Feenstra and Taylor Chapter 18

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    Output, Exchange Rates, and

    Macroeconomic Policies in the Short Run

    Prepared by:

    Fernando Quijano

    Dickinson State University

    181 Demand in the OpenEconomy

    2 Goods Market

    Equilibrium: The

    Keynesian Cross

    3 Goods and Forex

    Market Equilibria:

    Deriving the IS Curve

    4 Money Market

    Equilibrium: Deriving

    the LM Curve

    5 The Short-Run IS-LM

    Model of an Open

    Economy

    6 Stabilization Policy

    7 Conclusions

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    • To gain a more complete understanding of how an open

    economy works, we now extend our theory and explore

    what happens when exchange rates and output fluctuate

    in the short run.

    • We examine how macroeconomic aggregates (including

    output, income, consumption, investment, and the trade

    balance) in response to shocks in an open economy.

    • Recall that Y = GDP = C + I + G + TB

    • Our goal is to build a model that explains the

    relationships among all the major macroeconomic

    variables in an open economy in the short run.

    • One key lesson we learn in this chapter is that the

    feasibility and effectiveness of macroeconomic policies

    depend crucially on the type of exchange rate regime in

    operation.

    Introduction

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    1 Demand in the Open Economy

    Preliminaries and Assumptions

    • For our purposes, the foreign economy can be thoughtof as “the rest of the world” (ROW). The key

    assumptions we make are as follows:

    Because we are examining the short run, we assume

    that home and foreign price levels, P  and P *, are fixeddue to price stickiness. As a result of price stickiness,

    expected inflation is fixed at zero, π e = 0. If prices are

    fixed, all quantities can be viewed as both real and

    nominal quantities in the short run because there is no

    inflation.

    We assume that government spending G and taxes T  

    are fixed at some constant level, which are subject to

    policy change.

    − − 

    − 

    − − 

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    1 Demand in the Open Economy

    Preliminaries and Assumptions

    We assume that conditions in the foreign economysuch as foreign output Y * and the foreign interest rate

    i * are fixed and taken as given. Our main interest is in

    the equilibrium and fluctuations in the home economy.

    We assume that income Y  is equivalent to output: thatis, gross domestic product (GDP) equals gross

    national disposable income (GNDI).

    We further assume that net factor income from

    abroad (NFIA) and net unilateral transfers (NUT ) are

    zero, which implies that the current account (CA)

    equals the trade balance (TB).

    − − 

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    1 Demand in the Open Economy

    Consumption

    • The simplest model of aggregate private consumptionrelates household consumption C to disposableincome Y d .

    • This equation is known as the Keynesian consumptionfunction.

    Marginal Effects The slope of the consumption function is

    called the marginal propensity to consume (MPC ). We

    can also define the marginal propensity to save (MPS) as1 − MPC. 

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    1 Demand in the Open Economy

    ConsumptionFIGURE 18-1

    The Consumption Function

    The consumption function relates private consumption, C, to disposableincome, Y − T .

    The slope of the function is the marginal propensity to consume, MPC. 

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    1 Demand in the Open Economy

    Investment

    • The firm’s borrowing cost is the expected real interestrate re, which equals the nominal interest rate i minusthe expected rate of inflation π e: r e = i − π e.

    • Since expected inflation is zero, the expected real

    interest rate equals the nominal interest rate, r 

    e

     = i .• Investment I is a decreasing function of the real interest

    rate; that is, investment falls as the real interest rate

    rises.

    • Remember that this is true only because when expectedinflation is zero, the real interest rate equals the nominal

    interest rate.

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    1 Demand in the Open Economy

    InvestmentFIGURE 18-2

    The Investment Function The investment function relates the quantity ofinvestment, I, to the level of the expected real interest rate, which equals thenominal interest rate, i , when (as assumed in this chapter) the expected rateof inflation, π e , is zero. The investment function slopes downward: as the

    real cost of borrowing falls, more investment projects are profitable.

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    1 Demand in the Open Economy

    The Government

    • We will assume that the government’s role is simple. Itcollects an amount T of taxes from private householdsand spends an amount G on government consumptionof goods and services.

    • Excluded from this concept are large sums involved ingovernment transfer programs, such as social security,medical care, or unemployment benefit systems.

    • In the unlikely event that G = T exactly, we say that the

    government has a balanced budget. If T > G, the

    government is said to be running a budget surplus (of

    size T − G); if G > T , a budget deficit (of size G − T or,

    equivalently, a negative surplus of T − G).

    • Government purchases = G = G

    Taxes = T = T. 

    − 

    − 

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    1 Demand in the Open Economy

    The Trade Balance

    • The Role of the Real Exchange Rate In the aggregate,when spending patterns change in response to changes

    in the real exchange rate, we say that there is

    expenditure switching from foreign purchases todomestic purchases.

    • If Home’s exchange rate is E, the Home price level is P  

    (fixed in the short run), and the Foreign price level is

    P *(also fixed in the short run), then the real exchange

    rate q of Home is defined as q = EP */P .

    We expect the trade balance of the home country to

    be an increasing function of the home country’s real

    exchange rate. That is, as the home country’s real

    exchange rate rises (depreciates), it will export more

    and import less, and the trade balance rises. 

    − 

    − −  − 

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    1 Demand in the Open Economy

    The Trade Balance

    • The Role of Income Levels  We expect an increase in home income to be

    associated with an increase in home imports and a fall

    in the home country’s trade balance. 

    We expect an increase in rest of the world income tobe associated with an increase in home exports and a

    rise in the home country’s trade balance. 

    • The trade balance is, therefore, a function of three

    variables:),,/(

    function Increasing 

    **

    function Decreasing 

    functionIncreasing 

    *

    T Y T Y  P  P  E TBTB  

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    1 Demand in the Open Economy

    The Trade BalanceFIGURE 18-3 (1 of 2) 

    The Trade Balance and the Real Exchange Rate

    The trade balance is an increasing function of the real exchange rate, EP */P .

    When there is a real depreciation (a rise in q ), foreign goods become moreexpensive relative to home goods, and we expect the trade balance toincrease as exports rise and imports fall (a rise in TB ).

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    1 Demand in the Open Economy

    The Trade BalanceFIGURE 18-3 (2 of 2) 

    The Trade Balance and the Real Exchange Rate (continued)

    The trade balance may also depend on income. If home income levels rise,then some of the increase in income may be spent on the consumption ofimports. For example, if home income rises from Y 1 to Y 2, then the tradebalance will decrease, whatever the level of the real exchange rate, and the

    trade balance function will shift down.

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    1 Demand in the Open Economy

    The Trade Balance

    Marginal Effects Once More We refer to MPC F  as themarginal propensity to consume foreign imports.

    Let MPC H  > 0 be the marginal propensity to consume

    home goods. By assumption MP C  = MPC H  + MPC F .

    For example, if MPC F  = 0.10 and MPC H  = 0.65, then MPC= 0.75; for every extra dollar of disposable income, home

    consumers spend 75 cents, 10 cents on imported foreign

    goods and 65 cents on home goods (and they save 25

    cents).

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    FIGURE 18-4

    The Real Exchange Rate andthe Trade Balance: UnitedStates, 1975 –2006

    Does the real exchange rateaffect the trade balance inthe way we have assumed?The data show that the U.S.trade balance is correlatedwith the U.S. real effectiveexchange rate index.Because the trade balancealso depends on changes in

    U.S. and rest of the worlddisposable income (andother factors), it mayrespond with a lag tochanges in the real exchangerate, so the correlation is notperfect (as seen in the years

    2000 –2006).

    APPLICATION

    The Trade Balance and the Real Exchange Rate

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    APPLICATION

    The Trade Balance and the Real Exchange Rate

    Barriers to Expenditure Switching: Pass-Through and the J Curve

    FIGURE 18-5 (2 of 2)

    The J Curve (continued)

    However, home imports nowcost more due to the

    depreciation. Thus, the valueof imports, IM, would actuallyr ise after a depreciation,causing the trade balance TB= EX − IM to fall.

    Only after some time would

    exports rise and imports fall,allowing the trade balance torise relative to its pre-depreciation level. The pathtraced by the trade balanceduring this process looksvaguely like a letter J.

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    1 Demand in the Open Economy

    Exogenous Changes in DemandFIGURE 18-6 (1 of 3) 

    Exogenous Shocks to Consumption, Investment, and the Trade Balance

    (a) When households decide to consume more at any given level of disposableincome, the consumption function shifts up.

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    1 Demand in the Open Economy

    Exogenous Changes in DemandFIGURE 18-6 (2 of 3) 

    Exogenous Shocks to Consumption, Investment, and the Trade Balance (continued)

    (b) When firms decide to invest more at any given level of the interest rate, theinvestment function shifts right.

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    1 Demand in the Open Economy

    Exogenous Changes in DemandFIGURE 18-6 (3 of 3) 

    Exogenous Shocks to Consumption, Investment, and the Trade Balance (continued)

    (c) When the trade balance increases at any given level of the real exchange rate,the trade balance function shifts up.

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    2 Goods Market Equilibrium: The Keynesian Cross

    Supply and Demand

    Given our assumption that the current account equals thetrade balance, gross national income Y equals GDP:

     Aggregate demand, or just “demand,” consists of all the

    possible sources of demand for this supply of output.

    Substituting we have

    The goods market equilibrium condition is

    Supply = GDP   Y 

     

    Demand = DC  I GTB

     

     DC (Y T ) I (i)G TB EP * / P,Y T ,Y * T *

                     

     D

    T Y T Y  P  P  E TBGi I T Y C Y *** ,,/)()(  

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       h  a  p   t  e  r   1   8  :   O  u   t  p  u   t ,   E  x  c   h  a  n  g  e

       R  a   t  e  s ,  a  n   d   M  a  c  r  o  e  c  o  n  o  m   i  c

       P  o   l   i  c   i  e  s   i  n   t   h  e   S   h  o  r   t   R  u  n

    2 Goods Market Equilibrium: The Keynesian Cross

    Determinants of DemandFIGURE 18-7 (a) (1 of 2)

    Panel (a): The GoodsMarket Equilibrium andthe Keynesian Cross

    Equilibrium is wheredemand, D , equals realoutput or income, Y . In

    this diagram,equilibrium is a point1, at an income oroutput level of Y 1. Thegoods market willadjust toward this

    equilibrium.

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       P  o   l   i  c   i  e  s   i  n   t   h  e   S   h  o  r   t   R  u  n

    2 Goods Market Equilibrium: The Keynesian Cross

    Determinants of DemandFIGURE 18-7 (a) (2 of 2)

    Panel (a): The GoodsMarket Equilibrium andthe Keynesian Cross(continued)

    At point 2, the outputlevel is Y 2 and demand,D , exceeds supply, Y ;as inventories fall,firms expandproduction and outputrises toward Y 1.

    At point 3, the output

    level is Y 3 and supplyY exceeds demand; asinventories rise, firmscut production andoutput falls toward Y 1.

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       P  o   l   i  c   i  e  s   i  n   t   h  e   S   h  o  r   t   R  u  n

    2 Goods Market Equilibrium: The Keynesian Cross

    Determinants of DemandFIGURE 18-7 (b) 

    Panel (b): Shifts in Demand

    The goods market isinitially in equilibrium atpoint 1, at which demandand supply both equal Y 1.

    An increase in demand, D,at all levels of real output,Y, shifts the demand curveup from D 1 to D 2.

    Equilibrium shifts to point2, where demand andsupply are higher and bothequal Y 2. Such an increasein demand could resultfrom changes in one ormore of the components ofdemand: C, I, G, or TB .

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       h  a  p   t  e  r   1   8  :   O  u   t  p  u   t ,   E  x  c   h  a  n  g  e   R  a   t  e  s ,  a  n   d   M  a  c  r  o  e  c  o  n  o  m   i  c

       P  o   l   i  c   i  e  s   i  n   t   h  e   S   h  o  r   t   R  u  n

    2 Goods Market Equilibrium: The Keynesian Cross

    Factors That Shift the Demand Curve

       

     D

     D

    TB

     I 

     P 

     P 

     E 

    i

    outputof levelgivenaatdemandinIncrease

    *

    upshifts

     curveDemand

    function balancetradein theupshiftAny

    functioninvestmentin theupshiftAny

    functionnconsumptioin theupshiftAny

     priceshomeinFall

      pricesforeigninRise

     rateexchangenominalin theRise

     rateinteresthomein theFall

    GspendinggovernmentinRise in taxesFall

    The opposite changes lead to a decrease in

    demand and shift the demand curve in. 

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       P  o   l   i  c   i  e  s   i  n   t   h  e   S   h  o  r   t   R  u  n

    3 Goods and Forex Market Equilibria: Deriving the IS Curve

    Equilibrium in Two Markets

    •  A general equilibrium requires equilibrium in allmarkets—that is, equilibrium in the goods market,

    the money market, and the forex market.

    • The IS curve shows combinations of output Y and

    the interest rate i for which the goods and forex

    markets are in equilibrium.

    Forex Market Recap

    Uncovered interest parity (UIP) (Equation (18-3)) : 

     

             

      

    returnforeignExpected

    currencydomestictheof ondepreciatiof rateExpected

    rateinterestForeign

    *

    returnDomestic

    rateinterestDomestic

    1  

        E 

     E ii

    e

    Exchange Rates and Interest Rates in the Short Run:

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       I   I  :   T   h  e   A  s  s  e   t   A  p  p  r  o  a  c   h   i  n   t   h  e

       S   h  o  r   t   R  u  n

    TABLE 15-1

    Interest Rates, Exchange Rates, Expected Returns, and FX Market Equilibrium: A

    Numerical ExampleThe foreign exchange (FX) market is in equilibrium when the domestic and foreign returnsare equal. In this example, the dollar interest rate is 5%, the euro interest rate is 3%, andthe expected future exchange rate (one year ahead) is = 1.224 $/ €. The equilibrium ishighlighted in bold type, where both returns are 5% in annual dollar terms. Figure 12-2plots the domestic and foreign returns (columns 1 and 6) against the spot exchange rate(column 3). Figures are rounded in this table.

    Exchange Rates and Interest Rates in the Short Run:UIP and FX Market Equilibrium

    Exchange Rates and Interest Rates in the Short Run:

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       I   I  :   T   h  e   A  s  s  e   t   A  p  p  r  o  a  c   h   i  n   t   h  e

       S   h  o  r   t   R  u  n

    Equilibrium in the FX Market: An Example

    FIGURE 15-2

    FX Market Equilibrium: ANumerical Example

    The returns calculated inTable 15-1 are plotted inthis figure.

    The dollar interest rate is5%, the euro interest rateis 3%, and the expectedfuture exchange rate is1.224 $/ €.

    The foreign exchangemarket is in equilibrium at

    point 1, where thedomestic returns DR  andexpected foreign returnsFR  are equal at 5% andthe spot exchange rate is1.20 $/ €.

    Exchange Rates and Interest Rates in the Short Run:UIP and FX Market Equilibrium

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    3 Goods and Forex Market Equilibria: Deriving the IS Curve

    Deriving the IS Curve

    FIGURE 18-8 (1 of 3) 

    Deriving the IS Curve

    The Keynesian cross isin panel (a), IS curve inpanel (b), and forex (FX)market in panel (c).

    The economy starts inequilibrium with output,Y 1; interest rate, i 1; andexchange rate, E 1.

    Consider the effect of adecrease in the interestrate from i 1 to i 2, all else

    equal. In panel (c), alower interest ratecauses a depreciation;equilibrium moves from1′ to 2′. 

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    3 Goods and Forex Market Equilibria: Deriving the IS Curve

    Equilibrium in Two Markets

    FIGURE 18-8 (2 of 3) 

    Deriving the IS Curve(continued)

    A lower interest rateboosts investment and adepreciation boosts thetrade balance.

    In panel (a), demandshifts up from D 1 to D 2,equilibrium from 1” to 2”,

    output from Y 1 to Y 2.

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    3 Goods and Forex Market Equilibria: Deriving the IS Curve

    Deriving the IS Curve

    FIGURE 18-8 (3 of 3) 

    Deriving the IS Curve(continued)

    In panel (b), we go frompoint 1 to point 2. The IScurve is thus traced out,a downward-slopingrelationship between theinterest rate and output.

    When the interest ratefalls from i 1 to i 2, outputrises from Y 1 to Y 2.

    The IS curve describes

    all combinations of i andY consistent with goodsand FX market equilibriain panels (a) and (c).

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       P  o   l   i  c   i  e  s   i  n   t   h  e   S   h  o  r   t   R  u  n

    3 Goods and Forex Market Equilibria: Deriving the IS Curve

    Deriving the IS Curve

    • One important observation is in order:In an open economy, lower interest rates stimulate

    demand through the traditional closed-economy

    investment channel and through the trade balance.

    The trade balance effect occurs because lower interestrates cause a nominal depreciation (in the short run, it

    is also a real depreciation), which stimulates external

    demand via the trade balance. 

    • The IS curve is downward-sloping. It illustrates the

    negative relationship between the interest rate i and

    output Y.

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       P  o   l   i  c   i  e  s   i  n   t   h  e   S   h  o  r   t   R  u  n

    3 Goods and Forex Market Equilibria: Deriving the IS Curve

    Factors That Shift the IS Curve

    FIGURE 18-9 (1 of 2) 

    Exogenous Shifts inDemand Cause the ISCurve to Shift

    In the Keynesian cross inpanel (a), when theinterest rate is heldconstant at i 1 , anexogenous increase indemand (due to otherfactors) causes thedemand curve to shift upfrom D 1 to D 2 as shown,

    all else equal. Thismoves the equilibriumfrom 1” to 2”, raising

    output from Y 1 to Y 2.

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       P  o   l   i  c   i  e  s   i  n   t   h  e   S   h  o  r   t   R  u  n

    3 Goods and Forex Market Equilibria: Deriving the IS Curve

    Factors That Shift the IS Curve

    FIGURE 18-9 (2 of 2) 

    Exogenous Shifts inDemand Cause the ISCurve to Shift(continued)

    In the IS  diagram in panel(b), output has risen, withno change in the interestrate.

    The IS curve hastherefore shifted rightfrom IS 1 to IS 2.

    The nominal interest rate

    and hence the exchangerate are unchanged inthis example, as seen inpanel (c).

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    3 Goods and Forex Market Equilibria: Deriving the IS Curve

    Summing Up the IS Curve

     IS 

     IS 

    (G

    ,T 

    ,i

    *

    , E 

    e

    , P 

    *, P 

    )

       

    i

    i

     D

    e

    *

     D

    TB

     I 

     P 

     P 

     E 

    i

    G

     rateinteresthome givenaat

    outputmequilibriuinIncrease

     rateinteresthome givenaatand

    outputof levelanyatdemandinIncrease

    *

    rightshifts

    curveIS

    upshifts

     curveDemand

    function balancetradein theupshiftAny

    functioninvestmentin theupshiftAnyfunctionnconsumptioin theupshiftAny

     priceshomeinFall

      pricesforeigninRise

     rateexchangeexpectedfutureinRise

     rateinterestforeigninRise

     spendinggovernmentinRise

     in taxesFall

    Factors That Shift the IS Curve

    The opposite changes lead to a decrease in demand and shift the

    demand curve down and the IS curve to the left. 

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      e   R  a   t  e  s ,  a  n   d   M  a  c  r  o  e  c  o  n  o  m   i  c   P  o   l   i  c   i  e  s   i  n   t   h  e   S   h  o  r   t   R  u  n

    4 Money Market Equilibrium: Deriving the LM Curve

    Money Market Recap

    • In this section, we derive a set of combinations of Y

    and i that ensures equilibrium in the money market, a

    concept that can be represented graphically as the LMcurve.

    demandmoneyReal

    supplymoneyReal

    )(   Y i L P 

     M 

    • In the short-run, the price level is assumed to be sticky

    at a level P , and the money market is in equilibrium

    when the demand for real money balances L(i )Y equals

    the real money supply M /P :  – 

     – 

    (18-2)

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      e   R  a   t  e  s ,  a  n   d   M  a  c  r  o  e  c  o  n  o  m   i  c   P  o   l   i  c   i  e  s   i  n   t   h  e   S   h  o  r   t   R  u  n

    4 Money Market Equilibrium: Deriving the LM Curve

    Deriving the LM Curve

    FIGURE 18-10 (1 of 2) 

    Deriving the LM Curve

    If there is an increase in real income or output from Y 1 to Y 2 in panel (b), the effectin the money market in panel (a) is to shift the demand for real money balances tothe right, all else equal.

    If the real supply of money, MS, is held fixed at M  /P , then the interest rate rises

    from i 1 to i 2 and money market equilibrium moves from point 1′ to point 2′. 

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      e   R  a   t  e  s ,  a  n   d   M  a  c  r  o  e  c  o  n  o  m   i  c   P  o   l   i  c   i  e  s   i  n   t   h  e   S   h  o  r   t   R  u  n

    4 Money Market Equilibrium: Deriving the LM Curve

    Deriving the LM Curve

    FIGURE 18-10 (2 of 2) 

    Deriving the LM Curve (continued)

    The relationship thus described between the interest rate and income, all elseequal, is known as the LM curve and is depicted in panel (b) by the movement frompoint 1 to point 2. The LM curve is upward-sloping: when the output level risesfrom Y 1 to Y 2, the interest rate rises from i 1 to i 2. The LM curve describes all

    combinations of i and Y that are consistent with money market equilibrium in panel(a).

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      e   R  a   t  e  s ,  a  n   d   M  a  c  r  o  e  c  o  n  o  m   i  c   P  o   l   i  c   i  e  s   i  n   t   h  e   S   h  o  r   t   R  u  n

    4 Money Market Equilibrium: Deriving the LM Curve

    Factors That Shift the LM Curve

    FIGURE 18-11 (1 of 2) 

    Change in the Money Supply Shifts the LM Curve

    In the money market, shown in panel (a), we hold fixed the level of real income oroutput, Y, and hence real money demand, MD .

    All else equal, we show the effect of an increase in money supply from M 1 to M 2.The real money supply curve moves out from MS 1 to MS 2. This moves the

    equilibrium from 1′ to 2′, lowering the interest rate from i 1 to i 2.

    4 M M k t E ilib i D i i th LM C

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      e   R  a   t  e  s ,  a  n   d   M  a  c  r  o  e  c  o  n  o  m   i  c   P  o   l   i  c   i  e  s   i  n   t   h  e   S   h  o  r   t   R  u  n

    4 Money Market Equilibrium: Deriving the LM Curve

    Factors That Shift the LM Curve

    FIGURE 18-11 (2 of 2) 

    Change in the Money Supply Shifts the LM Curve (continued)

    In the LM diagram, shown in panel (b), the interest rate has fallen, with no changein the level of income or output, so the economy moves from point 1 to point 2.

    The LM curve has therefore shift down from LM 1 to LM 2.

    4 M M k t E ilib i D i i th LM C

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      e   R  a   t  e  s ,  a  n   d   M  a  c  r  o  e  c  o  n  o  m   i  c   P  o   l   i  c   i  e  s   i  n   t   h  e   S   h  o  r   t   R  u  n

    4 Money Market Equilibrium: Deriving the LM Curve

    Summing Up the LM Curve

     LM 

      LM 

    ( M 

    / P

    )

         

    i

     L

     M 

    outputof levelgivenatrateinteresthomemequilibriu inDecrease

    rightordownshifts

    curveLM

    functiondemandmoneyin theleftshiftAny

    supplymoney(nominal)inRise

    Factors That Shift the LM Curve

    5 Th Sh t R IS LM FX M d l f O E

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      e   R  a   t  e  s ,  a  n   d   M  a  c  r  o  e  c  o  n  o  m   i  c   P  o   l   i  c   i  e  s   i  n   t   h  e   S   h  o  r   t   R  u  n

    5 The Short-Run IS-LM-FX Model of an Open Economy

    FIGURE 18-12 (1 of 2) 

    Equilibrium in the IS-LM-FX Model

    In panel (a), the IS and LM curves are both drawn. The goods and forex markets arein equilibrium when the economy is on the IS curve. The money market is inequilibrium when the economy is on the LM curve. Both markets are in equilibriumif and only if the economy is at point 1, the unique point of intersection of IS andLM .

    5 Th Sh t R IS LM FX M d l f O E

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      e   R  a   t  e  s ,  a  n   d   M  a  c  r  o  e  c  o  n  o  m   i  c   P  o   l   i  c   i  e  s   i  n   t   h  e   S   h  o  r   t   R  u  n

    FIGURE 18-13 (2 of 2) 

    Equilibrium in the IS-LM-FX Model (continued)

    In panel (b), the forex (FX) market is shown. The domestic return, DR, in the forexmarket equals the money market interest rate.

    Equilibrium is at point 1′ where the foreign return FR equals domestic return, i .

    5 The Short-Run IS-LM-FX Model of an Open Economy

    5 Th Sh t R IS LM FX M d l f O E

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      e   R  a   t  e  s ,  a  n   d   M  a  c  r  o  e  c  o  n  o  m   i  c   P  o   l   i  c   i  e  s   i  n   t   h  e   S   h  o  r   t   R  u  n

    Macroeconomic Policies in the Short Run

    5 The Short-Run IS-LM-FX Model of an Open Economy

    • We focus on the two main policy actions: changes in monetarypolicy, implemented through changes in the money supply, andchanges in fiscal policy, involving changes in governmentspending or taxes.

    • The key assumptions of this section are as follows.

    • The economy begins in a state of long-run equilibrium. We then

    consider policy changes in the home economy, assuming that

    conditions in the foreign economy (i.e., the rest of the world)

    are unchanged.

    • The home economy is subject to the usual short-run

    assumption of a sticky price level at home and abroad.

    • Furthermore, we assume that the forex market operates freely

    and unrestricted by capital controls and that the exchange rate

    is determined by market forces. 

    5 Th Sh t R IS LM FX M d l f O E

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      e   R  a   t  e  s ,  a  n   d   M  a  c  r  o  e  c  o  n  o  m   i  c   P  o   l   i  c   i  e  s   i  n   t   h  e   S   h  o  r   t   R  u  n

    Monetary Policy under Floating Exchange RatesFIGURE 18-13 (1 of 2) 

    Monetary Policy under Floating Exchange RatesIn panel (a) in the IS-LM diagram, the goods and money markets are initially inequilibrium at point 1. The interest rate in the money market is also the domesticreturn, DR 1, that prevails in the forex market. In panel (b), the forex market isinitially in equilibrium at point 1′. A temporary monetary expansion that increases

    the money supply from M 1 to M 2 would shift the LM curve down in panel (a) from

    LM 1 to LM 2, causing the interest rate to fall from i 1 to i 2. DR falls from DR 1 to DR 2.

    5 The Short-Run IS-LM-FX Model of an Open Economy

    5 The Short R n IS LM FX Model of an Open Econom

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      e   R  a   t  e  s ,  a  n   d   M  a  c  r  o  e  c  o  n  o  m   i  c   P  o   l   i  c   i  e  s   i  n   t   h  e   S   h  o  r   t   R  u  n

    Monetary Policy under Floating Exchange RatesFIGURE 18-13 (2 of 2) 

    Monetary Policy under Floating Exchange Rates (continued)In panel (b), the lower interest rate implies that the exchange rate must depreciate,rising from E 1 to E 2.

    As the interest rate falls (increasing investment, I ) and the exchange ratedepreciates (increasing the trade balance), demand increases, which correspondsto the move down the IS curve from point 1 to point 2’.

    Output expands from Y 1 to Y 2. The new equilibrium corresponds to points 2 and 2′. 

    5 The Short-Run IS-LM-FX Model of an Open Economy

    5 The Short Run IS LM FX Model of an Open Economy

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      e   R  a   t  e  s ,  a  n   d   M  a  c  r  o  e  c  o  n  o  m   i  c   P  o   l   i  c   i  e  s   i  n   t   h  e   S   h  o  r   t   R  u  n

    Monetary Policy under Floating Exchange Rates

    5 The Short-Run IS-LM-FX Model of an Open Economy

    To sum up: a temporary monetary expansion under

    floating exchange rates is effective in combating

    economic downturns by boosting output. It raises output

    at home, lowers the interest rate, and causes a

    depreciation of the exchange rate. What happens to the

    trade balance cannot be predicted with certainty. 

    5 The Short Run IS LM FX Model of an Open Economy

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      e   R  a   t  e  s ,  a  n   d   M  a  c  r  o  e  c  o  n  o  m   i  c   P  o   l   i  c   i  e  s   i  n   t   h  e   S   h  o  r   t   R  u  n

    Monetary Policy under Fixed Exchange RatesFIGURE 18-14 (1 of 2) 

    Monetary Policy under Fixed Exchange Rates

    In panel (a) in the IS-LM diagram, the goods and money markets are initially inequilibrium at point 1. In panel (b), the forex market is initially in equilibrium atpoint 1′.

    A temporary monetary expansion that increases the money supply from M 1 to M 2 

    would shift the LM curve down in panel (a).

    5 The Short-Run IS-LM-FX Model of an Open Economy

    5 The Short Run IS LM FX Model of an Open Economy

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      e   R  a   t  e  s ,  a  n   d   M  a  c  r  o  e  c  o  n  o  m   i

      c   P  o   l   i  c   i  e  s   i  n   t   h  e   S   h  o  r   t   R  u  n

    Monetary Policy under Fixed Exchange RatesFIGURE 18-14 (2 of 2) 

    5 The Short-Run IS-LM-FX Model of an Open Economy

    Monetary Policy under Fixed Exchange Rates (continued)

    In panel (b), the lower interest rate would imply that the exchange rate mustdepreciate, rising from E 1 to E 2. This depreciation is inconsistent with the peggedexchange rate, so the policy makers cannot move LM in this way.

    They must leave the money supply equal to M 1. Implication: under a fixed

    exchange rate, autonomous monetary policy is not an option.

    5 The Short Run IS LM FX Model of an Open Economy

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      e   R  a   t  e  s ,  a  n   d   M  a  c  r  o  e  c  o  n  o  m   i  c   P  o   l   i  c   i  e  s   i  n   t   h  e   S   h  o  r   t   R  u  n

    Monetary Policy under Fixed Exchange Rates

    5 The Short-Run IS-LM-FX Model of an Open Economy

    To sum up: monetary policy under fixed exchange rates is

    impossible to undertake. Fixing the exchange rate means

    giving up monetary policy autonomy.

    Countries cannot simultaneously allow capital mobility,

    maintain fixed exchange rates, and pursue an autonomous

    monetary policy.

    5 The Short Run IS LM FX Model of an Open Economy

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      e   R  a   t  e  s ,  a  n   d   M  a  c  r  o  e  c  o  n  o  m   i  c   P  o   l   i  c   i  e  s   i  n   t   h  e   S   h  o  r   t   R  u  n

    Fiscal Policy under Floating Exchange RatesFIGURE 18-15 (1 of 3) 

    Fiscal Policy under Floating Exchange Rates

    In panel (a) in the IS-LM diagram, the goods and money markets are initially inequilibrium at point 1.

    The interest rate in the money market is also the domestic return, DR 1, that prevailsin the forex market. In panel (b), the forex market is initially in equilibrium at point1′.

    5 The Short-Run IS-LM-FX Model of an Open Economy

    5 The Short Run IS LM FX Model of an Open Economy

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      e   R  a   t  e  s ,  a  n   d   M  a  c  r  o  e  c  o  n  o  m   i  c   P  o   l   i  c   i  e  s   i  n   t   h  e   S   h  o  r   t   R  u  n

    Fiscal Policy under Floating Exchange RatesFIGURE 18-15 (2 of 3) 

    Fiscal Policy under Floating Exchange Rates (continued)

    A temporary fiscal expansion that increases government spending from G 1 to G 2 would shift the IS curve to the right in panel (a) from IS 1 to IS 2, causing the interestrate to rise from i 1 to i 2.

    The domestic return shifts up from DR 1 to DR 2.

    5 The Short-Run IS-LM-FX Model of an Open Economy

    5 The Short-Run IS-LM-FX Model of an Open Economy

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      e   R  a   t  e  s ,  a  n   d   M  a  c  r  o  e  c  o  n  o  m   i  c   P  o   l   i  c   i  e  s   i  n   t   h  e   S   h  o  r   t   R  u  n

    Fiscal Policy under Floating Exchange RatesFIGURE 18-15 (3 of 3) 

    Fiscal Policy under Floating Exchange Rates (continued)

    In panel (b), the higher interest rate would imply that the exchange rate mustappreciate, falling from E 1 to E 2.

    The initial shift in the IS curve and falling exchange rate corresponds in panel (a) tothe movement along the LM curve from point 1 to point 2. Output expands Y1 to Y2.The new equilibrium corresponds to points 2 and 2’. 

    5 The Short-Run IS-LM-FX Model of an Open Economy

    5 The Short-Run IS-LM-FX Model of an Open Economy

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      e   R  a   t  e  s ,  a  n   d   M  a  c  r  o  e  c  o  n  o  m   i  c   P  o   l   i  c   i  e  s   i  n   t   h  e   S   h  o  r   t   R  u  n

    Fiscal Policy under Floating Exchange Rates

    5 The Short-Run IS-LM-FX Model of an Open Economy

     As the interest rate rises (decreasing investment, I) and

    the exchange rate appreciates (decreasing the trade

    baland), demand falls. This impact of fiscal expansion is

    often referred to as crowding out. That is, the increase ingovernment spending is offset by a decline in private

    spending.

    Thus, in an open economy, fiscal expansion crowds out

    investment (by raising the interest rate) and decreases

    net exports (by causing the exchange rate to appreciate).Over time, it limits the rise in output to less than the

    increase in government spending.

    5 The Short-Run IS-LM-FX Model of an Open Economy

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      e   R  a   t  e  s ,  a  n   d   M  a  c  r  o  e  c  o  n  o  m   i  c   P  o   l   i  c   i  e  s   i  n   t   h  e   S   h  o  r   t   R  u  n

    Fiscal Policy under Floating Exchange Rates

    5 The Short-Run IS-LM-FX Model of an Open Economy

    To sum up: an expansion of fiscal policy under floating

    exchange rates might be temporary effective. It raises

    output at home, raises the interest rate, causes an

    appreciation of the exchange rate, and decreases the

    trade balance. It indirectly leads to crowding out ofinvestment and exports, and thus limits the rise in output

    to less than an increase in government spending.

    (A temporary contraction of fiscal policy has opposite

    effects.)

    5 The Short-Run IS-LM-FX Model of an Open Economy

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      e   R  a   t  e  s ,  a  n   d   M  a  c  r  o  e  c  o  n  o  m   i  c   P  o   l   i  c   i  e  s   i  n   t   h  e   S   h  o  r   t   R  u  n

    Fiscal Policy under Fixed Exchange RatesFIGURE 18-16 (1 of 3) 

    Fiscal Policy under Fixed Exchange Rates

    In panel (a) in the IS-LM diagram, the goods and money markets are initially inequilibrium at point 1. The interest rate in the money market is also the domesticreturn, DR 1, that prevails in the forex market. In panel (b), the forex market isinitially in equilibrium at point 1′. 

    5 The Short-Run IS-LM-FX Model of an Open Economy

    5 The Short-Run IS-LM-FX Model of an Open Economy

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      e   R  a   t  e  s ,  a  n   d   M  a  c  r  o  e  c  o  n  o  m   i  c   P  o   l   i  c   i  e  s   i  n   t   h  e   S   h  o  r   t   R  u  n

    Fiscal Policy under Fixed Exchange RatesFIGURE 18-16 (2 of 3) 

    Fiscal Policy under Fixed Exchange Rates (continued)A temporary fiscal expansion on its own increases government spending from G 1 to G 2 and would shift the IS curve to the right in panel (a) from IS 1 to IS 2, causingthe interest rate to rise from i 1 to i 2.

    The domestic return would then rise from DR 1 to DR 2.

    5 The Short-Run IS-LM-FX Model of an Open Economy

    ⎯ 

    ⎯ 

    5 The Short-Run IS-LM-FX Model of an Open Economy

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    Fiscal Policy under Fixed Exchange RatesFIGURE 18-16 (3 of 3) 

    Fiscal Policy under Fixed Exchange Rates (continued)In panel (b), the higher interest rate would imply that the exchange rate mustappreciate, falling from E to E 2. To maintain the peg, the monetary authority mustnow intervene, shifting the LM curve down, from LM 1 to LM 2. The fiscal expansionthus prompts a monetary expansion.

    In the end, the interest rate and exchange rate are left unchanged, and output

    expands dramat ical ly from Y 1 to Y 2. The new equilibrium is at to points 2 and 2′. 

    5 The Short Run IS LM FX Model of an Open Economy

    ⎯ 

    5 The Short-Run IS-LM-FX Model of an Open Economy

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    Summary

    5 The Short Run IS LM FX Model of an Open Economy

    To sum up: a temporary expansion of fiscal policy under

    fixed exchange rates raises output at home by a

    considerable amount. (The case of a temporary

    contraction of fiscal policy would have similar but opposite

    effects.) 

    6 Stabilization Policy

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    •  Authorities can use changes in policies to try to keep

    the economy at or near its full-employment level of

    output. This is the essence of stabilization policy.

    • If the economy is hit by a temporary adverse shock,

    policy makers could use expansionary monetary

    and fiscal policies to prevent a deep recession.

    • Conversely, if the economy is pushed by a shockabove its full employment level of output,

    contractionary policies could tame the boom. 

    6 Stabilization Policy

    6 Stabilization Policy

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    Policy Constraints A fixed exchange rate rules out any

    use of monetary policy. Other firm monetary or fiscal

    policy rules, such as interest rate rules or balanced-

    budget rules, place limits on policy.

    Incomplete Information and the Inside Lag It may take

    weeks or months for policy makers to fully understand thestate of the economy today. Even then, it will take time to

    formulate a policy response (the lag between shock and

    policy actions is called the inside lag ).

    Policy Response and the Outside Lag It takes time forwhatever policies are enacted to have any effect on the

    economy, through the spending decisions of the public

    and private sectors (the lag between policyactions and

    effects is called the outside lag ).

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    Long-Horizon Plans If the private sector understands that

    a policy change is temporary, then there may be reasons

    not to change consumption or investment expenditure.

    Similarly, a temporary real appreciation may have little

    effect on whether a firm can profit in the long run from

    sales in the foreign market.Weak Links from the Nominal Exchange Rate to the Real

    Exchange Rate Changes in the nominal exchange rate

    may not translate into changes in the real exchange rate

    for some goods and services.Pegged Currency Blocs Exchange rate arrangements in

    some countries may be characterized—often not as a

    result of their own choice—by a mix of floating and fixed

    exchange rate systems with different trading partners.

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       i  c   P  o   l   i  c   i  e  s   i  n   t   h  e   S   h  o  r   t   R  u  n

    Weak Links from the Real Exchange Rate to the Trade

    Balance Changes in the real exchange rate may not lead

    to changes in the trade balance. The reasons for this

    weak linkage include transaction costs in trade, and the J

    Curve effects.

    These effects may cause expenditure switching to be be anonlinear phenomenon: it will be weak at first and then

    much stronger as the real exchange rate change grows

    larger.

    For example: Prices of BMWs in the U.S. barely changein response to changes in the dollar-euro exchange rate.

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