1. Lecture 6 - Open Economy Model
6.1 Introducing medium-run AD-ERU-BT model 6.2 Fiscal Policy in AD-ERU-BT model (compare fixed and flexible exchange rate) 6.3 Monetary Policy in AD-ERU-BT model 6.4 External Supply Shock in AD-ERU-BT model 6.5 Long-run equilibrium in AD-ERU-BT model

2. 6.1 Introducing 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)

3. 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 (assume Marshall-Lerner condition holds)
ERU curve –ve slope : θ and y as θ rising (weaker currency) results in falling real wages (i.e. downward shift in PS curve as for every level of demand for labour real wages fall) and reduced y (as PS=WS intersects at lower wages and a lower level of employment E)
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]

5. Supply side – deriving the ERU
Derive the Supply Side’s downward sloping ERU curve in Fig 10.4 (in the θy space)
At A (θH):
When real exchange rate is depreciated θH then real wages are Low (and workers have less buying power)
As wages are low PS is low (as θH means that real wages are lower for every level of demand for labour)
Employment levels are low (E0) (as labour supply at PS=WS is reduced due to lower real wages) and
Output (y0) is low as employment (E0) is low
At B (θL):
When real exchange rate is appreciated θL then real wages are High (and workers have more buying power)
As wages are high PS is high (as θL means that real wages are higher for every level of demand for labour)
Employment levels are high (E1) (as labour supply at PS=WS is increased due to higher real wages) and
Output (y1) is high as employment (E1) is high

7. ye occurs over a range, not unique in open economy
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, for all points from yo to y1 WS=PS and there is supply side equilibrium

8. At points Off the ERU – θ and inflation are not constant
At every point on ERU: WS = PS (there is supply-side equilibrium) i.e. inflation is constant (Nairu) e.g. inflation is not constantly accelerating in an attempt to maintain y>ye
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 (with rise in wages) (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)

10. Short-run and Medium–run effects of expansionary fiscal policy
Short-run, then medium run
First, in the short-run, use Mundell-Fleming model with 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 in short-run)

12. Fiscal expansion in the medium-run
Second in the medium run, use AD-ERU-BT model at Fig 10.8
At A (there is s-r equilibrium in goods market due to effective short-run expansionary fiscal policy as per point B in the Mundell-Fleming model
But A is above the ERU curve (i.e. there is no supply side equilibrium WS curve is above PS curve so prices and wages must rise, the economy will experience rising inflation in the medium run)
If nominal exchange rate (e) is fixed rising wages and prices depress price competitiveness (i.e. θ real appreciation as θ=P*e/P )
On the demand side - As a result of θ economy moves along AD curve from A to B (output y falls due to lower export demand and increased imports due to fall in competitiveness θ )
On the supply side – As a result of θ and the reltated rise in real wages (worker purchasing power) the PS curve rises until WS = PS, therefore y  and economy moves down ERU curve to point B (where there is no further inflationary pressure as there is supply side equilibrium)

14. Policy interventions and shocks
1. Fiscal policy e.g. 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 e.g. 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

15. 6.2 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 (as θ=P*e/P assuming no offsetting decrease in P)
Tendency to trade deficit as growth in M > growth in X
Inflation is constant (medium-run equilibrium on the supply side WS=PS)

17. 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*

18. 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. as exports are less competitive and imports are more competitive) 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 (purchasing power of workers increases) (θ and PS shifted up) (equilibrium output is at a higher level B than at its initial equilibrium position at A)

19. Fiscal expansion and Fixed exchange rate – Labour Market
A = Initial position
Short-run: at C where fiscal expansion (G) has taken place pushing up employment to E2 and wages and prices are fixed so real wages remain at w0
Medium-run (move from C to B):
at C (or E2) there are inflationary pressures WS>PS (C is above the ERU curve), so prices and wages begin to rise, resulting in Upward shift in PS
As wages and prices rise, PS shifts up then Θ appreciates Θ=P*e/P
B = final position where there is equilibrium in the labour market (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

21. 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)

23. Fiscal expansion with flexible exchange rates
In short-run: (move from A to D no change in y0 in Fig 11.1)
In the short-run we know, from Mundell-Fleming model that a fiscal expansion with a flexible exchange rate is INEFFECTIVE
G i eΘ X => no change in y0
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 (See Mundell-Fleming figure where economy moves from A to Z, no change at y0)
Note: θ appreciation can result in deterioration of trade balance (X-M)

26. 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, as result y falls to new equilibrium level y1

27. 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) even though nominal wages and prices are fixed
Why do real wages rise even though nominal wages and prices are fixed? The transmission is as follows: G i eΘ as due to Θ =P*e/P, when Θ then PS curve shifts up (increased worker purchasing power with stronger currency) from point A to point D in labour market
Medium-run (move from D to B):
At D (or E0) there are disinflationary pressures (below ERU and 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 rise in the real wage overshoots to w2) at the new equilibrium level of employment E1 which is related to y1

29. Changes over time fiscal policy with flexible exchange rates
In Fig 11.3 Wages:
at time t0 real wages rise (and overshoot) due to currency appreciation G i eΘ
At time t1 medium-run begins and real wages fall to new equilibrium level of w1 by time t2
In Fig 11.3 Inflation:
At time t0 inflation is unchanged
At time t1 the medium-run begins and inflation falls temporarily as nominal wages and prices fall
At time t2 adjustment is complete and inflation is back at its initial level

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

32. 6.3 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 (effective 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)

34. 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 Fig. 11.4) as ito UIP condition interest rate falls (i)and nominal exchange rate depreciates (e) therefore output and employment is expanded
At B there has been a real depreciation of the exchange rate θ(=P*e/P) (with nominal wages and prices fixed) and real wages have fallen due to a reduced worker purchasing power (See Labour market in Fig where PS curve shifts down due to lower w1)
At B economy is above ERU, resulting in inflation pressure
Medium-run (move from B to A):
in the medium-run the economy returns from point B 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 in P*e/P and PS shifts back up to its original position in labour market in Fig. 11.5)
The rise in home inflation reduces price competiveness due to the depreciation/devaluation and the economy moves back to A

37. Changes over time monetary policy with flexible exchange rates
In Fig 11.6 Wages:
In short-run – At time t0 nominal wages and prices are fixed but real wages fall due to real deprecation of currency as i  and e  θ(=P*e/P) (note: real wages fall as terms of trade fall 1/ θ)
In medium-run - At time t1 real wages start to rise again as prices and wages rise, as at B WS is above PS (no equilibrium in labour market) until WS=PS at t2
In Fig 11.6 Inflation:
In short-run – At time t0 inflation is stable
In medium-run – At time t1 there is a burst of inflation due to inflationary pressures that have built up due to currency deprecation until inflation returns to its original level at t2

39. 6.4 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

41. Movements in AD, ERU and BT
See Fig 11.14:
Oil price shock results in left shift of AD and BT (as at each level of θ the 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 (A is above new ERU)
Costs of adjustment are high if monetary accommodation is used (and allow sharp depreciation of flexible exchange rate) moving from A to A’ – risking very high inflation (as in 1973 oil crisis)
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, θ(=P*e/P) but at A’ the economy will be on a very high inflation path, there has been a sharp currency depreciation and adjustment costs will be high to disinflate the economy.

43. 6.5 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)

45. 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 more balanced growth i.e. improved balance between local consumption and exports and between consumption and investment