Open economy macroeconomics

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Open economy macroeconomics• Short-run open-economy output determination (Mundell -

Fleming model)• International financial system• The rise, crisis, and (fall?) of the Euro

Open Economy Macro

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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

Classical

Keynesian model (sticky wages

and prices, upward-sloping

AS

Tree of Macroeconomics

Closed economy

IS-MP, dynamic AS-AD

Open economy

Mundell-Fleming; small open economy

and large open economy

Non-classical

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The output decline in the Great Recession (real GDP)

Percent change from prior year

Good reading: IMF, World Economic Outlook

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Unemployment during the Great Recession

Percent of labor force

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The sharp decline in world trade during the Great Recession

(Note that trade change is > output change.)

Percent change from prior three months at annual rate

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The growth in the public debt around the worldDebt/GDP ratio (%)

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The risk premium on corporate securities in the US and Europe

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Housing bubble:The Old and theNew world

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The Mundell-Fleming Model for Open Economy

Mundell-Fleming (MF) model is short run Keynesian model for open economy.

Hybrid of IS-MP and open-economy classical model.It derives the impacts of policies and shocks in the short

run for an open economy.Usual stuff for domestic sectors:

- Price and wage stickiness, unemployment- 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 (CF) determined by rd and rw

- Net exports a function of real exchange rate, NX = NX(R) - We consider primarily a flexible exchange rate.

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Goods marketStart with usual expenditure-output equilibrium condition.New wrinkle is the NX function:(Exp) Y = C(Y - T) + I(rd) + G + NX(R)

Financial marketsThen the monetary policy equation.(MP$) r = L (Y)

Mankiw has LM, but there is no difference in the analysis except for monetary policy.

Balance of PaymentsCapital flows are determined by domestic and foreign interest rates. This leads to balance of payments:

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

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

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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

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Real exchange rate of $ relative to major currencies (R)

Appreciation

Depreciation

Dollar bubble with high interest rates

Flight to $safety

Dot.com stockbubble

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CF

rd MP

Y

C+I(rd)+G (IS)

CLOSED ECONOMY

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CF

rd MP$

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

Y

CF=NX=0

C+I(rd)+G (IS)

Equilibrium

OPEN ECONOMY

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CF

rd

Tiny open economy

Y

Closed economy

MP$(IS$)

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Special Case I. Fiscal Stimulus

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)

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CF

rd MP$

IS$

Y

IS$’

Fiscal Expansion

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CF

rd MP$

IS$

Y

IS$’

Open economy

Closed economy

IS IS’

Fiscal Expansion

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Special Case II. Normal Monetary Expansion

How does openness change the impact of a monetary policy?

Double barreled effect of monetary policy- Lower r → higher I (domestic investment)

- Lower r → higher CF → depreciates exchange rate (R) → raises NX (foreign investment)

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CF

rd MP$

IS$

Y

MP$’

Monetary Expansion

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CF

rd MP$

IS$

Y

MP$’

IS

Monetary Expansion

Open economy

Closed economy

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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, no change in CF

(financial flows), no change exchange rate, no change NX

So open economy does not change the basic liquidity trap dilemma!- Fiscal policy super-effective- Monetary policy super-ineffective

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CF

rd

MP$

Y

IS$

Equilibrium

MP$’

Monetary Expansion in Liquidity Trap

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CF

rd

MP$

Y

IS$

Equilibrium

You do fiscal expansion

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The International Monetary System

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What is the international monetary system?

International monetary system denotes the institutions under which payments are made for transactions that cross national boundaries and are made in different currencies.

In particular, the international monetary system determines how foreign exchange rates are set and how governments can affect exchange rates.

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I. . Fixed exchange rateA. Currency union: currencies irrevocably fixed

- US states (1789 - )- Eurozone (2001- ?)

B. Other fixed exchange rate regimes:– Gold standard (1717 - 1933)– Bretton Woods (1945 - 1971)- Hard and soft fixed rates of different varieties (China)

II. Flexible exchange rates (US, Eurozone, UK pound, BOJ)- Currencies are market determined - Governments use monetary policies to affect exchange

rates

Exchange rate regimes

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What are desirable characteristics of an international financial system?

1. Stability of exchange rates to lower risk and promote trade and capital flows.

2. Openness of financial markets to promote efficient allocation and diffusion of best-practice technologies

3. Adjustment to macroeconomic shocks through monetary policy

But we will see that these three goals are not compatible in the “fundamental trilemma”

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Evolution of Exchange Rate Regimes (% of countries)The Evolution of Exchange Rate Systems: # countries

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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