# Introduction to Macroeconomics TOPIC 5: The IS-LM Model in an Open Economy

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1 TOPIC 5: The IS-LM Model in an Open Economy Annaïg Morin CBS - Department of Economics August 2013

2 The IS-LM Model in an Open Economy Road map: Two concepts to better understand openness The goods market in an open economy IS-LM in an open economy

3 1. Two concepts to better understand openness 1. Two concepts to better understand openness 1.1. Balance of payments 1.2. Real exchange rate

4 1.1. The balance of payments Balance of payments: summary of all the transactions between a country and the rest of the world trade flows financial flows

5 1.1. The balance of payments Two primary components of the balance of payments Current account Trade balance: exports - imports Net income: income received - income paid (salaries, income from asset holdings -dividends-,...) Net transfers received (aids, donations, workers remittances...) Capital account Capital account balance: Purchases of foreign holdings by foreigners - purchases of foreign assets by the country Statistical discrepancy

6 1.1. The balance of payments Figure: The US balance of payments, 2010, in billions of US dollars.

7 1.1. The balance of payments A country which runs a current account deficit is generally buying from the rest of the world more than what it is selling to the rest of the world. In order to finance this overspending, the country must borrow from the rest of the world by selling more assets to foreigners than domestic citizens buy foreign assets. In this case, the country is a net debtor to the rest of the world. Symmetrically, a country running a current account surplus is a net creditor to the rest of the world.

8 1.1. The balance of payments Remember: Y = C + I + G + X M Y T C is private saving and T G is public saving. The sum is denoted S T (total saving). Reorganizing the equation, we get: S T I = X M Current account surplus = the country is saving more than it invests, providing an abundance of resources to other economies. Current account deficit = the country is investing more than it saves, using resources from other economies (borrowing).

9 1.2. Nominal and real exchange rate Nominal exchange rate: price of the domestic currency in terms of the foreign currency price of the foreign currency in terms of the domestic currency Convention I will be using (same as in the book): price of the domestic currency in terms of the foreign currency, denoted by E. If we say that Denmark is the domestic country, we have: E = 0.13 (1DKK =e0.13)

10 1.2. Nominal and real exchange rate Exchange rate regimes: Flexible exchange rates: the central bank lets the exchange rate adjust freely on the foreign exchange market. Fixed exchange rates: the central bank has an explicit exchange rate target and uses monetary policy to achieve this target.

11 1.2. Nominal and real exchange rate Vocabulary: Appreciation of the domestic currency: increase in the nominal exchange rate Depreciation of the domestic currency: decrease in the nominal exchange rate Revaluation of the domestic currency: increase in the nominal exchange rate, under fixed exchange rates Devaluation of the domestic currency: decrease in the nominal exchange rate, under fixed exchange rates

12 1.2. Nominal and real exchange rate Nominal exchange rate: price of the domestic currency in terms of the foreign currency, denoted by E Real exchange rate: price of domestic goods in terms of the foreign goods, denoted by ɛ ɛ = EP P changes in ɛ are called real appreciations and real depreciations.

13 2. The goods market in open economy

14 2. The goods market in open economy 2. The goods market in open economy 2.1. Determination of the equilibrium The demand for domestic goods The equilibrium 2.2. Changes in demand 2.3. Depreciation

15 The goods market in open economy - The demand Remember Topic 2 the goods market, the demand for domestic goods is: Z = C + I + G + X IM This would be if IM would denote the value of imports in terms of domestic goods. But if IM denotes the value of imports in terms of foreign goods, then we have to write: Z = C + I + G + X IM/ɛ C is function of the disposable income Y T I is function of the level of output Y and the interest rate r G is exogenous What about X and IM?

16 The goods market in open economy - The demand Determinants of imports: IM = IM (Y, ɛ) }{{} (+,+) Domestic income Y : the higher the domestic income, the higher the demand of goods, domestic and foreign. Real exchange rate ɛ: the higher the price of domestic goods in terms of foreign goods, the higher the level of imports Determinants of exports: X = X (Y, ɛ) }{{} (+, ) Domestic income Y : the higher the foreign income, the higher the demand of goods, domestic and foreign. Real exchange rate ɛ: the higher the price of domestic goods in terms of foreign goods, the lower the level of exports

17 The goods market in open economy - The demand Demand for domestic goods: Z = C(Y T ) + I (Y, i) + G + X (Y, ɛ) IM(Y, ɛ) Assumption: E and ɛ are exogenous. (We will relax this later.)

18 The goods market in open economy - The demand Figure: The IS relation in open economy

19 The goods market in open economy - The demand NB1: The difference between DD and AA is imports. Given that imports increase with the level of income, the difference gets larger as Y increases. The AA line is flatter than the DD line. NB2: The difference between ZZ and AA is exports. Given that exports do not vary with the level of income, the difference remains the same as Y increases. The AA line and the ZZ line have the same slope. NB3: Net exports are decreasing with Y because imports increase with Y (while exports are unaffected). NB4: Net exports are equal to zero at the level of output for which DD crosses ZZ. Why?

20 The goods market in open economy - The equilibrium The demand is: Z = C(Y T ) + I (Y, i) + G + X (Y, ɛ) IM(Y, ɛ) The offer is: Y The IS relation in open economy is: Y = C(Y T ) + I (Y, i) + G + X (Y, ɛ) IM(Y, ɛ)

21 The goods market in open economy - The equilibrium Figure: The equilibrium on the goods market

22 2.2. The goods market in open economy - Changes in demand What happens when government spending increases?

23 2.2. The goods market in open economy - Changes in demand Figure: Fiscal policy: increase in government spending

24 2.2. The goods market in open economy - Changes in demand Fiscal policy: government spending increases: Demand is higher, the demand relation shifts up. Output increases (more than the initial increase in G: multiplier effect) Increase in output leads to an increase in imports (keeping the level of exports unaffected): trade deficit

25 2.2. The goods market in open economy - Changes in demand Is the multiplier larger or smaller in open economy than in closed economy?

26 2.2. The goods market in open economy - Changes in demand An increase in G leads to an increase in demand and then in supply. Output increases. Therefore consumption increases too but the increase in consumption falls not only on domestic goods but also on foreign goods. The effect on the demand for domestic goods is smaller than it would be in a closed economy. The multiplier is smaller. Graphically: the slope of the demand relation is smaller in open economy the multiplier is smaller.

27 2.2. The goods market in open economy - Changes in demand What happens when foreign demand increases?

28 2.2. The goods market in open economy - Changes in demand Figure: Effects of an increase in foreign demand

29 2.2. The goods market in open economy - Changes in demand Increase in foreign demand Increase in the demand of domestic goods, shift of the ZZ curve. Output increases, pushing up income and demand, etc (multiplier) Upward shift of the net export line: now the country runs a trade surplus NB: At the initial point, the total demand for domestic goods was equal to the domestic demand for domestic goods. At the new equilibrium point, the total demand is larger than the domestic demand which means that the trade balance shows a surplus. Exports increase (initial change), imports increase due to the increase in income (multiplier effect), but the increase in imports is smaller than the increase in exports.

30 2.2. The goods market in open economy - Changes in demand Importance of taking openness into account The multiplier is smaller in open economy. Smaller efficiency of fiscal policies. An expansionary fiscal policy deteriorates the trade surplus. Accumulation of debt vis à vis the rest of the world No control on an important determinant of output: foreign demand. Policy coordination?

31 2.3. The goods market in open economy - Depreciation NX = X (Y, ɛ) IM(Y, ɛ)/ɛ with X (Y, ɛ) }{{} (+, ) Direct effects of a depreciation: Exports increase Imports decrease and IM (Y, ɛ) }{{} (+,+) The relative price of foreign goods in terms of domestic goods, 1/ɛ increases, pushing the import bill up. Marshall-Lerner condition (valid in reality): exports increase enough and imports decrease enough to compensate for the increase in the price of imports. A real depreciation leads to an increase in net exports.

32 2.3. The goods market in open economy - Depreciation Indirect effects of a depreciation: Net exports increase (Marshall-Lerner), the NX line shifts up, which leads to an increase in domestic output and an upward shift of the ZZ line. Same graph as in the case of an increase in foreign demand Improvement of the trade balance even if increase in imports

33 2.3. The goods market in open economy - Depreciation: dynamics In the two previous slides, we assumed that quantities (exports and imports) adjust immediately to a change in the real exchange rate. In reality it is not the case. How will net exports change following a depreciation if quantities does not adjust immediately? What would be the first effect of a depreciation on net exports? How would net exports be impacted by a change in quantities?

34 2.3. The goods market in open economy - Depreciation: dynamics Figure: the J-curve

35 2.3. The goods market in open economy - Depreciation: dynamics The J-curve shows that the improvement of the trade balance following a depreciation (Marshall-Lerner condition) only comes with a delay. At the moment of the depreciation, a temporary deterioration of the trade balance might take place.

36 2.3. The goods market in open economy - Depreciation: dynamics Figure: Showing the lag with which the trade balance reacts to changes in the real exchange rate.

37 3. IS-LM in an open economy

38 3. IS-LM in an open economy 3. IS-LM in an open economy 3.1. The goods market 3.2. The financial market 3.3. The goods and financial markets together: the open IS-LM model 3.4. Effects of policy in a flexible exchange rate regime 3.5. Effects of policy in a fixed exchange rate regime

39 3.1. Open IS-LM - The goods market Equilibrium in the goods market: Y = C (Y T ) +I (Y, i) +G + NX (Y, Y, E) }{{}}{{}}{{} (+) (+, ) (,+, ) In the short run, prices do not change. Which means that changes in the nominal exchange rate impact the real exchange rate proportionally. Therefore, to simplify, we choose P and P so that P/P = 1, which is: E = ɛ.

40 3.2. Open IS-LM - The financial market In a closed economy, the financial market has only one component: the money market (determining how much money vs. bonds people hold). In an open economy, the financial market has two components: the money market (determining how much money vs. bonds people hold) the bond market (determining how much domestic bonds vs. foreign bonds people hold)

41 3.2. Open IS-LM - The financial market Equilibrium on the money market: M P = YL(i) The equilibrium is the same as in a close economy.

42 3.2. Open IS-LM - The financial market Equilibrium on the bond market: How to choose between domestic and foreign assets?

43 3.2. Open IS-LM - The financial market Figure: Expected returns from holdings one-year US bonds vs. one-year UK bonds.

44 3.2. Open IS-LM - The financial market Arbitrage (investors will take advantage of a price difference and buy the bonds with highest expected rate of return): The returns of both bonds must be equal: 1 + i t = (1 + i t ) Et E e t+1 This equation is called the Interest Parity Condition. It can be rewritten so: i t i t E e t+1 Et E t Because of arbitrage, the domestic interest rate must be equal to the foreign interest rate minus the expected appreciation rate of the domestic currency.

45 3.2. Exercise Investors have 100DKK and can choose between Danish and European bonds. Both type of bonds offer an interest rate of 2%. The current and future exchange rate is Is the interest parity condition respected? Lets suppose that the Danish interest rate increase from 2 to 3%. 2. Is the interest parity condition respected? Lets suppose that investors engage in arbitrage. 3. How will the investors react? 4. What would be the impact on the current exchange rate? 5. After arbitrage, is the interest parity condition respected?

46 3.2. Open IS-LM - The financial market The Interest Parity Condition can also be rewritten as: E = 1+i 1+i E e with E = E (i, i, E e ) }{{} (+,,+)

47 3.2. Open IS-LM - The financial market Figure: The relation between the interest rate and the exchange rate implied by the interest parity condition

48 3.3. Open IS-LM - The goods and financial markets together The goods market: Y = C(Y T ) + I (Y, i) + G + NX (Y, Y, E) The financial market (money market): M P = YL(i) The financial market (bonds market): E = 1+i 1+i E e In order to decrease the number of equations, we plug the interest parity equation into the goods market equation.

49 3.3. Open IS-LM - The goods and financial markets together The IS-LM model in an open economy: IS: Y = C(Y T ) + I (Y, i) + G + NX (Y, Y, 1+i 1+i E e ) LM: M P = YL(i) And we find the value of the exchange rate by using the interest parity condition. This model is also called the Mundell-Fleming model (1960 s).

50 3.3. Open IS-LM - The goods and financial markets together Figure: The IS-LM model in an open economy

51 3.3. Open IS-LM - The goods and financial markets together How to interpret the downward slope of the IS curve? An increase in the interest rate leads to a drop in investment, in demand, and in output New channel (open economy): An increase in the interest rate leads to an appreciation of the domestic currency, a decrease in exports, in demand, and in output

52 3.4. Open IS-LM - Effects of policy What are the effects of an expansionary fiscal policy?

53 3.4. Open IS-LM - Effects of policy Figure: The effects of an expansionary fiscal policy

54 3.4. Open IS-LM - Effects of policy The effects of an expansionary fiscal policy: Increase in demand, leading to an increase in output The demand for money goes up due to the increase in output: upward pressure on the interest rate (to decrease the demand for money and maintain the equilibrium). The increase in the interest rate makes domestic bonds more attractive and lead to an appreciation. Both increases in the interest rate and in the exchange rate partly offset the increase in output.

55 3.4. Open IS-LM - Effects of policy How do the components of demand vary? Consumption and government spending both increase Investment: ambiguous Net exports decrease due to both the increase in output and the appreciation

56 3.4. Open IS-LM - Effects of policy What are the effects of a contractionary monetary policy?

57 3.4. Open IS-LM - Effects of policy Figure: The effects of a contractionary monetary policy

58 3.4. Open IS-LM - Effects of policy The effects of a contractionary monetary policy: The monetary contraction leads to an increase in the interest rate. This increase in the interest rate leads to an appreciation. The increase in the interest rate and the appreciation both lead to a fall in demand and output. Money demand falls due to the output fall, leading to a lower interest rate, partly offsetting the initial increase in the interest rate and the initial appreciation.

59 3.5. Open IS-LM - Effects of policy in a regime of fixed exchange rates Fixed exchange rate: Some countries peg their currency to another currency or to a basket of foreign currencies. How? By fixing E and therefore setting i equal to i. These countries use their money supply to maintain a certain interest rate and exchange rate.

60 3.5. Open IS-LM - Effects of policy in a regime of fixed exchange rates What are the effects of an expansionary fiscal policy in a regime of fixed exchange rates?

61 3.5. Open IS-LM - Effects of policy in a regime of fixed exchange rates Figure: The effects of an expansionary fiscal policy in a regime of fixed exchange rates

62 3.5. Open IS-LM - Effects of policy in a regime of fixed exchange rates The effects of an expansionary fiscal policy in a regime of fixed exchange rates: Increase in demand, leading to an increase in output The demand for money goes up due to the increase in output: upward pressure on the interest rate (to decrease the demand for money and maintain the equilibrium). The central bank must react otherwise there would be an appreciation of the currency. Increase in the money supply: shift of the LM curve. The fiscal policy has to be accompanied by a monetary accommodation in order to keep the interest rate and the exchange rate at their initial levels.

63 3.5. Open IS-LM - Effects of policy in a regime of fixed exchange rates In a regime of fixed exchange rate, the countries give up a precious tool for correcting imbalances or changing the level of economic activity: their monetary policy.

64 Conclusion This course: Understanding of the functioning of the goods market and the financial market, and of the interactions between these two markets Understanding how openness affects the functioning of these markets Understanding the effects of economic policies So much more to see: the labor market medium run and long run better understanding the financial market exchange rate regimes introducing risk in the bonds market history of financial crisis

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