Chapter 7: Output, Exchange Rates and Macroeconomic Policy Goals: Study the open-economy IS-LM-FX model

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Chapter 7: Output, Exchange Rates and Macroeconomic
Policy


Goals: Study the open
-
economy IS
-
LM
-
FX model


In the short run, demand determines output. Many factors affect
demand, from consumer confidence, to fiscal and monetary
policy.


7.1 Demand in
open economy


For simplicity, we assume NFIA = NUT = 0, CA = TB


Our main objective is to understand how output (income) is
determined in the home country in the
short

run
during which
price is
sticky
.

First we see how
the four

component
s
of total
expendit
ure

(consumption, investment, government expenditure
and net export)
are

determined in short run.


Consumption
,

, is
positively

related to the
disposable

income
,



̅


and the consumption function is given by









̅



A typical consumption functio
n looks like




The consumption curve slops upward: consumption goes up as
disposable income rises.


The
slope

of the consumption line is
marginal propensity to
consume

(MPC), which satisfies 0<MPC<1.


Exercise: A fall in the income tax

̅

will shift the consumption
line (up or down)

Exercise: A bull stock market will shift the consumption line (up
or down)


Investment is
negatively

related to real interest rate,



(or
nominal interest rate,



since

we assume sticky price
and thus
zero expected inflation)














The investment curve slopes downward: as the real cost of
borrowing falls, more investment are undertaken.


Exercise: what happens to the investment curve if the
government offers companies investment tax

credit?


Both the tax,



and government expenditure,



are set
exogenously

at some
fixed

levels.





̅




̅


Fiscal policy can change

̅

and

̅
.


The trade balance, TB, (net export) is
positively

related to
real

exchange rate,







.


As real exchange rate increases,
home currency (depreciates or
appreciates). As a result
home goods or services become (more
or less) expensive relative to foreign goods or services, and
so net export (falls or rises)


Reminder 1:
home currency depreciates when


rises.


Reminder 2: net export of home country rises when home
currency depreciates.



A rise in home country’s income will increase import and
decrease TB.

A rise in foreign country’s income will increase export and
in
crease TB.


Empirically, TB is
mostly

(not perfectly)
positively

correlated
with real exchange rate
;

see the graph below




Discuss: what happens to the year 2000 and later years?


7.2
Goods

market equilibrium: The Keynesian Cross


The total demand

(or planned expenditure)

is










̅









̅








̅





̅




When the goods market i
s in equilibrium, total demand
= total
supply







Mathematically, we can solve the following equation










̅









̅








̅





̅




for the equilibrium

. The above equation also defines an
implicit

function

for










̅


̅







̅





Graphically w
e can use Keynesian Cross to show the
equilibrium in goods market:


If we put demand,



on the vertical axis, and output (income),



on the horizontal axis, t
he total demand curve is
upward

sloping because

























The equilibrium condition




can be represented by a
45
-
degree line
.


The market is in equilibrium w
here the two lines cross (point 1).




At point 3, demand (> or <) supply, and inventory will go
(up or down)


At point 2, demand (> or <) supply, and inventory will go
(up or down)


An increase of

̅

will shift


curve (up or down)

An increase of


will shift


curve (up or down)

An increase of


will shift


curve (up or down)

An increase of



will shift


curve (up or down)





We can see the shift in


is greater in magnitud
e than the shift in
the demand curve. This fact illustrates the
multiplier effect
.



7.3 Goods
and

Foreign exchange market equilibriums: IS curve


The IS curve s
h
ows combinations of output


and interest rate


for which the goods and foreign exchange m
arket are both in
equilibriums.


A fall in the interest rate will (increase or decrease) the
investment, and thus total demand. As a result, the


line in the
Keynesian Cross will shift (up or down), and


will (rise
or fall)
. I
n short, when goods market is in equilibrium, interest
rate and


move in (the same or opposite) direction. In other
words
, the IS curve is
downward

sloping
.



Uncovered interest parity (UIP) states that when the foreign
exchange market is in
equilibrium domestic i
nterest rate and
nominal exchange rate
are
negatively

related:























A

fall in the interest rate will cause


rise (depreciation of home
currency)

as the supply of home currency
increases

when
investors swit
ch to foreign asset which offers higher rate
.
Due to
the depreciation of home currency and rising net export,

the


line will shift up
further
.


Lesson:
in open economy
falling


will increase total demand
directly

by boosting investment, and
indirectly

by boosting net
export.






Exercise: show what happens to IS curve if



goes up







Exercise: the IS curve in open economy is (flatter or steeper)
than the one in closed economy.






Exercise: show what happens to IS curve if

̅

goes up






Any factor which increases demand


at a given interest rate


must cause the demand curve to shift up, leading to higher
output


and, as a result, an outward shift in the IS curve.


Mathematically, we can write this observation using notation






























7.4
Money

market equilibrium: LM curve


The LM curve depicts the combination of


and


which ensures
the equilibrium at the money market.


An increase in real income or output shifts the demand curve for
rea
l money balance to the right, then the interest rate
must
rise if
the money supply is fixed.


In short, the LM curve is upward sloping.










Exercise: show what happens to LM curve if money supply rises.





Mathematically, we can write this
observation using the notation





(


̅
)


7.5 The short
-
run IS
-
LM
-
FX model of an open economy




We can use this model to analyze macroeconomic policy.











Monetary policy
under

floating exchange rate
s






Monetary policy is highly effective

under

floating exchange
rate
s
.








Discuss: how does the expansionary monetary policy (
or

quantitative easing
, QE) in US affect
the economy of UK?


The effect
on UK investment is
_______________________


The effect
on UK net export is
_________________________



Discuss: how does the QE in US affect the economy of China if
the IS curve of US is
vertical
?


What causes vertical IS curve:________________________


The effects on US income and interest rate
are___________________________


T
he effect on
world
stock market
is__________________________


The effect on the value of China
-
held US treasury bond
is___________________





Monetary policy with fixed exchange rate




Monetary policy is
ineffective

with fixed exchange rate. So for
country using fixed exchange rate (and imposing
no restriction

on capital mobility), autonomous monetary policy is not an
option.


Discuss: Can governments in Hong Kong and China use
monetary policy effectively?








Read page 144 on
Trilemma


Trilemma means that a country cannot fulfill the following three
goals all at once. The country must drop one of the three:


(1)

Fixed exchange rate

(2)

International capital mobility

(3)

Monetary policy autonomy



Fiscal policy under floati
ng exchange rates



In open economy fiscal policy is less effective than closed
economy. Fiscal expansion will increase interest rate, which
crowds out not only investment, but also net export.









If the economy is hit by a temporary adverse shock, policy
makers could use expansionary monetary (and / or fiscal) policy
to prevent a deep recession. This is the essence of
stabilization

policy: