7

BALANCE OF PAYMENTS II: 1

Demand in the Open
OUTPUT, EXCHANGE RATES, Economy
2
AND MACROECONOMIC Goods Market Equilibrium
3
Goods and Forex Market
POLICIES Equilibrium
4
IN THE SHORT RUN Money Market Equilibrium
5
The Short-Run IS-LM-FX
Model of an Open
Economy
6
Stabilization Policy
7
Conclusions
 Announcement

Problem set 2 is composed of

Chapter 5: Problem 2

Chapter 6: Problem 12

Chapter 7: Problem 1

To be returned on Wednesday April 1

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 Chapter Outline

1. Demand in the Open Economy

2. Goods Market Equilibrium: The Keynesian Cross
3. Goods and Forex Market Equilibria: Deriving the
IS Curve
4. Money Market Equilibrium: Deriving the LM
Curve
5. Macroeconomic Policies in the Short Run
6. Stabilization Policy

Today: 3 to 6

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 Questions

• How does a Keynesian fiscal stimulus work in the

open economy? What can we expect from the
Obama stimulus?
• How does a monetary stimulus work in the open
economy? What can we expect of the Bernanke
stimulus?
• What questions will be debated at the G-20 April 2
London summit? What can we expect?

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 General equilibrium

• Last time: we saw how output adjusts to ensure

demand=supply (Keynesian cross)

• But the interest rate (i) and the exchange rate (E)
were taken as given: in fact they are endogenous
to fiscal and monetary policy

• We need to bring two more markets into the

analysis
Š The foreign exchange market
Š The money market
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 General equilibrium

• Once we have done that we will be able to see

how the exogenous policy variables…
Š fiscal policy: G, T
Š monetary policy: M
determine the endogenous variables…
Š interest rate
Š exchange rate
Š consumption, investment, trade balance
Š Output

• Like a little machine to run policy experiments…

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 3. Goods and Forex Market Equilibria

• IS-LM model in the open economy

Š IS stands for “Investment & Saving”
Š LM stands for “Liquidity & Money”

• First, we focus on the IS curve

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 Forex Market Recap

• Recap: Forex market equilibrium is given by the

uncovered interest parity condition (UIP).

• Forex market equilibrium determines the nominal

exchange rate, E given all the other variables.

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Goods and Forex Market Equilibria: The IS Curve

• A decrease in
the interest rate
leads to an
increase in
demand
because of
Š higher
investment (I ↑)
Š more exports
(TB ↑)

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 Factors that Shift the IS Curve

• Example:
exogenous
increase in
demand.

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 4. Money Market Equilibrium

• Now for the LM curve…

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 Money Market Recap
• The LM curve shows combinations of output and
the nominal interest rate such that the money
market is in equilibrium.

ƒ Real money demand (MD) varies inversely with the nominal

interest rate, so the demand for real money balances is
downward sloping.
ƒ Real money supply (MS) is fixed, with the price level fixed and
the supply of money chosen by the central bank.

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 Deriving the LM Curve

• Increase in output.

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5. Short-Run IS-LM-FX Model for Open Economy

• Putting things together

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Short-Run IS-LM-FX Model of an Open Economy

• Overview
Š Combine the IS-LM diagram with the forex market
diagram to study how changes in the economy affect
key macroeconomic variables.

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Macroeconomic Policies in the Short Run

• Two policy actions

Š Monetary policy: central bank changes in the money
supply.
Š Fiscal policy: government changes in taxes and
government spending.
• The effects of fiscal depend on the country’s
exchange rate regime
Š Floating exchange rate: M is kept constant
Š Fixed exchange rate: E is kept constant

• There cannot be a fiscal stimulus with a fixed

exchange rate
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Monetary Policy under Floating Exchange Rates

• Example: Monetary expansion

Š A monetary contraction will have the reverse effects.

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Fiscal Policy under Floating Exchange Rates

• Fiscal expansion
Š A fiscal contraction will have the reverse effects.

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Fiscal Policy under Fixed Exchange Rates

• Fiscal expansion
Š A fiscal contraction will have the reverse effects.

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 Summary

• The responses to expansionary policy are

summarized below.

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 The Rise and Fall of the Dollar in the 1980s

APPLICATION
• Policy actions circa 1980
Š Paul Volcker’s Fed implemented contractionary
monetary policy 1979–1982.
Š At the same time, the Reagan administration
implemented a fiscal expansion through a
combination of tax cuts and increases in government
spending.
Š Policy mix reversed in the mid-1980s

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 The Rise and Fall of the Dollar in the 1980s

APPLICATION
• Model predictions

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 The Rise and Fall of the Dollar in the 1980s

APPLICATION
• Model predictions
Š Increase in nominal interest rate.
Š Appreciation in the U.S. dollar.
Š Decrease in investment and the trade balance.
Š Ambiguous impact on output
Š Reversed in the mid-1980s

• Data?

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 The Rise and Fall of the Dollar in the 1980s

APPLICATION

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 6. Stabilization Policy
• Stabilization policy refers to monetary and fiscal
policies designed to keep output at (or near) its
full employment level.
Š If the economy experiences an adverse shock,
policymakers can react against it.
ƒ Fiscal policy can increase demand through shifting the IS curve
to the right, or,
ƒ Monetary policy can expand the money supply, shifting the LM
curve to the right.
Š In practice, stabilization policy can be challenging.
ƒ Mistimed or inappropriate policies can create instability.

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Australia, New Zealand, and the Asian Crisis of 1997

APPLICATION
• A successful case: Australia and New Zealand
post-1997
• Australia and New Zealand rely on export
demand from East Asian economies.
Š In 1997, the East Asian economic crisis lead to a
recession in these countries, reducing demand for
exports from Australia and New Zealand.
Š Central banks in both Australia and N.Z. expanded
real money supply, reducing interest rates.

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Australia, New Zealand, and the Asian Crisis of 1997

APPLICATION
• Stabilization policy—the model

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Australia, New Zealand, and the Asian Crisis of 1997

APPLICATION

• What
happened?
Š Both countries
experienced a
sharp decrease
in nominal
interest rates
accompanied by
depreciations.
Š The declines in
the trade
balance were
slowed and even
reversed by
1999.

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 Global Financial Crisis

• We talked about fiscal stimulus last time. How

does the new model change the conclusions?

• If the nominal interest rate is constant (i.e. if the

central bank accomodates fiscal stimulus by
expanding money supply) nothing is changed.

• Are central banks accommodating? Yes, and they

try to add a stimulus of their own.

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 Global financial crisis

• Interest rate and money supply in the U.S.

1800 6.00 
%
1600
5.00 
1400

1200 4.00 
billions of dollars

1000
3.00  Monetary base
800
Federal Funds rate
600 2.00 

400
1.00 
200

0 0.00 

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 Global financial crisis

• But bad news: when the interest rate is down to

zero, the textbook monetary stimulus does not
work any more
Æ“liquidity trap”

• Money and short-term interest bearing assets

become perfectly substitutable: increasing money
supply has no effect (“pushing on a string”)

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 Global financial crisis

• IS-LM with liquidity trap

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 Global financial crisis

• Monetary stimulus if no liquidity trap

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 Global financial crisis

• In the liquidity trap

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 Global financial crisis

• Another thing not in the textbook model: debt

deflation
• Deflation: general decrease in price of goods and
assets
• Deflation depresses demand even further

Irving Fisher, american economist,

1867-1947

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 Global financial crisis

Debt deflation: an example,

Š You buy a house worth 100 with 80 of debt (20% of

equity)
Š The price of the house falls to 80: to rebuild 20% equity
need to repay/save extra 16 (say 4 per year for 4 years)
Š But now assume that the price of the house falls by 4%
per year (Æ worth 68 in 4 years)
Š Now to rebuild 20% equity need to repay/save extra 26
(more than 6 per year for 4 years)

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 Global financial crisis

• So it is important to avoid deflation…

• Scary little secret: central bankers don’t really
know how to do it in a liquidity trap…
Š one needs to increase expected inflation
Š but increasing money supply doesn’t mechanically
achieve that
Š Japanese “lost decade”
• Central bankers are trying things: especially US and
UK in recent period (quantitative easing, credit easing)

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 Global financial crisis

• One dimension in which the textbook models gets

it right: unlike fiscal stimulus, monetary stimulus
hurts the rest of the world

• Domestic monetary expansion depreciates the

exchange rate and so reduces demand for foreign
goods

• Lack of coordination may lead to excessive

monetary stimulus
Š beggar-thy-neighbor policies in the 1930s
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 Global financial crisis

• The exchange rate problem

• We have some idea of how exchange rates
should adjust to achieve new sustainable
equilibrium
Š Deficit countries (mainly US): depreciation
Š Surplus countries (Germany, China, Japan):
appreciation

• But short-run economic and political pressures

stand in the way: surplus countries will resist
appreciation.

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 Global financial crisis

International policy coordination in G-20 meeting

• A lot of good stuff in the agenda

Š Long-run financial regulation
Š Fiscal stimulus
Š More money for the IMF

• But to some extent a side show, the main

adjustment mechanisms are missing
Š What about exchange rates?
Š How to deal with deflation risk?
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