1 Economic Modelling Lecture 17 Small Open Economy

2 Determinants of Output in an Open Economy Aggregate demand depends on consumption, investment, government spending and net exports. Consumption depends on disposable income. Investment on the real interest rate. Tax revenues on national income. Exports on foreign income and the real exchange rates. Imports on domestic income and the real exchange rate. The real exchange rate is determined by domestic and foreign price levels and the nominal exchange rates. Nominal interest rate is determined in the money market. Capital inflow/outflow depends on the difference in the domestic and foreign real interest rates. Aggregate supply depends on capital stock and labour force.

3 Mundell-Fleming Small Open Economy Model

4 Notations in the Above Open Economy Model

5 T =100 G = 100 National Income Consumption Investment Tax and Spending Net exports Real exchange rate Financial integration Demand for Money An Example of an Open Economy Model Parameters

6 A Solution of the Model S = Y-T-C = = 36 = =1280 Equilibrium Condition: Model Closure: Private Saving:

7 Three GAPs: Investment-Saving, Budget and Trade Gaps i Saving and Investment I(r) S(Y) Private saving +public saving = net export Trade Surplus Trade deficit 0 i K-outflow K-inflow

Y Y 0 AD Trade balance Keynesian Open Economy Model How an Expansion in Income causes Trade Deficit? X=X0 Surplus Deficit M=M(Y) NX=X-M

9 Derivation of Net Exports and Investment Saving in an Open Economy ΔNX AD Y e2 Y1Y2 e2 e1 IS*(e) y1 Y2 AD NX (e) NX2NX1 (a) (b) (c) Note: (a) Shows reduction in AD following an increase in ER (b) Shows investment saving balance in an open economy (c) Shows net export as a function of the exchange rate e1

10 IS-LM Model in an Open Economy: Mundell-Fleming Model IS* e* LM (y, i) Output Exchange Rate o y Assumption: Money supply does not depend on exchange rate

11 Impact of Fiscal Policy under Fixed and Flexible Exchange Rate Systems IS* e1 e2 Y No Impact of Fiscal Policy LM LM1 LM2 Fixed Exchange Rate System Y1Y2 e IS* Flexible Exchange Rate System Full Impact of Fiscal Policy

12 Impact of Monetary Policy under Fixed and Flexible Exchange Rate Systems IS* e1 e2 Full Impact of Monetary Policy LM LM1 LM2 Fixed Exchange Rate System Y1Y2 e IS* Y1Y2 Flexible Exchange Rate System No Impact of Monetary Policy

13 Open Economy Fixed Exchange Rate Effectiveness of Fiscal Policy and Ineffectiveness of Monetary Policy i=i* LM0 IS0 IS1 LM BOP=X-M=0 i1 0 y1y2

14 Exchange rate i LM IS Y0 00 i IS-LM and Uncovered Interest Parity Model Y1E0E1 1 2 Appreciation

15 Time J-Curve Hypothesis: Impact of Devaluation on Net Exports Net Exports o Export creation and Import substitution or demand switching takes time

16 Determinants of Net Export

17 Marshall-Lerner condition

18 Numerical Example of the Marshall-Lerner Condition

19 References Blanchard (18) Mankiw (2) M&S (20) Bhattarai (2002) Welfare Gains to the UK from a Global Free Trade, European Research Studies, vol. IV, Issue 3-4, 2001, pp pp Fleming J. Marcus (1962) Domestic financial policies under fixed and under floating exchange rates, IMF staff paper 9, November, Krugman Paul (1979) A Model of Balance of Payment Crisis, Journal of Money Credit and Banking, 11, Aug. Krugman P. and L. Taylor (1978) Contractionary Effects of Devaluation Journal of International Economics, Miller, Marcus; Salmon, Mark When Does Coordination Pay? Journal of Economic Dynamics and Control, July-Oct. 1990, v. 14, iss. 3-4, pp Mundell R. A (1962) Capital mobility and stabilisation policy under fixed and flexible exchange rates, Canadian Journal of Economic and Political Science, 29, Sebastian E (1986) Are Devaluations Contractionary? Review of Economics and Statistics, vol. 68, 3, Taylor Mark (1995) The Economics of Exchange Rates, Journal of Economic Literature, March, vol 33, No. 1, pp Whalley (1985) Trade Liberalisation among Major World Trading Areas, MIT Press for developments on trade arrangement among various trading regions.