change (C+I+G same as before, DD) but demand for domestic goods rise due to a rise in exports (ZZ to ZZ') So, an increase in foreign demand leads to an increase in output and to a trade surplus.
So we derived two basic results:
1. An increase in domestic demand leads to an increase in domestic output but also leads to a deterioration of the trade balance.
2. An increase in foreign demand leads to an increase in domestic output and an improvement in the trade balance.
These results, in turn, have a number of important implications. First, the stronger the trade links between countries, the stronger the interaction, and the more countries move together. Second, these interactions very much complicate the task of policymakers, especially in the case of fiscal policy.
Suppose output is at its natural level, but the economy is running a large trade deficit. Then, the right answer is to use the right combination of depreciation and fiscal contraction. If the government wants to eliminate the trade deficit without changing output, it must do two things:
1. It must achieve a depreciation sufficient to eliminate the trade deficit at the initial level of output.
2. The government must reduce expenditure.
By using both the fiscal and exchange rate policies, the government can steer the economy as shown,
EFFECTS OF POLICY IN AN OPEN ECONOMY - SHORT RUN
1. An increase in domestic demand leads to an increase in domestic output but also leads to a deterioration of the trade balance.
2. An increase in foreign demand leads to an increase in domestic output and an improvement in the trade balance.
These results, in turn, have a number of important implications. First, the stronger the trade links between countries, the stronger the interaction, and the more countries move together. Second, these interactions very much complicate the task of policymakers, especially in the case of fiscal policy.
Suppose output is at its natural level, but the economy is running a large trade deficit. Then, the right answer is to use the right combination of depreciation and fiscal contraction. If the government wants to eliminate the trade deficit without changing output, it must do two things:
1. It must achieve a depreciation sufficient to eliminate the trade deficit at the initial level of output.
2. The government must reduce expenditure.
EFFECTS OF POLICY IN AN OPEN ECONOMY - SHORT RUN
FLOATING EXCHANGE RATES
- Fiscal Policy (with floating exchange rate)
Increased government expenditure (suppose), shifts IS curve to the left while moving along the LM curve. This leads to an increase in demand, leading to an increase in output. As output increases, so does the demand for money, leading to upward pressure on the interest rate. The increase in the interest rate, which makes domestic bonds more attractive, leads to an appreciation. The higher interest rate and the appreciation both decrease the domestic demand for goods, offsetting some of the effect of government spending on demand and output.
Regarding the composition of GDP, C would rise since Y has risen. Since output (Y) and interest rates (r) have both increased, the effect on investment (I) is ambiguous. G has risen, we know. And using the ML condition, NX has reduced.
Note that the change in nominal interest rates (i) will have the same effect on the real interest rates (r) since prices are assumed to be fixed in the model and so there is no inflation.
The multiplier of foreign's fiscal policy would be,
So, fiscal stimuli abroad have expansionary effects also at home.
- Monetary Policy (with floating exchange rate)
Suppose the money supply has been decreased then this would shift LM upwards while moving along the IS. So, interest rates (i) would increase and outputs (Y) would decrease. Higher nominal interest rate leads to an appreciation (E increases) of the domestic currency, as per UIP relation. Increased epsilon would increase imports but the reduced output (Y) would decrease imports. Also, increased epsilon would decrease exports. So, in net, the effect on net exports (NX) is ambiguous. If we assume ML condition to hold then we can say that appreciation of exchange rate (increased E) would lead to a decrement in net exports (decreased NX).
Regarding the composition of GDP, C would fall since Y has fallen. Since output (Y) has fallen and interest rates (r) have risen, investments (I) would reduce. Using the ML condition, NX has reduced.
As we did in the short run model, this equilibrium can be alternatively looked from the condition that investment equals savings. Using that we get,
Using the definition NX = X - IM/epsilon and reorganising we get,
This condition says that, in equilibrium, the trade balance must be equal to saving minus investment. It follows that a trade surplus must correspond to an excess of saving over investment; a trade deficit must correspond to an excess investment over saving.
From the equation above, we conclude that,
From the equation above, we conclude that,
1. An increase in investment must be reflected in either an increase in private saving or public saving or in a deterioration of trade balance.
2. An increase in the budget deficit must be reflected in an increase in either private saving or a decrease in investment or deterioration of the trade balance.
3. A country with a high savings rate must have either a high investment rate or a large trade surplus.
FIXED EXCHANGE RATES
Central banks act under implicit and explicit exchange rate targets and use monetary policy to achieve those targets. Some countries operate under fixed exchange rates. These countries maintain a fixed exchange rate in terms of some foreign currency. Some countries, however, operate under a crawling peg. Now, we will discuss how the Mundell-Fleming model operates under fixed exchange rates.
FIXED EXCHANGE RATES
Central banks act under implicit and explicit exchange rate targets and use monetary policy to achieve those targets. Some countries operate under fixed exchange rates. These countries maintain a fixed exchange rate in terms of some foreign currency. Some countries, however, operate under a crawling peg. Now, we will discuss how the Mundell-Fleming model operates under fixed exchange rates.
Pegging the exchange rate turns the UIP relation:
into i(t) = i*(t), since Ee(t+1) = E(t). So, if the exchange rate is expected to remain unchanged, the domestic interest rate must be equal to the foreign interest rate.
- Monetary Policy (with the fixed exchange rate)
Under the fixed exchange rate regime, the IS and LM relations transform into,
Given G, Y* and i* domestic output Y is fully determined by the fixed exchange rate and the equilibrium in the goods market. Monetary policy is endogenous, that is, given Y, the supply of money must adjust to maintain the interest rate constant. The CB loses the ability to use the money supply to control the interest rate.
Suppose we have a contractionary monetary policy then, LM shifts to the left moving along the IS. This leads to a decrease in output (Y) and an increase in interest rates (i). Increased interest rates lead to capital inflow as foreigners buy domestic bonds. This leads to the growing demand for domestic currency and puts an appreciatory pressure in the foreign exchange markets. Now in the foreign exchange markets, the currency has appreciated (so you would get 0.5 pounds for 1 dollar, say) but the home country's CB has struck to the fixed peg (0.6 pounds for 1 dollar, say). This creates an arbitrage opportunity for foreign exchange dealers who can use it to sell foreign currency to the CB and get the home countries currency. Every time the CB gives 0.6 pounds, it increases the money supply bringing the LM curve back to its original place, that it, where i=i*.
- Fiscal Policy (with the fixed exchange rate)
Suppose we have an expansionary fiscal policy. So the increase in G leads to an increase in the interest rates (i) which would lead to increase capital inflows from abroad. This would cause the market exchange rate (ER) to appreciate. Foreign exchange dealers can exploit the difference in currency prices and earn profits (exchange arbitrage). So, they sell the purchased foreign currency to the CB, which therefore leads to the increased money supply. Thus LM shifts to the left until i=i*.
So, the effect of fiscal policy on output is magnified relative to the case of flexible exchange rates, since here fiscal policy triggers accommodating monetary policy.
There is a number of reasons why choosing a fix exchange rate is a bad idea:
1. By fixing the exchange rate, a country gives up a powerful tool for correcting trade imbalances or changing the level of economic activity.
2. By committing to a particular exchange rate, a country also gives up control of its interest rate. Not only that, the country must match the movements in the foreign interest rate, at the risk of unwanted effects on its own activity.
3. Although the country retains control of fiscal policy, one policy instrument may not be enough. For example, a fiscal expansion can help the economy get out of a recession, but only at the cost of a larger trade deficit.
THE MEDIUM RUN AND EXCHANGE RATE REGIMES
The short run analysis, so far, seems to suggest that a fixed exchange rate is more attractive than a flexible exchange rate. In the medium run, however, the economy reaches the same output level, whether it operates under a fixed or flexible exchange rate regime.
OPEN ECONOMY IN THE STATIC AD-AS MODEL
Assumptions
1. IS
a. Consumption - Depends on disposable income
b. Investment - Depends on income and interest rate
c. Government Expenditure - Exogenous
d. Taxation - Exogenous
e. Net exports - Determined by domestic (imports) and foreign (exports) income and real exchange rate
f. Exchange rate - Determined by uncovered interest parity condition with perfect capital mobility
2. LM
a. Money demand - Choice between money and bonds
b. Money supply - Exogenous, growth rate of money supply is zero in the medium run
3. Production function - One type of output and technological change. Depends on labour only, with constant returns to scale. Labour force is constant
4. Labout market - Determined by the interaction of wage setting and price setting equations. Expectations of prices are fixed in the short run
5. Technological change - Equal to zero
Before understanding the medium run adjustment using the AS-AD model, we need to develop the AD and AS curves for the open economy. So, we first being by constructing the AD curves for the open economy and then will discuss the AS curve.
AD curve for the open economy:
In the closed economy, an increase in price (P) leads to a decrease in the real money stock (M/P), which increases interest rates (i), which then leads to decrease in demand (Z), consequently, decrease in output (Y).
In the open economy, however, an increase in price (P), increases the real exchange rates (epsilon) {assuming fixed exchange rates}, which then reduces exports, leading to reduced demand (Z) and subsequently the output (Y).
So we see that in an open economy the price level also affects output through its effects on the real exchange rate, which means that the IS curve would also shift along with the LM curve.
AD under fixed exchange rate (E(t) = E_bar) and perfect capital mobility (i = i* => r = i* - pi_e). So, the equilibrium in the goods market would then be summarized by the following relation,
AD under fixed exchange rate (E(t) = E_bar) and perfect capital mobility (i = i* => r = i* - pi_e). So, the equilibrium in the goods market would then be summarized by the following relation,
Assuming inflation expectations (pi_e) as fixed, we get AD relation in an open economy with the fixed exchange rates,
In a closed economy, the AD relation took the same form, except for the presence of the real money stock, M/P, instead of the real exchange rate, EP/P*. The reason for the presence of M/P in a closed economy was that by controlling the money supply, the central bank could change the interest rate and affect output. In an open economy, and under fixed exchange rates and perfect capital mobility, the central bank can no longer change the interest rate - which is pinned down by the foreign interest rate. So, under fixed exchange rates, the central bank gives up monetary policy as a policy instrument.
In a closed economy, the price level affects output through its effect on the real money stock and, in turn, its effect on the interest rate. In an open economy under fixed exchange rates, the price level affects output through its effect on the real exchange rate.
As prices increase, the real money supply falls (as in the closed economy). But for the open economy, the IS curve also shifts. The real exchange rate increases and the IS shifts to the left. Size of the LM shift, however, depends on the exchange rate regime. In the fixed case, the LM must change sufficiently to maintain the interest rate and the nominal exchange rate. The derivation of the AD curve in the open economy: an increase in the price level leads to a decrease in output but the slope differs (steepest in the closed economy case and shallowest in the open economy with the fixed exchange rate)
In a closed economy, the price level affects output through its effect on the real money stock and, in turn, its effect on the interest rate. In an open economy under fixed exchange rates, the price level affects output through its effect on the real exchange rate.
As prices increase, the real money supply falls (as in the closed economy). But for the open economy, the IS curve also shifts. The real exchange rate increases and the IS shifts to the left. Size of the LM shift, however, depends on the exchange rate regime. In the fixed case, the LM must change sufficiently to maintain the interest rate and the nominal exchange rate. The derivation of the AD curve in the open economy: an increase in the price level leads to a decrease in output but the slope differs (steepest in the closed economy case and shallowest in the open economy with the fixed exchange rate)
So, an increase in the price level leads to a real appreciation and a decrease in the output, the AD curve is downward sloping.
NOTE:
1. AD shifts due to change of T, G, M or E. However, IS would shift due to T, G, E or P as well, since E & P will change epsilon. LM would only shift due to the change in M/P.
2. Shifts in AS remain the same as before.
AS curve for the open economy:
The AS curve does not change under the open economy. Under the assumption P_e = P(t-1). For a given P_e = P(t-1), the AS is upward sloping in the Y-P space.
Equilibrium:
In the medium run, the economy reaches the same real exchange rate and the same level of output, whether it operates under fixed or under flexible exchange rates. Also, in the short run, a fixed nominal exchange rate implies a fix real exchange rate. In the medium run, the real exchange rate can adjust even if the nominal exchange rate is fixed. This adjustment is achieved through movements in the price level.
Let's discuss an example. Suppose that the authorities allow for a one-time devaluation. For a given P, E decreases, and so epsilon decreases. This would lead to a decrement in NX (net exports) in the short run but the increment in NX and Y (output) in the medium run (J-curve dynamics). So, over time the economy converges to the natural rate of growth. New equilibrium at C, so, the real exchange rate at C is the same as no devaluation case.
Had there been no devaluation, the AS curve would have shifted in order to get back to the medium run equilibrium. This, the economy would have settled in that case at a lower price level.
A devaluation may cause a contraction before expansion occurs (J-curve). A devaluation is likely to have a direct effect on the price level. A devaluation, however, speeds up the process of adjustment.
A devaluation may cause a contraction before expansion occurs (J-curve). A devaluation is likely to have a direct effect on the price level. A devaluation, however, speeds up the process of adjustment.
In reality, it is difficult to achieve the "right size" of devaluation. The initial effects of a devaluation may be contractionary as discussed. Since the price of imported goods increase (epsilon decreased) so the consumers are worse off. This may lead workers to ask for higher nominal wages, and firms to increase their prices as well.
If agents expect devaluation, that is, change of E_e(bar), then the UIP line would shift upwards. Now, including expectations in the model, we know that depreciation will lead to an increase in the output and therefore, the IS would shift towards the right. Now, in order to maintain the same exchange rate, that is, if government tries to defend the exchange rate against the expectations of the agents, the government will have to reduce the money supply, shifting LM leftwards so that it intersects IS at a point such that the equivalent point on the (pink) line marks the horizontal axis at the same exchange rate as before. Thus, we see that the government will have to spend their foreign exchange reserves to defend the exchange rate against the speculative attack. This process is given by the pink lines in the diagram.
However, if the government decides to go with the expectations and let the currency devalue, then the government would increase the money supply shifting the LM curve to the right such that it intersects the pink line at the same as before interest rates, that is, it defends the interest rate without caring for the exchange rates. The movements in such a scenario are shown by blue curves in the diagram.
If agents expect devaluation, that is, change of E_e(bar), then the UIP line would shift upwards. Now, including expectations in the model, we know that depreciation will lead to an increase in the output and therefore, the IS would shift towards the right. Now, in order to maintain the same exchange rate, that is, if government tries to defend the exchange rate against the expectations of the agents, the government will have to reduce the money supply, shifting LM leftwards so that it intersects IS at a point such that the equivalent point on the (pink) line marks the horizontal axis at the same exchange rate as before. Thus, we see that the government will have to spend their foreign exchange reserves to defend the exchange rate against the speculative attack. This process is given by the pink lines in the diagram.
However, if the government decides to go with the expectations and let the currency devalue, then the government would increase the money supply shifting the LM curve to the right such that it intersects the pink line at the same as before interest rates, that is, it defends the interest rate without caring for the exchange rates. The movements in such a scenario are shown by blue curves in the diagram.
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