International Macroeconommics

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1 International Macroeconommics Chapter 7. The Open Economy IS-LM Model Department of Economics, UCDavis

2 Outline 1 Building the IS-LM-FX Model 2 Monetary Policy Fiscal Policy

3 Outline Building the IS-LM-FX Model 1 Building the IS-LM-FX Model 2 Monetary Policy Fiscal Policy

4 The Open Economy IS-LM Model What the model does: Explains the relationship among all the major macroeconomic variables in an open economy in the short run. Why it is useful: How monetary policy and fiscal policy affect the economy. Important conclustions: The feasibiliy and effectiveness of macroeconomic policies depend crucially on the type of exchange rate regime in operation.

5 Assumptions A Model can not catch everything in the real world. Extract the relationship amongs variables of our interests, ignore or simplify the other non-important, non-related relations. Two countries: home (the U.S.) and foreign (rest of the world). Focus on the short run fluctuations: price is sticky. Ḡ and T are fixed. Foreign variables are taken as given: Y, i. CA = TB and CA = FA: NUT = 0, NFIA = 0, KA = 0.

6 Output is driven by demand in the short run. Price is sticky in the short run, so output adjusts to fluctuations in demand to clear the goods market. Components of demand: consumption, investment, government spending, and net exports. D = C + I + G + TB

7 Consumption Building the IS-LM-FX Model Consumption is a function of disposable income. C = C(Y T ) Example: C = (Y T )

8 Investment Building the IS-LM-FX Model Investment is a negative function of nominal interest rate. I = I(i) nominal interest rate represents the cost of borrowing capital. We expect less investment projects be undertaken.

9 Government Spending Ḡ, T Government spending Ḡ and taxing income T are exogenous. They are subject only to policy change. Expansionary fiscal policy: rise in Ḡ, and fall in T Contractionary fiscal policy: fall in Ḡ, and rise in T

10 Trade Balance Building the IS-LM-FX Model Real exchange rate q = EP P = E $/europ EU P US rise in q means that it takes more home goods basket to exchange for one foreign goods basket. Home goods measured in real term becomes cheaper, foreign goods measured in real term becomes more expensive. Exports increases, foreign country demands more home goods. Imports decreases, home country demands less foreign goods. TB increases.

11 Trade Balance Real exchange rate q = EP P = E $/europ EU P US Rise in q leads to a rise in TB. rise in foreign price (P ) rise in nominal exchange rate (depreciation of home currency) fall in home price (P)

12 Trade Balance Income: rise in income raises consumption, some of which is consumption of goods produced abroad. MPC H marginal propensity to consumption of home goods MPC F marginal propensity to consumption of foreign goods MPC = MPC H + MPC F Example: MPC = 0.75, MPC H = 0.6, MPC F = Receive extra $1 of disposable income, spend $0.75. $0.6 is spent on home goods, $0.15 is spent on foreign goods.

13 Trade Balance Income: rise in income raises consumption, some of which is consumption of goods produced abroad. Y T IM TB Y T EX TB TB = TB( EP P, Y T, Y T )

14 Shocks Building the IS-LM-FX Model Shocks are exogenous changes, shifts in functions above, which can affect each part of demand. Example: rise in wealth shifts the consumption function above. consumption rises at any income level.

15 Shocks Building the IS-LM-FX Model Example:optimism about investment opportunities. rise in investment at any interest rate level.

16 Shocks Building the IS-LM-FX Model Example: tasts shifts between home and foreign goods. Trade balance increases at any real exchange rate level.

17 The Keynesian Cross Goods market equilibrium: All goods produced must be willingly demanded and purchased.

18 They Keynesian Cross Thins that shifts the demand line up: rise in Ḡ fall in T fall in i rise in q any exogenous change that shifts up consumption, investment, or trade balance.

19 The Keynesian Cross

20 Summary Level of output is determined by demand in the short run. Each component of the demand has its particular determinants. Shifts in these determinants, or shifts in other exogenous factors, shift the level of demand, thus change the equilibrium level of output.

21 The IS curve shows combinations of output Y and the interest rate i for which the goods and FOREX markets are in equilibrium.

22 A fall in i from i 1 to i 2 : leads to a rise of investment. Demand shifts up. Output in equilibrium rises. leads to a rise of nominal exchange rate (home currency depreciation). Home goods become cheaper. Demand shifts up. Output in equilibrium rises. Lower interest rate stimulate the economy (higher output level) via: investment channel Net exports (TB) channel

23 Factors that shift IS curve:

24 Any factor which increases demand at a given home interest rate i must cause the demand curve to shift up, leading to a higher output, and as a result, an outward shift in the IS curve. a rise in Ḡ (Expansionary Fiscal Policy) a fall in T (Expansionary Fiscal Policy) a rise in q any exogenous change that shifts up C, I or TB.

25 The LM curve shows the combinations of Y and i at which the money market is in equilibrium.

26 Factors that shift LM curve: a rise in nominal money supply an exogenous drop in money demand

27 At i 1, Y 1, goods market, FOREX market, money market are all in equilibrium.

28 Monetary Policy Fiscal Policy Outline 1 Building the IS-LM-FX Model 2 Monetary Policy Fiscal Policy

29 Monetary Policy Fiscal Policy Monetary Policy under Flexible exchange rate regime

30 Monetary Policy Fiscal Policy Monetary Policy under Fixed exchange rate regime

31 Monetary Policy Fiscal Policy Fiscal Policy under Flexible exchange rate regime

32 Monetary Policy Fiscal Policy Fiscal Policy under Fixed exchange rate regime

33 Monetary Policy Fiscal Policy Case Study Monetary policy is used to stabilize the economy such that it maintains full employment level. Shock 1997 Asia financial crisis. Output drops a lot in these Asia countries. A large proportion of Australia s and New Zealand s exports were purchased by these Asia Countries. Policy Response Both Australia and New Zealand adopted expansionary monetary policy to stablize the economy against such a negative shock.

34 Monetary Policy Fiscal Policy Case Study

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