Economics 442

Prof. Sebastian Sotelo

October 28, November 2 and 4, 2016

Introduction1

Topics:
I

The joint determination of output, current account and exchange

rates in the short run
The effect of monetary and fiscal policy

Method:
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Models in the family of IS-LM

Draws materials and follows the structure from Feenstra and Taylor, Ch.7

Motivation

From Paul Krugmans Blog: The really amazing thing is that

Iceland has been very well served by its independent currency,
which spared it the immense cost of internal devaluation [...]
3/22/2015

Organization

1. Demand in an Open Economy

2. The IS-LM Model in an Open Economy
3. The effect of policy

Demand - Assumptions

Price stickiness:
I
I

P,
Inflation
e =
e = 0

Government policy: G,

Conditions in Foreign are fixed

I
I

Y
i

Income is equal to output

I
I
I

NFIA = 0, NUT = 0
GDP = GNDI
CA = TB

Demand - Components

We will arrive at
Demand = C + I + G + TB
where:
I
I
I
I

C is Consumption
I is investment
G is Government Spending
TB is the Trade Balance

Demand - Consumption

Consumption is an increasing function of disposable income:

Disposable income

Yd = Y T

Consumption:

C = C |Y {z
T
}
=Y d

This is the Keynesian consumption function

I

Different from permanent income!

Demand - Consumption
I

Slope measures the marginal propensity to consume (MPC),

with 0 < MPC < 1

Demand - Investment

Investment is a decreasing function of expected real interest rate

r e = i e

Investment
I = I (i)

We write it this way, because we asssume

e , so changes in r e are
reflected completely in changes in i

Demand - Investment

Demand - Government

in Consumption
We have already seen T

The government
I
I

If
I
I

Collects T = T

Spends G = G

G < T , Government runs a surplus

G > T , Government runs a deficit

But we dont constrain the budget

Demand - Trade Balance

Remember
TB = EX IM

Demand - Trade Balance

Real Exchange Rate

We assume expenditure switching

I

spending in Home goods relative to Foreign goods reacts to changes

in the real exchange rate
if the RER depreciates, TB increases

Demand - Trade Balance

Income at Home and Foreign

We assume that when income increases people spend more in

domestic and foreign goods
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When Homes income increases, Homes expenditure in Foreign

goods increases (TB decreases)
When Foreigns income increases, Foreigns expenditure in Home
goods increases (TB increases)

Demand - Trade Balance

Putting it all together:

EP

,Y T

,
Y

T
TB = TB
P
| {z } | {z }
|{z}

+
+

At the margin:
I

Y IM given by MPCF or marginal propensity to consume

Foreign imports
Note that, if MPCH is the marginal propensity to consume
Home goods,
MPC = MPCH + MPCF

Demand - Trade Balance

Income at Home and Foreign

We assume that when income increases people spend more in

domestic and foreign goods
I

When Homes income increases, Homes expenditure in Foreign

goods increases (TB decreases)
When Foreigns income increases, Foreigns expenditure in Home
goods increases (TB increases)

Demand - Trade Balance

Demand - Exogenous Changes

Demand - Exogenous Changes

Goods Markets Equilibrium

I

Supply is equal to output (GDP).

Because we assumed that CA = TB

Supply = GDP = Y

Demand collects the uses of output

D = C + I + G + TB

Equilibrium states Supply = Demand



E
P

+ I (i) + G
+ TB
Y =C Y T
, Y T, Y T
P

Goods Markets Equilibrium

What happens if there is a rise in output, Y , ceteris paribus?

I
I
I

Consumption increases by MPC

Imports increase by MPCF
Demand increases by
MPCH = MPC MPCF
where MPCH is the marginal propensity to consume Home goods

We assume
0 < MPCH < 1

Goods Market Equilibrium

Goods Markets Equilibrium

How do we think of a positive shock to demand in this context?

For example:
I
I
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An increase in government spending (or decrease in taxes)

A drop in the interest rate
A real exchange rate depreciation

Goods Markets Equilibrium

Goods Market Equilibrium Summary

In this model, D shifts up after

I
I
I
I
I

Fall in taxes T

Increase in government spending G

Drop in interest rate i
/P
Real exchange rate depreciation E P
Exogenous shifts in C , I, TB

Organization

1. Demand in an Open Economy

2. The IS-LM Model in an Open Economy
3. The effect of policy

IS-LM Model in an Open Economy

We study equilibrium in an economy consisting of 3 markets:

I
I
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Goods Market
FOREX Market
Money Market

The IS Curve

What is the IS Curve in an open economy?

A collection of pairs of (i, Y ) such that the Goods and FOREX

Markets are in equilibrium

The IS Curve FOREX

Recall the FOREX Market

i i +

Ee E
E

We represent it with the usual FX Market Graph

The IS Curve

Recall: we are looking for a relation between i and Y such that the
Goods and FX Markets are in equilibrium

1. Assume both markets are at an equilibrium

2. Suppose there is a drop in Homes interest rate (ceteris paribus)
2.1 Domestic returns shift down in the FX market E
2.2 Demand shifts up in the goods market Y

3. We conclude i and Y go together

4. But whats the economics behind those mechanisms?
I

Graphic analysis

The IS Curve

But how do we think of the shocks to demand we studied before?

A common theme: Shocks that shift demand up shift the IS curve

to the right

Lets see an example:

I
I
I
I

Suppose the RER depreciates (ceteris paribus)

Trade Balance increases
Output increases, but interest rate didnt change
The IS curve shifts to the right

Graphic analysis

The IS Curve

In summary, the position of the IS curve depends on the exogenous

factors on which Demand depends
IS = IS (G, T , i , E e , P , P)

The LM Curve

What is the LM Curve in an open economy?

A collection of pairs of (i, Y ) such that the Money Market is in

equilibrium

The LM Curve

Recall the Money Market equilibrium

M
= L (i) Y
P

We represent it in the usual money market graph

The LM Curve

Recall: we are looking for a relation between i and Y such that the
Money market is in equilibrium

1. Assume the market is in equilibrium

2. Suppose there is an increase in output Y
2.1 Real money demand increases i

3. We conclude Y
4. What is the economics?
I

Graphic analysis

The LM Curve

In this model, the position of the LM curve is essentially a function

of real money supply

LM = LM M/P

IS-LM-FX

We are in a position to study the short run equilibrium in our

economy:
I

the Goods and FX market are in equilibrium if (i, Y ) are on the IS

curve
the Money Market is in equilibrium if (i, Y ) are on the LM curve

The economy is in equilibrium when IS and LM intersect

IS-LM-FX

Organization

1. Demand in an Open Economy

2. The IS-LM Model in an Open Economy
3. The effect of policy

Short Run Policy

Assumptions:
I

Besides our previous assumptions, we assume that policies are

temporary
This means that expectations (inflation, exchange rate) are
unchanged

The importance of exchange rate regimes (fixed vs float) will come

out very clearly

Monetary Policy with Floating ER

Capital flows freely

The spot exchange rate is determined by market forces

The CB at Home temporarily increases the money supply

Monetary Policy with Floating ER

Lets work through the example...

Monetary Policy with Floating ER

Use the IS-LM machinery

1. An increase in the money supply shifts the LM curve to the right

2. In the new equilibrium
2.1 The interest rate i decreases
2.2 The exchange rate
2.3 Output Y increases

Monetary Policy with Floating ER

But why? What is the economics? Lets look at our three markets

1. In the money market: the shift in the money supply decreases the
Home interest rate
2. In the FX market: domestic returns decrease, prompting a
depreciation of the spot exchange rate
3. In the goods market: The drop in the interest rate and the
exchange rate depreciation stimulate output, so it increases
4. Trade Balance:
4.1 Decreases due to increase in output
4.2 Increases due to exchange rate depreciation
4.3 We assume the second effect dominates, so the TB increases

Monetary Policy with Floating ER

Monetary Policy with Floating ER

Work through a decrease in the money supply in the problem set

Monetary Policy with Fixed ER

Now monetary policy adjusts to ensure the exchange rate remains

at the level chosen by the CB

Monetary Policy with Fixed ER

Lets look at our three markets again

1. In the money market: the shift in the money supply decreases the
Home interest rate
2. In the FX market: domestic returns decrease, putting pressure on
the spot exchange rate to depreciate...
3. ... but the Central Bank wants to keep the ER fixed, so it undoes
its temporary policy

Monetary Policy with Fixed ER

Fiscal Policy

What is fiscal policy in this model?

I
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The government changes spending G

The government changes taxes T

Fiscal Policy with Floating ER

Suppose the government increases spending G

Fiscal Policy with Floating ER

Lets work through the example...

Fiscal Policy with Floating ER

Use the IS-LM machinery

1. An increase in the government spending shifts the IS curve to the

right
2. In the new equilibrium
2.1 The interest rate i increases
2.2 The exchange rate E appreciates
2.3 Output Y increases

Fiscal Policy with Floating ER

I

But why? What is the economics? Lets look at our three markets

1. In the goods market: the increase in government expenditure shifts

demand out, at any interest rate
2. In the money market: the increase in output raises money demand,
which in turn increases the interest rate
3. In the FX market: the increase in the interest rate prompts an
exchange rate appreciation
4. Trade Balance:
4.1 Decreases due to increase in output (Imports increase)
4.2 Decreases due to exchange rate depreciation (Exports decrease)

5. Note:
5.1 Exports decrease
5.2 The increase in the interest rate decreases investment (crowding
out)
5.3 But we assume that output increases in net

Fiscal Policy with Floating ER

Fiscal Policy with Fixed ER

Remember: monetary policy adjusts to ensure the exchange rate

remains at the level chosen by the CB

Fiscal Policy with Fixed ER

Lets look at our three markets again

1. In the goods market: The increase in government expenditure

shifts demand out
2. In the money market: the increase in output increases money
demand, so the interest rate increases
3. In the FX market: pressure for the ER to appreciate ...
4. ... But the CB ensure the ER is fixed, so increases the money
supply
5. There is no crowd out of investment or exports

Fiscal Policy with Fixed ER