Handout 2 pot

LM - Money market equilibrium in the open The money supply is affected by changes in e NOM under fixed exchange rates, hence the LM shifts if e NOM is different from the target level e N

EC202A Macroeconomics

Handout 2

Laura Povoledo The University of Reading

EC202A Macroeconomics

The IS-LM-BP model

Reading material that you may find useful:

- Abel, Bernanke and McNabb, Chapters 5 and 14.

- Abel, Bernanke, 5 th ed, Chapters 5 and 13.

- Dornbusch, Fisher and Startz, 9 th ed, Chapter 12.

-Begg, Fischer an Dornbusch, 7 th ed, Chapters 28 and 29.

1 The Goods Market Equilibrium in an Open

Economy ;

2 The open-economy IS curve ;

3 The Balance of Payments and Capital Flows ;

4 The BP curve ;

5 The Mundell-Fleming model

The Goods Market Equilibrium in an Open

Economy

Economies are linked internationally through two main channels:

• trade in goods and services;

• international financial markets

First, let’s consider the effects of trade with the rest of the world on the goods market equilibrium and then we’ll understand how

to modify the IS curve.

The Goods Market Equilibrium in an Open

Economy

Previously, we have seen that the goods

market equilibrium condition can be

expressed in two ways:

1) National saving equals investment:

S = I (1) Closed economy Equation

2) Aggregate supply equals aggregate demand:

Y = C + I + G (2) Closed economy Eq

The Goods Market Equilibrium in an Open

Economy

What changes in an open economy?

National saving now has two uses:

• increase the nation’s capital stock by domestic investment ;

• increase the stock of net foreign assets by

The Goods Market Equilibrium in an Open

Economy

Eq (1)’ shows the uses of savings in an open economy Investment I is accrued to the domestic capital stock The current account balance CA indicates the amount of funds that the country has available for net foreign lending.

Hence, Eq (1)’ states that in goods market

equilibrium in an open economy, the amount of

national saving S must equal the amount of

domestic investment I plus the amount lent abroad

CA.

The Goods Market Equilibrium in an Open

Economy

The closed economy equilibrium condition (1)

is a special case of the open economy

equilibrium condition (1)’, with CA =0.

Change no 2

What else changes in an open economy?

Domestic spending on goods and

services is no longer equal to domestic output This happens because:

- Part of domestic output is sold to foreigners (exports);

- Part of spending by domestic residents purchases foreign goods (imports)

The Goods Market Equilibrium in an Open

Economy

We can also re-write the equilibrium

condition (2) - aggregate supply equals

aggregate demand – for an open economy.

The main change is that domestic spending

no longer determines domestic output

Instead, spending on domestic goods

determines domestic output

Define:

A = spending by domestic residents

Then:

A = C + I + G

The Goods Market Equilibrium in an Open

Economy

Spending on domestic goods is total spending

by domestic residents less their spending on imports plus foreign demand or exports.

Note:

A is also called absorption

The Goods Market Equilibrium in an Open

Economy

In order to obtain an equilibrium condition,

we write:

Y = C + I + G + NX (2)’ Open economy Equation

Eq (2)’ states that in goods market equilibrium in an

open economy, the supply of domestic goods Y is

equal to spending on domestic goods, A + NX.

The Goods Market Equilibrium in an Open

Economy

What affects net exports NX?

• Foreign output Y F (higher foreign output

increases X and NX)

• Domestic output Y (higher domestic output

increases Q and decreases NX)

• The real exchange rate (higher

means more exports and less imports)

The open-economy IS curve

The IS curve shows the possible combinations of the interest rate r and domestic output Y, for

which the goods market is in equilibrium.

In the closed economy, the IS curve can be

written as:

Meaning: the goods market is in equilibrium

when aggregate supply is equal to aggregate

demand for goods Consumption depends on Y, investment depends on r We draw the IS line (goods market equilibrium condition) in the (r, Y) plane.

Y = C (Y) + I(r) + G

AS = AD

The open-economy IS curve

In the open economy, the goods market

equilibrium condition becomes:

Or simply:

AS = AD

Y = C (Y) + I(r) + G + NX(Y F , Y, )

Y = C (Y) + I(r) + G + NX(Y)

r The slope of the IS depends on

size of multiplier and the elasticity

of investment to domestic interest rate (which is negative, hence the negative slope of the IS)

The open-economy IS curve

The IS curve is shifted by changes in G, YF and

the real exchange rate (we are assuming that prices are fixed).

NX

The open-economy IS curve

NX

Note: above the IS line AS > AD (aggregate

supply > aggregate demand).

Below, AS < AD.

LM - Money market equilibrium in the open

The money supply is affected

by changes in e NOM under fixed exchange rates, hence

the LM shifts if e NOM is different from the target level

e NOM* Under floating exchange rates, the LM is not

affected by e NOM

Balance of Payments

The Balance of Payments and Capital Flows

the record of transactions between one country and the rest of the world.

The two main accounts in the BP are the current account and the capital account:

The current account records trade in goods,

services, and transfer payments.

The capital account records the trade in assets.

Current Account Capital Account

The Balance of Payments and Capital Flows

Balance of payments accounts = The record of

a country’s international transactions.

Any transaction that involves a flow of money into the UK is a credit item (enters with a

plus sign).

Any transaction involving a flow of money out

of the UK is a debit item (enters with a

minus sign).

The Balance of Payments and Capital Flows

The overall BP surplus or deficit is the sum of the current and capital account surpluses or

Investment income from abroad

The Balance of Payments and Capital Flows

But what are the economic forces that affect the BP? To answer this question we must look at

each separate component of the BP.

For convenience we divide the current account into 3 components:

NX

NT NFP

Net exports of goods and services

Net unilateral transfers

CA

Note: NFP (Net factor payments) is almost (but not always) equal to Investment income from abroad Why?

Net exports depend on:

• real exchange rate

• the level of domestic income Y

• the level of foreign income Y F

The Balance of Payments and Capital Flows

P

P e

e NOM F R

In general, NFP and NT are not much affected

by current macroeconomic developments

From now on, we assume them to be equal to 0 for simplicity.

We write: CA = X ( Y F, ) - Q ( Y , )

The Balance of Payments and Capital Flows

• A real depreciation improves net exports:

• A rise in domestic income increases imports:

So the CA is a function of 3 variables:

The real exchange rate measures a

country's competitiveness in foreign trade If prices stay fixed then e R and e NOM (real and nominal

exchange rate respectively) always move in the same direction.

P

P e

e NOM F R

e NOM F

The Balance of Payments and Capital Flows

Again, we look first at the separate components.

It is often useful to split the capital account into two separate components: (1) the transactions

of the country’s private sector and (2) official reserve transactions, which correspond to the central bank activities:

What about the KA ?

KA Net private capital inflows

Official reserve transactions

NPKI ORT

The Balance of Payments and Capital Flows

Private residents selling off

Exercise: what are the implications of the two options

above for the capital account KA?

The Balance of Payments and Capital Flows

NPKI depends on:

• the interest rates differential: (r – r F)

• the expected depreciation of the

currency: E Δe NOM /e NOM

But what affects KA?

ORT depends on the choice of

exchange rate regime: fixed and floating exchange rate system

Since the role of ORT is

better understood in relation

to the adjustment process,

we write KA as a function of

(r – r F ) and E Δe NOM /e NOM:

KA(r – r F, E Δe NOM /e NOM )

Answer:

The Balance of Payments and Capital Flows

The sensitivity of KA to changes in interest

rate differentials is a crucial issue, since it

depends on the degree of capital mobility.

Three cases are possible (partial derivatives):

KA

No capital mobilityImperfect capital mobilityPerfect capital mobility

The Balance of Payments and Capital Flows

Explanation :

If capital is assumed to be perfectly mobile, investors

in one country can trade assets with investors in any other country without restrictions, that is, at low transaction costs and in unlimited amounts, in search

of the highest yield or the lowest borrowing costs

As a result, under perfect capital mobility interest rates in one country cannot differ from the interest rates in other countries without infinite capital flows taking place.

In practice, capital controls and transaction

costs dampen the sensitivity of KA to changes in interest rate differentials.

But as the world economies become more and more

integrated, perfect capital mobility becomes

increasingly the “reality”.

We are now ready to write the BP equation:

This equation shows the BP equilibrium condition

as a function of 6 macroeconomic variables.

The next task is to obtain a diagram on the (r, Y) plane that represents all the possible

combinations of the domestic real interest rate r and domestic output Y, for which the above

equation BP = CA + KA = 0 We call this line the

BP curve/line

BP = CA (Y F , Y, )+ KA (r – r F , E Δe NOM /e NOM ) = 0

The BP curve

P P

e NOM ⋅ F

The BP curve

In the (r, Y) plane the balance of payments

becomes a function of the domestic real

interest rate r and domestic output Y only:

The slope of the BP line depends on the

degree of capital mobility

e NOM F

The BP curve

The level of r does not affect the

BP since KA = 0 always (only private KA) As a result, there is

only one level of Y such that CA

= 0 and the BP is in equilibrium

Case 1: No capital mobility

r

Y

BP

Note: in the case of no

capital mobility, the BP

line corresponds in

practice to the condition

that the Current Account is

in balance.

To the left of the BP line, BP > 0

To the right , BP < 0

The BP curve

BP is upward sloping because if

Y rises, there will be an increase

in imports leading to a deficit in the CA, and (to balance this with

a surplus in the KA) r must raise

to attract more capital

Case 2: Imperfect capital mobility

r

Y

BP

Note: in the case of imperfect

capital mobility, the BP line

corresponds to the condition

that the Current Account

surplus/deficit is exactly offset

by Net Private Capital Inflows.

Above the BP line

BP > 0

Below, BP < 0

The BP curve

If capital can instantaneously

move, the only level of r that

ensures the equilibrium in the

KA is r F Y can be at any level

because the KA dominates over

exchange rate regime, fixed

or floating.

Note: in the case of

perfect capital mobility,

the BP line corresponds to

the condition that Net

Private Capital Inflows (or

outflows) not be infinite.

The BP curve

• If then

• If then

• If there is an expected nominal depreciation then

Shifts in the BP curve

mobility (Why?)

The BP curve

• If then

• If then

• If there is an expected nominal appreciation then

Shifts in the BP curve

Note 2: changes in r F, and

E Δe NOM /e NOM do not affect the BP curve if there is no

capital mobility (Why?)

The Mundell-Fleming model

model

This model is used to explore the effects of fiscal and monetary policies under both fixed and flexible exchange rate systems

It can also be extended to

cases other than perfect

capital mobility

EC202A Macroeconomics

Monetary Policy in the

IS-LM-BP model

Reading material that you may find useful:

- Dornbusch, Fisher and Startz, Chapter 12 (9th ed)

- Begg, Fischer an Dornbusch, Chapter 29 (7th ed)

Objective of the lectures

While the IS-LM-BP model still works under the assumption that the price level is

given, it nevertheless clearly establishes the key linkages among open economies: trade, the exchange rate and capital flows.

In this lecture, we want to understand how

economy, under fixed or floating exchange rates.

1 Exchange rates and the equilibrium in the

Balance of Payments ;

2 The IS-LM-BP model (revision) ;

3 Monetary Policy under imperfect capital

Exchange rates and the equilibrium in the

Balance of Payments

Choice of exchange rate regime:

Fixed: Monetary authority has to intervene in foreign

currency markets to maintain fixed nominal exchange rate e NOM ;

Managed flexibility: free float but interventions to

prevent excessive fluctuations ;

Floating: no intervention in foreign exchange market

Can be joint floating: a group of currencies are

pegged to each other, but fluctuate with respect to all the other currencies

ERM (before Euro) was joint float with adjustably pegged exchange rate band

Exchange rates and the equilibrium in the

Balance of Payments

The way in which the equilibrium in the balance of payments is achieved depends on the choice of the exchange rate regime and on the degree of capital mobility

Let’s consider 3 cases:

1 Fixed exchange rates, no capital mobility ;

2 Fixed exchange rates, perfect capital mobility ;

3 Floating exchange rates

Exchange rates and the equilibrium in the

Balance of Payments

1 Fixed

exchange rates Suppose initially that there are no private sector capital flows, perhaps

because of capital controls.

Without capital mobility, a current account deficit

(CA < 0) can only be financed by the Central Bank

The Central Bank sells foreign exchange and buys domestic currency As a result, domestic money in circulation falls, as pounds disappear back into the

Bank of England This is called unsterilized

intervention Forex reserves fall to restore the

equilibrium in the BP

Exchange rates and the equilibrium in the

Balance of Payments

Another possibility is sterilized intervention This

happens when the Central Bank (to offset the fall in domestic money supply) buys domestic bonds – thereby restoring the domestic money supply

Both sterilized and unsterilized interventions restore the BP equilibrium under fixed exchange rates

However, with no long term remedial action to resolve the original reason for the CA deficit, eventually the Central Bank will run out of foreign reserves, and will be forced to adjust exchange rates

Exchange rates and the equilibrium in the

The Central Bank no longer defends the exchange rate by buying and selling foreign reserves Instead,

it sets domestic interest rates to provide the correct incentive for speculators

Exchange rates and the equilibrium in the

Balance of Payments

The Central Bank must set the correct interest rate,

to eliminate one-way capital flows This is the only option open to the Central Bank if it wishes to keep exchange rates fixed, yet faces perfect capital mobility

This interest rate, coupled with the level of income, determines money demand Sterilisation options in this case do not work (as international capital flows will nullify them)

Thus perfect capital mobility undermines monetary sovereignty