1. Lecture 6 - Open Economy Model
6.1 Recap on short-run Mundell-Fleming Model 6.2 Introduction to medium-run AD-ERU-BT model 6.3 Fiscal Policy 6.4 Monetary Policy 6.5 External Supply Shock 6.6 Long-run equilibrium in the AD-ERU-BT model

2. 6.1 Recap on Mundell-Fleming (M-F) model for the short-run
M-F model shows impact of (1) policy shocks and (2) domestic and foreign shocks on output and the balance of trade (BT) in the short-run (when prices and wages are fixed)
M-F model assumptions:
1. prices and wages are fixed (inflation = 0, R and r equal)
2. home economy small – home country cannot affect world interest rate or output
3.perfect capital mobility and assets perfect substitutes (UIP holds) – home country residents can buy and sell foreign bonds without limitation

3. M-F and monetary policy
Fixed exchange rate – as per Fig 9.9
monetary expansion is ineffective as the LM curve shifts, then interest rate falls below i*, then currency tends to depreciate (i down e up ito UIP)
so CB must use reserves to buy local currency and money supply falls and LM curve shifts back to original position (monetary policy not effective)
ΔR<0, reserves used to buy local currency to avoid depreciation =>MS down => LM down

5. M-F and monetary policy
Flexible exchange rate – as per Fig 9.10
monetary expansion leads to falling i, (ito UIP i falls and e rises ie exchange rate depreciates),
Depreciated currency boosts exports and output(Marshall-Lerner condition) (shifting ISXM), leading to rising i back to i*,
LM curve shift is followed by ISXM shifts as currency depreciates (monetary policy is effective)

7. M-F model and fiscal policy
Fixed exchange rates:
As per Fig 9.13, fiscal expansion leads to rightward shift of ISXM, y rises and i > i*, then in order to avoid a currency appreciation CB must purchase foreign currency (building reserves ΔR > 0)
This leads to an increase in money supply shifting LM curve until i = i* (move from A to B) (fiscal policy is effective)

9. M-F model and fiscal policy
Flexible exchange rates
As per Fig 9.14, fiscal expansion causes the rightward shift in the ISXM curve, pushing up i, so currency appreciates causing ISXM curve to return to original position (A,Z) (fiscal policy is not effective)
G i e Θ IS shifts back (due to lost competiveness)

11. 6.2 Introduction to medium run AD-ERU-BT model
Develop a model that brings together:
demand side (AD)
the imperfect competition supply-side (ERU), and
trade balance (BT)
Characteristics of the model:
In the short-run output is determined by AD and wages and prices are fixed
In the medium-run wages and prices adjust to bring equilibrium on the supply-side (WS=PS) so inflation is constant (along ERU)
In the long-run an economy underlying forces will make the economy move towards current account balance (on BT curve)

12. AD-ERU-BT model is in θy space
Unlike normal AS-AD (in Py space), AD-ERU-BT model is in the (θy space)
As θ rises (real currency depreciation, more price competitive)
AD curve +ve slope : θ and y due to increased exports and reduced imports as real exchange rate depreciates
ERU curve –ve slope : θ and y as θ rising (weaker currency) is associated with falling real wages (i.e. downward shift in PS curve) and reduced y
BT curve +ve slope : θ and y due to θ rising exports rise and therefore output and imports can rise and still adhere to the condition that X = M is maintained [BT is less steep than AD as BT has fewer leakages than AD]

14. Supply side – deriving the ERU
Derive the Supply Side’s ERU curve in the second panel of Fig 10.4 (in the θy space)
At A: When currency is weak θH then real wages are Low (less buying power) and PS is low and employment and output are low
At B: When currency is strong θL then real wages are High (more buying power) and PS is high and employment and output are high
Implication: Due to changes in θ there is a range of medium-run equilibrium rates of employment/output in the open economy ye ≈ yo to y1 where WS=PS

16. At points Off the ERU – θ and inflation are not constant
At every point on ERU: WS = PS i.e. inflation is constant (there is supply-side equilibrium)
Off ERU – price and wage changes move the economy towards the ERU (See Fig10.5):
Above ERU (B’)
the real wage is below the WS curve (at B’) so there is upward pressure on inflation,
as prices and wages rise θ falls (appreciation) (θ =P*e/P) and PS shifts up (until equilibrium at B where WS=PS)
Below ERU (A’)
the real wage is above the WS curve (at A’) so there is downward pressure on inflation,
as prices and wages fall θ is rising (depreciation) (θ =P*e/P) and real wages are falling and PS shifts down (until equilibrium at A where WS=PS)

18. Example of Short-run and medium-run equilibria
Fig 10.8 at A (e.g. s-r equilibrium in goods market due to effective short-run expansionary fiscal policy using Mundell-Fleming model, but it is inflationary in the medium run):
output is at y0 and the real exchange rate is θ0
Economy is above ERU (a point where WS is above PS) i.e. wages and prices will rise
If nominal exchange rate (e) is fixed this depresses price competitiveness (θ real appreciation as θ=P*e/P )
On the demand side - As result of θ economy moves along AD curve from A to B (output y falls due to lower export demand due to rising prices and fall in competitiveness θ )
On the supply side of the economy θ means PS curve rises until WS = PS, therefore y  and economy moves down ERU curve to point B (where there is no further inflationary pressure)

20. Policy interventions and shocks
1. Fiscal policy eg increase in G shifts the AD curve –
economy moves to a new medium-run level of output,
adjustment process depends on whether exchange rates are fixed (inflation spike π) or flexible (inflation trough π)
2. Monetary policy eg cut in r causes a movement along the AD curve:
does not lead to a new medium run equilibrium output (i.e. output/employment only change in the short-run),
3. External Supply shocks – causes movements of the ERU, AD and BT curves

21. 6.3 Fiscal Policy
Analyse the implications of fiscal expansion (should also be able to analyse the effects of a fiscal contraction)
In the short-run:
See Fig 11.1 adjustment path depends on whether exchange rates are fixed or floating
In the Medium-run:
See Fig 11.1 Fiscal expansion causes movement from A to B
Output is higher and unemployment lower
Θ (real appreciation) and real wage due to GieΘ
Trade deficit as M > X
Inflation is constant (medium-run equilibrium on the supply side WS=PS)

23. Fiscal expansion with fixed exchange rates
In short-run (A to C) (Mundell Fleming):
G i (but e fixed and therefore Θ fixed so ΔR>0 and MS) y
Prices and wages are fixed so G leads to output increase y
Fiscal policy is effective in short-run as per (Mundell-Fleming model, Fig 9.13)
fiscal expansion leads to rightward shift of ISXM, y rises and i > i*,
then in order to avoid a currency appreciation CB must purchase foreign currency (building reserves ΔR > 0)
leading to an increase in money supply shifting LM curve until i = i*

24. Fiscal expansion with fixed exchange rates
In medium-run (C to B):
Prices and wages begin to respond, prices and wages will rise as the new output level at (C) is above ERU (indicating inflationary pressures W above PS)
The real exchange rate appreciates Θ (=P*e/P) as price competitiveness is reduced due to the fact that ΔP > ΔP*
On the demand side: As a result of θ (reduced competitiveness i.e. real cost of imports have declined) the economy moves down the AD curve from C to B
On the supply-side / labour market: As a result of the increase in the real wage (θ and PS shifted up) (equilibrium output is at a higher level B than at its initial equilibrium position at A)

25. Fiscal expansion and Fixed exchange rate – Labour Market
A = Initial position
Short-run: at C where fiscal expansion has taken place
Medium-run (move from C to B):
at C (or E2) there are inflationary pressures WS>PS (above the ERU curve), so prices and wages begin to rise, resulting in Upward shift in PS as Θ=P*e/P
B = final position where there is equilibrium in the labour marker (WS=PS)
net effect is a rise in the real wage to w1 at the new equilibrium level of employment E1 which is related to y1

27. Changes to W and P over time due to fiscal expansion with fixed exchange rate
In Fig 11.2
At time t0 (A) fiscal expansion G occurs and between t0 and t1 economy moves to C (y );
time t1 (C) marks the beginning of the medium-run period during which prices and wages respond
at time t2 (B) the medium-run adjustment is completed and a new medium-run equilibrium is attained (at B)

29. Fiscal expansion with flexible exchange rates
In short-run: (move from A to D in Fig 11.1)
From Mundell-Fleming model we know a fiscal expansion with a flexible exchange rate is INEFFECTIVE
G i eΘ X => no change in y
the increase in y due to G is wiped out in the short-run due to an exchange rate appreciation θ induced by the increase in i

30. Fiscal expansion with flexible exchange rates
In the medium-run: (move from D to B)
At D there is downward pressure on prices and wages as D below the ERU,
As a result of P => θ (real exchange rate depreciates) as θ=P*e/P, where P falls and P* is unchanged
On the demand side: There is movement along the AD curve and y  (due to increased X and decreased M as θ )
On the supply side θ means that real wages are falling and the PS curve moves down

32. Fiscal expansion and Flexible exchange rate – Labour Market
A = Initial position
Short-run: at D where fiscal expansion has taken place, but there is no increase in y (as fiscal policy is ineffective), interestingly the real wage rises to w2 (and PS curve shift up) due to the appreciation of e, Θ =P*e/P even though nominal wages and prices are fixed
Medium-run (move from D to B):
At D (or E0) there are disinflationary pressures (below ERU where PS is above WS), so prices and wages begin to fall, resulting in a downward shift in PS as Θ=P*e/P
The increased competitiveness of Θ means that employment (to E1) and output begins to rise
B = the final position where there is equilibrium in the labour market (WS=PS)
net effect is a rise in the real wage to w1 (but first the real wage overshoots to w2) at the new equilibrium level of employment E1 which is related to y1

34. Changes over time fiscal policy with flexible exchange rates
In Fig 11.3:
at time t0 (A) real wages rise and from time t1 real wages fall
At time t1 (D) the medium-run begins and inflation begins to run below world inflation temporarily
At time t2 (B) adjustment is complete and real wages are higher than their original level and inflation is back at its initial level

36. Summary – fiscal expansion
Fiscal policy with fixed exchange rates:
Adjustment is via rising output (y),
temporary increase in inflation which weakens competitiveness and dampens expansion, but overall achieves a higher y
Fiscal policy with flexible exchange rates:
Adjustment is via an initial exchange rate appreciation that offsets the effects of the fiscal expansion on output (making it ineffective in relation to y),
followed by a temporary period disinflation, which boosts competitiveness and raises output y

37. 6.4 Monetary Policy In flexible exchange rate system (depreciation):
a change in monetary policy leads to a change in the interest rate and change in nominal exchange rate (ieUIP)
leading to short-run changes in output and employment (move from A to Z in the Mundell-Flemming model), but no medium run change in output and employment
In a fixed exchange rate system (devaluation):
monetary policy is ineffective even in the short-run as any change in monetary policy is immediately wiped out by off-setting changes in the monetary base necessary to keep exchange rate unchanged
in Mundell-Flemming model as i with LM expansion then to avoid depreciation foreign reserves must be used to buy local currency leading to LM contraction – move from A to A)

39. Monetary expansion via depreciation
Short-run (move from A to B along AD curve):
flexible e: monetary expansion leads to boost of AD (from A to B in Fig11.4) as interest rate falls and currency depreciates (e)therefore output and employment is expanded
At B there has been a real depreciation of the exchange rate θ(=P*e/P) and real wages have fallen due to a deterioration in the terms of trade (1/θ) (See Fig 11.5 where PS curve shifts down to lower w1)
At B economy is above ERU, resulting in a temporary burst of inflation, until the real wage has risen to equal the WS real wage (see time paths in Fig 11.6)
Medium-run (move from B to A):
there is no increase in output and employment in the medium-run (see Fig 11.4 where medium-run equilibrium returns to point A)
Why does the economy move from B back to A? Due to inflationary pressure on wages and prices leading to a real appreciation (θ  as P P*e/P and PS shifts back up to its original position in 11.5)
The rise in home inflation relative to world inflation reduces price competiveness due to the depreciation/devaluation and the economy moves back to A
Time t0 (A) real wages fall due to deprecation, at time t1 (B) real wages start to rise again due to inflationary pressures, at t2 (A) real wages return to original position

43. 6.5 External supply shocks
An external supply shocks is an unanticipated change in the world terms of trade between manufactures and raw materials
e.g. changes in the terms of trade at the world level between manufactures and raw materials τ = P*rm/P*manuf (eg if oil price goes up – this is a change in the relative price or the real price of oil - for oil importing country there is a deterioration in the terms of trade τ)
See Fig if τ then PS curves shifts down as real wages are down (given that more exports must be used to purchase oil imports) => ERU shifts left

45. Movements in AD, ERU and BT
See Fig 11.14:
Oil price shock results in left shift of AD and BT (as for each θ higher cost of oil absorbs and reduces home income and net exports)
ERU shifts left (as real wages and PS falls) so at A there is inflation pressure as costs have risen cutting consumption real wages (A is above new ERU)
Costs of adjustment are high if monetary accommodation is used (with flexible exchange rate) moving from A to A’ – very high inflation (1973)
Cost of adjustment are reduced if tight monetary policy is used to prevent depreciation and inflation allowing adjustments from A to C to B’
At B’ output y has fallen, prices have risen and there has been some real appreciation θ, but at A’ the economy will be on a very high inflation path, there has been a sharp currency deprecation and adjustment costs will be high to disinflate the economy.

47. 6.6 Long-run equilibrium
Question: what forces tend to bring the economy back to long-run equilibrium on the BT curve?
In Fig at A (like China)
economy experiences medium-run equilibrium with a constant inflation level, but has a current account surplus (X>M)
Capital account deficit (outflow) and is acquiring foreign assets, stream of interest receipts and growing wealth
In Fig at B (like SA)
economy experiences medium-run equilibrium with a constant inflation level, but has a current account deficit (M>X)
Capital account surplus (inflow) and is selling assets, must pay out interest receipts on its accumulated debt, reducing wealth
Question: since wealth is changing at A and B will economy eventually shift to Z (i.e. will AD curves shift to AD2)

49. Mechanisms to push economy to Z (with stable exchange rate expectations)
Wealth effects
For a deficit country at B (like SA) consumers may realise that their wealth is being reduced and that the deficit does not represent growth enhancing investment from abroad, they will reduce consumption – shifting AD curve to the left towards Z
Market pressure
For a deficit country at B (like SA) sentiment in international financial markets may view deficit as representing wasteful C or I and funds will cease being available at world interest rate i.e. inflow of funds will require a higher domestic interest rate due to higher risk – shifting AD curve to the left towards Z
Political pressure
For a surplus country like A (Like China) the wisdom of running a persistent surplus is questionable (unless there are particularly profitable investment opportunities abroad), therefore political pressure may mount for increased imports and local consumption, shifting the AD curve rightwards towards Z
China has stated its is seeking form more balanced growth i.e. balance between local consumption and exports and between consumption and investment