Open Economy AS/AD Model

Prof. Lutz Hendricks

Econ520

November 13, 2013

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Objectives

In this section you will learn:

1 how to analyze an open economy in the medium run (AS/AD model)2 how the effects of policies and shocks differ from the short run3 why the medium run outcomes under floating and pegging are similar

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Short vs Medium Run

Short run:

P is fixed.Any adjustment of the real exchange rate must work through thenominal exchange rate:

= EP/P (1)

Medium run:

P adjustsAny change in E can be mimicked by a change in P

same effect on no other real effects of money in the medium run

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Fixed Exchange Rates

Fixed Exchange Rate Model

We need to clear these markets:

1 Foreign exchange: UIP with fixed E implies: i = i

2 Money:M/P = YL(i) (2)

Endogenous: M/P,Y3 Goods:

1 demand:

Y = C(YT) + I(Y, ipie) +G+NX(Y,Y, EP/P) (3)

2 supply:P = Pe(1+m)F(1Y/L,z) (4)

Endogenous: Y,P (really also pie, but lets set that aside)5 / 35

Market Clearing

Short run:

Pe fixedAS is upward sloping

Medium run:

Pe = Pvertical AS curve determines Yn by itself:

1 = (1+m)F(1Yn/L,z) (5)

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Irrelevance of Money

We show:

The goods market determines Y and PThe money market determines M

so that i = i holds at all times

The Fed has no control over the money supplyThis is true in short run and medium runKey assumption: high capital mobility (UIP holds).

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Aggregate Demand

Start from IS with i = i:

Y = C(YT) + I(Y, ipie) +G+NX(Y,Y, EP/P) (6)

Simplify:

Y = Y(EP/P,G,T

)(7)

Negative slope: P = Y this works through the real exchange rate and NX

New shifters: Y, i,P,E

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Aggregate Demand

M/P no longer shifts ADWhy not?

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Analyzing the Model

We can forget about the money market and UIP and just analyzeAS:

P = Pe(1+m)F(1Y/L,z) (8)

AD:Y = Y

(EP/P,G,T

)(9)

Short run: Pe is given.Medium run: Pe = P.Transition: Pe P shifts AS.

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Analysis: Medium Run

P = Pe: AS is vertical and determines Yn:

1 = (1+m)F (1Yn/L,z) Yn

P adjusts to get the right real exchange rate, such that AD = Yn:

Yn = Y(EP/P,G,T

) P

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AS/AD GraphPr

ice

leve

l, P

AD

AS

A

Output, Y

YnY

Short run: Pe is fixed.Output is not at the naturalrate.

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Adjustment Over Time

AD

A

Yn

AS

B

AS !

Y

Output, Y

Pric

e le

vel,

P

Initially: Pe > P.W/P too high.Pe falls over time.AS shifts down

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What Differs From Closed Economy?

Closed economy:

P = M/P = i = I Open economy:

P = NX

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Devaluation

Instead of waiting for P to fall, why not simply lower E?The effect on the real exchange rate and on demand is the same.Avoid the painful period of unemployment.

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Devaluation

AD

A

Yn

AS

C

B

AD !

Output, Y

Pric

e le

vel,

P

"E < 0

Y

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A Free Lunch?

Now fixed exchange rates look like a free lunch.Avoid exchange rate volatilityGain instant adjustment to full employment through devaluation.Whats the catch?

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Example: Fiscal expansion

Y

P

AD

Yn

Pe

Shock: G Medium run:Short run:Process:

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Example: Increase in i

Y

P

AD

Yn

Pe

Shock: i Medium run:Short run:Process:

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Currency Crises

Currency Crises

Under the peg: UIP implies i = i

But what happens if investors doubt the peg?UIP:

it = it xt (10)

xt =Eet+1Et

Et(11)

In general, the depreciation term xt can be positive or negative.But the peg offers insurance to those to bet against the peg: xt cannever be positive.

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Currency Crises

Example:

25% chance of 20% devaluation over the next monthxt = 0.750+0.250.2 =0.05investors demand an interest premium of 5% per month tocompensate for this risk

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Policy Options

1 Raise i by 60%major recession as borrowing shuts down

2 Raise i by less than 60%

capital outflowsCB must sell FX and eventually runs out of reserves

3 Devalue the currency

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Lessons

1 Fixed exchange rates are fragile1 they can only be sustained as long as investors remain utterly

convinced that a peg will hold2 betting against a peg is insured by the government

2 Fixed exchange rates can collapse without reasonIf many investors believe the peg will fail, it will fail.

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Crisis Examples

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Crisis Examples19

92:1

=1.0

0

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec1992 1993

1.05

1.00

0.95

0.90

0.85

0.80

0.75

0.70

FINLANDSWEDENUKITALYSPAINFRANCEPORTUGAL

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Which Exchange Rate Regime Is Best?

The costs of fixing the exchange rate

1 Loss of monetary autonomy.

Import the U.S. inflation rate

2 Risk of speculative attacks.3 Volatile interest rates.4 Loss of automatic adjustment to certain shocks.

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Benefits of fixing the exchange rate

1 Loss of monetary autonomy.

Import the U.S. inflation rate

2 Incentives for fiscal discipline.

Cannot print money to finance budget deficits.

3 Stable exchange rate

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The Impossible Trinity

Exchange rate regimes pursue 3 goals:1 Stable exchange rates2 Monetary autonomy3 Free capital flows.

Only 2 of the 3 goals are attainable.

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The Impossible Trinity

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Which regime is best?

The answer depends on the characteristics of the country.Large, relatively closed countries can handle volatile currencies - theyusually float.Small countries with a major trading partner may want to peg

But beware of pegging against the wrong country (Argentina).

Countries with questionable central banks may want to peg

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Example: Regime Choice

1 USA vs rest of the world2 Canada vs USA3 Argentina vs USA vs Brazil

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Currency Unions

If the exchange rate is fixed, why not get rid of it?Main example: EuroBenefits:

lower transactions costscredibilityspeculative attacks no longer possible.

Costs:

irreversible: cannot devalue in response to shocksloss of monetary policy

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Reading

Blanchard / Johson, Macroeconomics, 6th ed., ch. 21

Additional reading:

Jones, Macroeconomics, ch. 15.

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IntroductionModel: Fixed ePolicy analysis: fixed e

CrisesChoice of regime