LECTURE 6: MACROECONOMIC INTERDEPENDENCE (I) Interdependence: Y depends on Y*. (II) The two-country model, to be used for a country big enough to affect world income Y*. Simultaneous determination of Y & Y*. Implication of repercussion effects for the multiplier. (III) International transmission under fixed vs. floating exchange rates of a disturbance originating domestically. of a disturbance originating abroad.

ITF-220 Prof.J.Frankel, HKS Re-endogenizing Exports }=>}=> I.e., Y depends on Y*. “When the US sneezes, Canada catches cold.” where

ITF-220 Prof.J.Frankel, HKS Y depends on Y*. For every $1 of foreign income, how much is spent on our goods ? For every $1 of demand for our exports, how much does our income rise?

ITF-220 Prof.J.Frankel, HKS The other equation of the two-country model: Y* depends on Y Instead of deriving the equation for Y* from scratch, use equation for Y, and substitute foreign for domestic and domestic for foreign: For every $1 of domestic income, how much is spent on foreign goods ? For every $1 of demand for foreign goods, how much does foreign income rise?

Fiscal expansion shifts Y to D in small-country Keynesian model (too small to affect Y*), Combine two simul- taneous relationships: => equilibrium at B. but further, to D ´, in large-country model. FIGURE 17.A.1 2-COUNTRY MODEL ITF-220 Prof.J.Frankel, HKS

of which m is leakage abroad through imports, m/(s*+m* ) is the multiplier effect of our imports on Y*, and m* [m /(s*+m* )] is the repercussion effect: how much comes back as demand for our goods. In two-country model, multiplier is increased by subtraction from denominator of m*m /(s*+m* ), ITF-220 Prof.J.Frankel, HKS

The same result -- fiscal expansion raises Y to D in small-country Keynesian model, but further, to D´, in large-country model -- can be shown in our traditional graph. The X-M line is flatter now, because it captures the repercussion effect on TB: Beyond Y↑ => IM↑, also X*↑ =>Y*↑ => X↑ BIG-COUNTRY VS. SMALL-COUNTRY MODEL FIGURE 17.5 ● D’’ ITF-220 Prof.J.Frankel, HKS

ITF-220 Prof.J.Frankel, HKS adverse trend in TB (D ´´ lies above TB=0 line, which is deficit territory) is rising faster than, But this model may not work in the long run, when growth is supply-driven rather than demand-driven. FIG.17.A.1 or m>m* (TB=0 line is flat). If both countries expand: can result if either:

Fix International Transmission ↓ ↓ Floating increases effect on Y Floating decreases effect on Y => appreciation => depreciation = “insulation.” Float Fix Float = “bottling up” of disturbance.

ITF-220 Prof.J.Frankel, HKS Conclusions regarding transmission (with no capital mobility) (i) Trade makes economies interdependent (at a given exchange rate). –TB can act as a safety valve, releasing pressure from expansion:. –Disturbances are transmitted from one country to another:.

ITF-220 Prof.J.Frankel, HKS Conclusions regarding transmission (with no capital mobility), continued (ii) Floating exchange rates work to isolate effects of demand disturbances within the country where they originate: –Effects of a domestic disturbance tend to be “bottled up” within the country. In the extreme, floating reproduces the closed economy multiplier:.. – The floating rate tends to insulate the domestic economy from effects of foreign disturbances. In the extreme, floating reproduces a closed economy:..

ITF-220 Prof.J.Frankel, HKS End of Lecture 6: International Transmission