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

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 Y E E1E1 E2E2 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)

E returns Return on foreign deposits E Y AA

What shifts AA curve? Change in domestic money supply M S Change in price P Change in expectations E e 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 DD AA 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 policyFiscal policy E Y DD Y E AA

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 M S increase –Shift due E e 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 AA 1 DD 1 YfYf E1E1 AA 2 Y2Y2 E2E2 DD 2 AA 3 E3E

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 E e → shift of AA curve “down and left”

E Y DD 1 AA 1 YfYf E1E1 DD 2 AA 2 1 X 2 E2E2

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

r E L(Y 1,r) r1r1 E1E1 L(Y 2,r)

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 Basic text and references there. Dornbush, Fischer, ch. 6. Slightly different way of explanation, but it might seem more comprehensive to some