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 components of total expenditure (consumption, investment, government expenditure and net export) are determined in short run.

Consumption,C, is positively related to the disposable income, Y−T , and the consumption function is given by

C=C (Y−T )

A typical consumption function 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 T 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, r , (or nominal interest rate, i , since we assume sticky price and thus zero expected inflation)

I=I (i)

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, T , and government expenditure, G , are set exogenously at some fixed levels.

T=T ,G=G

Fiscal policy can change T and G.

The trade balance, TB, (net export) is positively related to real exchange rate, q= EP

¿

P .

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 q 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 increase 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

D=C (Y−T )+ I ( i )+G+TB(q ,Y−T ,Y ¿−T¿)

When the goods market is in equilibrium, total demand = total supply

D=Y

Mathematically, we can solve the following equation

Y=C (Y−T )+ I (i )+G+TB(q ,Y−T ,Y ¿−T¿)

for the equilibrium Y . The above equation also defines an implicit function for Y

Y=Y (i , T ,G ,q ,Y ¿ , T¿)

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

If we put demand, D , on the vertical axis, and output (income), Y , on the horizontal axis, the total demand curve is upward sloping because dDdY =¿¿

The equilibrium condition D=Y can be represented by a 45-degree line.

The market is in equilibrium where 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 G will shift D curve (up or down)An increase of i will shift D curve (up or down)An increase of E will shift D curve (up or down)An increase of Y ¿ will shift D curve (up or down)

We can see the shift in Y is greater in magnitude 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 shows combinations of output Y and interest rate i for which the goods and foreign exchange market are both in equilibriums.

A fall in the interest rate will (increase or decrease) the investment, and thus total demand. As a result, the D line in the Keynesian Cross will shift (up or down), and Y will (rise or fall). In short, when goods market is in equilibrium, interest rate and Y 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 interest rate and nominal exchange rate are negatively related:

i=i¿+ Ee−EE

=i¿+Ee

E−1

A fall in the interest rate will cause E rise (depreciation of home currency) as the supply of home currency increases when investors switch to foreign asset which offers higher rate. Due to the depreciation of home currency and rising net export, the D line will shift up further.

Lesson: in open economy falling i will increase total demand directly by boosting investment, and indirectly by boosting net export.

Exercise: show what happens to IS curve if Ee 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 G goes up

Any factor which increases demand D at a given interest rate i must cause the demand curve to shift up, leading to higher output Y and, as a result, an outward shift in the IS curve.

Mathematically, we can write this observation using notation

IS=IS (G ,T , i¿ ,Ee , P ,P¿ , Y ¿ , T ¿)

7.4 Money market equilibrium: LM curve

The LM curve depicts the combination of Y and i which ensures the equilibrium at the money market.

An increase in real income or output shifts the demand curve for real 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

LM=LM (MP )

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 rates

Monetary policy is highly effective under floating exchange rates.

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___________________________

The 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 floating 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: