Chapter Two: Open Economy
Macroeconomics
Heijdra and van der Plog (2002), Ch
11
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Aims of this Chapter
• How do we add the international sector to the IS-
LM model? The Mundell-Fleming contribution.
• What are the implications of openness on the
effects of fiscal and monetary policy?
• How do the degree of capital mobility and the
exchange rate system affect the conclusions?
• How are shocks transmitted across countries and
how does international policy coordination work?
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National Income and Monetary
Accounting
3
National Income and Monetary
Accounting
4
National Income and Monetary
Accounting…
5
National Income and Monetary
Accounting…
• The current account surplus (CA) is identically
equal to the private sector savings surplus
(S—I) plus the government budget surplus (T—
G).
• In other words, spending less than income (as
a nation) build up claims on the RoW .
• That is if CA > 0 means that the domestic country
is lending to RoW.
• A country for which S = I and G > T is of
necessity running down its stock of net
foreign assets (it is borrowing from the RoW).
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National Income and Monetary
Accounting…
7
National Income and Monetary
Accounting…
• NFAcb is:
• – foreign exchange reserves less liabilities to
foreign official holders.
• DC includes:
• – securities held by the central bank (such as T-
bills, loans and other credit).
• High powered money consists of:
• – currency (CP ) plus commercial bank deposits at
the central bank (RE) H= CP + RE.
• – “H” is often referred to as base money.
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National Income and Monetary
Accounting…
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National Income and Monetary
Accounting…
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Open Economy IS-LM Model
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Open Economy IS-LM Model…
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Open Economy IS-LM Model…
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Open Economy IS-LM Model…
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Open Economy IS-LM Model…
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Open Economy IS-LM Model…
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Open Economy IS-LM Model…
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Degrees of Financial Openness
• Case I: Capital immobility
• there is no trade in financial assets with the ROW.
• was applicable in 1940s and early 1950s in the current
advanced nations.
• Case II: Perfect capital mobility
• capital freely flows to that location where it earns the
highest yield.
• applicable in 1980s on ward.
• Domestic and foreign bonds are perfect substitutes.
• portfolio adjustment is instantaneous.
• therefore yields (returns) are equated across the world.
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Degrees of Financial Openness…
• Case III: Imperfect capital mobility
• the intermediate case that lies between the two extremes.
That is:
• there is trade in financial assets with the ROW.
• capital does not freely flow to that location where it earns
the highest yield.
• Domestic and foreign bonds are not perfect substitutes.
• portfolio adjustment is not instantaneous.
• therefore yields (returns) are not equated across the
world.
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At equilibrium slope of the B curve is
given by:
But mind you that
the slope of B varies
with degree of
financial openness
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21
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The Degree of Capital Mobility and
the Balance of Payments
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Capital Mobility and Economic Policy
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Capital Mobility and Economic Policy
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Economic Policy Effectiveness
• Exchange rate regime matters a lot
– completely fixed exchange rates
– completely flexible exchange rates
– intermediate case: managed float
• Mobility of financial capital matters a lot
– no mobility
– perfect mobility
– intermediate case: imperfect capital mobility
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Economic Policy Effectiveness
• Scenario I: Monetary and fiscal policy with
immobile capital and fixed exchange rates.
• Scenario II : Monetary and fiscal policy with
perfect capital mobility under fixed exchange
rates.
• Scenario III: Monetary and fiscal policy with
perfect capital mobility under flexible exchange
rates.
• Scenario IV: Monetary policy with imperfect
capital mobility and flexible exchange rates
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Scenario I: Immobile Capital and Fixed
Exchange Rates
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Figure 11.2: Monetary and Fiscal Policy with Immobile
Capital and Fixed Exchange Rates
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Scenario I: Immobile Capital and Fixed
Exchange Rates…
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Scenario I: Immobile Capital and Fixed
Exchange Rates…
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Scenario II: Perfectly Mobile Capital
and Fixed Exchange Rates
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Figure 11.3: Monetary and Fiscal Policy
with PCM and Fixed Exchange Rates
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Scenario II: Perfectly Mobile Capital
and Fixed Exchange Rates…
34
Figure 11.3: Monetary and Fiscal Policy
with PCM and Fixed Exchange Rates
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Scenario III: Perfect Capital Mobility
and Flexible Exchange Rates
• Under flexible exchange rates variations in the
value of the domestic currency (E) ensure that
the balance of payments is always in
equilibrium.
• Indeed, the exchange rate is determined by
balance of payments equilibrium, since it
implies that the demand for and supply of
foreign exchange are equated:
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Scenario III: Perfect Capital Mobility
and Flexible Exchange Rates…
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Scenario III: Perfect Capital Mobility
and Flexible Exchange Rates…
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Scenario III: Perfect Capital Mobility
and Flexible Exchange Rates…
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Figure 11.5: Fiscal Policy with Perfect Capital
Mobility and Flexible Exchange Rates
An immediate policy consequence
of this ineffectiveness result is that
the small
open economy operating under
flexible exchange rates is, in a
sense, insulated
from foreign spending
disturbances (such as shocks to
the demand for its exports),
provided these shocks are
uncoordinated and consequently
have no effect on the
world rate of interest.
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Scenario III: Perfect Capital Mobility
and Flexible Exchange Rates…
42
Figure 11.6: World Interest Rate Shock with PCM
and Flexible Exchange Rates
The domestic currency
depreciates,
due to the capital outflows,
and output increases.
A global shock is
transmitted to
the small open economy
through its effect on the
world rate of interest.
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Scenario IV: Monetary and fiscal policy with
imperfect capital mobility and flexible
exchange rates.
• If financial capital is imperfectly mobile, we
have a weighted average of the two extreme
cases.
• The balance of payments curve is upward
sloping .
• Points to the left (right) of the BP curve are
consistent with a balance of payments surplus
(deficit).
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Scenario IV: Monetary and fiscal policy
with imperfect…
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Figure 11.7: Monetary Policy with Imperfect
Capital Mobility and Flexible Exchange Rates
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Figure 11.7 shows that:
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Scenario IV: Monetary and fiscal policy
with imperfect…
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Table 11.1. Imperfect Capital Mobility
Comparative Static Effects
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Table 11.1. Imperfect Capital Mobility
Comparative Static Effects(continued)
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Aggregate Supply Considerations
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Supply Side
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The Armington Approach
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The Armington Approach
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The Armington Approach…
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The Model
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The Model of Armington Approach
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The Model of Armington Approach
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The Model of Armington Approach
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The Armington Approach…
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The Model of Armington Approach
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The Model of Armington Approach
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The Model of Armington Approach
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The Model of Armington Approach
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The Model of Armington Approach
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Armington Approach…
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Armington Approach…
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Armington Approach…
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Armington Approach…
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Real Exports (NX)
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Armington Approach…
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Armington Approach…
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Armington Approach…
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Armington Approach…
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Armington Approach…
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Armington Approach…
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The Marshall-Lerner condition
• A depreciation of the currency (a rise in Q) makes
domestic goods cheaper for the ROW and increases
export earnings. This improves net exports.
• The rise in Q also makes foreign goods more expensive
to domestic residents. If real imports were unchanged,
spending on imports would rise because of the
depreciation, which would worsen net exports.
• Domestic residents, however, substitute domestic
goods for foreign goods, as a result of the depreciation,
and this effect mitigates the rise in import spending
and its adverse effect on net exports.
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The Marshall-Lerner condition
• The strength of the export effect is regulated
by the export elasticity β and that of the
import spending effect is regulated by 1 - α.
• The Marshall-Lerner condition ensures that
the export effect dominates the import
spending effect, which translates as β > 1 - α
or, equivalently, β + α > 1.
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Extended Mundell-Fleming Model
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Extended Mundell-Fleming Model…
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Extended Mundell-Fleming Model…
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Extended Mundell-Fleming Model…
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Extended Mundell-Fleming Model…
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Extended Mundell-Fleming Model…
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Extended Mundell-Fleming Model…
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Extended Mundell-Fleming Model…
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Extended Mundell-Fleming Model…
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Extended Mundell-Fleming Model…
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Extended Mundell-Fleming Model…
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Extended Mundell-Fleming Model…
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Extended Mundell-Fleming Model…
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Extended Mundell-Fleming Model…
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Extended Mundell-Fleming Model…
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Extended Mundell-Fleming Model…
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Extended Mundell-Fleming Model…
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Extended Mundell-Fleming Model…
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Aggregate supply curve for the open
economy
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Aggregate supply curve for the open
economy
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Extended Mundell-Fleming Model…
102
Relationship b/n Y and Q
1. Once the aggregate output (Y) and the
domestic price level (P) are determined, the
nominal exchange rate is also determined
small open economy assumption
2. Substitute LM curve into the AS curve
103
Extended Mundell-Fleming Model…
In Figure 11.9, AS(LM) is the combination of the LM
curve and the AS curve:
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Figure 11.9: Aggregate demand shocks
under wage rigidity
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Extended Mundell-Fleming Model…
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Extended Mundell-Fleming Model…
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Extended Mundell-Fleming Model…
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Extended Mundell-Fleming Model…
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Shock transmission in a two-country
world
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Shock transmission in a two-country
world
111
Shock transmission in a two-country
world
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Table 10.4: A two-country extended
Mundell-Fleming model
All variables except the interest rate are in logarithms and starred variables refer to the foreign
country.
Endogenous variables are
the outputs (y, y*), the
real exchange rate (q),
the rate of interest
(r*),price levels (p, p*),
nominal wages (w, w*),
and consumer price
indexes (p c , p c *).
Exogenous are
government
spending (g, g*), the
money stocks (m, m*),
and the wage targets
(wo, wo*).
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Nominal wage rigidity and economic
policy
114
Nominal wage rigidity and economic
policy
The goods market equilibrium schedule under nominal wage rigidity, GMEN, is
obtained by substituting LM(ASN) into the IS curve and solving for r* in terms of the
real exchange rate and the exogenous variables (
115
Nominal wage rigidity and economic
policy
116
Nominal wage rigidity and economic
policy
117
Figure 10.11: Fiscal policy with nominal wage
rigidity in both countries
118
How locomotive policy works?
• The increased government spending in the domestic
economy leads to upward pressure on domestic
interest rates.
• The resulting capital inflows cause the domestic
currency to appreciate, so that the demand for foreign
goods is increased. This stimulates output in the foreign
country.
• The resulting increase in the interest rate causes the
price levels of both countries to rise by the same
amount.
• Since nominal wages are fixed, the real producer wage
falls in both countries, which explains the increase in
output and employment.
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Nominal wage rigidity and economic
policy
120
Figure 10.12: Monetary policy with
nominal wage rigidity in both countries
121
Beggar-thy-neighbour policy
• There is downward pressure on domestic interest rates,
and the capital outflows lead to a depreciation of the
currency.
• This shifts domestic demand towards domestically
produced goods and away from foreign goods.
• Also, foreigners shift towards goods produced in the
domestic economy.
• Moreover, the foreign price level falls and
consequently the real producer wage rises.
• This explains the fall in output and employment in the
foreign country.
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Real wage rigidity and economic policy
123
Real wage rigidity and economic policy
124
Figure 10.13: Fiscal policy with real wage rigidity
in both countries
The increase in government spending in the
domestic country (g) raises the interest rate
and causes a real appreciation of the
domestic economy. Since consumer wages
are fixed, the producer wage falls in the
domestic economy and output and
employment are stimulated.
The opposite holds in the foreign country,
where the producer wage rises.
By raising g, the domestic policy maker
causes the foreign producer wage to rise, as
foreign workers demand higher nominal
wages in order to keep their consumption
wage constant after the real depreciation of
the foreign currency.
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International policy coordination
126
International policy coordination…
127
Uncoordinated fiscal policy
128
Uncoordinated fiscal policy…
129
Uncoordinated fiscal policy…
130
Figure 10.17: International coordination of fiscal
policy under nominal wage rigidity in both
countries
131
Figure 10.18: International coordination of fiscal
policy under real wage rigidity in both countries
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Coordinated fiscal policy
133
Coordinated fiscal policy…
134
Coordinated fiscal policy…
135
Nominal wage rigidity in both
countries
• With nominal wage rigidity in both countries, fiscal
policy constitutes a locomotive policy.
• In the absence of coordination, however, individual
countries do not take into account that their own fiscal
spending also aids the other country.
• They therefore both underestimate the benefit of their
own spending and consequently choose spending
levels that are too low.
• In the cooperative solution, on the other hand, this
external effect is internalized, and spending levels are
raised to make full use of the locomotive feature of
fiscal policy.
136
Real wage rigidity in both countries
• Fiscal policy constitutes a beggar-thy-
neighbour policy and uncoordinated actions
by national governments lead to spending
levels that are too high.
• The coordinated policy solution internalizes
this "pollution-like" aspect of government
spending and consequently leads to lower
spending levels.
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