1. Chapter 23. Aggregate demand and aggregate supply in the open economy ECON320 Prof Mike Kennedy

2. Key assumptions The economy is small and so cannot affect developments in the rest of the world The economy is specialized and its goods are imperfect substitutes for those in the rest of the world, implying that domestic prices can vary relative to the rest of the world International capital mobility is perfect and accordingly domestic and foreign assets are perfect substitutes Investors are risk neutral, caring only about returns and not the stochastic variability of those returns These last two assumptions imply that rates of return are equalised between countries

3. Capital mobility and nominal interest rate parity We define the nominal exchange rate ( E ) as the number of domestic currency units needed to buy one unit of the foreign currency Note that a rise (fall) in E is a depreciation (appreciation) With perfect capital mobility we get the arbitrage condition that investors will be indifferent to investing in the home or foreign economy Note that is the exchange rate expect to prevail in the next period after the bond matures This arbitrage condition says that domestic and foreign investments must generate the same returns

4. Interest rate parity: Uncovered In logs we get the following approximation of the IRP Note that the expected rate of depreciation is equal to the expected capital gain on holding foreign bonds If the domestic currency is expected to depreciate then domestic interest rates must rise by enough to make domestic and foreign bonds equally attractive The above equation is referred to as the uncovered interest parity condition or UIP: – In this case the investor is bearing the exchange rate risk

5. Interest rate parity: Uncovered The investor could “cover” the risk by selling the proceeds of the investment forward at an agreed upon forward rate which is known or agreed to at the beginning of the period The above is the covered interest parity condition Taking logs of both sides Covered and uncovered interest parity can hold at the same time if This condition holds if there is risk neutrality

6. The more exchange rates are fixed the less volatile are interest rates

7. The real exchange rate The real exchange rate is defined as the nominal rate ( E ) times the foreign price level ( P f ) divided by the domestic price level ( P ) In log this becomes Looking at rates of change we get In the long run, the real exchange rate is constant (otherwise the trade balance would keep changing) and the above becomes This condition is known as relative purchasing power parity which implies that the real interest rate is equal to the foreign rate

8. The tri-lemma and its resolution Capital mobility and its effect on interest rates leads to the “tri-lemma” for policymakers in which they can choose only two of the following three 1.Free capital mobility 2.Fixed exchange rate 3.Independent monetary policy Under the gold standard, countries chose mostly to opt for 1) and 2) Under Bretton-Woods they chose 2) and 3) and used capital controls With the breakdown of Bretton-Woods, we entered a period of free floating Now exchange rate regimes have polarised

9. Exchange rate systems

10. Aggregate demand in an open economy Equilibrium in the goods market is The nominal value of imports measured in the domestic currency is EP f M and the real value in terms of the domestic good is EP f M/P = E r M The variable net exports is then Suppose we have the following equations for exports and imports: X = X(E r, Y f ) and M = M(E r, Y, τ, r, ε ) then

11. Aggregate demand and the Marshall-Lerner condition We want to know how changes in the real exchange rate will affect trade balance ( NX ) We assume that initially X 0 = E r 0 M 0 which implies The condition states that a rise in E r (a depreciation of the real exchange rate) will improve the trade balance as long as the sum of the export and import elasticities ( η X and η M, respectively) is greater than one, which we will assume

12. Aggregate demand in an open economy Using the above equations and what we know about the other components of demand we can derive the AD curve The function measures total private demand from both the domestic and foreign sectors Note that E r influences domestic demand through an income effect For the response of demand to income we will assume that only a fraction of demand is devoted to imports Maintaining the condition that ∂D/∂Y < 1 then

13. How demand responds to changes in key variables That only a fraction of demand is directed towards imports implies Finally we assume that Since ∂D/∂E r 0 ) has a large enough margin to overcome the negative income effect

14. How demand responds to changes in key variables Using the above and the same procedure as in Chapter 16 yields We now show that there is a negative relationship between output and actual inflation Recall the definition of the change in the real exchange rate (2 nd equation, Slide 7) and the final equation on Slide 7 Assume that which implies that In long-run equilibrium we have

15. How demand responds to changes in key variables Plugging these into the first equation on the previous slide where To complete the model, we need to make assumptions about the formation of expectations of inflation and exchange rate changes Exchange rate expectations will depend on the exchange rate regime – fixed versus flexible Note that an increase in inflation will erode competitiveness, thereby reducing output – The first term in brackets is equal to e r – The response will be greater, the larger is β 1, which in turn is dependent on the Marshall-Lerner conditions

16. How demand responds to changes in key variables Note as well that the AD curve will shift whenever relative purchasing power parity fails to hold This can be seen by the presence of the lagged real exchange rate in the curve In an open economy, shifts in the AD curve will be part of the adjustment process

17. Aggregate supply We will assume that aggregate supply is given by an equation liked that derived in Chapter 17 When unemployment benefits are linked to the general price level, wage setting will be characterised by relative wage resistance A trade-union model of wage setting leads to a short-run aggregate supply curve for the open economy that is the same as in a closed economy If unemployment benefits are indexed to the consumer price level, then they will be affected by the exchange rate Without deriving we will assume that the SRAS is the familiar where a is productivity

18. Long-run equilibrium in an open economy Even in the absence of an assumption about exchange rate regimes we can find the long-run equilibrium AD Start by noting that in equilibrium the real exchange rate does not change and this implies not only relative purchasing power parity but that the real interest rate is equal to the world real rate ( r = r f ) We also know that Inserting these two relationship into the AD curve we get the LRAD

19. Long-run equilibrium in an open economy con’t Note that the LRAD curve slopes upward in terms of the real exchange rate – a higher value of e (a depreciation of the real exchange rate) makes domestic goods more competitive The long-run equilibrium condition for supply occurs when actual equals expected inflation and shocks are absent, which gives The above implies that the LRAS is vertical Long-run equilibrium occurs at a real exchange rate given by the intersection of the two curves (see next slide) Note that a permanent demand shock ( z ≠ 0 ) will get absorbed into the real exchange rate

20. Long-run equilibrium in an open economy

21. Long-run equilibrium in an open economy con’t The long-run equilibrium values of the real variables in the economy are all independent of the exchange rate regime – We did not have to make any assumption about the exchange rate regime It follows that in the long run the exchange rate regime is neutral in the sense that it does not have any impact on the equilibrium values of the key variables Here the authorities can choose to have either a fixed or a floating exchange rate, but they cannot determine the long- run value of EP f /P That said, it will turn out that the exchange rate regime is important for determining the adjustment in the short run

22. Current accounts and wealth effects Not taken into account are wealth effects emanating from abroad If a country is running a persistent current account deficit (surplus) then its net foreign asset position is worsening (improving) In Canada’s case, it has generally run current account deficits (next slide) and its net foreign asset position has deteriorated These wealth effects typically take a long time to materialise and will be ignored in this couse

23. Canada’s current account balance