Oer 8 the open economy

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1. 1 The Open Economy ® MANKIW'S MACROECONOMICS MODULES A PowerPoint  Tutorial To Accompany MACROECONOMICS, 7th. Edition N. Gregory Mankiw Tutorial written by: Mannig J. Simidian B.A. in Economics with Distinction, Duke University M.P.A., Harvard University Kennedy School of Government M.B.A., Massachusetts Institute of Technology (MIT) Sloan School of Management

2. 2 The International Flows of Capital and Goods When an economy is so-called, “open,” it means that a country’s spending in any given year is not equal to its output of goods and services. A country can spend more that it produces by borrowing from abroad, or it can spend less and lend the difference to foreigners. Let’s turn to national income accounting to explain.

3. 3 Government purchases of goods and services National Income Accounts Identity in an Open Economy Y = C + I + G + NX Total demand for domestic output Consumption spending by households Investment spending by businesses and households Net exports or net foreign demand Notice we’ve added net exports, NX, defined as EX - IM . Also, note that domestic spending on all goods and services is the sum of domestic spending on domestics goods and services and on foreign goods and services. is composed of

4. 4 Y = C + I + G + NX After some manipulation, the national income accounts identity can be re-written as: NX = Y - (C + I + G) Net Exports Output This equation shows that in an open economy, domestic spending need not equal the output of goods and services. If output exceeds domestic spending, we export the difference: net exports are positive. If output falls short of domestic spending, we import the difference: net exports are negative. Domestic Spending

5. 5 Net Foreign Investment & the Trade Balance Start with the national income accounts identity. Y = C + I + G + NX . Subtract C and G from both sides and obtain Y – C - G = I + NX . Let’s call this S , national saving . So, now we have S = I + NX . Subtract I from both sides to obtain the new equation, S – I = NX . This form of the national income accounts identity shows that an economy’s net exports must always equal the difference between its saving and its investment . S – I = NX Trade Balance Net Foreign Investment

6. 6 S – I = NX If S - I and NX are positive, we have a trade surplus . We would be net lenders in world financial markets, and we are exporting more goods than we are importing. Simply put, if Saving > Investment then Net Capital Outflow > . If S - I and NX are negative, we have a trade deficit . We would be net borrowers in world financial markets, and we are importing more goods than we are exporting. Simply put, if Saving < Investment then Net Capital Outflow < . If S - I and NX are exactly zero, we have balanced trade since the value of imports equals the value of exports. Simply put, if Saving = Investment then Net Capital Outflow = 0. Net Capital Outflow = Trade Balance

7. 7 bilateral trade balance A bilateral trade balance between two countries means that the value of what a country sells to one country is equal to the value of what it buys from that country. For example, there would be a bilateral trade balance between the United States. and China if the United States buys a pair of shoes from China valued at $300, but also sells a pair of jeans to China for $300. A nation can have large trade deficits and surpluses with different countries but have balanced trade overall. For example, there would be balanced trade overall if the United States sells a $300 pair of jeans to Japan, Japan sells a $300 car seat to China, and China sells a $300 pair of shoes to the United States. In this case, each country that bought something without having sold something to the country it bought the good from has a bilateral trade deficit. But, each nation has balanced trade overall, exporting and importing $300 worth of goods.

8. 8 Saving and Investment in a Small Open Economy We are now going to develop a model of the international flows of capital and goods. Then, we’ll address issues such as how the trade balance responds to changes in policy.

9. 9 Capital Mobility and the World Interest Rate Recall that the trade balance equals the net capital outflow, which in turn equals saving minus investment. Our model focuses on saving and investment. We’ll borrow a part of the model from Chapter 3, but won’t assume that the real interest rate equilibrates saving and investment. Instead, we’ll allow the economy to run a trade deficit and borrow from other countries, or to run a trade surplus and lend to other countries. Consider a small open economy with perfect capital mobility in which it takes the world interest rate r * as given, denoted r = r *. Remember in a closed economy, what determines the interest rate is the equilibrium of domestic saving and investment—and in a way, the world is like a closed economy—therefore, the equilibrium of world saving and world investment determines the world interest rate.

10. 10 The Model C = C (Y-T) I = I (r) Y = Y = F(K, L) NX = (Y-C-G) - I or NX = S - I The economy’s output Y is fixed by the factors of production and the production function. Consumption is positively related to disposable income ( Y - T ). Investment is negatively related to the real interest rate. The national income accounts identity, expressed in terms of saving and investment. Now substitute our three assumptions from Chapter 3 and the assumption that the interest rate equals the world interest rate, r *. NX = ( Y - C ( Y-T ) - G) - I (r * ) NX = S - I (r * ) This equation suggests that the trade balance is determined by the difference between saving and investment at the world interest rate.

11. 11 How Policies Influence the Trade Balance Suppose the economy begins in a position of balanced trade. In other words, at the world interest rate, investment I equals savings S , and net exports equal zero. Let’s use our model to predict the effects of government policies at home or abroad.

12. 12 S I(r) Investment, Saving, I , S Real interest rate, r * r closed r * NX In a closed economy, r adjusts to equilibrate saving and investment. In a small open economy, the interest rate is set by world financial markets. The difference between saving and investment determines the trade balance. Hence, starting from balanced trade, an increase in the world interest rate due to a fiscal expansion abroad leads to a trade surplus. r * ' NX If the world interest rate decreased to r * ' , I would exceed S and there would be a trade deficit . Saving and Investment in a Small Open Economy In this case, since r * is Above r closed and saving exceeds investment, there is a trade surplus .

13. 13 S I(r) Investment, Saving, I , S Real interest rate, r * r * A Domestic Fiscal Expansion in a Small Open Economy S ' An increase in government purchases or a cut in taxes decreases national saving and thus shifts the national saving schedule to the left. NX The result is a reduction in national saving which leads to a trade deficit, where I > S . NX = ( Y - C ( Y - T ) - G) - I (r*) NX = S - I (r*)

14. 14 S I(r) Investment, Saving, I , S Real interest rate, r * r 1 * A Fiscal Expansion Abroad in a Small Open Economy A fiscal expansion in a foreign economy large enough to influence world saving and investment raises the world interest rate from r 1 * to r 2 *. NX The higher world interest rate reduces investment in this small open economy, causing a trade surplus where S > I . r 2 *

15. 15 A Shift in the Investment Schedule in a Small Open Economy An outward shift in the investment schedule from I(r) 1 to I(r) 2 increases the amount of investment at the world interest rate r*. NX As a result, investment now exceeds saving I > S , which means the economy is borrowing from abroad and running a trade deficit. S I(r) 1 Investment, Saving, I , S Real interest rate, r * r 1 * I(r) 2

16. 16 The U.S. Trade Deficit During the 1980s, 1990s, and 2000s, the U.S. ran large trade deficits , with the exact size fluctuating over time yet still quite large. In 2007, the trade deficit was $708 billion or 5.1% of GDP. As accounting identities require, this trade deficit had to be financed by borrowing from abroad (i.e. selling U.S. assets abroad). During this period the U.S. went from being the world’s largest creditor to the largest debtor. What caused the U.S. trade deficit? There is no single explanation. But to understand some of the forces at work, look at national saving and domestic investment (remember that the trade deficit is the difference between saving and investment). The start of the trade deficit coincided with a fall in national saving. This development can be explained by the expansionary fiscal policy in the 1980s. With the support of President Reagan, the U.S. Congress passed legislation in 1981 that substantially cut personal income taxes over the next three years. Because these tax cuts were not met with equal cuts in government spending, the federal budget went into deficit. These budget deficits were the largest ever experienced in a period of peace and prosperity, and they continued long after Reagan left office. According to our model, such a policy would reduce national saving, causing a trade deficit. Because the government budget and the trade balance went into deficit at the same time, these shortfalls were called the TWIN DEFICITS. Lets see what happens as things start to change in the 90s on the next slide… A Mankiw Macroeconomics Case Study

17. 17 A Mankiw Macroeconomics Case Study Things started to change in the 1990s, when the U.S. federal government got its fiscal house in order. The first President Bush and President Clinton both signed tax increases, while Congress put a lid on spending. In addition to these policy changes, rapid productivity growth in the late 1990s raising incomes and thus further increased tax revenue. These developments moved the U.S. federal budget to surplus, which in turn caused national savings to rise. In contrast to what our model predicts, the increase in national saving did not coincide with a shrinking trade deficit, because domestic investment rose at the same time. The likely explanation is that the boom in information technology caused an expansionary shift in the U.S. investment function . Even though fiscal policy was pushing the trade deficit toward surplus, the investment boom was an even stronger force pushing the trade balance toward deficit. In the early 2000s, fiscal policy once again put downward pressure on national saving. With the second President Bush, tax cuts were signed into law in 2001 and 2003, while the war on terror led to substantial increases in government spending. The federal government was again running budget deficits. National saving fell into historic lows, and the trade deficit reached historic highs. A few years later, the trade deficit started to shrink, as the economy experienced a substantial decline in housing prices (see Chapters 11 and 18). Lower house prices reduced housing investment. They also made households poorer, inducing them to reduce consumption and increase saving. The trade deficit fell from .1% of GDP as its peak in the fourth quarter of 2005 to 4.9% in the third quarter of 2007. The history of the U.S. trade deficit shows that this statistic, by itself, does not tell us much about what is happening in the economy. We have to look deeper at saving, investment, and the policies and events that cause them (and thus the trade balance) to change over time. More on the U.S. Trade Deficit

18. 18 Exchange Rates In the next few slides, we’ll learn about the foreign exchange market, exchange rates and much more!

19. 19 The Mechanics of the Foreign Exchange Market Let’s think about when the United States and Japan engage in trade. Each country has different cultures, languages, and currencies, all of which could hinder trade. But, because of the foreign exchange market, trade transactions become more efficient. The foreign exchange market is a global market in which banks are connected through high-tech telecommunications systems in order to purchase currencies for their customers. The next slide is a graphical representation of the flow of the trade between the United States and Japan, and how the mix of traded things might be different, but is always balanced. Also, notice how the foreign exchange market will play the middle-man in these transactions. For instance, the foreign exchange market converts the supply of dollars from the United States into the demand for yen, and conversely, the supply of yen into the demand for dollars.

20. 20 Japan U.S. it must supply yen which are then converted into dollars by the foreign exchange market. Foreign Exchange Market Supply $ Demand YEN Demand $ Supply YEN In order for Japan to pay for its imports of goods and services and securities from the U.S., In order for the U.S to pay for its imports of goods and services and securities from Japan, it must supply dollars which are then converted into yen by the foreign exchange market. & Securities GOODS & SERVICES Goods and Services & SECURITIES The Foreign Exchange Market

21. 21 Exchange Rates Nominal versus real The exchange rate between two countries is the price at which residents of those countries trade with each other. Economists distinguish between two exchange rates: the nominal exchange rate and the real exchange rate. The nominal exchange rate is the relative price of the currency of two countries. The real exchange rate is the relative price of the goods of two countries.

22. 22 -relative price of the currency of two countries -denoted as e Nominal Exchange Rate -relative price of the goods of two countries -sometimes called the terms of trade - denoted as e Real Exchange Rate

23. 23 Nominal Exchange Rate, e The nominal exchange rate is the relative price of the currency of two countries. For example, if the exchange rate between the U.S. dollar and the Japanese yen is 120 yen per dollar, then you can exchange a dollar for 120 yen in world markets for foreign currency. A Japanese who wants to obtain dollars would pay 120 yen for each dollar he bought. An American who wants to obtain yen would get 120 yen for each dollar he paid. When people refer to “the exchange rate” between two countries, they usually mean the nominal exchange rate.

24. 24 D $ shifts rightward and increases the nominal exchange rate, e. This is known as appreciation of the dollar. B e 1 e Dollar Value of Transactions D $ A e S $ $ Appreciation and Depreciation Suppose that there is an increase in the demand for U.S. goods and services. How will this affect the nominal exchange rate ? Events which decrease the demand for the dollar, and thus decrease e, would be a depreciation of the dollar. D $ 

25. 25 The real exchange rate is the relative price of the goods of two countries. That is, the real exchange rate tells us the rate at which we can trade the goods of one country for the goods of another. To see the difference between the real and nominal exchange rates, consider a single good produced in many countries: cars. Suppose an American car costs $10,000 and a similar Japanese car costs 2,400,000 yen. To compare the prices of the two cars, we must convert them into a common currency. If a dollar is worth 120 yen, then the American car costs 1,200,000 yen. Comparing the price of the American car (1,200,000 yen) and the price of the Japanese car (2,400,000 yen), we conclude that the American car costs one-half of what the Japanese car costs. In other words, at current prices, we can exchange two American cars for one Japanese car. Real Exchange Rate, e

26. 26 We can summarize our calculation as follows: Real Exchange Rate = (120 yen/dollar)  (10,000 dollars/American car) (2,400,000 yen/Japanese Car) = 0.5 Japanese Car American Car At these prices, and this exchange rate, we obtain one-half of a Japanese car per American car. More generally, we can write this calculation as Real Exchange Rate = Nominal Exchange Rate  Price of Domestic Good Price of Foreign Good The rate at which we exchange foreign and domestic goods depends on the prices of the goods in the local currencies and on the rate at which the currencies are exchanged. Real Exchange Rate

27. 27 e = e × (P/P*) Real Exchange Rate Nominal Exchange Rate Ratio of Price Levels Relationship between the real and nominal exchange rate Note: P is the price level of the domestic country (measured in the domestic currency) and P * is the price level of the foreign country (measured in the foreign currency).

28. 28 e = e × (P/P*) The real exchange rate between two countries is computed from the nominal exchange rate and the price levels in the two countries. If the real exchange rate is high, foreign goods are relatively cheap, and domestic goods are relatively expensive. If the real exchange rate is low, foreign goods are relatively expensive, and domestic goods are relatively cheap. Real Exchange Rate Nominal Exchange Rate Ratio of Price Levels

29. 29 Purchasing-Power Parity How does the level of prices effect exchange rates? It doesn’t. All changes in a nation’s price level will be fully incorporated into the nominal exchange rate. It is the law of one price applied to the international marketplace. Purchasing-Power Parity suggests that nominal exchange rate movements primarily reflect differences in price levels of nations. It states that if international arbitrage is possible, then a dollar must have the same purchasing power in every country. Purchasing power parity does not always hold because some goods are not easily traded, and sometimes traded goods are not always perfect substitutes — but it does give us reason to expect that fluctuations in the real exchange rate will be small and temporary.

30. 30 NX( e ) Net Exports, NX Real exchange rate, e The law of one price applied to the international marketplace suggests that net exports are highly sensitive to small movements in the real exchange rate. This high sensitivity is reflected here with a very flat net-exports schedule. S-I Purchasing-Power Parity

31. 31 NX( e ) Net Exports, NX Real exchange rate, e The Real Exchange Rate and the Trade Balance The real exchange rate is determined by the intersection of the vertical line representing saving minus investment and downward-sloping net exports schedule. S-I The relationship between the real exchange rate and net exports is negative: the lower the real exchange rate, the less expensive are domestic goods relative to foreign goods, and thus the greater are our net exports. Here the quantity of dollars supplied for net foreign investment equals the quantity of dollars demanded for the net exports of goods and services.

32. 32 NX( e ) Net Exports, NX Real exchange rate, e NX 1 The Impact of Expansionary Fiscal Policy at Home on the Real Exchange Rate The fall in saving reduces the supply of dollars to be exchanged into foreign currency, from S 1 - I to S 2 - I . This shift raises the equilibrium real exchange rate from e 1 to e 2 . S 1 - I Expansionary fiscal policy at home, such as an increase in government purchases G or a cut in taxes, reduces national saving. A reduction in saving reduces the supply of dollars, which causes the real exchange rate to rise and causes net exports to fall. S 2 - I NX 2 e 2 e 1

33. 33 NX( e ) Net Exports, NX Real exchange rate, e NX 2 The Impact of Expansionary Fiscal Policy Abroad on the Real Exchange Rate The increase in the world interest rate reduces investment at home, which in turn raises the supply of dollars to be exchanged into foreign currencies. S - I (r 2 *) Expansionary fiscal policy abroad reduces world saving and raises the world interest rate from r 1 * to r 2 *. As a result, the equilibrium real exchange rate falls from e 1 to e 2. NX 1 e 1 e 2 S - I(r 1 *)

34. 34 NX( e ) Net Exports, NX Real exchange rate, e NX 1 The Impact of an Increase in Investment Demand on the Real Exchange Rate As a result, the supply of dollars to be exchanged into foreign currencies falls from S - I 1 to S - I 2 . S - I 1 An increase in investment demand raises the quantity of domestic investment from I 1 to I 2 . This fall in supply raises the equilibrium real exchange rate from e 1 to e 2 . NX 2 e 1 e 2 S - I 2

35. The Open Economy Revisited: The Mundell -Fleming Model and the Exchange-rate Regime ® MANKIW'S MACROECONOMICS MODULES A PowerPoint  Tutorial To Accompany MACROECONOMICS, 7th. Edition N. Gregory Mankiw Tutorial written by: Mannig J. Simidian B.A. in Economics with Distinction, Duke University M.P.A., Harvard University Kennedy School of Government M.B.A., Massachusetts Institute of Technology (MIT) Sloan School of Management

36. The Mundell-Fleming Model Introducing… e Income, output, Y LM * IS * Equilibrium exchange rate Equilibrium income This model is a close relative of the IS-LM model; both stress the interaction between the goods market and the money market. Price levels are fixed, and both show short-run fluctuations in aggregate income. The Mundell-Fleming Model assumes an open economy in which trade and finance are added; the IS-LM assumes a closed economy.

37. The Mundell-Fleming Model This model, often described as “the dominant policy paradigm for studying open-economy monetary and fiscal policy,” makes one important and extreme assumption: the economy being studied is a small open economy and there is perfect capital mobility , meaning that it can borrow or lend as much as it wants in world financial markets, and therefore, the economy’s interest rate is controlled by the world interest rate, mathematically denoted as r = r*. One key lesson about this model is that the behavior of an economy depends on the exchange rate regime it adopts — floating or fixed. This model will help answer the question of which exchange rate regime should a nation adopt?

38. floating exchange rates Under a system of floating exchange rates, the exchange rate is set by market forces and is allowed to fluctuate in response to changing economic conditions. The exchange rate e, adjusts to achieve simultaneous equilibrium in the goods market and the money market. When something changes that equilibrium, the exchange rate is allowed to adjust to a new rate.

39. Assumption 1 : The domestic interest rate is equal to the world interest rate (r = r*). Assumption 2 : The price level is exogenously fixed since the model is used to analyze the short run (P). This implies that the nominal exchange rate is proportional to the real exchange rate. Assumption 3 : The money supply is also set exogenously by the central bank (M). Assumption 4 : Our LM* curve will be vertical because the exchange rate does not enter into our LM* equation. Building the Mundell-Fleming Model IS*: Y = C(Y-T) + I(r*) + G + NX(e) Let’s start with two equations (notice the asterisk next to IS and LM to remind us that the equations hold the interest rate constant): The Small Open Economy Under Floating Exchange Rates LM*: M/P = L (r*,Y)

40. The IS* Curve The IS * curve slopes downward because a higher exchange rate reduces net exports (since a currency appreciation makes domestic goods more expensive to foreigners), which in turn, lowers aggregate income. Income, output, Y IS * Exchange rate, e

41. Deriving the Mundell-Fleming IS* Curve Expenditure, E Income, output, Y Y=E Planned expenditure, E = C + I + G + NX Exchange rate, e Income, output, Y Exchange rate, e , Net exports, NX NX(e) IS * An increase in the exchange rate, lowers net exports, which shifts planned expenditure downward and lowers income. The IS * curve summarizes these changes in the goods market equilibrium. The Keynesian Cross The IS* Curve The NX Schedule (a) (c) (b)

42. The LM curve and the world interest rate together determine the level of income. The LM* curve is vertical because the exchange rate does not enter into the LM * equation. Recall the LM * equation is: M/P = L (r*,Y) Deriving the Mundell-Fleming LM* Curve Interest rate, r Income, output, Y LM Exchange rate, e Income, output, Y LM* The LM Curve The LM* Curve r = r *

43. e Income, output, Y LM * IS * e Income, output, Y LM * IS * IS * ' LM * ' Expansionary Fiscal Policy Expansionary Monetary Policy When income rises in a small open economy, due to the fiscal expansion, the interest rate tries to rise but capital inflows from abroad put downward pressure on the interest rate. This inflow causes an increase in the demand for the currency pushing up its value and thus making domestic goods more expensive to foreigners (causing a – D NX ). The – D NX offsets the expansionary fiscal policy and the effect on Y. When the increase in the money supply puts downward pressure on the domestic interest rate, capital flows out as investors seek a higher return elsewhere. The capital outflow prevents the interest rate from falling. The outflow also causes the exchange rate to depreciate, making domestic goods less expensive relative to foreign goods, and stimulates NX. Hence, monetary policy influences the e rather than r. + D G, or – D T  + D e, no D Y + D M  - D e , + D Y The Mundell-Fleming Model Under Floating Exchange Rates

44. Fixed Exchange Rates Under a fixed exchange rate, the central bank announces a value for the exchange rate and stands ready to buy and sell the domestic currency at a predetermined price to keep the exchange rate at its announced level. Fixed exchange rates require a commitment of a central bank to allow the money supply to adjust to whatever level will ensure that the equilibrium exchange rate in the market for foreign- currency exchange equals the announced exchange rate. Most recently, China fixed the value of its currency against the U.S. dollar, which has resulted in a lot of tension between the two nations. It is important to realize that this exchange-rate system fixes the nominal exchange rate. Whether it fixes the real exchange rate depends on the time horizon.

45. e Income, output, Y LM* IS* e Income, output, Y LM * IS * IS * ' Expansionary Fiscal Policy Expansionary Monetary Policy A fiscal expansion shifts IS* to the right. To maintain the fixed exchange rate, the Fed must increase the money supply, thus increasing LM* to the right. Unlike the case with flexible exchange rates, there is no crowding out effect on NX due to a higher exchange rate. If the Fed tried to increase the money supply by buying bonds from the public, that would put down- ward pressure on the interest rate. Arbitragers respond by selling the domestic currency to the central bank, causing the money supply and the LM curve to contract to their initial positions. + D G, or – D T  + D Y LM* ' + DM  no D Y The Mundell-Fleming Model Under Fixed Exchange Rates

46. Fixed vs. Exchange Rate Conclusions Fixed Exchange Rates Floating Exchange Rates Fiscal Policy is Powerful . Monetary Policy is Powerless. Fiscal Policy is Powerless. Monetary Policy is Powerful . The Mundell-Fleming model shows that fiscal policy does not influence aggregate income under floating exchange rates. A fiscal expansion causes the currency to appreciate, reducing net exports and offsetting the usual expansionary impact on aggregate demand. The Mundell-Fleming model shows that monetary policy does not influence aggregate income under fixed exchange rates. Any attempt to expand the money supply is futile, because the money supply must adjust to ensure that the exchange rate stays at its announced level. Hint: (Think of “floating” money.) Hint: (“Fixed” and “Fiscal” sound alike). Floating

47. Policy in the Mundell-Fleming Model: A Summary The Mundell-Fleming model shows that the effect of almost any economic policy on a small open economy depends on whether the exchange rate is floating or fixed. The Mundell-Fleming model shows that the power of monetary and fiscal policy to influence aggregate demand depends on the exchange rate regime.

48. Devaluation & Revaluation A country with fixed exchange rates can, however, conduct a type of monetary policy by deciding to change the level at which the exchange rate is fixed. A reduction in the official value of the currency is called a devaluation, and an increase in the value is called a revaluation.

49. Interest Rate Differentials & the International Flow of Capital The higher return will attract funds from the rest of the world, driving the domestic interest rate back down. And, if the domestic interest rate were below the world interest rate, r*, domestic residents would lend abroad to earn a higher return, driving the domestic interest rate back up. In the end, the domestic interest rate would equal the world interest rate. What if the domestic interest rate were above the world interest rate?

50. Why doesn’t this logic always apply? There are two reasons why interest rates differ across countries: 1) Country Risk: when investors buy U.S. government bonds, or make loans to U.S. corporations, they are fairly confident that they will be repaid with interest. By contrast, in some less developed countries, it is plausible to fear that political upheaval may lead to a default on loan repayments. Borrowers in such countries often have to pay higher interest rates to compensate lenders for this risk. 2) Exchange Rate Expectations: suppose that people expect the French franc to fall in value relative to the U.S. dollar. Then loans made in francs will be repaid in a less valuable currency than loans made in dollars. To compensate for the expected fall in the French currency, the interest rate in France will be higher than the interest rate in the United States. Country Risk and Exchange Rate Expectations

51. Differentials in the Mundell-Fleming Model To incorporate interest-rate differentials into the Mundell-Fleming model, we assume that the interest rate in our small open economy is determined by the world interest rate plus a risk premium q . r = r* + q The risk premium is determined by the perceived political risk of making loans in a country and the expected change in the real interest rate. We’ll take the risk premium q as exogenously determined. For any given fiscal policy, monetary policy, price level, and risk premium, these two equations determine the level of income and exchange rate that equilibrate the goods market and the money market. IS*: Y = C(Y-T) + I(r* + q ) + G + NX(e) LM*: M/P = L (r* + q ,Y)

52. Now suppose that political turmoil causes the country’s risk premium q to rise. The most direct effect is that the domestic interest rate r rises. The higher interest rate has two effects: 1) IS * curve shifts to the left, because the higher interest rate reduces investment. 2) LM* shifts to the right, because the higher interest rate reduces the demand for money, and this allows a higher level of income for any given money supply. These two shifts cause income to rise and thus push down the equilibrium exchange rate on world markets. The important implication: expectations of the exchange rate are partially self-fulfilling. For example, suppose that people come to believe that the French franc will not be valuable in the future. Investors will place a larger risk premium on French assets: q will rise in France. This expectation will drive up French interest rates and will drive down the value of the French franc. Thus, the expectation that a currency will lose value in the future causes it to lose value today. The next slide will demonstrate the mechanics.

53. e Income, output, Y LM* IS * LM * ' IS * ' An Increase in the Risk Premium An increase in the risk premium associated with a country drives up its interest rate. Because the higher interest rate reduces investment, the IS * curve shifts to the left. Because it also reduces money demand, the LM * curve shifts to the right. Income rises, and the exchange rate depreciates. Is this really where the economy ends up? In the next slide, we’ll see that increases in country risk are undesirable.

54. There are three reasons why, in practice, such a boom in income does not occur . First, the central bank might want to avoid the large depreciation of the domestic currency and therefore, may respond by decreasing the money supply M. Second, the depreciation of the domestic currency may suddenly increase the price of domestic goods, causing an increase in the overall price level P. Third, when some event increase the country risk premium q , residents of the country might respond to the same event by increasing their demand for money (for any given income and interest rate), because money is often the safest asset available. All three of these changes would tend to shift the LM * curve toward the left , which mitigates the fall in the exchange rate but also tends to depress income.

55. Should Exchange Rates Be Floating or Fixed? Floating Pros Floating Cons Fixed Pros Fixed Cons Allows monetary policy to be used for other purposes such as stabilizing employment or prices. Monetary policy is committed to the single goal of maintaining the announced level. 2) May lead to greater volatility in income and employment. Exchange-rate volatility creates uncertainty and makes trade more difficult. 2) Tempers overuse of monetary authority. More speculation and volatility expected.

56. Speculative Attacks, Currency Boards, and Dollarization A speculative attack is a case where a change in investors’ perceptions makes a fixed rate untenable. To avoid these kinds of attacks, some economists suggest the use of a currency board, an arrangement by which the central bank holds enough foreign currency to back each unit of the domestic currency. The next for a nation is to consider dollarization , a plan in which the domestic currency is abandoned and the U.S. dollar is used instead.

57. The Impossible Trinity It is impossible for a nation to have free capital flows, a fixed exchange rate, and independent monetary policy. Free capital flows Independent Monetary Policy Fixed Exchange Rates Option 1: United States Option 3: China Option 2: Hong Kong

58. China’s Currency Situation By January 2009, the exchange rate had moved to 6.84 yuan per dollar– a 21% appreciation of the yuan. Despite this large change in the exchange rate, China’s critics continued to complain about that nation’s intervention in foreign-exchange markets. In January 2009, the new Treasury Secretary Timothy Geithner said, “President Obama– backed by the conclusions of a broad range of economists—believes that China is manipulating its currency. So, President Obama had pledged to use aggressively all diplomatic avenues open to him to seek change in China’s currency practices.

59. The Mundell-Fleming Model with a Changing Price Level IS*: Y=C(Y-T) + I(r*) + G + NX(e) LM*: M/P=L (r*,Y) Recall the two equations of the Mundell-Fleming model: e Income, output, Y LM* IS * LM * ' P Income, output, Y AD When the price level falls, the LM * curve shifts to the right. The equilibrium level of income rises. The second graph displays the negative relationship between P and Y, which is summarized by the aggregate demand curve.

60. The Short-run and Long-run Equilibria in a Small Open Economy Real exchange rate Income, output, Y LM* IS* LM * ' P Income, output, Y AD SRAS 2 SRAS 1 K C P 1 P 2 e 1 e 2 Point K in both panels shows the equilibrium under the Keynesian assumption that prices are fixed at P 1 . Point C in both diagrams shows the equilibrium under the classical assumption that the price level adjusts to maintain income at its natural level Y . K C