1. Aggregate Demand in the Open Economy
CHAPTER Thirteen
Aggregate Demand in the Open Economy
Chapter 12 covers a lot of material.
First, it develops the Mundell-Fleming open-economy IS-LM model for a small open economy with perfect capital mobility. The model is used to analyze the effects of fiscal & monetary policy under floating and flexible exchange rates. Trade policy is also considered.
Then, the chapter explores interest rate differentials, or risk premia that arise due to country risk or expected changes in exchange rates. The Mundell-Fleming model is used to analyze the effects of a change in the risk premium. The Mexican Peso Crisis is an important real-world example of this.
The chapter summarizes the debate over fixed vs. floating exchange rates.
Following that discussion, the Mundell-Fleming model is used to derive the aggregate demand curve for a small open economy.
And finally, the chapter discusses how the results it derives would be different in a large open economy.
To reinforce this material, I urge you to do some in-class exercises (I’ve suggested several in the lecture notes accompanying some of the slides in this presentation) *and* to assign a homework consisting of several of the “Questions for Review” and “Problems and Applications” starting on p.339 of the text.

2. Learning objectives
The Mundell-Fleming model: IS-LM for the small open economy
Causes and effects of interest rate differentials
Arguments for fixed vs. floating exchange rates
The aggregate demand curve for the small open economy

3. The Mundell-Fleming Model
Key assumption: Small open economy with perfect capital mobility.
r = r*
Goods market equilibrium---the IS* curve:
In this and the following sections (in which we analyze policies with the M-F model), we assume the price level is fixed---just as we did when we first used the closed economy IS-LM model to do policy analysis in chapter 11.
As we learned in chapter 5, NX depends on the real exchange rate. However, with price levels fixed, the real & nominal exchange rates move together. So, for simplicity, we write NX as a function of the nominal exchange rate here.
(At the end of this chapter, when we use M-F to derive the aggregate demand curve, we go back to writing NX as a function of the real exchange rate, because the nominal & real exchange rates may behave differently when the price level is changing.)
Chapter 5 introduced the notation r* for the world interest rate, and explained why r = r* in a small open economy with perfect capital mobility.
Perfect capital mobility means that there are no restrictions on the international flow of financial capital: the country’s residents can borrow or lend as much as they wish in the world financial markets; and because the country is small, the amount its residents borrow or lend in the world financial market has no impact on the world interest rate.
Chapter 5 also explained why net exports depend negatively on the exchange rate.
where
e = nominal exchange rate
= foreign currency per unit of domestic currency

4. The IS* curve: Goods Market Eq’m
The IS* curve is drawn for a given value of r*.
Intuition for the slope: Y e
IS*
Again, “eq’m” is an abbreviation for “equilibrium.”
The text (p.315) shows how the Keynesian Cross can be used to derive the IS* curve.
Suggestion: Before continuing, ask your students to figure out what happens to this IS* curve if taxes are reduced.
Answer: The IS* curve shifts rightward (i.e., upward).
Explanation: Start at any point on the initial IS* curve. At this point, initially, Y = C + I + G + NX. Now cut taxes. At the initial value of Y, disposable income is higher, causing consumption to be higher. Other things equal, the goods market is out of whack: C + I + G + NX > Y. An increase in Y (of just the right amount) would restore equilibrium. Hence, each value of e is associated with a larger value of Y. OR, a decrease in NX of just the right amount would restore equilibrium at the initial value of Y. But the decrease in NX requires an increase in e. Hence, each value of Y is associated with a higher value of e.
Rationale: Doing this exercise now will break up your lecture, and will prepare students for the fiscal policy experiment that is coming up in just a few slides.

5. The LM* curve: Money Market Eq’m
is drawn for a given value of r*
is vertical because: given r*, there is only one value of Y that equates money demand with supply, regardless of e. Y e
LM*
The text (p.316) shows how the LM curve in (Y,r) space, together with the fixed r*, determines the value of Y at which the LM* curve here is vertical.
Suggestion: Before continuing, ask your students to figure out what happens to this LM* curve if the money supply is increased.
Answer: LM* shifts to the right.
Explanation: The equation for the LM* curve is:
M/P = L(r*, Y)
P is fixed, r* is exogenous, the central bank sets M, then Y must adjust to equate money demand (L) with money supply (M/P). Now, if M is raised, then money demand must rise to restore equilibrium (remember: P is fixed). A fall in r would cause money demand to rise, but in a small open economy, r = r* is exogenous. Hence, the only way to restore equilibrium is for Y to rise.
Rationale: Doing this exercise now will break up your lecture, and will prepare students for the monetary policy experiment that is coming up in just a few slides.

6. Equilibrium in the Mundell-Fleming modelY e
LM*
IS*
equilibrium
exchange
rate
equilibrium
level of
income

7. Floating & fixed exchange rates
In a system of floating exchange rates, e is allowed to fluctuate in response to changing economic conditions.
In contrast, under fixed exchange rates, the central bank trades domestic for foreign currency at a predetermined price.
We now consider fiscal, monetary, and trade policy: first in a floating exchange rate system, then in a fixed exchange rate system.

8. Fiscal policy under floating exchange rates
At any given value of e, a fiscal expansion increases Y, shifting IS* to the right. e2 e1
Intuition for the shift in IS*:
At a given value of e (and hence NX), an increase in G causes an increase in the value of Y that equates planned expenditure with actual expenditure.
Intuition for the results:
As we learned in earlier chapters, a fiscal expansion puts upward pressure on the country’s interest rate. In a small open economy with perfect capital mobility, as soon as the domestic interest rate rises even the tiniest bit about the world rate, tons of foreign (financial) capital will flow in to take advantage of the rate difference. But in order for foreigners to buy these U.S. bonds, they must first acquire U.S. dollars. Hence, the capital inflows cause an increase in foreign demand for dollars in the foreign exchange market, causing the dollar to appreciate. This appreciation makes exports more expensive to foreigners, and imports cheaper to people at home, and thus causes NX to fall. The fall in NX offsets the effect of the fiscal expansion.
How do we know that Y = 0? Because maintaining equilibrium in the money market requires that Y be unchanged: the fiscal expansion does not affect either the real money supply (M/P) or the world interest rate (because this economy is “small”). Hence, any change in income would throw the money market out of whack. So, the exchange rate has to rise until NX has fallen enough to perfectly offset the expansionary impact of the fiscal policy on output.
Results:
e > 0, Y = 0 Y1

9. Lessons about fiscal policy
In a small open economy with perfect capital mobility, fiscal policy cannot affect real GDP.
“Crowding out”
closed economy: Fiscal policy crowds out investment by causing the interest rate to rise.
small open economy: Fiscal policy crowds out net exports by causing the exchange rate to appreciate.

10. Mon. policy under floating exchange rates
An increase in M shifts LM* right because Y must rise to restore eq’m in the money market. e1
Suggestion: Treat this experiment as an in-class exercise. Display the graph with the initial equilibrium. Then give students 2-3 minutes to use the model to determine the effects of an increase in M on e and Y.
Intuition for the rightward LM* shift:
At the initial (r*,Y), an increase in M throws the money market out of whack. To restore equilibrium, either Y must rise or the interest rate must fall, or some combination of the two. In a small open economy, though, the interest rate cannot fall. So Y must rise to restore equilibrium in the money market.
Intuition for the results:
Initially, the increase in the money supply puts downward pressure on the interest rate. (In a closed economy, the interest rate would fall.) Because the economy is small and open, when the interest rate tries to fall below r*, savers send their loanable funds to the world financial market. This capital outflow causes the exchange rate to fall, which causes NX --- and hence Y --- to increase. e2
Results:
e < 0, Y > 0 Y2

11. Lessons about monetary policy
Monetary policy affects output by affecting one (or more) of the components of aggregate demand:
closed economy: M  r  I  Y
small open economy: M  e  NX  Y
Expansionary mon. policy does not raise world aggregate demand, it shifts demand from foreign to domestic products.
Thus, the increases in income and employment at home come at the expense of losses abroad.
Suggestion:
Before revealing the text on this slide, ask students to take out a piece of paper and answer this question:
“Contrast the way in which monetary policy affects output in the closed economy with the small open economy.” Or something to that effect.

12. Trade policy under floating exchange rates
At any given value of e, a tariff or quota reduces imports, increases NX, and shifts IS* to the right. e2
Intuition for results:
At the initial exchange rate, the tariff or quota shifts domestic residents’ demand from foreign to domestic goods. The reduction in their demand for foreign goods causes a corresponding reduction in the supply of the country’s currency in the foreign exchange market. This causes the exchange rate to rise. The appreciation reduces NX, offsetting the import restriction’s initial expansion of NX.
How do we know that the effect of the appreciation on NX exactly cancels out the effect of the import restriction on NX? There is only one value of Y that allows the money market to clear; since Y, C, I, and G are all unchanged, NX = Y-(C+I+G) must also be unchanged.
Or looking at it differently: As we learned in chapter 5, the accounting identities say that NX = S - I. The import restriction does not affect S or I, so it cannot affect the equilibrium value of NX.
Results:
e > 0, Y = 0

13. Lessons about trade policy
Import restrictions cannot reduce a trade deficit.
Even though NX is unchanged, there is less trade:
the trade restriction reduces imports
the exchange rate appreciation reduces exports
Less trade means fewer ‘gains from trade.’
Import restrictions on specific products save jobs in the domestic industries that produce those products, but destroy jobs in export-producing sectors.
Hence, import restrictions fail to increase total employment.
Worse yet, import restrictions create “sectoral shifts,” which cause frictional unemployment.
Import restrictions cause a sectoral shift, a shift in demand from export-producing sectors to import-competing sectors. As we learned in chapter 6, sectoral shifts contribute to the natural rate of unemployment, because displaced workers in declining sectors take time to be matched with appropriate jobs in other sectors.

14. Fixed exchange rates
Under a system of fixed exchange rates, the country’s central bank stands ready to buy or sell the domestic currency for foreign currency at a predetermined rate.
In the context of the Mundell-Fleming model, the central bank shifts the LM* curve as required to keep e at its preannounced rate.
This system fixes the nominal exchange rate. In the long run, when prices are flexible, the real exchange rate can move even if the nominal rate is fixed.

15. Fiscal policy under fixed exchange rates
Under floating rates, a fiscal expansion would raise e.
Under floating rates, fiscal policy ineffective at changing output.
Under fixed rates, fiscal policy is very effective at changing output. Y e
To keep e from rising, the central bank must sell domestic currency, which increases M and shifts LM* right. e1
Results:
e = 0, Y > 0 Y1 Y2

16. Mon. policy under fixed exchange rates
An increase in M would shift LM* right and reduce e.
Under floating rates, monetary policy is very effective at changing output.
Under fixed rates, monetary policy cannot be used to affect output. Y e Y1 e1
To prevent the fall in e, the central bank must buy domestic currency, which reduces M and shifts LM* back left.
The monetary expansion puts downward pressure on the exchange rate. To prevent it from falling, the central bank starts buying domestic currency in greater quantities to “prop up” the value of the currency in foreign exchange markets. This buying removes domestic currency from circulation, causing the money supply to fall, which shifts the LM* curve back.
Another way of looking at it: To keep the exchange rate fixed, the central bank must use monetary policy to shift LM* as required so that the intersection of LM* and IS* always occurs at the desired exchange rate. Unless the IS* curve shifts right (an experiment we are not considering now), the central bank simply cannot increase the money supply.
Results:
e = 0, Y = 0

17. Trade policy under fixed exchange rates
Under floating rates, import restrictions do not affect Y or NX.
Under fixed rates, import restrictions increase Y and NX.
But, these gains come at the expense of other countries, as the policy merely shifts demand from foreign to domestic goods.
A restriction on imports puts upward pressure on e. Y e Y1 e1
To keep e from rising, the central bank must sell domestic currency, which increases M and shifts LM* right.
Suggestion: Assign this experiment as an in-class exercise. Give students 3 minutes to work on it before displaying the answer on the screen.
Results:
e = 0, Y > 0 Y2

18. M-F: summary of policy effects
type of exchange rate regime:
floating
fixed
impact on:
Policy Y e NX
fiscal expansion  
mon. expansion
import restriction
Table 12-1 on p (“M-F” = “Mundell-Fleming”)
This table makes it easy to see that the effects of policies depend very much on whether exchange rates are fixed or flexible.

19. Interest-rate differentials
Two reasons why r may differ from r*
country risk: The risk that the country’s borrowers will default on their loan repayments because of political or economic turmoil.
Lenders require a higher interest rate to compensate them for this risk.
expected exchange rate changes: If a country’s exchange rate is expected to fall, then its borrowers must pay a higher interest rate to compensate lenders for the expected currency depreciation.

20. Differentials in the M-F model
where  is a risk premium.
Substitute the expression for r into the IS* and LM* equations:
The first equation says that a country’s interest rate equals the world interest rate plus a risk premium (whose size depends on investors’ perceptions of the political & economic risk of holding that country’s assets and on the expected rate of depreciation or appreciation of the country’s currency.
We can now use the M-F model to analyze the effects of a change in the risk premium. The next few slides present this analysis, then discuss an important real-world example (the Mexican peso crisis).

21. The effects of an increase in 
IS* shifts left, because
   r  I Y e Y1 e1
LM* shifts right, because
   r  (M/P )d,
so Y must rise to restore money market eq’m.
Intuition:
If prospective lenders expect the country’s currency to depreciation, or if they perceive that the country’s assets are especially risky, then they will demand that borrowers in that country pay them a higher interest rate (over and above r*).
The higher interest rate reduces investment and shifts the IS* curve to the left.
But it also lowers money demand, so income must rise to restore money market equilibrium.
Why does the exchange rate fall? The increase in the risk premium causes foreign investors to sell some of their holdings of domestic assets and pull their ‘loanable funds’ out of the country. The capital outflow causes an increase in the supply of domestic currency in the foreign exchange market, which causes the fall in the exchange rate. Or, in simpler terms, an increase in country risk or an expected depreciation makes holding the country’s currency less desirable. e2
Results: e < 0, Y > 0 Y2

22. The effects of an increase in 
The fall in e is intuitive: An increase in country risk or an expected depreciation makes holding the country’s currency less attractive.
Note: an expected depreciation is a self-fulfilling prophecy.
The increase in Y occurs because
the boost in NX (from the depreciation)
is even greater than the fall in I (from the rise in r ).

23. Why income might not rise
The central bank may try to prevent the depreciation by reducing the money supply
The depreciation might boost the price of imports enough to increase the price level (which would reduce the real money supply)
Consumers might respond to the increased risk by holding more money.
Each of the above would shift LM* leftward.
The result that income rises when the risk premium rises seems counter-intuitive and inaccurate. This slide explains why the increase in the risk premium may cause other things to occur that prevent income from rising, and may even cause income to fall.

24. CASE STUDY: The Mexican Peso Crisis
Mexico’s central bank had maintained a fixed exchange rate with the U.S. dollar at about 29 cents per peso.

25. CASE STUDY: The Mexican Peso Crisis
In the week before Christmas 1994, the central bank abandoned the fixed exchange rate, allowing the peso’s value to “float.” Then, in just one week, the peso lost nearly 40% of its value, and fell further during the following months.

26. The Peso Crisis didn’t just hurt Mexico
U.S. goods more expensive to Mexicans
U.S. firms lost revenue
Hundreds of bankruptcies along U.S.-Mex border
Mexican assets worth less in dollars
Affected retirement savings of millions of U.S. citizens
The purpose of this slide is to motivate the topic. Even though this occurred in another country some years ago, it was very important for the U.S. The parents of many of your students probably held Mexican assets (indirectly through mutual funds in their 401k accounts and pension funds, which viewed Mexico very favorably prior to the crisis) and took losses when the crisis occurred.

27. Understanding the crisis
In the early 1990s, Mexico was an attractive place for foreign investment.
During 1994, political developments caused an increase in Mexico’s risk premium ( ):
peasant uprising in Chiapas
assassination of leading presidential candidate
Another factor: The Federal Reserve raised U.S. interest rates several times during 1994 to prevent U.S. inflation. (So, r* > 0)
When the last line displays, it might be helpful to note that, from Mexico’s viewpoint, the U.S. interest rate is r*.

28. Understanding the crisis
These events put downward pressure on the peso.
Mexico’s central bank had repeatedly promised foreign investors that it would not allow the peso’s value to fall,
so it bought pesos and sold dollars to “prop up” the peso exchange rate.
Doing this requires that Mexico’s central bank have adequate reserves of dollars. Did it?
We have already seen why an increase in a country’s risk premium causes its exchange rate to fall. One could also use the M-F model to show that an increase in r* also causes the exchange rate to fall. The intuition is as follows: An increase in foreign interest rates causes capital outflows: investors shift some of their funds out of the country to take advantage of higher returns abroad. This capital outflow causes the exchange rate to fall as it implies an increase in the supply of the country’s currency in the foreign exchange market.

29. Dollar reserves of Mexico’s central bank
December 1993 ……………… $28 billion
August 17, 1994 ……………… $17 billion
December 1, 1994 …………… $ 9 billion
December 15, 1994 ………… $ 7 billion
Defending the peso in the face of large capital outflows was draining the reserves of Mexico’s central bank.
(August 17, 1994 was the date of the presidential election.)
Ask your students if they can figure out why Mexico’s central bank didn’t tell anybody it was running out of reserves.
The answer: If people had known that the reserves were dwindling, then they would also have known that the central bank would soon have to devalue or abandon the fixed exchange rate altogether. They would have expected the peso to fall, which would have caused a further increase in Mexico’s risk premium, which would have put even more downward pressure on Mexico’s exchange rate and made it even harder for the central bank to “defend the peso.”
Source (not only for the data on this slide, but some of the other information in this case study): Washington Post National Weekly Edition, pp8‑9, Feb 20‑ , various issues of The Economist in Jan & Feb '95.
During 1994, Mexico’s central bank hid the fact that its reserves were being depleted.

30.  the disaster  Dec. 20: Mexico devalues the peso by 13%
(fixes e at 25 cents instead of 29 cents)
Investors are shocked ! ! !
…and realize the central bank must be running out of reserves…
, Investors dump their Mexican assets and pull their capital out of Mexico.
Dec. 22: central bank’s reserves nearly gone. It abandons the fixed rate and lets e float.
In a week, e falls another 30%.

31. The rescue package
1995: U.S. & IMF set up $50b line of credit to provide loan guarantees to Mexico’s govt.
This helped restore confidence in Mexico, reduced the risk premium.
After a hard recession in 1995, Mexico began a strong recovery from the crisis.
The case study on pp gives more detail on the peso crisis.

32. Floating vs. Fixed Exchange Rates
Argument for floating rates:
allows monetary policy to be used to pursue other goals (stable growth, low inflation)
Arguments for fixed rates:
avoids uncertainty and volatility, making international transactions easier
disciplines monetary policy to prevent excessive money growth & hyperinflation

33. Mundell-Fleming and the AD curve
So far in M-F model, P has been fixed.
Next: to derive the AD curve, consider the impact of a change in P in the M-F model.
We now write the M-F equations as:
Net exports really depend on the real exchange rate, not the nominal exchange rate. Earlier in the chapter, we wrote NX as a function of the nominal rate, because the price level was assumed fixed, so the nominal & real rates always moved together. But now, with the price level changing also, we need to write NX as a function of the real exchange rate.
(Earlier in this chapter, P was fixed, so we could write NX as a function of e instead of .)

34. Deriving the AD curve  Y Why AD curve has negative slope: 2 1 P
LM*(P2)
LM*(P1)
Why AD curve has negative slope:
IS* 2 1 P
 (M/P )
 LM shifts left Y2 Y1 Y P
  P2
Like figure on p.336, except here we are showing what happens to Y when P increases (not falls).
The derivation of the open economy AD curve is very similar to that of the closed economy AD curve (see chapter 11).
 NX P1
 Y AD Y2 Y1

35. From the short run to the long runY  P
IS* AD
LRAS
LM*(P2) P2
SRAS2
LM*(P1)
then there is downward pressure on prices. 1 2
Over time, P will move down, causing
(M/P )
 
NX 
Y  P1
SRAS1
Figure on p.337.
Suggestion:
Have your students draw the two panels of the diagram on this screen, with the economy in an initial equilibrium with output equal to its natural rate. Then, have them use their diagrams to analyze the short-run and long-run effects of a negative IS* shock.

36. Large: between small and closed
Many countries - including the U.S. - are neither closed nor small open economies.
A large open economy is in between the polar cases of closed & small open.
Consider a monetary expansion:
Like in a closed economy, M > 0  r  I (though not as much)
Like in a small open economy, M > 0    NX (though not as much)
For more details, see the Appendix to chapter 12 (not included in this PowerPoint presentation).

37. Chapter summary the IS-LM model for a small open economy.
1. Mundell-Fleming model
the IS-LM model for a small open economy.
takes P as given
can show how policies and shocks affect income and the exchange rate
2. Fiscal policy
affects income under fixed exchange rates, but not under floating exchange rates.

38. Chapter summary affects income under floating exchange rates.
3. Monetary policy
affects income under floating exchange rates.
Under fixed exchange rates, monetary policy is not available to affect output.
4. Interest rate differentials
exist if investors require a risk premium to hold a country’s assets.
An increase in this risk premium raises domestic interest rates and causes the country’s exchange rate to depreciate.

39. Chapter summary
5. Fixed vs. floating exchange rates
Under floating rates, monetary policy is available for can purposes other than maintaining exchange rate stability.
Fixed exchange rates reduce some of the uncertainty in international transactions.