Macroeconomic Theory and Policy

Transcription

1 ECO 209 Macroeconomic Theory and olicy Lecture 13: The S and D in an Open Economy Gustavo Indart Slide 1

2 Trade Balance and the rice Level In a closed economy, an increase in the price level () reduces the real supply of money (M/) In the IS-LM model, the increase in only affects the position of the LM curve In an open economy, the increase in not only affects the real supply of money (M/) but also the real exchange rate (e f /) In the IS-LM model, the increase in affects the position of both the LM and the IS curves Recall the expression for the IS curve: i = E/b (1/bα E ), where E = C + ctr ct + I + G + X Q + (x + s) (e f /) Gustavo Indart Slide 2

3 The Effect of an Increase in on the IS and LM Curves i IS: i = E/b (1/bα E ) LM: i = (M/)/h + (k/h) LM In a closed economy, the real money supply would decrease and would fall to 2. LM IS IS In an open economy, the real exchange rate would also decrease and would fall further to Gustavo Indart Slide 3

4 The Effect of an Increase in on Exports and Imports X Q X = X + x(e f /) Q = Q s(e f /) + m Q Q X Initially, NX = 0 at = 1. The increase in causes exports to decrease and imports to increase. Therefore, now NX < 0 at = 1. X Therefore, there is a deterioration in the current account and now NX = 0 at = Gustavo Indart Slide 4

5 Fixed Exchange Rate and No Capital Mobility In the absence of capital mobility, the balance of payments (B) is equal to the balance in the current account (NX) Under fixed exchange rates, the external sector doesn t need to be in equilibrium in the short run (i.e., B 0) But the Bank of Canada will have to buy or sell foreign currency to keep the exchange rate unchanged However, the external sector could also be in equilibrium, and thus NX = 0 What we will do now is to derive a relationship between and for which NX = 0 Gustavo Indart Slide 5

6 The Relationship between and when NX = 0 X Q 2 > 1 We will assume that the NX curve is steeper than the D curve. Q( 2 ) Q( 1 ) 2 X( 1 ) X( 2 ) 1 NX Gustavo Indart Slide 6

7 oint Off the NX Curve X Q D 2 Q( 2 ) Q( 1 ) 2 B Trade Deficit D C 2 X( 1 ) B X( 2 ) 1 C C 1 D 1 Trade Surplus NX Gustavo Indart Slide 7

8 The S-D-NX Diagram 1 S The economy could be in equilibrium without achieving internal balance. Under fixed exchange rates, the economy could be in equilibrium without achieving external balance either. Trade Surplus D NX 1 * Gustavo Indart Slide 8

9 olicy Options to chieve Internal and External Balance S Suppose that the economy is initially in a situation of internal balance, but with a deficit in the external sector. 1 Trade Deficit NX D What can the government do to move the economy to a situation of both internal and external balance? We will look at two possible policy options the government could follow to move the economy to a situation of both internal and external balance. * Gustavo Indart Slide 9

10 Option 1: Classical djustment rocess S 0 S: = -1 [1 + λ( *)] One option would be to do nothing and let the market achieve both internal and external balance S 2 D 0 S 0 D 1 D 2 Under fixed exchange rates, the Bank of Canada must sell foreign currency to eliminate the deficit in the external sector. Therefore, the money supply decreases and the D curve shifts down. The decrease in the price level causes the S curve to shift down the following period. 1 2 * NX D 0 trade deficit arises again and the Bank of Canada sells foreign currency. The money supply decreases and the D curve shifts down once again. This approach is called Internal Devaluation. Gustavo Indart Slide 10

11 Option 2: Devaluation 1 Trade Deficit S nother policy option is to devalue the Canadian dollar to improve the balance of payment at each level of income. D devaluation of the currency (i.e., a revaluation of the exchange rate) will shift the NX curve up. NX NX Let s look at the impact of a devaluation on NX. 1 * Gustavo Indart Slide 11

12 The Impact of a Devaluation on X Q devaluation of the Canadian dollar (e 2 > e 1 ) increases X and decreases Q at all levels of, including 1. Net Exports When e = e 1 and = 1, NX = 0 at = 1. Q( 1, e 1 ) When e = e 2 and = 1, NX = 0 at = *. B Q( 1, e 2 ) X( 1, e 2 ) 1 B X( 1, e 1 ) NX(e 2 ) NX(e 1 ) 1 * 1 * Gustavo Indart Slide 12

13 Option 2: Devaluation and Contractionary olicy 1 D S D The devaluation of the domestic currency (i.e., revaluation of the exchange rate) shifts the NX curve to the right. In turn, the increase in NX causes the D curve to shift to the right. NX NX To maintain internal balance, the government must implement contractionary fiscal or monetary policy at the same time that the Bank of Canada devalues the currency. 1 * Gustavo Indart Slide 13

14 Trade Surplus China Classical djustment rocess S 0 S: = -1 [1 + λ( *)] D 0 S 2 S 0 D 2 The increase in the price level causes the S curve to shift up until external balance is achieved. D 1 0 NX Trade Surplus D 0 * 2 1 Gustavo Indart Slide 14

15 Trade Surplus China Revaluation S Trade Surplus S: = -1 [1 + λ( *)] revaluation of the currency (i.e., a devaluation of the exchange rate) will shift the NX curve down. 1 NX NX D D To maintain internal balance, the government must implement expansionary fiscal or monetary policy at the same time that the central bank revalues the currency. * 0 Gustavo Indart Slide 15

16 Expansionary Fiscal olicy with Fixed Exchange Rates and erfect Capital Mobility i i* S: = -1 [1 + λ( *)] E D LM( 0 ) = LM ( 0 ) LM ( 2 ) LM ( 1 ) C IS ( 1 ) IS ( 2 ) IS( 0 ) = IS ( 0 ) LM ( 0 ) B B IS ( 0 ) Under fixed exchange rates and perfect capital mobility, fiscal policy is effective with respect to income in the short-run. * * E D S 0 C D S 2 S 0 B D Gustavo Indart Slide 16

17 Expansionary Monetary olicy with Fixed Exchange Rates and erfect Capital Mobility i LM( 0 ) Under fixed exchange rates and perfect capital mobility, monetary policy is completely ineffective with respect to income. LM ( 0 ) S 0 i* B 0 IS( 0 ) * * D Gustavo Indart Slide 17

18 Expansionary Fiscal olicy with Flexible Exchange Rates and erfect Capital Mobility i LM( 0 ) Under flexible exchange rates and perfect capital mobility, fiscal policy is completely ineffective with respect to income: the increase in G completely crowds-out NX. S 0 i* B 0 IS ( 0 ) IS( 0 ) * * D Gustavo Indart Slide 18

19 Expansionary Monetary olicy with Flexible Exchange Rates and erfect Capital Mobility i i* S: = -1 [1 + λ( *)] E D LM( 0 ) = LM ( 0 ) LM ( 2 ) LM ( 1 ) C IS ( 1 ) IS ( 2 ) IS( 0 ) = IS ( 0 ) LM ( 0 ) B B IS ( 0 ) Under flexible exchange rates and perfect capital mobility, monetary policy is effective with respect to income in the short-run. * * E D S 0 C D S 2 S 0 B D Gustavo Indart Slide 19