Chapter 3 Open Economy Macroeconomics n Aggregate Demand

Chapter 3. Open Economy Macroeconomics n Aggregate Demand: IS – LM Models n Aggregate Supply: Fixed Prices, Flexible Prices and Sticky Prices

Derivation of IS Curve for AD n Y = C + I + G + NX n n Where; n n n Y C I G NX = real national income = expenditure on consumption = expenditure on investment = net government purchases of goods and services = net exports (exports minus imports) n n If we subtract C, I, and NX from both sides, we get: n n S – I – NX = G

Real Exchange Rate Components of AD: by + zr – h. Q = G 0 by + zr = G 0 + h. Q 0 by 0 + zr 0 = G 0 + h. Q 0

The IS Curve

The LM Curve n Definitions of Money M 1 = currency in circulation + checkable deposits M 2 = M 1 + noncheckable savings deposits + MMDA + small time deposits + MMMFs M 3 = M 2 + large time deposits MMDA = money market deposit accounts MMMF = money market mutual funds Near monies: M 2 and M 3 Small time deposits: less than 100, 000 US$ in USA Large time deposits: 100, 000 US$ or more in USA

Demand For Money n n n Md = k. Y k > 0 Y = Py Md = k Py

Government Budget Constraint n G – T = the budget deficit = total government spending n G – T = MB + BS

Money Supply in an Open Economy n FX + DC = (MB – MBb) + D FX + DC = MBp + D FX + DC = MS n n Where: n n n FX = gold and foreign currency reserves DC = domestic credit (L + LG) L: loans advanced to personal and corporate sector by commercial banks LG: lending to government by central bank n n n MB = currency issued (monetary base) MBb = currency plus deposits with central bank n n MBp = currency in circulation D = deposits by public MS = money supply n n FX + DC = MS

The LM Curve

The LM Curve

Aggregate Demand n IS curve : by + zr = G 0 + h. Q 0 n LM curve : k, l > 0

AD Curve

AS: Flexible Prices

AS: Fixed Prices

AS: Sticky Prices