1 1 Open Economy Macro

2 Agenda for Open Economy Macro A few slides on the Great Recession in the world economy Short reminder on the international monetary system Short-run open-economy output determination (Mundell Fleming model) Some important cases

3 Short run or long run? (full adjustment of capital, expectations, etc.) Classical or non-classical? (sticky wages and prices, rational expectations, etc.) long- run short- run yes Keynesian model (sticky wages and prices, upward-sloping AS Tree of Macroeconomics Closed economy IS-LM, dynamic AS-AD Open economy Mundell-Fleming flexible ER; small open economy and large open economy) no

4 The output decline in the Great Recession (industry) Percent change from prior three months at annual rate

5 The employment drop during the Great Recession Percent change from prior three months at annual rate

6 The sharp decline in world trade during the Great Recession (Note that trade change is more than output change.) Percent change from prior three months at annual rate

7 The growth in the public debt around the world Debt/GDP ratio (%)

8 The risk premium on corporate securities in the US and Europe

9 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

10 Real exchange rate of $ against broad currency group

11 The share of floating has increased sharply (% of world GDP)

12 The Mundell-Fleming Model Mundell-Fleming (MF) model is short run Keynesian model (usually applies to small open economy but we will do large open economy) Very similar to IS-LM model. It derives impact of policies and shocks in the short run for an open economy. Usual stuff for domestic sectors: -Price and wage stickiness, unemployment, no inflation -Standard determinants for domestic industries (C, I, G, financial markets, etc.) Open economy aspects: -Small open economy would have r d = r w -Large open economy financial flows determined by r d and r w -Net exports a function of real exchange rate, NX = NX(R)

13 Goods market Start with usual expenditure-output equilibrium condition. New wrinkle is the NX function: (1) Y = C(Y - T) + I(r d ) + G + NX(R) Financial markets Then the monetary policy equation. (2) r = L (Y) Important note: This can be interpreted as LM or as Taylor rule. π = 0 for this discussion. Balance of Payments Capital flows are determined by domestic and foreign interest rates. But have BP balance: (3) CF(r d, r w ) = NX(R) Substituting (3) into (1), we get equation in Y and r d : (IS) Y = C(Y - T) + I(r d ) + G + CF(r d, r w )

14 CF rdrd LM C+I(r d )+G+CF(r d ) (IS$) CF Y CF=NX=0 C+I(r d )+G (IS) Equilibrium

15 Two little reminders added after lecture 1.Remember the difference between real investment and financial investment. Real investment (I) goes down as domestic interest rates rise. Financial investment (CF) goes up as domestic interest rates rise because financial investments are attracted from abroad. 2.We and Mankiw define CF as the capital outflow. This is the opposite of the financial account in the balance of payments, so CF = - Financial surplus. This is somewhat confusing, but that’s what he does and we follow that. Remember the picture on the next page.

16 Financial capital outflow(CF +)

17 CF rdrd CF (capital outflow) = - Financial surplus CF(r d, r w ) r d * CF*

18 CF CF(r) rdrd Y LM IS$ CF Real exchange rate, R 0 NX NX(R) R* NX* r* 0 CF* Mundell-Fleming for large open economy: the case of the US with a large financial surplus and current account deficit rdrd

19 Interesting polar case: very open CF CF(r) Y LM IS$ CF Real exchange rate, R 0 NX NX(R) R* 0 Effects of policy just like small open economy rdrd rdrd

20 Interesting polar case: almost closed CF CF(r) Y LM IS$ CF Real exchange rate, R 0 NX NX(R) R* 0 Effects of policy just like closed economy rdrd rdrd

21 Special Case I. Stimulus plan 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)

22 CF CF(r) Y LM IS$ CF Real exchange rate, R 0 NX NX(R) R* 0 Effect of fiscal stimulus IS$’ rdrd rdrd

23 Special Case II. Normal Monetary Expansion How does openness change the impact of a monetary policy? Effect is larger because lower i → depreciation → higher NX. - Double barreled effect of monetary policy

24 CF CF(r) Y LM IS$ CF Real exchange rate, R 0 NX NX(R) R* 0 Normal monetary expansion rdrd rdrd LM’

25 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, cannot repel foreign investment and depreciate currency. So open economy does not change the basic liquidity trap dilemma!

26 CF rdrd LM CF Y IS$ Equilibrium LM’

27 New Fed policy (QE2) Use unconventional policies to reduce long-run interest rates: -verbal language that Fed funds rate will be low for long time. -Buy long-term securities (add to excess reserves) This will lower r d, depreciating dollar. Source of criticism from foreign governments of “competitive depreciation.” But this is what monetary policy is supposed to do

28 Term structure of interest rates

29 Other cases Show that protectionism has no effect on net exports or output. What about effect of China buying large quantities of US$ securities to appreciate its currency?