Macroeconomic fluctuations, and the traditional Keynesian theory Nikolina Kosteletou 1 Keynesian theories: open economy National and Kapodistrian University of Athens Department of Economics Master Program in Applied Economics UADPhilEcon

outline Open economy Fleming- Mundell model Overshooting Imperfect capital mobility

Open economy

Nominal ε ε: price of a unit of foreign currency in terms of domestic currency – [1$ → 0,81€] – (in euro area: 1 € → 0,24 $) ε ↑ : devaluation – depreciation (foreign currency is more expensive…(exports cheaper, imports more expensive) ε ↓ : overvaluation - appreciation

Real devaluation: ε ↑ P* ↑ P↓ Domestically produced goods cheaper (exports ↑, imports ↓) NE ↑ = X-M P*: exogenous

Exchange rates Regime: – fixed – floating Expectations: – static – rational Flows of capital: – Perfect capital mobility – Imperfect capital mobility

Perfect capital mobility

The keynesian model

The Fleming – Mundell model Assumptions: short run: prices constant Static expectations Free trade (perfect commodity arbitrage (perfect information, no transportation and other transaction costs) Perfect capital mobility, i=i* Freely floating exchange rates

The Fleming – Mundell model

The money market: LM* (ε,Y) (M/P)=L(i,Y) The Fleming – Mundell model

ε Y LM*

The Fleming – Mundell model

ε Y IS* 16

ε Y IS* 17 LM* Output – employment determined in the money market

Fiscal policy: ineffective Suppose G increases: E ↑, → Y ↑, → demand for money increases, i tends to increase, inflow of foreign capital, supply of foreign money increases in the country: Appreciation of the domestic currency The appreciation absorbs the initial increase in output.

ε Y IS* 19 LM* Fiscal expansion IS*’

Monetary policy Increase in Ms,→ Y increases Demand for goods increases Demand for foreign goods increases Demand for foreign currency increases Depreciation of domestic currency This allows an increase in output

ε Y IS* 21 LM* Monetary expansion LM*’