Open Economies with Flexible Exchange Rates

Macroeconomic Theory I

ECON222

Fall 2017

Macroeconomic Theory I (ECON222) Exchange Rates & Business Cycles Fall 2017 1 / 20
Key Questions

How can we adapt the IS-LM-FE model for an open economy?

How does the economy react to shocks under exible exchange rates?

How does the response to scal and monetary policy change?

Macroeconomic Theory I (ECON222) Exchange Rates & Business Cycles Fall 2017 2 / 20
The open-economy IS curve

Net exports must be incorporated into the IS curve

The goods market equilibrium condition for an open economy is:

Sd I d = NX

The S-I curve is upward sloping: it increases when r rises

The NX curve is downward sloping: it decreases when r rises

,! higher r ) increase in demand for domestic assets
) increase in e ) fall in NX

Macroeconomic Theory I (ECON222) Exchange Rates & Business Cycles Fall 2017 3 / 20
 Figure: Goods market equilibrium in an open economy

Macroeconomic Theory I (ECON222) Exchange Rates & Business Cycles Fall 2017 4 / 20
The open-economy IS curve

Suppose that Y rises. There are two eects:

(1) S d increases ) the S-I curve shifts to the right
(2) imports rise so that NX falls ) the NX curve shifts to the left
,! the equilibrium is restored with lower r

It follows that the IS curve still slopes downward

Macroeconomic Theory I (ECON222) Exchange Rates & Business Cycles Fall 2017 5 / 20
 Figure: Open Economy IS Curve

Macroeconomic Theory I (ECON222) Exchange Rates & Business Cycles Fall 2017 6 / 20
Factors that shift the open-economy IS curve

Factors that change S d I d for a given Y will shift the IS curve

,! changes in G , MPK f , etc.

Factors that change NX for a given Y will also shift the IS curve
,! changes in e, foreign income, etc.

Macroeconomic Theory I (ECON222) Exchange Rates & Business Cycles Fall 2017 7 / 20
 Figure: Increase in net exports

Macroeconomic Theory I (ECON222) Exchange Rates & Business Cycles Fall 2017 8 / 20
The Mundell-Fleming Model

A small open economy IS-LM-FE model with exible exchange rates

Assumes international asset markets adjust rapidly so that r = rFor

,! perfect international (nancial) capital mobility

In the short-run goods prices do not adjust (fully)

,! but enom and NX adjust rapidly
,! the IS curve shifts to intersect the LM curve where r = rFor

Macroeconomic Theory I (ECON222) Exchange Rates & Business Cycles Fall 2017 9 / 20
 Figure: Open Economy General Equilibrium

Macroeconomic Theory I (ECON222) Exchange Rates & Business Cycles Fall 2017 10 / 20
The self-correcting small open economy

A decline in US output reduces NX

,! shifts the Canadian IS curve down
,! as r < rFor ) the demand for Canadian assets decreases
,! e decreases and NX rises again
,! the IS curve shifts back to the right so that r = rFor

The exible exchange rate acts as a shock-absorber

,! mitigates the impact of shocks in the goods market

Macroeconomic Theory I (ECON222) Exchange Rates & Business Cycles Fall 2017 11 / 20
 Figure: A decline in US output

Macroeconomic Theory I (ECON222) Exchange Rates & Business Cycles Fall 2017 12 / 20
Macroeconomic policy with exible exchange rates

Eects of scal and monetary policy in an open economy

,! dier from those in a closed economy
,! depend crucially on the exchange rate regime

In the short-run with exible exchange rates

,! scal policy is less eective
,! monetary policy is more eective

Macroeconomic Theory I (ECON222) Exchange Rates & Business Cycles Fall 2017 13 / 20
A scal expansion with exible exchange rates

An increase in G
,! IS curve shifts to the right
,! as r > rFor ) the demand for Canadian assets increases
,! e increases and NX falls
,! the IS curve shifts back to the left so that r = rFor

No change in Y in the short run or P in the long run

,! crowding out of NX
,! scal policy is impotent even in the short-run

Macroeconomic Theory I (ECON222) Exchange Rates & Business Cycles Fall 2017 14 / 20
 Figure: Fiscal expansion

Macroeconomic Theory I (ECON222) Exchange Rates & Business Cycles Fall 2017 15 / 20
A monetary expansion with exible exchange rates
Short run

An increase in M:
,! shifts the LM curve to the right
,! as r < rFor ) the demand for Canadian assets decreases
,! e decreases and NX rises
,! the IS curve shifts to the right so that r = rFor

Short-run increase in Y exceeds that in the closed economy

,! crowding in of NX
,! monetary policy eectiveness is increased in a SOE with exible e

Macroeconomic Theory I (ECON222) Exchange Rates & Business Cycles Fall 2017 16 / 20
 Figure: Monetary expansion: Short run

Macroeconomic Theory I (ECON222) Exchange Rates & Business Cycles Fall 2017 17 / 20
A monetary expansion with exible exchange rates
General equilibrium

Now Y > Y ) P increases due to excess aggregate demand

,! the LM curve shifts to the left
,! as r > rFor ) the demand for Canadian assets increases
,! e increases and NX falls
,! the IS curve shifts back to the left so that r = rFor

Macroeconomic Theory I (ECON222) Exchange Rates & Business Cycles Fall 2017 18 / 20
 Figure: Monetary expansion: return to General Equilibrium

Macroeconomic Theory I (ECON222) Exchange Rates & Business Cycles Fall 2017 19 / 20
Monetary neutrality

The Keynesian model predicts that in the long-run:

,! no change in real variables Y , r , NX , e
,! monetary neutrality holds

In the Classical model money is neutral in the short run too

,! only P rises

Macroeconomic Theory I (ECON222) Exchange Rates & Business Cycles Fall 2017 20 / 20