Mankiw 6e PowerPoints

Mankiw 6e PowerPoints

CHAPTER 13 The Open Economy Revisited: The Mundell-Fleming Model and the Exchange-Rate Regime CHAPTER 13 The Open Economy Revisited 1 IN THIS CHAPTER, YOU WILL LEARN: 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 how to derive the aggregate demand curve for a small open economy CHAPTER 13 The Open Economy Revisited 2 The Mundell-Fleming model

Key assumption: Small open economy with perfect capital mobility. r = r* Goods market equilibriumthe IS* curve: Y C (Y T ) I (r * ) G NX (e ) where e = nominal exchange rate = foreign currency per unit domestic currency CHAPTER 13 The Open Economy Revisited 3 The IS* curve: goods market equilibrium Y C (Y T ) I (r * ) G NX (e ) The IS* curve is drawn for a given value of r*. e Intuition for the slope: e NX Y

IS* Y CHAPTER 13 The Open Economy Revisited 4 The LM* curve: money market equilibrium M P L(r * ,Y ) The LM* curve: is drawn for a given e LM* value of r*. is vertical because given r*, there is only one value of Y that equates money demand with supply, regardless of e.

CHAPTER 13 The Open Economy Revisited Y 5 Equilibrium in the Mundell-Fleming model Y C (Y T ) I (r * ) G NX (e ) M P L(r * ,Y ) e LM* equilibrium exchange rate IS* equilibrium income CHAPTER 13 The Open Economy Revisited

Y 6 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. Next, policy analysis: in a floating exchange rate system in a fixed exchange rate system CHAPTER 13 The Open Economy Revisited 7 Fiscal policy under floating exchange rates Y C (Y T ) I (r * ) G NX (e ) M P L(r * ,Y )

At any given value of e, a fiscal expansion increases Y, shifting Results:IS* to the right. e LM1* e2 e1 e > 0, Y = 0 I S 2* I S1* Y1 Y G pressure r arbitr. r = r*,e NX Y= Y1 CHAPTER 13 The Open Economy Revisited 8

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. CHAPTER 13 The Open Economy Revisited 9 Monetary policy under floating exchange rates Y C (Y T ) I (r * ) G NX (e ) M P L(r * ,Y ) An increase in M shifts LM* right because Y must rise

to restore eqm in the money market. Results: e e1 e2 e < 0, Y > 0 CHAPTER 13 LM1*LM2* The Open Economy Revisited I S1* Y1 Y2 Y 10 Lessons about monetary policy Monetary policy affects output by affecting 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 agg. demand, it merely shifts demand from foreign to domestic products. So, the increases in domestic income and employment are at the expense of losses abroad. CHAPTER 13 The Open Economy Revisited 11 Trade policy under floating exchange rates Y C (Y T ) I (r * ) G NX (e ) M P L(r * ,Y ) At any given value of e, a tariff or quota reduces imports, increases NX, and shifts IS* to the right. e LM1* e2

e1 I S 2* Results: e > 0, Y = 0 I S1* Y1 Y NX(e) demand of dom. curr. e NX Y= Y1 CHAPTER 13 The Open Economy Revisited 12 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. CHAPTER 13 The Open Economy Revisited 13 Lessons about trade policy, cont. Import restrictions on specific products save jobs in the domestic industries that produce those products but destroy jobs in exportproducing sectors. Hence, import restrictions fail to increase total employment. Also, import restrictions create sectoral shifts, which cause frictional unemployment. CHAPTER 13 The Open Economy Revisited 14

Fixed exchange rates Under fixed exchange rates, the central bank stands ready to buy or sell the domestic currency for foreign currency at a predetermined rate. In 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. CHAPTER 13 The Open Economy Revisited 15 Fiscal policy under fixed exchange rates Under Underfloating floatingrates, rates, afiscal fiscalpolicy expansion

is ineffective would raise e.output. at changing To keepfixed e from rising, Under rates, the central bank must fiscal policy is very sell domestic currency, effective at changing which increases M output. and shifts LM* right. e

e1 Results: e = 0, Y > 0 CHAPTER 13 LM1*LM2* The Open Economy Revisited I S 2* I S1* Y1 Y2 Y 16 Monetary policy under fixed exchange rates An increase in Mrates, would Under floating

monetary policy shift LM* right andisreduce e. e very effective at in e, To prevent the fall changing the central output. bank must buy domestic currency, Under fixed rates, e1 which reduces M and monetary policy cannot

shifts be used LM* toback affect left.output. LM1*LM2* I S1* Results: e = 0, Y = 0 CHAPTER 13 The Open Economy Revisited Y1 Y 17 Trade policy under fixed exchange rates Under floating rates, A restriction on imports puts import restrictions

upward pressure on e. do not affect Y or NX. e To keep e from Under fixed rates,rising, the central bank must import restrictions sell domestic increase Y andcurrency, NX. e1 But, these gains come increases atwhich the expense of M other countries:

and shifts the LM*policy right. Results: merely shifts demand from e = 0, Y > 0 foreign to domestic goods. CHAPTER 13 The Open Economy Revisited LM1*LM2* I S 2* I S1* Y1 Y2 Y 18 Summary of policy effects in the Mundell-Fleming model type of exchange rate regime: floating fixed

impact on: Policy Y e NX Y e NX fiscal expansion 0 0

0 mon. expansion 0 0 0 import restriction 0 0 0

CHAPTER 13 The Open Economy Revisited 19 Interest-rate differentials Two reasons why r may differ from r* country risk: The risk that the countrys 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 countrys exchange rate is expected to fall, then its borrowers must pay a higher interest rate to compensate lenders for the expected currency depreciation. CHAPTER 13 The Open Economy Revisited 20 Differentials in the M-F model

r r* where (Greek letter theta) is a risk premium, assumed exogenous. Substitute the expression for r into the IS* and LM* equations: Y C (Y T ) I (r * ) G NX (e ) M P L(r * ,Y ) CHAPTER 13 The Open Economy Revisited 21 The effects of an increase in IS* shifts left, because r I LM* shifts right, because r (M/P)d, so Y must rise to restore money market eqm. e e1 e2

Results: e < 0, Y > 0 CHAPTER 13 LM1*LM2* The Open Economy Revisited Y1 Y2 I S1* I S 2* Y 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 countrys 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 greater than the fall in I (from the rise in r ).

CHAPTER 13 The Open Economy Revisited 23 Why income may 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. CHAPTER 13 The Open Economy Revisited 24 CASE STUDY: International financial crises: Europe 1992

European exchange mechanism: quasi-fixed e 2.25% oscillation band (6% for Italy) 1992: George Soros (and others) bear against pound and lira (bet on their devaluation) Borrow pounds and liras and sell them, hoping to buy them at a lower price to give them back Bank of England and Bank of Italy try to defend their currencies, but run out of foreign currency reserves Pound and lira devaluate (Soros gains 1 bln pounds) CHAPTER 13 The Open Economy Revisited 25 CASE STUDY: The Mexican peso crisis U.S. Cents per Mexican Peso 35 30 25

20 15 10 7/10/94 CHAPTER 13 8/29/94 10/18/94 12/7/94 The Open Economy Revisited 1/26/95 3/17/95 5/6/95 26 CASE STUDY:

The Mexican peso crisis U.S. Cents per Mexican Peso 35 30 25 20 15 10 7/10/94 CHAPTER 13 8/29/94 10/18/94 12/7/94 The Open Economy Revisited 1/26/95

3/17/95 5/6/95 27 Understanding the crisis In the early 1990s, Mexico was an attractive place for foreign investment. During 1994, political developments caused an increase in Mexicos 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. (r* > 0) CHAPTER 13 The Open Economy Revisited 28 Understanding the crisis These events put downward pressure on the peso.

Mexicos central bank had repeatedly promised foreign investors that it would not allow the pesos value to fall, so it bought pesos and sold dollars to prop up the peso exchange rate. Doing this requires that Mexicos central bank have adequate reserves of dollars. Did it? CHAPTER 13 The Open Economy Revisited 29 Dollar reserves of Mexicos central bank December December 1993 1993 $28 $28 billion billion August August 17, 17, 1994 1994

$17 $17 billion billion December December 1, 1, 1994 1994 $$ 99 billion billion December December 15, 15, 1994 1994 $$ 77 billion billion During 1994, Mexicos central bank hid the fact that its reserves were being depleted. CHAPTER 13 The Open Economy Revisited 30 the disaster Dec. 20: Mexico devalues the peso by 13% (fixes e at 25 cents instead of 29 cents)

Investors are SHOCKED! they had no idea Mexico was running out of reserves. , investors dump their Mexican assets and pull their capital out of Mexico. Dec. 22: central banks reserves nearly gone. It abandons the fixed rate and lets e float. In a week, e falls another 30%. CHAPTER 13 The Open Economy Revisited 31 The rescue package 1995: U.S. & IMF set up $50b line of credit to provide loan guarantees to Mexicos 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. CHAPTER 13

The Open Economy Revisited 32 CASE STUDY: The Southeast Asian crisis 199798 Problems in the banking system eroded international confidence in SE Asian economies. Risk premiums and interest rates rose. Stock prices fell as foreign investors sold assets and pulled their capital out. Falling stock prices reduced the value of collateral used for bank loans, increasing default rates, which exacerbated the crisis. Capital outflows depressed exchange rates. CHAPTER 13 The Open Economy Revisited 33 Data on the SE Asian crisis exchange rate

stock market % change from % change from 7/97 to 1/98 7/97 to 1/98 Indonesia nominal GDP % change 199798 59.4 32.6 16.2 Japan 12.0 18.2 4.3 Malaysia 36.4

43.8 6.8 Singapore 15.6 36.0 0.1 S. Korea 47.5 21.9 7.3 Taiwan 14.6 19.7 n.a.

25.6 1.2 Thailand U.S. CHAPTER 13 48.3 n.a. 2.7 The Open Economy Revisited 2.3 34 CASE STUDY: The Argentine 2001 crisis Peso-dollar parity reduced competitiveness. High risk premiums and high interest rates lead to government default. Currency devaluation, bank run, corralito. Debt renegotiation

With less debt, a devaluated currency and high export demand (especially raw materials, such as soya and meat) by emerging countries (China, Brasil), Argentina started to grow again. CHAPTER 13 The Open Economy Revisited 35 Floating vs. fixed exchange rates Argument for floating rates: allow monetary policy to be used to pursue other goals (stable growth, low inflation). Arguments for fixed rates: avoid uncertainty and volatility, making international transactions easier. discipline monetary policy to prevent excessive money growth & hyperinflation. CHAPTER 13 The Open Economy Revisited 36 The Impossible Trinity A nation cannot have free

capital flows, independent Free capital monetary policy, and a flows fixed exchange rate simultaneously. Option 2 Option 1 (Hong Kong) (U.S.) A nation must choose one side of this triangle and give up the Fixed Independent Option 3 opposite exchange monetary (China) corner. policy rate CHAPTER 13 The Open Economy Revisited

37 CASE STUDY: The Chinese Currency Controversy 19952005: China fixed its exchange rate at 0.12 dollars per yuan and restricted capital flows. Many observers believed the yuan was significantly undervalued. U.S. producers complained the cheap yuan gave Chinese producers an unfair advantage. President Bush called on China to let its currency float; others wanted tariffs on Chinese goods. July 2005: China began to allow gradual changes in the dollar/yuan rate. Since 2011, the yuan fluctuates around 0.16Revisited $/yuan (30% appreciation). CHAPTER 13 The Open Economy 38

CASE STUDY: Monetary Unions The U.S. and the Euro Area are monetary unions (extreme case of fixed exchange rates). Pros: less transaction costs, no exchange risk, more competition and trade, political importance. Cons: no national monetary policy (asynchronous business cycles, different national needs). U.S. and Europe: differences in language, labor mobility, central fiscal government. CHAPTER 13 The Open Economy Revisited 39 CASE STUDY: The Greek 2010 crisis High historical debt and deficits 2010: discovery of misreported accounting raises

investors perceived risk of Greek default, exit from the Euro and devaluation, pushing up interest rates on government bonds To receive loans from EC, ECB and IMF, Greece was forced to cut G, raise T and enact reforms Absent the monetary union, it might have raised M and devalued, stimulating NX Yet, the Greeks do not want to leave the Euro CHAPTER 13 The Open Economy Revisited 40 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: (IS* ) (LM* )

Y C (Y T ) I (r * ) G NX ( ) M P L(r * ,Y ) (Earlier in this chapter, P was fixed, so we could write NX as a function of e instead of .) CHAPTER 13 The Open Economy Revisited 41 Deriving the AD curve Why AD curve has negative slope: P (M/P) 2 1 IS* LM shifts left NX

LM*(P2) LM*(P1) P Y2 Y1 P2 P1 Y AD Y2 CHAPTER 13 Y The Open Economy Revisited Y1 Y 42

From the short run to the long run If Y1 Y , then there is downward pressure on prices. 1 2 Over time, P will move down, causing (M/P ) IS* P Y1 Y Y

LRAS P1 SRAS1 P2 SRAS2 NX Y CHAPTER 13 LM*(P1) LM*(P2) AD Y1 The Open Economy Revisited Y Y 43 Large: Between small and closed Many countriesincluding the U.S.are neither

closed nor small open economies. A large open economy is between the polar cases of closed and small open. Consider a monetary expansion: As in a closed economy, M > 0 r I (though not as much) As in a small open economy, M > 0 NX (though not as much) CHAPTER 13 The Open Economy Revisited 44 CHAPTER SUMMARY 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. CHAPTER 13 The Open Economy Revisited 45 CHAPTER SUMMARY 3. Monetary policy: affects income under floating exchange rates. under fixed exchange rates is not available to affect output. 4. Interest rate differentials: exist if investors require a risk premium to hold a countrys assets. An increase in this risk premium raises domestic interest rates and causes the countrys exchange rate to depreciate. CHAPTER 13 The Open Economy Revisited 46

CHAPTER SUMMARY 5. Fixed vs. floating exchange rates Under floating rates, monetary policy is available for purposes other than maintaining exchange rate stability. Fixed exchange rates reduce some of the uncertainty in international transactions. CHAPTER 13 The Open Economy Revisited 47

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