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11
Shocks and Policy
Responses in the Open
Economy
In this chapter, the open economy model developed in Chapters 9 and 10 is put to work
to examine government policy instruments and to analyse shocks that may disturb the
economy. The term shocks is used to describe a disturbance to the economy that is
unanticipated. Firms and households are likely to be forward looking and, at least to
some extent, are able to incorporate anticipated changes in their economic environment
into their behaviour. It is the different kinds of unanticipated changes in the economic
environment on which we focus in this chapter. We use the model to analyse
aggregate demand shocks,
supply shocks, and
external shocks.
In each case, it is necessary to diagnose the implications of the disturbance for the
private sector and for policy makersdoes it shift the AD curve, is it a shift along the AD
curve, does it shift the BT curve or the ERU curve? Some shocks are relatively simple to
analyse in the sense that they have an impact on only one of the three relationships in
the model. Others are more complexfor example, shifting more than one relationship.
The importance of the correct diagnosis of the type of shock is demonstrated by the
experience of the advanced countries in the 1970s. In 1973 and again in 1979, the world
price of oil increased sharply. The immediate consequence of the rst oil shock was a fall
in aggregate demand in the oil-importing OECD countries. Policy makers responded by
treating it as an aggregate demand shockone that shifted the aggregate demand curve
to the left. Yet the attempt to offset the impact of the shock on employment through
scal expansionand loosening monetary policy was accompanied by rapid deterioration
in the trade balance and rising ination. A number of European countries experienced
inationrates rising well intodouble digits at a time of rising unemployment. The second
oil shock in 1979 was met by quite a different policy response. By then it was clearer to
policy makers that the rise in the price of oil was an external supply shock, which had the
effect of shifting the AD, BT, and ERU curves in an adverse direction.
This chapter begins with an introductory section that looks at scal, monetary, and
supply-side policy inthe openeconomy. This ties together the MundellFleming analysis
(fromChapter 9) withthe medium- and long-runanalysis inChapter 10. This is followed
by an examination of four different kinds of shocks: domestic aggregate demand shocks,
domestic supply shocks, foreign trade shocks, and external supply shocks. In each case,
Keyn: chap11 2005/11/22 page 378 #2
378 THE OPEN ECONOMY
we ask what the implication of such a shock is for the short-run, the medium-run, and
the long-run equilibrium. This helps us to analyse what would happen after each kind of
shockif the government didnot react toit at all. We canthenaskwhether there are appro-
priate tools available to the government with which to offset such a shock or to mitigate
its effects on the economy. Section 5 brings together the implications of uctuations in
aggregate demand and of supply-side policy measures for the behaviour of real wages.
Section 6 applies the lessons of the chapter to the analysis of howa currency union oper-
ates and the advantages and disadvantages of membership. Inthe nal section, section7,
we showhowto interpret a monetary policy reaction function in the open economy and
howthe way the economy adjusts to a demand shock differs under anination-targeting
regime froma regime of oating exchange rates witha constant growthrate of the money
supply.
1 Fiscal, monetary, exchange rate, and supply-side
policies
The open economy model is very useful for analysing the impact on the economy of pol-
icy changes at home andabroadas well as the impact of shifts inprivate sector behaviour.
The key components of the model set out in Chapter 10 are:
the AD curve. This shows the combinations of the real exchange rate and level of
output y at which the goods market is in equilibrium and the real interest rate is equal
to the world real interest rate.
the ERU curve. This is denedas the combinations of the real exchange rate andoutput
at which the wage-setting real wage is equal to the price-setting real wage. At any point
on the ERU curve, ination is constant.
the BT curve. This shows the combinations of the real exchange rate and the level of
output y at which trade is balanced: x = m.
1.1 Timing assumptions
This is an appropriate point at which to spell out the assumptions that are being
made about the speed of adjustment of different macroeconomic variables in the open
economy.
The short run. In the short run, the goods market equilibrium is established and
arbitrage in nancial markets ensures that the home real interest rate is equal to the
world real interest rate. In the short run, we observe changes in the nominal interest
rate, the nominal exchange rate, output, and employment.
1
The end of the short-run
adjustment is marked by the attainment of the short-run equilibrium on the AD curve.
In the short run, it is assumed that wage and price setters do not change wages or prices.
1
Byvirtue of anychange inthe exchange rate, the consumer price indexchanges. Althoughthis will inuence
the short-run equilibriumin the money market, this effect is normally ignored.
Keyn: chap11 2005/11/22 page 379 #3
SHOCKS AND POLICY RESPONSES 379
The medium run. The medium run begins when wage and price setters start to
respond to two things:
(a) to any change in the level of activity (output, employment) in the economy that has
occurred in the short run and
(b) to any change in the real wage that has been brought about by a change in the
nominal (and hence the real) exchange rate in the short run.
Wage setting is assumed to happen periodically and price setters are assumed to
adjust their prices rapidly in the wake of wage changes. This means that the actual real
wage in the economy is always equal to the price-setting real wage.
2
The end of the
mediumrun is marked by the attainment of the medium-run equilibriumwith the econ-
omy at the intersection of the AD curve and the ERU curve, and hence with constant
ination.
The long run. In the long run, the presence of a current account surplus or decit
may produce shifts inthe ADcurve (as consumers react to the changes inwealthimplied,
or the government adjusts scal policy in response to market or political pressures). The
presence of a persistent surplus or decit may lead to a change in the way exchange
rate expectations are formed, with the consequence that there is constant ination only
at the intersection of the ERU and BT curves as discussed in Chapter 10. This in turn
may lead the government to adjust scal policy to shift the economy to the long-run
equilibrium.
In this section, we concentrate on three key results fromthe open economy model:
a change in scal policy shifts the aggregate demand curve, which implies there is
a new medium-run equilibrium for the economy at a different level of output and real
exchange rate. In the absence of government intervention, the economy moves from
the new short-run equilibrium to the new constant-ination rate of unemployment.
Since the short-run equilibrium is different under xed and exible exchange rates, the
adjustment path to the new medium-run equilibrium differs under xed and exible
exchange rates. In particular, the impact on inationwhether there is a temporary rise
or a temporary fall in inationdepends on the exchange rate regime.
a change inmonetary policy under exible exchange rates or a change inthe exchange
rate peg in a xed exchange rate system is a shift along the aggregate demand curve
and therefore does not lead to a new medium-run equilibrium. The levels of output and
unemployment change only in the short run. A temporary rise in ination in the case of
a devaluation/expansionary monetary policy or a temporary fall in ination in the case
of a revaluation/contractionary monetary policy leads the economy back to the original
medium-run equilibrium.
a change insupply-side policy is a shift inthe ERU curve (under bothxedandexible
exchange rates). This changes both the mediumand the long-run equilibrium.
2
This is obviously a simplicationif price setting is sluggish in the wake of cost increases, then the real
wage will lie between the wage-setting real wage and the price-setting real wage (i.e. between the WS curve and
the PS curve).
Keyn: chap11 2005/11/22 page 380 #4
380 THE OPEN ECONOMY
We are not concerned here with why the government might want to use scal or
monetary/exchange rate policy or supply-side policywe come to that when we look at
the different kinds of shocks that may affect the economy. For now, the aim is simply to
pin down the effects of different policies. This is easiest to understand if we begin in full
equilibriumat the intersection of the AD, BT, and ERU curves. Our standard assumption
is that world ination is constant and that under xed exchange rates home sets the
ination rate in the medium-run equilibriumat a rate equal to world ination.
1.2 Fiscal policy
We focus rst on the implications for aggregate demand of a change in scal policy: we
examine the supply-side aspects of some kinds of scal policy later on when we look at
supply-side policy. Suppose the economy is at point Aat full equilibriuminFig. 11.1. The
government undertakes an expansionary scal policy. The aggregate demand curve then
shifts to the right. (Ascal contractionwill produce anexactly symmetrical set of results.)
1.2.1 New medium-run equilibrium
Ascal expansion implies a rightward shift of the ADcurve. This leads to a newmedium-
run equilibriumat point B. At the newmedium-run equilibrium,
output is higher and unemployment lower,
is lower (i.e. a real appreciation), and the real wage is higher,
there is a trade decit, and
ination is constant.
u
AD(g
0
)
AD(g
1
)
BT
C
A
B
ERU
D
y
o
y
Figure 11.1 Fiscal policy shifts the AD curve: new medium-run equilibrium at B and comparison with
MundellFleming predictions
Keyn: chap11 2005/11/22 page 381 #5
SHOCKS AND POLICY RESPONSES 381
This example was discussed at the beginning of Chapter 10, where we used the labour
market diagram to discuss the implications of a scal expansion. The adjustment path
fromA to B depends on the exchange rate regime.
1.2.2 Under xed exchange rates
As we saw in Chapter 10, under xed exchange rates, output in the economy expands
with the real exchange rate constant. In the MundellFleming model expansionary scal
policy has the full multiplier effect on output because in the new short-run equilibrium,
the interest rate remains unchanged at the world rate. In Fig. 11.1, this is the move from
A to C. But in the medium run, after output and employment in the economy have
expanded, wages and prices will begin to respond. At a position above the ERU curve (see
Fig. 11.1), the existing real wage lies below the wage-setting real wage at the new higher
level of activity (see Fig. 10.2). The reason is that the WS curve is upward sloping: as
employment rises, so does the real wage that wage setters can expect when money wages
are set. As a consequence, at the next occasion on which wages are set, wages rise relative
to expected ination. From the pricing equation (P =
1
1
W
e), it follows
that consumer prices rise in the wake of the home price rise. However, the consumer
price index will not rise by as much as does the price level of home produced output
because nothing has happened to the rate of inationfor imported goods. This implies
that the real wage, (W/P
c
), has increased.
Second, because home inationhas risenandnothinghas happenedtoworldination,
price competitiveness
=
P
e
P
e),
due to the exchange rate depreciation from e
0
to e
1
, implies a deterioration in the terms
of trade for the home economy. Since the price of exports has not changed, a rise in the
price of imports turns the terms of trade against the home economy. This cuts real wages
because workers consume both imported and home produced goods. The higher price of
imports feeds directly into the consumer price index and cuts the real wage.
In the mediumrun, wage setters will react to the rise in employment and the fall in the
real wage. Since output has increased in the short run fromy
0
to y
1
, there are two sources
of pressure pushing money wages up: the fall in unemployment means a higher wage-
setting real wage and the depreciation means that the actual real wage has fallen. The
result will be a rise in money wages relative to expected prices followed by an increase in
the prices of home produced goods relative to world prices. After the initial depreciation,
the nominal exchange rate remains xed so that there are no further changes in import
prices. As a consequence, the consumer price index rises by less than money wages: real
wages rise and price competitiveness falls. This pattern is familiar: the economy is above
the ERU curve and, as we have seen before, this results in a temporary burst of ination
(above world ination) until the real wage has risen to a level equal to the wage-setting
real wage. The rise in home relative to world ination eats away at the initial rise in
competitiveness due to the depreciation/devaluation and the economy moves back to
point A (see Fig. 11.4).
Keyn: chap11 2005/11/22 page 385 #9
SHOCKS AND POLICY RESPONSES 385
E
0
E
1
E
WS
PS (u
L
)
B
A
Real wage
PS (u
H
)
w
0
w
1
Figure 11.5 Monetary policy expansion under exible exchange rates: ination erodes short-run effect
on employment
Table 11.1 Monetary expansion under exible exchange rates
1st New short-run equil. at B i e (x m) =
E > 0 and w < 0
2nd W and P adjust to change in E & w E and w W P rel. to P
y E
3rd Medium-run equil. at A , w, , E back to initial levels
It is a good idea to see how the adjustment process is represented in the labour market
diagram. This is shown in Fig. 11.5 and the steps are summarized in Table 11.1.
Why does the economy end up back at its initial level of employment? Monetary
policy raised output because it caused a real depreciation of the exchange rate and raised
net exports and therefore aggregate demand. But a real depreciation cuts real wages and
we knowthat the labour market is only in equilibriumat the initial level of employment
(E
0
) when the real wage is w
0
. Therefore a burst of domestic wage and price ination
above world ination will drive the economy back to its initial position at A. Monetary
policy has only a short-run impact on output and employment in the open economy:
there is a burst of ination above world ination and above the ination target. In the
new medium-run equilibrium, ination is once again equal to its initial level. The time
paths of the real wage and ination are shown in Fig. 11.6 .
1.3.1 Summing up
Following an expansionary monetary policy or a devaluation, output and employment
expand due to the effect of the rise in competitiveness on net exports. But this is only a
temporary effect: since the devaluation has its effect by raising the real cost of imports,
once wages and prices respond to this, there will be a bout of domestic wage and price
ination in excess of world ination. The higher ination will reverse the boost to com-
petitiveness andthe cut inreal wages andthe economy will returntoits original position.
Keyn: chap11 2005/11/22 page 386 #10
386 THE OPEN ECONOMY
W
P
c
w
0
p
0
p
Time
t
0
t
1
t
2 Time
t
0
t
1
t
2
Figure 11.6 Adjustment of real wages and ination: looser monetary policy under exible exchange
rates, or devaluation
1.4 Supply-side policy
To analyse supply-side policies, we have to focus our attentiononthe ERU curve. Supply-
side policies are those that shift the ERU curveeither by shifting the wage-setting curve
(WS) or by shifting the price-setting curve (PS()). In Chapters 2 and 4 the determinants
of the wage- and price-setting curves were introduced. Here we apply that discussion to
the open economy.
It is useful to separate out the factors that shift the WS curve from those that shift the
PS() curve. We can recall from Chapter 4 that when we introduce taxes into the supply
side of the model, it is necessary to be careful in dening both the money wage and the
price level. We stick to the principle that the real wage shown on the vertical axis of the
WSPS diagram is the real wage relevant to wage setters. This is the real consumption
wage dened as the take home wage deated by the consumer price index:
w =
W
P
c
=
wage net of income tax and social security
consumer price index including VAT
. (real consumption wage)
1.4.1 Policies that shift the wage-setting curve
The wage-setting curve shows the real take home wage at each level of employment that
workers believe they have negotiated. As discussed in Chapter 2, the wage-setting curve
lies above the competitive labour supply curve either because of the presence of unions or
because of efciency wage considerations. At each level of employment, wage setters set
the money wage to secure this real wage, assuming that a specic price level will prevail
over the course of the wage contract.
W = P
E
c
b(E). (wage equation)
The wage-setting curve is therefore:
w
WS
=
W
P
E
c
= b(E). (wage-setting real wage)
Keyn: chap11 2005/11/22 page 387 #11
SHOCKS AND POLICY RESPONSES 387
Any policy that affects the wage-setting decision will shift the WS curve. Policies dis-
cussed in Chapter 4 include changes in the workers outside option such as changes in
unemployment benet, labour legislation, or the negotiation by the government of a
wages accord with unions and employers associations.
The WS curve shifts down
if there is a fall in unemployment benets (or more precisely in the replacement ratio,
which is the ratio of benets to the average wage),
if unions are given less legal protection or become weaker as union density or coverage
declines,
if unions agree to exercise bargaining restraintin the context, for example, of a
wages accord.
1.4.2 Policies that shift the price-setting curve for a given real exchange rate
We turn now to the policies that shift the PS() curve. The price-setting curve shows the
outcome for real consumptionwages of the decisions of the price setters inthe economy.
Price setters set their prices in order to secure the mark-up , given the unit labour costs
that they face. We saw in the closed economy that the price-setting curve will shift up if
there is a
reduction in the tax wedge
reduction in the mark-up, due, for example, to a change in competitive conditions
fall in the real interest rate
rise in efciency, such as a change in the level or the trend of labour productivity
growth. Note that this is likely to be incorporated eventually into workers beliefsin
which case, the WS curve will shift as well (see the discussion in Chapter 4).
In the open economy, the PS() curve shifts upshowing that real take home wages
in the economy consistent with price-setting behaviour are higherin response to any
of these changes. We also know that in the open economy, the price-setting curve shifts
as a consequence of changes in the real exchange rate. Since the ERU curve is drawn in
real exchange rateoutput space, although a change in shifts the price-setting curve,
it does not shift the ERU curve. If the price-setting curve shifts for any other reason, this
implies a shift in the ERU curve.
Lookingat eachof thesefactors inturn, intheopeneconomy, changes inthepressureof
product market competition can arise fromtrade liberalization policies. A good example
for European countries is the reduction of tariff barriers to trade between members of the
European Economic Community, which began in 1957 with the Treaty of Rome. This
was followed in the late 1980s with an initiative to remove non-tariff barriers to trade so
as to increase product market competitioninthe internal market of the EuropeanUnion.
There is some evidence to suggest that monopoly power has fallen in the EU following
the so-called 1992 Single Market measures.
3
Anincrease inproduct market competition
is likely not only to shift the PS curve upwards but also shift the WS curve downwards.
3
See, for example, Allen, Gasiorek, and Smith (1998).
Keyn: chap11 2005/11/22 page 388 #12
388 THE OPEN ECONOMY
Morepressureintheproduct market has theeffect of dampeningunionbargainingpower.
However, since both of these effects (an upward shift in the PS() curve and a downward
shift in the WS curve) shift the ERU curve in the same direction, we simplify here by
considering competition effects under price setting only.
The analysis of taxes is very similar to that in the closed economy. The only extra
considerationis the tax treatment of exports and imports. Exports are exempt fromvalue
added tax. The logic of this arrangement is that indirect taxes should be destination
based in order that cross-country differences in tax rates do not distort competition in
the domestic market for nal goods. This principle means that imports attract the VAT
rate of the importing country. In the derivation of the price-setting real wage that is set
out in detail in the appendix to this chapter, these factors are taken into account.
The impact of a change in productivity (or in the rate of productivity growth in a
dynamic context) onequilibriumemployment depends onits effects onthe wage-setting
andprice-settingcurves. If we abstract fromproductivitygrowth, andexamine the impact
of a policy that raises the level of productivity, the most obvious effect is toshift the price-
setting real wage upward.
4
More output per head is available for real wages at each level
of employment. Educationand training policies may have the effect of raising efciency.
By recalling the derivation of the ERU curve (Chapter 10, section 1), it is clear that any
policy that shifts the wage-setting curve or shifts the PS() curve implies a shift inthe ERU
curve. A downward shift in the WS curve implies ceteris paribus a rightward shift in the
ERU curve. An upward shift in the PS() curve implies ceteris paribus a rightward shift in
the ERU curve. We take an example of a supply-side policy that shifts the WS curve and
another that shifts the PS() curve.
1.4.3 Example: wage accord
InFig. 11.7, the WS curve shifts down. This couldbe for any of the reasons listedabove. In
this example, we assume that it shifts because of the negotiation of a wages accord by the
government. The conclusion of an agreement through which unions agree to exercise
bargaining restraint implies a rightward shift in the ERU curve, as explained above.
What are the implications for the economy? Consider an initial position of medium-
run equilibrium. Then shift the WS curve down. This reects the fact that at the existing
employment level, wage setters will set a lower nominal wage tosecure the lower expected
real wage. At an unchanged level of the real exchange rate (i.e. an unchanged real cost of
imports) and with a given prot margin, this implies that lower unemployment will be
compatible with medium-run equilibrium. At lower unemployment the wage claims of
wage setters will be boosted sufciently so as to restore equality betweenthe price-setting
real wage (given and ) and the wage-setting real wage. The shift in the wage-setting
curve fromWS toWS
= PS(
0
) at employment level E
2
, i.e. at point A
of (y
2
,
0
).
Nothinghappens intheshort runbecausewages andprices areassumedtobegiven. The
new medium-run equilibrium for the economy is at point B with lower unemployment
and higher price competitiveness. The economy adjusts gradually from A to B in the
following way: at Afollowing the shift inthe WS curve, the existing real wage, w
0
, is above
the new wage-setting real wage on the WS
. This is in turn
reected in the point (y
2
,
0
) which denes the newERU
curve (point A
).
Inorder to focus entirely onthe supply-side implications of the tax fall, we assume that
the impact onaggregate demandof the tax cut is fully offset by anappropriate decrease in
government spending. Hence, the AD curve remains xed. The new medium-run equi-
librium is at point B with lower unemployment and higher price competitiveness. The
newlong-run equilibriumis at point Z at lower unemployment. In the newmedium-run
equilibrium, real prots are unchanged but both real wages and real import costs are
higherreal taxes per worker are lower.
Keyn: chap11 2005/11/22 page 391 #15
SHOCKS AND POLICY RESPONSES 391
The economy adjusts to the new medium-run equilibrium as follows. The economy
begins at point A on the PS(
0
, t
0
) curve. The cut in tax rates (e.g. income tax) raises the
real consumption wage. This is shown by point A
on the newPS(
0
, t
1
) curve. Note that
nothing has happened to the real exchange ratethe upward shift in the PS() curve is
entirely due to the cut in the tax rate. The real wage is above the wage-setting real wage
(compare A
rm
/P
manuf
, where P
rm
is the world price index of raw materials and P
manuf
is the world
price index of manufactures. An example of an increase in is a rise in the world price of
oil. A rise in the price of oil relative to manufactures means that for the home country,
which is assumed to import raw materials and export manufactures, a higher volume of
exports must be sold to purchase a given volume of imports. This represents a negative
external trade shock for the home country and is a deterioration in its terms of trade. As
we will see in the next section, a raw materials price shock is not only an external trade
shock but also a supply shock because it shifts the ERU curve.
The analysis of the impact of an external trade shock is straightforward. It will shift the
ADcurve andthe BT curve inthe same direction. The horizontal shift of the BT curve will
be greater than that of the ADcurve for the same reason that the ADcurve is steeper than
the BT curve (refer back to section 2 in Chapter 10). A simple way of seeing this is that if
we look at the initial output level, y
0
, at which the AD curve and the BT curve intersect
(see point A in Fig. 11.12) then the new AD curve, AD
, will
intersect at y
0
(at point A
curve takes place. The possibility of changing the exchange rate can reduce the output
cost of the adjustment to point B but with the consequence that there is a bout of rising
wages and prices in the home economy relative to the rest of the world.
The difference between the impact of an external trade shock and a pure aggregate
demand shock is that the BT curve moves in the case of an external trade shock. This has
two consequences: rst, points C and B are positions of trade surplus if there is a pure
aggregate demand shock and of trade decit if there is anexternal trade shock. Second, in
the case of anexternal trade shock, the long-runequilibriumof the economy shifts (from
A to Z).
4.2 External supply shocks
An external supply shock is dened as an unanticipated change in the world terms of
trade between manufactures and raw materials: a change in the world price of oil is a
good example. As noted in the previous section, this type of shock combines the effects
of an external trade shock with a supply-side impact on the price-setting real wage curve.
The consequence is that there is a shift in the AD curve, in the BT curve, and in the ERU
curve: all curves shift in the same direction.
To see why the ERU curve shifts, we need to look closely at what is meant by a change
in the world price of oil. If we say that the world price of oil rises, this means that it rises
relative to the world price of manufactured goods, where = P
rm
/P
manuf
. Inother words,
we are talking about a change in relative prices, or to put it another way, a change in the
real price of oil. The price-setting curve is dened for a given real exchange rate, . Now
suppose that the world price of oil rises. For a given , a rise in the price of an essential
input like oil raises costs for rms in the home economy so if rms are to protect their
prot margins, then real wages must be lower. Hence the price-setting real wage curve
shifts downward when the world price of oil rises (see Fig. 11.13). This implies a leftward
shift in the ERU curve. The derivation of the price-setting curve incorporating imported
materials is presented in a footnote.
7
7
It is simplest to assume that there is no mark-up on imported materials. Assume the only imports are of raw
materials. Then
P
c
= P + vP
e
Keyn: chap11 2005/11/22 page 397 #21
SHOCKS AND POLICY RESPONSES 397
Figure 11.13 A negative external supply shock:
increase in the oil price shifts ERU curve left
W
P
c
B
E
0
y
1
y
0
y
E
1
E
A
WS
PS (u
0
, t
0
)
PS (u
0
, t
1
)
B
A
ERU
ERU
u
u
0
We can now analyse the full impact of an exogenous and permanent change in the
world price of anessential commodity suchas oil. We take the case of a rise inthe price of
oil. For simplicity, we assume that the home country only imports oilit does not import
nal goods. This changes nothing essential and allows for a more direct examination of
the issue at hand. We can investigate the three effects:
(1) the impact on aggregate demand
(2) the impact on the trade balance
(3) the impact on price and wage setting and hence on the ERU curve.
We have already examinedthe rst twoeffects inthe analysis of anexternal trade shock
in Fig. 11.12: there is a downward shock to net exports because the increase in the cost
of the essential imported raw material absorbs a higher proportion of home income at a
given real exchange rate. This shifts the ADcurve and the BT curve to the left.
8
where P =
W
(1)
is the price index of value added and v is unit materials requirement. This implies a price-
setting real wage:
w
PS
=
(1 )
1 + v
.
Any rise in reduces the price-setting real wage. Note that any fall in unit materials requirement through
increased energy efciency, for example, would tend to offset this.
8
Since the oil price shock is a world phenomenon, there will be a fall in world aggregate demand and world
output, y
, as all exporters of manufactures suffer from the supply shock. This assumesrealisticallythat
the exporters of raw materials, who have experienced an increase in their wealth, are unable to increase their
expenditure sufciently to compensate. This would reinforce the leftward shifts in the ADand BT curves.
Keyn: chap11 2005/11/22 page 398 #22
398 THE OPEN ECONOMY
Figure 11.14 External supply shock
BT
BT
B
A
B
A
AD
ERU
ERU
y
0
y
1
y
u
AD
Z
C
We turn to the consequences of the shift in the ERU curve. The rst observation is
that the inationary consequences of the commodity price rise are clear. Following the
external supply shock, the initial equilibrium point A is above the new ERU curve. This
means that at y
0
, the real wage is below the wage-setting real wage. The reason is that
the costs of home rms have gone up and higher domestic prices cut the real consump-
tion wage. There will be upward pressure on ination.
In terms of the assessment of the adjustment paths under xed and exible exchange
rates, it is clear that as compared with a pure external trade shock, the costs of the adjust-
ment via exchange rate depreciation (higher ination via point A
in Fig. 11.14) go up
relative to the costs of adjustment with a xed exchange rate. This is clearly illustrated
by reference to the two oil shocks in the 1970s. In response to the rst oil shock in 1973,
many countries focused on the aggregate demand consequences and sought to offset
themvia expansionary scal and monetary policies. If we look at the consequences of an
accommodating monetary policy, this allowed the exchange rate to depreciate (to A
).
The consequence was the onset of so-called stagation: rising unemployment and rising
ination (as the economy eventually adjusted from A
to B
= log e
E
t+1
log e
t
. Withthe slight fudge that
E
=
=
E
, we canwrite
this as
r
t
r
= log e
E
t+1
log e
t
Thinkof this as the equationwhichdetermines e
t
. If r > r
; that is d where y = y
e
= y
2
and =
e
=
1
. This is
because being at Dis a necessary condition for being at D
2
in yspace; and it is only at D
2
that the central bank
will want r =r
. Now in period t = 0, =
.
Start at A, before g has increased. Then the rationally expected exchange rate as soon as g has increased is the
nominal exchange rate which takes the economy immediately to
1
. If =
1
, and if r = r
, the relevant AD
schedule is AD(g
1
, r
, we are at D
2
so that the central
bank will indeed set r = r
. Since
0
= P
e
0
/P, and since neither P
e
1
/P; so e
1
= e
0
1
/
0
. At D it is
indeed true that e
E
= e
1
, since r = r
.
Keyn: chap11 2005/11/22 page 407 #31
SHOCKS AND POLICY RESPONSES 407
does this as follows: it observes =
1
<
1
with y = y
e0
. Hence it infers that the new
equilibrium, y
e
1
is given by
y
e1
y
e0
=
1
(
1
1
).
In other words, the central bank knows that the correct short-run Phillips curve must go
through the correct vertical Phillips curve at
1
. The correct Phillips curve must also go
through the observation
1
, y
0
. The correct Phillips curve is then derived by joining up
these two points. The new equilibrium output level is then given by the output level at
which =
1
.
If this argument is correct, the central bank can immediately infer from any new data
what the new level of equilibrium output, y
e
, is. It therefore behaves no differently from
the central bank that does have a model of the economy. Of course, this is to take no
account of measurement errors and random uctuations in the economy. The central
bank might think, for instance, that the output increase does not imply an increase
in equilibrium output but simply represents a one-off demand shock. However, it is
interpreted as being accompanied by a measurement error in the rate of ination, hence
explaining why ination is unexpectedly low. In that case, if the central bank was sure
of its analysis, it would raise interest rates according to the pre-existing MR after making
some assumption about what the true ination rate was.
7.2 Summing up
Adjustment to a shock in a exible exchange rate open economy is different when mon-
etarypolicyis operatedwithamonetaryrulefromwhenthereis amonetarygrowthtarget.
With ination inertia, but rational exchange rate expectations, the economy will move
directly to the new medium-run equilibrium when the monetary rule is in place. The
real exchange rate overshooting characteristic of adjustment with a money supply target
disappears. When exchange rate expectations also exhibit inertia, the new medium-run
equilibrium is approached along the MR line. In the case of a positive aggregate demand
shock withthe (nominal andreal) exchange rate appreciating andinationfalling gradu-
ally back to the target level.
8 Conclusions
In this chapter the open economy model has been used to examine the impact on
the economy of a series of different kinds of policies and shocks. Fiscal policy, mon-
etary/exchange rate policy, and supply-side policy have been investigated. The analysis
has been applied to the question of how real wages move over the cycle and to the costs
of joining a common currency area.
Aggregate demand shocks that shift the AD curve and therefore the medium-run
equilibrium are changes in autonomous consumption and investment. The short-run
effects of an aggregate demand shock can be best offset by using scal policy.
Keyn: chap11 2005/11/22 page 408 #32
408 THE OPEN ECONOMY
Changes in monetary policy in a exible exchange rate regime or discrete changes in
the exchange rate peg in a xed rate system lead to a shift along the AD curve and
therefore do not change the medium-run equilibrium.
Supply shocks and supply-side policies are dened as those that shift either the wage-
setting curve, the price-setting curve (for a given real exchange rate) or both. In the
open economy, a supply shock or policy is one that shifts the ERU curve and hence
shifts the medium- and long-run equilibriumrate of unemployment.
External trade shocks are dened as those that change the level of net exports for a
given real exchange rate. Such shocks shift the AD and the BT curves and therefore
change the short-, medium-, and long-run equilibria.
External supply shocks such as a change in the world price of an essential commodity
shift all three of the AD, BT, and ERU curves.
The model predicts that there will not be a xed relationship between real wages and
employment e.g. procyclical or countercyclical real wages in the open economy. The
pattern will depend on the nature of the shock (e.g. IS shock, LM shock, or supply-side
shock).
The costs of giving up the nominal exchange rate by joining a common currency area
depend on the nature of the shocks the economy is likely to encounter, its structural
characteristics (e.g. the lags in wage and price setting and the responsiveness of the
wage-setting real wage to changes in unemployment) and the availability of comple-
mentary policies (e.g. scal policy, supply-side policies).
The openeconomy model was extendedby showing howanination-targeting central
bank ina exible exchange rate small openeconomy responds to anaggregate demand
shock. The major difference that characterizes the ination-targeting regime from the
money supply-targeting one is that the central bank adjusts the interest rate so as to
keep the economy close to the constant-ination ERU line by prompting appropriate
changes in the nominal exchange rate. The economy adjusts to the new medium-run
equilibriumalong the MRline. Requiredchanges inthe real exchange rate are therefore
achieved without the larger than necessary swings in the nominal rate characteristic
of a oating regime with an LM-based monetary policy. With rational exchange rate
expectations, the monetary targeting regime shifts immediately to the new medium-
run equilibriumeven in the presence of ination inertia.
I QUESTIONS
Checklist questions
(1) An open economy experiences an unexpected fall in domestic aggregate demand.
Compare the policy responses available to the authorities if the economy is (a)
outside a currency union and (b) inside a currency union.
(2) Consider a xed exchange rate economy operating at medium-run equilibriumwith
a trade decit.
Keyn: chap11 2005/11/22 page 409 #33
SHOCKS AND POLICY RESPONSES 409
(a) Why is the combination of a wages accord and a devaluation particularly useful
to a policy maker if it wishes to restore trade balance?
(b) Howwould the economy adjust if the wages accord was not accompanied by a
devaluation?
(c) What would happen if only the devaluation was successfully implemented (e.g.
the wages accord collapsed)?
(d) What is the alternative for a policy maker to restore trade balance if it cannot
devalue (e.g. it is in a monetary union with its major trading partners) or
negotiate a wages accord (e.g. relations with trade unions are bad)?
(3) What is the difference between an external trade shock and an aggregate demand
shock? Provide two examples of each and clarify the difference by exploring the
implications for output, the trade balance, and for the policy responses that are most
appropriate.
(4) In a oating exchange rate economy, what policy combination can a government
use to bring about a move along the ERU curve without letting wages and prices
adjust? Assuming the policy maker can get this right, why might it prove particularly
useful?
(5) What is meant by the world terms of trade between manufactures and raw
materials? Explain howa change in themwill be reected in the AD, BT, and
ERU curves.
(6) Can involvement in a war abroad help a country to recover froma recession? Howis
your answer affected if the war has a major effect on world energy prices?
(7) Why is the combination of tight monetary policy and wage accords a better response
to an adverse external supply shock than expansionary scal and monetary policies?
Explain by comparing the process of adjustment to the newmedium-run
equilibrium.
(8) Consider a small economy that joins a currency union with its major trading
partners. In yspace showthe effect of increased product market competition,
increased investment, and an improved productivity trend and give the main
reasons why these benecial aspects may be expected to occur.
(9) Is the nominal exchange rate more valuable as a policy instrument to an economy
with real wages that are highly sensitive to unemployment than to an economy with
less sensitive real wages? Is it more valuable to an economy with a high propensity to
import than to one with a lower propensity to import? Explain why.
(10) Explain why a government might nd it desirable to give control of monetary policy
to unelected central bankers or to foreigners.
(11) Does international capital mobility undermine the ability of a central bank to control
ination in a country with oating exchange rates?
(12) Consider a small open economy with a xed exchange rate and imperfectly
competitive markets for output and labour. There is nominal stickiness of prices and
wages, but only in the short run. Trace the effects on output and the trade balance of
Keyn: chap11 2005/11/22 page 410 #34
410 THE OPEN ECONOMY
a reduction in income tax. What constraints limit the ability of the government of a
country with a xed exchange rate to maintain a high level of real income through
the use of scal policy? Howwould you expect such constraints to operate in
practice?
Problems and questions for discussion
QUESTIONA. In an open economy with a exible exchange rate, the government
wishes to see an unemployment rate of 5%of the labour force, but has been advised that
the current 10%is the equilibriumrate. Under what circumstances are there feasible
policies which would enable the government to achieve its unemployment objective
without compromising its ination record? What might such policies consist of? Why
might the government be reluctant to introduce them?
QUESTIONB. Consider a small open economy. There is perfect capital mobility and a
exible exchange rate. The initial position of the economy is one of constant ination
and trade balance. Four years later, unemployment is observed to be markedly lower (a
rate of 4%as compared with 6%). Ination is constant. Two hypotheses about what has
happened in the intervening period are discussed:
(1) The economy experienced a positive aggregage demand shock.
(2) Supply-side reforms to the labour market and welfare systemwere implemented.
Explain the logic of each of these hypotheses. Suggest the patterns in the data that
would be consistent with each hypothesis.
QUESTIONC. Consider a common currency area (CCA). Does the absence of pressure
fromthe foreign exchange market and the fact that ination is set by the central bank of
the CCA mean that a member country can achieve any desired unemployment rate
without having to worry about problems of ination or trade balance? What are the
consequences for the operation of the CCA? Explain your answer.
QUESTIOND. In January 2001, Milton Friedman said that although the high ination
of the 1970s followed the decision of oil producers to cut production, similar behaviour
by the oil producers nowwould not be followed by high ination because central
bankers behave differently. Provide an explanation of this statement. Does this mean
that we should not be concerned about oil price rises? Explain your answer.
QUESTIONE.It is possible to distinguish an aggregate demand shock froman aggregate
supply shock by looking at whether the subsequent changes in output and ination are
positively or negatively correlated. Do you agree with this statement? You may answer
this by referring to a model of the closed economy or the open economy or both.
QUESTIONF. Concern about the burden of government debt has led many countries to
introduce policies to try to reduce it. Howwould changes in government expenditure
and/or taxation help achieve this policy objective and which is likely to be more
effective in the longer run? Would a oating exchange rate make the task easier or more
difcult? Would you recommend other policies?
Keyn: chap11 2005/11/22 page 411 #35
SHOCKS AND POLICY RESPONSES 411
I APPENDIX: OPEN ECONOMY INFLATION AND SHORT-RUN PHILLIPS CURVES: AN EXAMPLE
It may be useful to work through an example to show in detail how ination changes as the economy
moves from one medium-run equilibrium to anotherfor example, in the aftermath of an aggregate
demand shock. This illustrates how the Phillips curve analysis operates in the open economy. As an
example, let us take the case under xed exchange rates in which the government decides to use a scal
expansion to push the economy to lower unemployment. The diagrammatic analysis is less messy if we
assume that expected ination in the economy is equal to world ination throughout. An assumption
of inertial or adaptive expectations could just as easily be used but this diverts attention from the shifts
in the Phillips curve caused by changes in the real exchange rate.
The example is developed using the ydiagram, the wage-setting and price-setting diagram, and the
Phillips curve diagram (Fig. 11.19). The economy begins at point A with output of y
0
and unemploy-
ment of U
0
. The government undertakes a scal expansion to take the economy to point Z at lower
A
B
AD(g
1
)
Z
ERU
y y
1
y
0
w
z
w
1
w
0
WS
C
AD(g
0
)
PS (u
z
)
u
u
0
u
1
u
2
PS (u
1
)
PS (u
0
)
E
L W
W
P*
P*
U U
0
U
1
Z
B
Inflation
PC(u
z
)
A B
C
Z
PC(u
0
)
A
U
^
W
P
c
E
0
E
1
PC(u
1
)
Figure 11.19 Phillips curves in the open economy: temporary rise in ination following a loosening of
scal policy under xed exchange rates
Keyn: chap11 2005/11/22 page 412 #36
412 THE OPEN ECONOMY
unemployment. Fromour analysis of the medium-run model, we knowthat there is a newmedium-run
equilibrium at Z at which ination will be constant. Since this is a xed exchange rate economy, the
ination rate at Z is equal to world inationjust as it was at A. But what happens to ination along the
path fromA to Z?
In this example, we assume:
_
P
P
_
E
=
P
and
e
e
= 0.
At point A, home wage and price inationare equal to world ination. The government increases spend-
ing from g
0
to g
1
. The AD curve shifts to the right. In the short run, the rise in aggregate demand drives
up output and employment through the usual multiplier process (point B in the top panel).
We nowturn to the mediumrun. The key equations are the following:
W = P
E
c
b(E) (wage equation)
P = P
x
=
1
1
W
(price equation)
P
c
= (1 )P +P
e
P
. (real exchange rate)
With a higher level of employment, E
1
, we can see from the wage- and price-setting diagram that the
wage-setting real wage at E
1
is well above the existing real wage of w
0
(in the middle panel, compare
point B on the price-setting curve PS(
0
) with point Z). The increase in money wages that this gives rise
to can be read off fromthe Phillips curve diagram: the Phillips curve that is relevant to point B is the one
dened by expected ination of
_
P
P
_
E
=
P
in the Phillips curve diagram (bottom panel). Home rms will immediately mark up their prices by the
same percentage. Fromthe price-setting equation, we knowthat price inationof home produced goods
and services will equal the rate at which unit labour costs have increased.
As we have seen before, the crucial point is that consumer prices do not rise by as much as domestic
producer prices. The reason is that consumer price ination depends on world ination (the rate at
which the prices of imported nal goods rise), domestic price ination, and on , the weight of foreign
goods in the consumption bundle. Nothing has happened to world ination and is constant. Hence,
consumer prices rise by less than the prices of home produced goods (i.e.
W
W
=
P
P
>
P
c
P
c
>
P
)
which implies that the real wage
_
W
P
c
_
increases and price competitiveness () decreases. In Fig. 11.19,
the real wage rises from w
0
to w
1
and falls from
0
to
1
. The economy is now at point C. The upward
shift of the price-setting curve is shown in the central panel: this means that the equilibrium rate of
unemployment has decreased to
U. A new Phillips curve must therefore be drawn: it is indexed by the
level of (i.e. PC(
1
)) and shows that in the following period, money wages will rise by less than in the
previous period. The reason is straightforward: the real wage has risen closer to the value of the wage-
setting real wage at U
1
. Thus there is less discrepancy between the real wage that workers anticipate and
the wage they actually receive, which in turn means that wage ination has to exceed expected ination
by a smaller percentage.
In subsequent periods, wages and prices increase according to the above pattern (i.e.
W
W
=
P
P
>
P
c
P
c
>
P
(price equation)
=
1
1
W(1 + t
d
)
.
Inorder to derive the price-setting real wage, it is necessary to note that we must express the price-setting
real wage in terms of the real consumption wage,
W
P
c
. We use the denition of the consumer price index
as before, but include value added tax at the rate t
v
. The home countrys VAT is levied on imported nal
goods.
P
c
= [(1 )P +P
e](1 + t
v
). (consumer price index)
After some tedious algebraic manipulation, which is shown in the footnote, we derive the expression for
the price-setting real wage in the open economy including tax variables:
11
w
PS
=
(1 )
(1 + t
d
)(1 + t
v
)[1 +( 1)]
. (price-setting real wage, open)
Although this expression looks complex, it is not difcult to interpret. It is simply the usual open econ-
omy price-setting real wage adjusted for the so-called tax wedge. Any increase in either direct or indirect
taxation reduces the price-setting real wage and therefore shifts the PS() curve downwards.
11
Divide P
c
by P
P
c
(1 )
W(1 + t
d
)
=
_
(1 ) +
P
e
P
_
(1 + t
v
)
therefore
W(1 + t
d
)
P
c
(1 )
=
1
_
(1 ) +
P
e
P
_
(1 + t
v
)
W
P
c
=
(1 )
(1 + t
d
)(1 + t
v
)[(1 ) +]
=
(1 )
(1 + t
d
)(1 + t
v
)[1 +( 1)]
.
Keyn: chap11 2005/11/22 page 414 #38