Economics 442 Mnzi D. Chinn Spring 208 Social Scincs 748 Univrsity of Wisconsin-Madison Th Opn Economy in th Short Run This st of nots outlins th IS-LM modl of th opn conomy. First, it covrs an accounting idntity. Thn th opn conomy IS curv, which incorporats an xchang rat/intrst rat rlationship, is drivd, and combind with th LM curv. Th modl is usd to xamin policy in an opn conomy, undr floating xchang rats. Finally, policy undr fixd xchang rats is xamind.. Th National Saving Idntity Considr th opn conomy dfinition of GDP, from th spnding sid: C I G IM / X (Whr all th variabls ar x post valus, not plannd or x ant valus. IM is dividd by ε, th ral xchang rat, to convrt imports xprssd forign ral units into domstic ral units. Incom can only b disposd of by bing taxd, savd or consumd: C S T Combining ths two dfinitions lads to: C S T C I G IM / X Canclling out consumption, and rarranging yilds: ( S I ( T G IM / X NX Whr NX is nt xports, which is dfind as xports minus imports; and ( EP / P, th ral xchang rat. 2. A Modl of Incom Dtrmination in th Opn Economy Equilibrium is givn by th condition output quals aggrgat dmand Z Aggrgat dmand in th opn conomy is givn by: Z C I G IM / X (9. Whr all th variabls now dnot plannd or x ant valus. Assum imports and xports bhav as in (9.2 and (9.3: IM IM (, IM IM 0, 0 (9.2 X X (, X X 0, 0 (9.3 Lt nt xports b r-writtn:
NX (,, X (, IM (, / Substituting into quation (9., using th functional forms for th domstic componnts of aggrgat dmand from Chaptr 4 yilds th IS curv for th opn conomy: C( T I(, r G NX (,, (20. If on assums that prics ar constant at hom and abroad, and P / P, thn E. Furthr, with constant pric lvl, inflation is zro, and th ral intrst rat quals th nominal. Hnc, quation (20. bcoms: C( T I(, i G NX (,, E (20.2 Th problm with this formulation of th IS curv is that any chang in th xchang rat shifts th curv; if on could mak E a function of th intrst rat, that would solv that problm. Thr is a rlationship that on can xploit, calld th intrst rat parity condition: ( it ( i t This is a no arbitrag profits condition, which stats that on can t xpct to gt a highr rturn in on location vrsus anothr, xprssd in a common currncy. Not: this is quivalnt to saying capital is frly mobil btwn countris. Rarranging: ( it ( i (20.4 t If th forign intrst rat stays constant, th xchang rat apprciats whnvr th hom intrst rat riss. It also riss if th futur xpctd xchang rat riss, which complicats mattrs. As a first approximation, assum th futur xpctd xchang rat stays constant. Thn: ( i E (20.5 ( i Equation (20.5 can b substitutd into th IS curv to yild: i C( T I(, i G NX (,, E i Th LM curv is as in Chaptr 4: M L(i P Solving this systm of quations would lad to th following quilibrium: M 0 G, T,,, E P i Th solution to this is shown in th blow graph. Notic that th highr th domstic intrst rat, th strongr th nominal xchang rat (valu of th hom conomy currncy. 2
Figur : IS-LM and Exchang rat-intrst rat rlationship 3. Policy in an Opn Economy, with Flxibl Exchang Rats W xamin fiscal and montary policy, rspctivly, in an opn conomy. First, xpansionary fiscal policy. Figur 2: Fiscal policy (xpansion 3
A fiscal xpansion inducs an incras in th intrst rat which apprciats th currncy. With th highr intrst rat, both invstmnt and nt xports ar crowdd out. On this scond point, bcaus incom is highr than initially, so too is th intrst rat. Th ral xchang rat is strongr, so nt xports ar unambiguously lowr than bfor. Figur 3: Montary policy (contraction Th highr intrst which rsults from a montary contraction inducs a strngthning of th currncy. Imports tnd to ris, and xports fall, from th currncy apprciation. Howvr, bcaus incom falls, imports fall somwhat. Th nt impact on nt xports is ambiguous. 4. An Exampl: th Unitd Stats 980-90 Soon aftr bing appointd Fd Chairman in August 979, Paul Volckr raisd th Fd funds rat to rcord highs, in ordr to rduc inflation. With th inauguration of Prsidnt Ronald Ragan in January 98, a program of tax cuts, and dfns xpnditurs wr implmntd, rsulting in a structural budgt dficit (solid lin, Figur 4. Ral intrst rats ros as a consqunc (dashd..0.08.06.04.02.00 -.02 -.04 -.06 -.08 Ragan BuS[n]/P[n] Ral Fd funds rat 970 975 980 985 990 995 2000 2005 200 205 Figur 4: Fdral structural budgt balanc to potntial GDP (blu, and Fd funds intrst rat minus laggd on yar CPI inflation (rd. 4
As th US ral intrst rat ros (solid lin, and th nominal rat ros rlativ to th forign intrst rat, th dollar strngthnd (dashd lin, as indicatd in th intrst parity condition, assuming th futur xchang rat is constant (quation 20.5..4.3.2. Ral Fd funds rat.0.08.06.04.0.02 -..00 -.2 -.3 -.4 Log ral valu of USD (73M03=0 970 975 980 985 990 995 2000 2005 200 205 -.02 -.04 -.06 5. Fiscal Policy in an Opn Economy, with Fixd Exchang Rats Figur 5: Fd funds rat minus laggd on yar inflation (solid lin, and log ral valu of th US dollar against a broad baskt of currncis (dashd lin. Whn xchang rats ar fixd (and thr ar no controls on capital flows, th montary authoritis ar committd to kping th xchang rat constant. This mans th intrst rat has to b kpt constant, and qual to th forign intrst rat. Hnc, if govrnmnt spnding is incrasd, th montary authority must incras th mony supply. Not that if th montary authority trid to undrtak an indpndnt montary contraction or xpansion, that policy would b undon by capital inflows/outflows. Figur 6: Policy undr fixd xchang rats, prfct capital mobility Not that th abov discussion applis whn capital mobility is prfct, i.., intrst rat parity holds. That condition applis to intractions btwn dvlopd countris, for instanc btwn th US and th UK. If barrirs to capital mobility xist du for instanc to lgal rstrictions on moving funds across bordrs (.g., China, thn th xchang rat can b influncd by othr factors than intrst rats in particular by buying or slling forign currncy. E442_opn_s8, 20.3.208 5