Agenda. Exchange Rates, Business Cycles, and Macroeconomic Policy in the Open Economy, Part 2. The supply of and demand for the dollar

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1 Agenda Exchange Rates, Business Cycles, and Macoeconomic Policy in the Open Economy, Pat 2 How Exchange Rates ae Detemined (again) The IS-LM Model fo an Open Economy Macoeconomic Policy in an Open Economy with Flexible Exchange Rates How exchange ates ae detemined In a flexible exchange-ate system, exchange ates ae detemined in the foeign exchange maket whee the demand fo the cuency equals the supply of the cuency. The supply of and demand fo the dolla P $ o e nom Q $

2 How exchange ates ae detemined The supply of dollas come fom domestic esidents who want to buy: Foeign made goods and sevices (impots), and/o Foeign eal and financial assets. How exchange ates ae detemined The demand fo dollas comes fom foeign esidents who want to buy: Domestic made goods and sevices (expots), and/o Domestic eal and financial assets How exchange ates ae detemined The exchange ate will change wheneve thee is a change in the supply of, o demand fo, the cuency. The supply of the cuency will incease if domestic esidents want to buy moe foeign goods, sevices, o assets. The demand fo the cuency will incease if foeign esidents want to buy moe domestic goods, sevices, o assets. How exchange ates ae detemined Factos that incease the supply of the cuency: An incease in domestic output,. A decease in the domestic eal inteest ate,. An incease in the foeign eal inteest ate, FOR. A shift in domestic demand towad foeign goods, sevices, o assets

3 How exchange ates ae detemined Factos that incease the demand fo the cuency: An incease in the domestic eal inteest ate P $ o e nom S$ An incease in foeign output, FOR. A decease in the foeign eal inteest ate, FOR. P $ An incease in the domestic eal inteest ate,. A shift in est of wold demand towads domestic goods, sevices, o assets. D $ Q $ An incease in the foeign eal inteest ate P $ o e nom S$ The IS-LM Model fo an Open Economy Only the IS cuve is affected by having an open economy instead of a closed economy; the LM cuve and FE line ae the same. P $ The IS cuve is affected because net expots ae pat of the demand fo goods. The IS cuve emains downwad sloping. D $ Q $

4 The IS-LM Model fo an Open Economy The goods-maket equilibium condition in an open economy is: S d I d = NX Desied foeign lending MUST equal foeign boowing. The IS-LM Model fo an Open Economy Goods maket equilibium, open economy: The S d I d cuve slopes upwad because a ise in the eal inteest ate inceases desied national saving and educes desied investment The IS-LM Model fo an Open Economy Goods maket equilibium, open economy: Goods maket equilibium, open economy The NX cuve slopes downwad because a ise in the eal inteest ate inceases the eal exchange ate and thus educes net expots. Net expots can be positive o negative. S d I d, NX

5 The IS-LM Model fo an Open Economy Goods maket equilibium, open economy If S d I d = NX then if S d I d > 0 then S d > I d and NX > 0 and CA > 0 and FKA < 0 and thee is: net foeign lending. S d I d, NX The IS-LM Model fo an Open Economy The IS-LM Model fo an Open Economy If S d I d = NX Goods maket equilibium, open economy: then if S d I d < 0 then S d < I d and NX < 0 and CA < 0 and FKA > 0 and thee is: net foeign boowing. Goods maket equilibium in an open economy occus whee the S d I d and NX cuves intesect. To deive an open-economy IS cuve, analyze what happens to goods maket equilibium when domestic output changes

6 Deivation of the IS cuve, open economy The IS-LM Model fo an Open Economy S d I d The open-economy IS cuve: Because highe output inceases saving, the S d I d cuve shifts to the ight. 0 Because highe output educes net expots, the NX cuve shifts to the left. NX S d I d, NX A new equilibium occus at a lowe eal inteest ate and the IS cuve is downwad sloping. The open-economy IS cuve is flatte than the closedeconomy IS cuve The IS-LM Model fo an Open Economy Factos that shift the open-economy IS cuve: The IS-LM Model fo an Open Economy Factos that shift the open-economy IS cuve: Any facto that shifts the closed-economy IS cuve also shifts the open-economy IS cuve and in the same diection. Any facto that changes net expots (fo a given domestic output and the domestic eal inteest ate) also shifts the open-economy IS cuve and in the same diection. The open-economy IS cuve shifts to the ight because of: an incease in expected futue output, an incease in wealth, an incease in govenment puchases,

7 The IS-LM Model fo an Open Economy An incease in govenment puchases Factos that shift the open-economy IS cuve: S d I d The open-economy IS cuve shifts to the ight because of: a decline in taxes, if Ricadian equivalence doesn t hold, 0 0 an incease in the expected futue maginal poduct of capital, and/o NX a decease in the effective tax ate on capital. S d I d, NX The IS-LM Model fo an Open Economy Factos that shift the open-economy IS cuve: The open-economy IS cuve also shifts to the ight because of: An incease in net expots that is NOT caused by a change in domestic output o the domestic eal inteest ate. The IS-LM Model fo an Open Economy Factos that shift the open-economy IS cuve: Thee things could incease net expots fo a given level of domestic output and the domestic eal inteest ate. Fist, an incease in foeign output, Fo. This inceases foeignes demand fo domestic expots.» And also causes the cuency to appeciate, cowding out some net expots although, on balance, net expots incease

8 The IS-LM Model fo an Open Economy Factos that shift the open-economy IS cuve: Thee things could incease net expots fo a given level of domestic output and the domestic eal inteest ate. Second, an incease in the foeign eal inteest ate, Fo. This makes domestic esidents want to buy foeign assets.» This causes the cuency to depeciate and net expots to ise. The IS-LM Model fo an Open Economy Factos that shift the open-economy IS cuve: Thee things could incease net expots fo a given level of domestic output and the domestic eal inteest ate. Thid, a shift in woldwide demand towad the domestic county s goods. This inceases the foeign demand fo domestic expots.» And also causes the cuency to appeciate, cowding out some net expots although, on balance, net expots incease An incease in (autonomous) net expots The IS-LM Model fo an Open Economy S d I d Intenational tansmission of business cycles: 0 0 The impact of foeign economic conditions on the eal exchange ate and net expots is one of the pincipal ways by which cycles ae tansmitted intenationally. NX S d I d, NX

9 The IS-LM Model fo an Open Economy A ecession in the U.S. Intenational tansmission of business cycles: U.S. Japan LM 0 What would be the effect on Japan of a ecession in the United States? LM 0 A simila effect could occu because of a shift in pefeences (o tade estictions) fo Japanese goods Maco policy in an open economy Two key questions: How do fiscal and monetay policy affect a county s eal exchange ate and net expots? How do the macoeconomic policies of one county affect the economies of othe counties? Maco policy in an open economy To analyze these questions: Use an IS-LM diagam to detemine the effects on domestic output and the eal inteest ate. Detemine how these changes affect the exchange ate and net expots. Use an IS-LM diagam to detemine the effects on foeign output and the eal inteest ate

10 Maco policy in an open economy An incease in domestic govenment puchases The shot-un effects of a fiscal expansion : Domestic Foeign LM 0 An incease in domestic govenment puchases and/o a decease in taxes. With no Ricadian equivalence. LM A fiscal expansion shifts the IS cuve to the ight Maco policy in an open economy The shot-un effects of a fiscal expansion: On the domestic economy: Domestic output inceases. Domestic eal inteest ates incease. Maco policy in an open economy The shot-un effects of a fiscal expansion: On the exchange ate: Highe domestic output inceases the supply of the cuency, causing the cuency to depeciate. Highe eal inteest ates incease the demand fo the cuency, causing the cuency to appeciate. The net effect on the exchange ate is ambiguous. Typically the inteest ate effect is lage

11 Maco policy in an open economy The shot-un effects of a fiscal expansion: On net expots: Highe output causes net expots to decease. Highe domestic eal inteest ates incease the demand fo the cuency, causing the cuency to appeciate, which in tun causes net expots to decease. The net effect is that net expots decease. Maco policy in an open economy The shot-un effects of a fiscal expansion : On the foeign economy: Domestic net expots decease, implying foeign net expots incease. The foeign county s IS cuve shifts to the ight. Foeign output inceases. Foeign eal inteest ates incease Maco policy in an open economy A decease in the domestic money supply The shot-un effects of monetay contaction: Domestic Foeign LM 0 A decease in the money supply. LM 0 A monetay contaction shifts the LM cuve to the left

12 Maco policy in an open economy The shot-un effects of monetay contaction : On the domestic economy: Domestic output deceases. Domestic eal inteest ates incease. Maco policy in an open economy The shot-un effects of monetay contaction : On the exchange ate: Lowe domestic output deceases the supply of the cuency, causing the cuency to appeciate. Highe domestic eal inteest ates inceases the demand fo the cuency, causing the cuency to appeciate. The net effect on the exchange ate is an appeciation Maco policy in an open economy The shot-un effects of monetay contaction : On net expots: Lowe domestic output causes net expots to incease. Highe domestic eal inteest ate incease the demand fo the cuency, causing the cuency to appeciate, which in tun causes net expots to decease. Following the J cuve analysis, assume the latte effect is weak in the shot un, so that net expots incease. Maco policy in an open economy The shot-un effects of monetay contaction : On the foeign economy: Domestic net expots incease, implying foeign net expots decease. The foeign county s IS cuve to the left. Foeign output decease. Foeign eal inteest ates decease

13 Maco policy in an open economy In the shot-un: Monetay policy has a lage effect on the domestic output than does fiscal policy. A monetay expansion causes cuency depeciation. Causing a incease in net expots and economic output. A fiscal expansion has an ambiguous effect on the cuency. Reduces any incease in net expots (elative to a monetay expansion) so net expots and economic output do not ise as much