XII Keynesian stabilization in an open economy XII
XII. Keynesian stabilization in an open economy
XII. 1 Aggregate demand in the short run
Net export and real Ex. R • In the short-run, export depends on foreign demand real exchange rate, import depends on domestic AD and real exchange rate • Usual assumption: Marshall-Lerner condition, i. e. net export depends on real exchange rate only (see Krugman, Obstfeld) • Consequently, assume: – The lower the real exchange rate, the less competitive domestic goods and services are, the higher the current account deficit (NX drops) – And vice versa
Aggregate demand real Ex. R • Considering relation between demand for real output and real Ex. R, ceteris paribus, i. e. when all other variables (interest, taxes, etc. ) unchanged – and standard assumption: economy at the potential output (full employment) equilibrium • AD = C + I + G + NX , but if only Y and real Ex. R allowed to vary, we might schematically write AD = AD(Y, e)
Output determination in the short run • Short run : prices (and wages) assumed fixed, than real Ex. R depends on nominal Ex. R only • Closed economy in the short run: relation between output and interest (ISLM) • Open economy in the short run: relation between output and Ex. R (interest considered as given) • “ISLM-type” adjustment (see next slide): – Excess demand → inventories↓ → output↑ – Excess supply, vice versa • Combinations of output and Ex. R, keeping goods market in short run equilibrium: DD curve (see next slide again)
AD E E 2 Y DD E 1 Y
What shifts DD curve? • In general: any disturbance, raising AD, shifts DD to the right; disturbance, lowering AD, shifts DD to the left • In our framework, following factors might be relevant: – Expenditures G, taxes T, investment I, domestic price P, foreign price P*, changes in autonomous consumption, demand shifts between domestic and foreign goods – Check yourself
XII. 2 Asset market in the short run
Output and Ex. R on the asset market • Asset market: interest parity condition • Interest rate determined by equilibrium on domestic money market (see LXI): • Short run: expectations, foreign interest rate, price and money supply given • Infinite combinations of output and Ex. R, keeping asset market in equilibrium: AA curve (see next slide)
E E AA Return on foreign deposits returns Y
What shifts AA curve? • • • Change in domestic money supply MS Change in price P Change in expectations Ee Change in foreign interest rate r* Shifts in demand for money function
XII. 3 Short run equilibrium in an open economy
Equilibrium and adjustment • Equilibrium both on goods and asset market: intersection of DD and AA curves • Adjustment speed: faster adjustment on assets market than on goods market E DD AA ● B● C A Y
XII. 4 Policies
XII. 4. 1 Temporary policies • Short term policies, expected to be reversed in the future, i. e. expections remain constant • Prices, wages, expectations fixed • Adjustment obvious – see above what changes DD and AA curves Monetary policy Fiscal policy E E DD Y AA Y
Use (and many warnings) • Both expansionary monetary and fiscal policies – Increase output – Monetary → depreciation, fiscal → appreciation • Application: short term reaction to exogenous shocks • Many pitfalls – Inflation bias – Time lags – Unclear origins of disturbances, etc.
XII. 4. 2 Permanent policies • Policies that are not reversed → change of expected Ex. R • Considering long term effects – after full adjustment of prices, wages and volumes • Starting point – potential output, natural values, Ex. R expectation equals actual Ex. R → domestic interest equals “foreign” interest
Robert Mundell • 1932 – • Stanford University • International institutions (namely IMF) • International economics • Mundell-Fleming model • Nobel price in 1999
Monetary policy • Money supply increase → shift of AA curve, but larger than in case of temporary case – Shift due to MS increase – Shift due Ee increase • Long term adjustment: price increase due to larger money supply (next slide: red color means final positions): – Real appreciation → domestic goods relatively more expensive → fall of foreign demand → shift of DD curve “up and left” – Real money supply falls → AA curve, after an initial shift „up“, shifts “down and left”
DD 2 E DD 1 E 2 2 3 E 3 AA 2 E 1 AA 3 1 AA 1 Yf Y 2 Y
Monetary policy efficiency • Long term adjustment: – Return to potential output – Higher price level – Nominal depreciation • However – in the short term (within a concept of Keynesian policy stimulation) monetary policy is efficient – Increase of output and employment • Remember Ex. R overshooting (see LXI)
Fiscal policy • Permanent fiscal expansion – In reality usually accompanied by permanent tax increase, otherwise unsustainable – Remember: balanced budget multiplier = 1 • Open economy – Short term shift of DD curve “up and right” – Permanent fiscal change → increase of Ee → shift of AA curve “down and left”
E DD 1 DD 2 1 E 2 X 2 Yf AA 1 AA 2 Y
Fiscal policy efficiency • Adjustment on the currency market extremely fast → after initial DD shift, change in expectation moves the AA curve immediately „down“ • There is no increase of output (and employment) even in the short term (economy will never reach point X) • Long term adjustment in closed economy – Return to potential output, government spending crowds-out private investment, inflation • Open economy – Remains at potential output at appreciated currency – Aggregate demand for domestic product crowdedout by demand foreign products (as they became cheaper) • Fiscal policy inefficient
XII. 5 Fixed exchange rate
Notice • When Ex. R fixed, but market pressures against the fix, then Central Bank must intervene – Pressure towards appreciation → purchase of foreign assets – Pressure towards depreciation → sale of foreign assets • Link between Central Bank intervention and money supply – Purchase of (foreign) assets → increase in money supply – Sale of (foreign) assets → decrease in money supply
Fixing the rate • Commitment of Central Bank to trade domestic currency at given rate • Why fix? – There is no ideal floating in reality – Arrangements for countries in a transitory stage of economies – Lessons from the past – Regional currency areas (e. g. Euro)
Equilibrium under Fix • Fix – expected Ex. R equals actual one • Interest rate parity implies that domestic interest must equal foreign interest • Implications for domestic money market – e. g. in case of output increase: – Push towards increase of domestic interest rate → push towards appreciation – To keep currency fixed, Central Bank must intervene → purchase of foreign assets → increase of money supply → interest rate and Ex. R remain at original levels • Under fix – automatic accommodation of monetary policy
E E 1 r 1 L(Y 1, r) L(Y 2, r) r
Stabilization policies under fix (1) • Only short term effects, try to derive yourselves diagrammatically • Monetary policies, e. g. increase of money supply by purchasing domestic assets → pressure towards decrease of interest and depreciation (shift in AA) → Central Bank must intervene selling foreign assets → decrease of money supply • No effect on output and employment, but decrease in foreign reserves exactly equal to original purchase of domestic assets
Stabilization policies under fix (2) • Fiscal expansion → increase of AD, shift of DD → increase of output and pressure towards appreciation, at the same excess demand for money and pressure towards interest increase → Central Bank must intervene, buying foreign assets to increase money supply (and to keep fix) → shift of AA → further increase of output, Ex. R remains at fix • Fiscal policy has an impact on output (and employment)
Stabilization policies under fix (3) • Changes in Ex. R, assume that Central Bank is credible, i. e. people accept new expected Ex. R immediately • Devaluation → increase of exports and AD (why? ) → increase of output, excess demand for money, pressure towards interest increase → Central Bank intervention, buying foreign assets → expansion of money supply, shift of AA, new equilibrium
XII. 6 Conclusions for stabilization policies The efficiency of fiscal, monetary and trade policy differs according the exchange rate regime • Flexible exchange rate (float) – Fiscal policy very little efficient – Monetary policy very efficient • Fixed exchange rate – Fiscal policy very efficient – Monetary policy very little efficient – Changes in Ex. R efficient
Literature to Ch. XII • Krugman, Obstfeld, ch. 15 -17. Basic text and references there. • Dornbush, Fischer, ch. 6. Slightly different way of explanation, but it might seem more comprehensive to some
- Slides: 34