Upload
neeebbbsy89
View
230
Download
0
Embed Size (px)
Citation preview
8/9/2019 Feenstra and Taylor Chapter 18
1/62
1 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C h a p t e r 1 8 : O u t p u t , E x c h a n g e
R a t e s , a n d M a c r o e c o n o m i c
P o l i c i e s i n t h e S h o r t R u n
Output, Exchange Rates, and
Macroeconomic Policies in the Short Run
Prepared by:
Fernando Quijano
Dickinson State University
181 Demand in the OpenEconomy
2 Goods Market
Equilibrium: The
Keynesian Cross
3 Goods and Forex
Market Equilibria:
Deriving the IS Curve
4 Money Market
Equilibrium: Deriving
the LM Curve
5 The Short-Run IS-LM
Model of an Open
Economy
6 Stabilization Policy
7 Conclusions
8/9/2019 Feenstra and Taylor Chapter 18
2/62
2 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C h a p t e r 1 8 : O u t p u t , E x c h a n g e
R a t e s , a n d M a c r o e c o n o m i c
P o l i c i e s i n t h e S h o r t R u n
• To gain a more complete understanding of how an open
economy works, we now extend our theory and explore
what happens when exchange rates and output fluctuate
in the short run.
• We examine how macroeconomic aggregates (including
output, income, consumption, investment, and the trade
balance) in response to shocks in an open economy.
• Recall that Y = GDP = C + I + G + TB
• Our goal is to build a model that explains the
relationships among all the major macroeconomic
variables in an open economy in the short run.
• One key lesson we learn in this chapter is that the
feasibility and effectiveness of macroeconomic policies
depend crucially on the type of exchange rate regime in
operation.
Introduction
8/9/2019 Feenstra and Taylor Chapter 18
3/62
3 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C
h a p t e r 1 8 : O u t p u t , E x c h a n g e
R a t e s , a n d M a c r o e c o n o m i c
P o l i c i e s i n t h e S h o r t R u n
1 Demand in the Open Economy
Preliminaries and Assumptions
• For our purposes, the foreign economy can be thoughtof as “the rest of the world” (ROW). The key
assumptions we make are as follows:
Because we are examining the short run, we assume
that home and foreign price levels, P and P *, are fixeddue to price stickiness. As a result of price stickiness,
expected inflation is fixed at zero, π e = 0. If prices are
fixed, all quantities can be viewed as both real and
nominal quantities in the short run because there is no
inflation.
We assume that government spending G and taxes T
are fixed at some constant level, which are subject to
policy change.
− −
−
− −
8/9/2019 Feenstra and Taylor Chapter 18
4/62
4 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C
h a p t e r 1 8 : O u t p u t , E x c h a n g e
R a t e s , a n d M a c r o e c o n o m i c
P o l i c i e s i n t h e S h o r t R u n
1 Demand in the Open Economy
Preliminaries and Assumptions
We assume that conditions in the foreign economysuch as foreign output Y * and the foreign interest rate
i * are fixed and taken as given. Our main interest is in
the equilibrium and fluctuations in the home economy.
We assume that income Y is equivalent to output: thatis, gross domestic product (GDP) equals gross
national disposable income (GNDI).
We further assume that net factor income from
abroad (NFIA) and net unilateral transfers (NUT ) are
zero, which implies that the current account (CA)
equals the trade balance (TB).
− −
8/9/2019 Feenstra and Taylor Chapter 18
5/62
5 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C
h a p t e r 1 8 : O u t p u t , E x c h a n g e
R a t e s , a n d M a c r o e c o n o m i c
P o l i c i e s i n t h e S h o r t R u n
1 Demand in the Open Economy
Consumption
• The simplest model of aggregate private consumptionrelates household consumption C to disposableincome Y d .
• This equation is known as the Keynesian consumptionfunction.
Marginal Effects The slope of the consumption function is
called the marginal propensity to consume (MPC ). We
can also define the marginal propensity to save (MPS) as1 − MPC.
8/9/2019 Feenstra and Taylor Chapter 18
6/62
6 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C
h a p t e r 1 8 : O u t p u t , E x c h a n g e
R a t e s , a n d M a c r o e c o n o m i c
P o l i c i e s i n t h e S h o r t R u n
1 Demand in the Open Economy
ConsumptionFIGURE 18-1
The Consumption Function
The consumption function relates private consumption, C, to disposableincome, Y − T .
The slope of the function is the marginal propensity to consume, MPC.
8/9/2019 Feenstra and Taylor Chapter 18
7/62
7 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C
h a p t e r 1 8 : O u t p u t , E x c h a n g e
R a t e s , a n d M a c r o e c o n o m i c
P o l i c i e s i n t h e S h o r t R u n
1 Demand in the Open Economy
Investment
• The firm’s borrowing cost is the expected real interestrate re, which equals the nominal interest rate i minusthe expected rate of inflation π e: r e = i − π e.
• Since expected inflation is zero, the expected real
interest rate equals the nominal interest rate, r
e
= i .• Investment I is a decreasing function of the real interest
rate; that is, investment falls as the real interest rate
rises.
• Remember that this is true only because when expectedinflation is zero, the real interest rate equals the nominal
interest rate.
8/9/2019 Feenstra and Taylor Chapter 18
8/62
8 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C
h a p t e r 1 8 : O u t p u t , E x c h a n g e
R a t e s , a n d M a c r o e c o n o m i c
P o l i c i e s i n t h e S h o r t R u n
1 Demand in the Open Economy
InvestmentFIGURE 18-2
The Investment Function The investment function relates the quantity ofinvestment, I, to the level of the expected real interest rate, which equals thenominal interest rate, i , when (as assumed in this chapter) the expected rateof inflation, π e , is zero. The investment function slopes downward: as the
real cost of borrowing falls, more investment projects are profitable.
8/9/2019 Feenstra and Taylor Chapter 18
9/629 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C
h a p t e r 1 8 : O u t p u t , E x c h a n g e
R a t e s , a n d M a c r o e c o n o m i c
P o l i c i e s i n t h e S h o r t R u n
1 Demand in the Open Economy
The Government
• We will assume that the government’s role is simple. Itcollects an amount T of taxes from private householdsand spends an amount G on government consumptionof goods and services.
• Excluded from this concept are large sums involved ingovernment transfer programs, such as social security,medical care, or unemployment benefit systems.
• In the unlikely event that G = T exactly, we say that the
government has a balanced budget. If T > G, the
government is said to be running a budget surplus (of
size T − G); if G > T , a budget deficit (of size G − T or,
equivalently, a negative surplus of T − G).
• Government purchases = G = G
Taxes = T = T.
−
−
8/9/2019 Feenstra and Taylor Chapter 18
10/6210 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C
h a p t e r 1 8 : O u t p u t , E x c h a n g e
R a t e s , a n d M a c r o e c o n o m i c
P o l i c i e s i n t h e S h o r t R u n
1 Demand in the Open Economy
The Trade Balance
• The Role of the Real Exchange Rate In the aggregate,when spending patterns change in response to changes
in the real exchange rate, we say that there is
expenditure switching from foreign purchases todomestic purchases.
• If Home’s exchange rate is E, the Home price level is P
(fixed in the short run), and the Foreign price level is
P *(also fixed in the short run), then the real exchange
rate q of Home is defined as q = EP */P .
We expect the trade balance of the home country to
be an increasing function of the home country’s real
exchange rate. That is, as the home country’s real
exchange rate rises (depreciates), it will export more
and import less, and the trade balance rises.
−
− − −
8/9/2019 Feenstra and Taylor Chapter 18
11/6211 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C
h a p t e r 1 8 : O u t p u t , E x c h a n g e
R a t e s , a n d M a c r o e c o n o m i c
P o l i c i e s i n t h e S h o r t R u n
1 Demand in the Open Economy
The Trade Balance
• The Role of Income Levels We expect an increase in home income to be
associated with an increase in home imports and a fall
in the home country’s trade balance.
We expect an increase in rest of the world income tobe associated with an increase in home exports and a
rise in the home country’s trade balance.
• The trade balance is, therefore, a function of three
variables:),,/(
function Increasing
**
function Decreasing
functionIncreasing
*
T Y T Y P P E TBTB
8/9/2019 Feenstra and Taylor Chapter 18
12/6212 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C
h a p t e r 1 8 : O u t p u t , E x c h a n g e
R a t e s , a n d M a c r o e c o n o m i c
P o l i c i e s i n t h e S h o r t R u n
1 Demand in the Open Economy
The Trade BalanceFIGURE 18-3 (1 of 2)
The Trade Balance and the Real Exchange Rate
The trade balance is an increasing function of the real exchange rate, EP */P .
When there is a real depreciation (a rise in q ), foreign goods become moreexpensive relative to home goods, and we expect the trade balance toincrease as exports rise and imports fall (a rise in TB ).
8/9/2019 Feenstra and Taylor Chapter 18
13/6213 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C
h a p t e r 1 8 : O u t p u t , E x c h a n g e
R a t e s , a n d M a c r o e c o n o m i c
P o l i c i e s i n t h e S h o r t R u n
1 Demand in the Open Economy
The Trade BalanceFIGURE 18-3 (2 of 2)
The Trade Balance and the Real Exchange Rate (continued)
The trade balance may also depend on income. If home income levels rise,then some of the increase in income may be spent on the consumption ofimports. For example, if home income rises from Y 1 to Y 2, then the tradebalance will decrease, whatever the level of the real exchange rate, and the
trade balance function will shift down.
8/9/2019 Feenstra and Taylor Chapter 18
14/6214 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C
h a p t e r 1 8 : O u t p u t , E x c h a n g e
R a t e s , a n d M a c r o e c o n o m i c
P o l i c i e s i n t h e S h o r t R u n
1 Demand in the Open Economy
The Trade Balance
Marginal Effects Once More We refer to MPC F as themarginal propensity to consume foreign imports.
Let MPC H > 0 be the marginal propensity to consume
home goods. By assumption MP C = MPC H + MPC F .
For example, if MPC F = 0.10 and MPC H = 0.65, then MPC= 0.75; for every extra dollar of disposable income, home
consumers spend 75 cents, 10 cents on imported foreign
goods and 65 cents on home goods (and they save 25
cents).
8/9/2019 Feenstra and Taylor Chapter 18
15/6215 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C
h a p t e r 1 8 : O u t p u t , E x c h a n g e
R a t e s , a n d M a c r o e c o n o m i c
P o l i c i e s i n t h e S h o r t R u n
FIGURE 18-4
The Real Exchange Rate andthe Trade Balance: UnitedStates, 1975 –2006
Does the real exchange rateaffect the trade balance inthe way we have assumed?The data show that the U.S.trade balance is correlatedwith the U.S. real effectiveexchange rate index.Because the trade balancealso depends on changes in
U.S. and rest of the worlddisposable income (andother factors), it mayrespond with a lag tochanges in the real exchangerate, so the correlation is notperfect (as seen in the years
2000 –2006).
APPLICATION
The Trade Balance and the Real Exchange Rate
8/9/2019 Feenstra and Taylor Chapter 18
16/6216 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C
h a p t e r 1 8 : O u t p u t , E x c h a n g e
R a t e s , a n d M a c r o e c o n o m i c
P o l i c i e s i n t h e S h o r t R u n
APPLICATION
The Trade Balance and the Real Exchange Rate
Barriers to Expenditure Switching: Pass-Through and the J Curve
FIGURE 18-5 (2 of 2)
The J Curve (continued)
However, home imports nowcost more due to the
depreciation. Thus, the valueof imports, IM, would actuallyr ise after a depreciation,causing the trade balance TB= EX − IM to fall.
Only after some time would
exports rise and imports fall,allowing the trade balance torise relative to its pre-depreciation level. The pathtraced by the trade balanceduring this process looksvaguely like a letter J.
8/9/2019 Feenstra and Taylor Chapter 18
17/6217 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C
h a p t e r 1 8 : O u t p u t , E x c h a n g e
R a t e s , a n d M a c r o e c o n o m i c
P o l i c i e s i n t h e S h o r t R u n
1 Demand in the Open Economy
Exogenous Changes in DemandFIGURE 18-6 (1 of 3)
Exogenous Shocks to Consumption, Investment, and the Trade Balance
(a) When households decide to consume more at any given level of disposableincome, the consumption function shifts up.
8/9/2019 Feenstra and Taylor Chapter 18
18/6218 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C
h a p t e r 1 8 : O u t p u t , E x c h a n g e
R a t e s , a n d M a c r o e c o n o m i c
P o l i c i e s i n t h e S h o r t R u n
1 Demand in the Open Economy
Exogenous Changes in DemandFIGURE 18-6 (2 of 3)
Exogenous Shocks to Consumption, Investment, and the Trade Balance (continued)
(b) When firms decide to invest more at any given level of the interest rate, theinvestment function shifts right.
8/9/2019 Feenstra and Taylor Chapter 18
19/6219 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C
h a p t e r 1 8 : O u t p u t , E x c h a n g e
R a t e s , a n d M a c r o e c o n o m i c
P o l i c i e s i n t h e S h o r t R u n
1 Demand in the Open Economy
Exogenous Changes in DemandFIGURE 18-6 (3 of 3)
Exogenous Shocks to Consumption, Investment, and the Trade Balance (continued)
(c) When the trade balance increases at any given level of the real exchange rate,the trade balance function shifts up.
8/9/2019 Feenstra and Taylor Chapter 18
20/6220 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C
h a p t e r 1 8 : O u t p u t , E x c h a n g e
R a t e s , a n d M a c r o e c o n o m i c
P o l i c i e s i n t h e S h o r t R u n
2 Goods Market Equilibrium: The Keynesian Cross
Supply and Demand
Given our assumption that the current account equals thetrade balance, gross national income Y equals GDP:
Aggregate demand, or just “demand,” consists of all the
possible sources of demand for this supply of output.
Substituting we have
The goods market equilibrium condition is
Supply = GDP Y
Demand = DC I GTB
DC (Y T ) I (i)G TB EP * / P,Y T ,Y * T *
D
T Y T Y P P E TBGi I T Y C Y *** ,,/)()(
8/9/2019 Feenstra and Taylor Chapter 18
21/6221 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C
h a p t e r 1 8 : O u t p u t , E x c h a n g e
R a t e s , a n d M a c r o e c o n o m i c
P o l i c i e s i n t h e S h o r t R u n
2 Goods Market Equilibrium: The Keynesian Cross
Determinants of DemandFIGURE 18-7 (a) (1 of 2)
Panel (a): The GoodsMarket Equilibrium andthe Keynesian Cross
Equilibrium is wheredemand, D , equals realoutput or income, Y . In
this diagram,equilibrium is a point1, at an income oroutput level of Y 1. Thegoods market willadjust toward this
equilibrium.
8/9/2019 Feenstra and Taylor Chapter 18
22/6222 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C
h a p t e r 1 8 : O u t p u t , E x c h a n g e R a t e s , a n d M a c r o e c o n o m i c
P o l i c i e s i n t h e S h o r t R u n
2 Goods Market Equilibrium: The Keynesian Cross
Determinants of DemandFIGURE 18-7 (a) (2 of 2)
Panel (a): The GoodsMarket Equilibrium andthe Keynesian Cross(continued)
At point 2, the outputlevel is Y 2 and demand,D , exceeds supply, Y ;as inventories fall,firms expandproduction and outputrises toward Y 1.
At point 3, the output
level is Y 3 and supplyY exceeds demand; asinventories rise, firmscut production andoutput falls toward Y 1.
8/9/2019 Feenstra and Taylor Chapter 18
23/6223 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C
h a p t e r 1 8 : O u t p u t , E x c h a n g e R a t e s , a n d M a c r o e c o n o m i c
P o l i c i e s i n t h e S h o r t R u n
2 Goods Market Equilibrium: The Keynesian Cross
Determinants of DemandFIGURE 18-7 (b)
Panel (b): Shifts in Demand
The goods market isinitially in equilibrium atpoint 1, at which demandand supply both equal Y 1.
An increase in demand, D,at all levels of real output,Y, shifts the demand curveup from D 1 to D 2.
Equilibrium shifts to point2, where demand andsupply are higher and bothequal Y 2. Such an increasein demand could resultfrom changes in one ormore of the components ofdemand: C, I, G, or TB .
8/9/2019 Feenstra and Taylor Chapter 18
24/6224 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C
h a p t e r 1 8 : O u t p u t , E x c h a n g e R a t e s , a n d M a c r o e c o n o m i c
P o l i c i e s i n t h e S h o r t R u n
2 Goods Market Equilibrium: The Keynesian Cross
Factors That Shift the Demand Curve
Y
D
D
TB
I
C
P
P
E
i
T
outputof levelgivenaatdemandinIncrease
*
upshifts
curveDemand
function balancetradein theupshiftAny
functioninvestmentin theupshiftAny
functionnconsumptioin theupshiftAny
priceshomeinFall
pricesforeigninRise
rateexchangenominalin theRise
rateinteresthomein theFall
GspendinggovernmentinRise in taxesFall
The opposite changes lead to a decrease in
demand and shift the demand curve in.
8/9/2019 Feenstra and Taylor Chapter 18
25/6225 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C
h a p t e r 1 8 : O u t p u t , E x c h a n g e R a t e s , a n d M a c r o e c o n o m i c
P o l i c i e s i n t h e S h o r t R u n
3 Goods and Forex Market Equilibria: Deriving the IS Curve
Equilibrium in Two Markets
• A general equilibrium requires equilibrium in allmarkets—that is, equilibrium in the goods market,
the money market, and the forex market.
• The IS curve shows combinations of output Y and
the interest rate i for which the goods and forex
markets are in equilibrium.
Forex Market Recap
Uncovered interest parity (UIP) (Equation (18-3)) :
returnforeignExpected
currencydomestictheof ondepreciatiof rateExpected
rateinterestForeign
*
returnDomestic
rateinterestDomestic
1
E
E ii
e
Exchange Rates and Interest Rates in the Short Run:
8/9/2019 Feenstra and Taylor Chapter 18
26/6226 of 75Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C
h a p t e r 1 5 : E x c h a n g e R a t e s
I I : T h e A s s e t A p p r o a c h i n t h e
S h o r t R u n
TABLE 15-1
Interest Rates, Exchange Rates, Expected Returns, and FX Market Equilibrium: A
Numerical ExampleThe foreign exchange (FX) market is in equilibrium when the domestic and foreign returnsare equal. In this example, the dollar interest rate is 5%, the euro interest rate is 3%, andthe expected future exchange rate (one year ahead) is = 1.224 $/ €. The equilibrium ishighlighted in bold type, where both returns are 5% in annual dollar terms. Figure 12-2plots the domestic and foreign returns (columns 1 and 6) against the spot exchange rate(column 3). Figures are rounded in this table.
Exchange Rates and Interest Rates in the Short Run:UIP and FX Market Equilibrium
Exchange Rates and Interest Rates in the Short Run:
8/9/2019 Feenstra and Taylor Chapter 18
27/6227 of 75Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C
h a p t e r 1 5 : E x c h a n g e R a t e s
I I : T h e A s s e t A p p r o a c h i n t h e
S h o r t R u n
Equilibrium in the FX Market: An Example
FIGURE 15-2
FX Market Equilibrium: ANumerical Example
The returns calculated inTable 15-1 are plotted inthis figure.
The dollar interest rate is5%, the euro interest rateis 3%, and the expectedfuture exchange rate is1.224 $/ €.
The foreign exchangemarket is in equilibrium at
point 1, where thedomestic returns DR andexpected foreign returnsFR are equal at 5% andthe spot exchange rate is1.20 $/ €.
Exchange Rates and Interest Rates in the Short Run:UIP and FX Market Equilibrium
8/9/2019 Feenstra and Taylor Chapter 18
28/62
28 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C
h a p t e r 1 8 : O u t p u t , E x c h a n g e R a t e s , a n d M a c r o e c o n o m i c
P o l i c i e s i n t h e S h o r t R u n
3 Goods and Forex Market Equilibria: Deriving the IS Curve
Deriving the IS Curve
FIGURE 18-8 (1 of 3)
Deriving the IS Curve
The Keynesian cross isin panel (a), IS curve inpanel (b), and forex (FX)market in panel (c).
The economy starts inequilibrium with output,Y 1; interest rate, i 1; andexchange rate, E 1.
Consider the effect of adecrease in the interestrate from i 1 to i 2, all else
equal. In panel (c), alower interest ratecauses a depreciation;equilibrium moves from1′ to 2′.
8/9/2019 Feenstra and Taylor Chapter 18
29/62
29 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C
h a p t e r 1 8 : O u t p u t , E x c h a n g e R a t e s , a n d M a c r o e c o n o m i c
P o l i c i e s i n t h e S h o r t R u n
3 Goods and Forex Market Equilibria: Deriving the IS Curve
Equilibrium in Two Markets
FIGURE 18-8 (2 of 3)
Deriving the IS Curve(continued)
A lower interest rateboosts investment and adepreciation boosts thetrade balance.
In panel (a), demandshifts up from D 1 to D 2,equilibrium from 1” to 2”,
output from Y 1 to Y 2.
8/9/2019 Feenstra and Taylor Chapter 18
30/62
30 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C
h a p t e r 1 8 : O u t p u t , E x c h a n g e R a t e s , a n d M a c r o e c o n o m i c
P o l i c i e s i n t h e S h o r t R u n
3 Goods and Forex Market Equilibria: Deriving the IS Curve
Deriving the IS Curve
FIGURE 18-8 (3 of 3)
Deriving the IS Curve(continued)
In panel (b), we go frompoint 1 to point 2. The IScurve is thus traced out,a downward-slopingrelationship between theinterest rate and output.
When the interest ratefalls from i 1 to i 2, outputrises from Y 1 to Y 2.
The IS curve describes
all combinations of i andY consistent with goodsand FX market equilibriain panels (a) and (c).
8/9/2019 Feenstra and Taylor Chapter 18
31/62
31 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C
h a p t e r 1 8 : O u t p u t , E x c h a n g e R a t e s , a n d M a c r o e c o n o m i c
P o l i c i e s i n t h e S h o r t R u n
3 Goods and Forex Market Equilibria: Deriving the IS Curve
Deriving the IS Curve
• One important observation is in order:In an open economy, lower interest rates stimulate
demand through the traditional closed-economy
investment channel and through the trade balance.
The trade balance effect occurs because lower interestrates cause a nominal depreciation (in the short run, it
is also a real depreciation), which stimulates external
demand via the trade balance.
• The IS curve is downward-sloping. It illustrates the
negative relationship between the interest rate i and
output Y.
8/9/2019 Feenstra and Taylor Chapter 18
32/62
32 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C
h a p t e r 1 8 : O u t p u t , E x c h a n g e R a t e s , a n d M a c r o e c o n o m i c
P o l i c i e s i n t h e S h o r t R u n
3 Goods and Forex Market Equilibria: Deriving the IS Curve
Factors That Shift the IS Curve
FIGURE 18-9 (1 of 2)
Exogenous Shifts inDemand Cause the ISCurve to Shift
In the Keynesian cross inpanel (a), when theinterest rate is heldconstant at i 1 , anexogenous increase indemand (due to otherfactors) causes thedemand curve to shift upfrom D 1 to D 2 as shown,
all else equal. Thismoves the equilibriumfrom 1” to 2”, raising
output from Y 1 to Y 2.
8/9/2019 Feenstra and Taylor Chapter 18
33/62
33 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C
h a p t e r 1 8 : O u t p u t , E x c h a n g e R a t e s , a n d M a c r o e c o n o m i c
P o l i c i e s i n t h e S h o r t R u n
3 Goods and Forex Market Equilibria: Deriving the IS Curve
Factors That Shift the IS Curve
FIGURE 18-9 (2 of 2)
Exogenous Shifts inDemand Cause the ISCurve to Shift(continued)
In the IS diagram in panel(b), output has risen, withno change in the interestrate.
The IS curve hastherefore shifted rightfrom IS 1 to IS 2.
The nominal interest rate
and hence the exchangerate are unchanged inthis example, as seen inpanel (c).
8/9/2019 Feenstra and Taylor Chapter 18
34/62
34 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C
h a p t e r 1 8 : O u t p u t , E x c h a n g e R a t e s , a n d M a c r o e c o n o m i c
P o l i c i e s i n t h e S h o r t R u n
3 Goods and Forex Market Equilibria: Deriving the IS Curve
Summing Up the IS Curve
IS
IS
(G
,T
,i
*
, E
e
, P
*, P
)
i
Y
i
Y
D
e
*
D
TB
I
C
P
P
E
i
G
T
rateinteresthome givenaat
outputmequilibriuinIncrease
rateinteresthome givenaatand
outputof levelanyatdemandinIncrease
*
rightshifts
curveIS
upshifts
curveDemand
function balancetradein theupshiftAny
functioninvestmentin theupshiftAnyfunctionnconsumptioin theupshiftAny
priceshomeinFall
pricesforeigninRise
rateexchangeexpectedfutureinRise
rateinterestforeigninRise
spendinggovernmentinRise
in taxesFall
Factors That Shift the IS Curve
The opposite changes lead to a decrease in demand and shift the
demand curve down and the IS curve to the left.
8/9/2019 Feenstra and Taylor Chapter 18
35/62
35 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C h a p t e r 1 8 : O u t p u t , E x c h a n g
e R a t e s , a n d M a c r o e c o n o m i c P o l i c i e s i n t h e S h o r t R u n
4 Money Market Equilibrium: Deriving the LM Curve
Money Market Recap
• In this section, we derive a set of combinations of Y
and i that ensures equilibrium in the money market, a
concept that can be represented graphically as the LMcurve.
demandmoneyReal
supplymoneyReal
)( Y i L P
M
• In the short-run, the price level is assumed to be sticky
at a level P , and the money market is in equilibrium
when the demand for real money balances L(i )Y equals
the real money supply M /P : –
–
(18-2)
8/9/2019 Feenstra and Taylor Chapter 18
36/62
36 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C h a p t e r 1 8 : O u t p u t , E x c h a n g
e R a t e s , a n d M a c r o e c o n o m i c P o l i c i e s i n t h e S h o r t R u n
4 Money Market Equilibrium: Deriving the LM Curve
Deriving the LM Curve
FIGURE 18-10 (1 of 2)
Deriving the LM Curve
If there is an increase in real income or output from Y 1 to Y 2 in panel (b), the effectin the money market in panel (a) is to shift the demand for real money balances tothe right, all else equal.
If the real supply of money, MS, is held fixed at M /P , then the interest rate rises
from i 1 to i 2 and money market equilibrium moves from point 1′ to point 2′.
8/9/2019 Feenstra and Taylor Chapter 18
37/62
37 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C h a p t e r 1 8 : O u t p u t , E x c h a n g
e R a t e s , a n d M a c r o e c o n o m i c P o l i c i e s i n t h e S h o r t R u n
4 Money Market Equilibrium: Deriving the LM Curve
Deriving the LM Curve
FIGURE 18-10 (2 of 2)
Deriving the LM Curve (continued)
The relationship thus described between the interest rate and income, all elseequal, is known as the LM curve and is depicted in panel (b) by the movement frompoint 1 to point 2. The LM curve is upward-sloping: when the output level risesfrom Y 1 to Y 2, the interest rate rises from i 1 to i 2. The LM curve describes all
combinations of i and Y that are consistent with money market equilibrium in panel(a).
8/9/2019 Feenstra and Taylor Chapter 18
38/62
38 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C h a p t e r 1 8 : O u t p u t , E x c h a n g
e R a t e s , a n d M a c r o e c o n o m i c P o l i c i e s i n t h e S h o r t R u n
4 Money Market Equilibrium: Deriving the LM Curve
Factors That Shift the LM Curve
FIGURE 18-11 (1 of 2)
Change in the Money Supply Shifts the LM Curve
In the money market, shown in panel (a), we hold fixed the level of real income oroutput, Y, and hence real money demand, MD .
All else equal, we show the effect of an increase in money supply from M 1 to M 2.The real money supply curve moves out from MS 1 to MS 2. This moves the
equilibrium from 1′ to 2′, lowering the interest rate from i 1 to i 2.
4 M M k t E ilib i D i i th LM C
8/9/2019 Feenstra and Taylor Chapter 18
39/62
39 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C h a p t e r 1 8 : O u t p u t , E x c h a n g
e R a t e s , a n d M a c r o e c o n o m i c P o l i c i e s i n t h e S h o r t R u n
4 Money Market Equilibrium: Deriving the LM Curve
Factors That Shift the LM Curve
FIGURE 18-11 (2 of 2)
Change in the Money Supply Shifts the LM Curve (continued)
In the LM diagram, shown in panel (b), the interest rate has fallen, with no changein the level of income or output, so the economy moves from point 1 to point 2.
The LM curve has therefore shift down from LM 1 to LM 2.
4 M M k t E ilib i D i i th LM C
8/9/2019 Feenstra and Taylor Chapter 18
40/62
40 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C h a p t e r 1 8 : O u t p u t , E x c h a n g
e R a t e s , a n d M a c r o e c o n o m i c P o l i c i e s i n t h e S h o r t R u n
4 Money Market Equilibrium: Deriving the LM Curve
Summing Up the LM Curve
LM
LM
( M
/ P
)
Y
i
L
M
outputof levelgivenatrateinteresthomemequilibriu inDecrease
rightordownshifts
curveLM
functiondemandmoneyin theleftshiftAny
supplymoney(nominal)inRise
Factors That Shift the LM Curve
5 Th Sh t R IS LM FX M d l f O E
8/9/2019 Feenstra and Taylor Chapter 18
41/62
41 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C h a p t e r 1 8 : O u t p u t , E x c h a n g
e R a t e s , a n d M a c r o e c o n o m i c P o l i c i e s i n t h e S h o r t R u n
5 The Short-Run IS-LM-FX Model of an Open Economy
FIGURE 18-12 (1 of 2)
Equilibrium in the IS-LM-FX Model
In panel (a), the IS and LM curves are both drawn. The goods and forex markets arein equilibrium when the economy is on the IS curve. The money market is inequilibrium when the economy is on the LM curve. Both markets are in equilibriumif and only if the economy is at point 1, the unique point of intersection of IS andLM .
5 Th Sh t R IS LM FX M d l f O E
8/9/2019 Feenstra and Taylor Chapter 18
42/62
42 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C h a p t e r 1 8 : O u t p u t , E x c h a n g
e R a t e s , a n d M a c r o e c o n o m i c P o l i c i e s i n t h e S h o r t R u n
FIGURE 18-13 (2 of 2)
Equilibrium in the IS-LM-FX Model (continued)
In panel (b), the forex (FX) market is shown. The domestic return, DR, in the forexmarket equals the money market interest rate.
Equilibrium is at point 1′ where the foreign return FR equals domestic return, i .
5 The Short-Run IS-LM-FX Model of an Open Economy
5 Th Sh t R IS LM FX M d l f O E
8/9/2019 Feenstra and Taylor Chapter 18
43/62
43 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C h a p t e r 1 8 : O u t p u t , E x c h a n g
e R a t e s , a n d M a c r o e c o n o m i c P o l i c i e s i n t h e S h o r t R u n
Macroeconomic Policies in the Short Run
5 The Short-Run IS-LM-FX Model of an Open Economy
• We focus on the two main policy actions: changes in monetarypolicy, implemented through changes in the money supply, andchanges in fiscal policy, involving changes in governmentspending or taxes.
• The key assumptions of this section are as follows.
• The economy begins in a state of long-run equilibrium. We then
consider policy changes in the home economy, assuming that
conditions in the foreign economy (i.e., the rest of the world)
are unchanged.
• The home economy is subject to the usual short-run
assumption of a sticky price level at home and abroad.
• Furthermore, we assume that the forex market operates freely
and unrestricted by capital controls and that the exchange rate
is determined by market forces.
5 Th Sh t R IS LM FX M d l f O E
8/9/2019 Feenstra and Taylor Chapter 18
44/62
44 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C h a p t e r 1 8 : O u t p u t , E x c h a n g
e R a t e s , a n d M a c r o e c o n o m i c P o l i c i e s i n t h e S h o r t R u n
Monetary Policy under Floating Exchange RatesFIGURE 18-13 (1 of 2)
Monetary Policy under Floating Exchange RatesIn panel (a) in the IS-LM diagram, the goods and money markets are initially inequilibrium at point 1. The interest rate in the money market is also the domesticreturn, DR 1, that prevails in the forex market. In panel (b), the forex market isinitially in equilibrium at point 1′. A temporary monetary expansion that increases
the money supply from M 1 to M 2 would shift the LM curve down in panel (a) from
LM 1 to LM 2, causing the interest rate to fall from i 1 to i 2. DR falls from DR 1 to DR 2.
5 The Short-Run IS-LM-FX Model of an Open Economy
5 The Short R n IS LM FX Model of an Open Econom
8/9/2019 Feenstra and Taylor Chapter 18
45/62
45 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C h a p t e r 1 8 : O u t p u t , E x c h a n g
e R a t e s , a n d M a c r o e c o n o m i c P o l i c i e s i n t h e S h o r t R u n
Monetary Policy under Floating Exchange RatesFIGURE 18-13 (2 of 2)
Monetary Policy under Floating Exchange Rates (continued)In panel (b), the lower interest rate implies that the exchange rate must depreciate,rising from E 1 to E 2.
As the interest rate falls (increasing investment, I ) and the exchange ratedepreciates (increasing the trade balance), demand increases, which correspondsto the move down the IS curve from point 1 to point 2’.
Output expands from Y 1 to Y 2. The new equilibrium corresponds to points 2 and 2′.
5 The Short-Run IS-LM-FX Model of an Open Economy
5 The Short Run IS LM FX Model of an Open Economy
8/9/2019 Feenstra and Taylor Chapter 18
46/62
46 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C h a p t e r 1 8 : O u t p u t , E x c h a n g
e R a t e s , a n d M a c r o e c o n o m i c P o l i c i e s i n t h e S h o r t R u n
Monetary Policy under Floating Exchange Rates
5 The Short-Run IS-LM-FX Model of an Open Economy
To sum up: a temporary monetary expansion under
floating exchange rates is effective in combating
economic downturns by boosting output. It raises output
at home, lowers the interest rate, and causes a
depreciation of the exchange rate. What happens to the
trade balance cannot be predicted with certainty.
5 The Short Run IS LM FX Model of an Open Economy
8/9/2019 Feenstra and Taylor Chapter 18
47/62
47 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C h a p t e r 1 8 : O u t p u t , E x c h a n g
e R a t e s , a n d M a c r o e c o n o m i c P o l i c i e s i n t h e S h o r t R u n
Monetary Policy under Fixed Exchange RatesFIGURE 18-14 (1 of 2)
Monetary Policy under Fixed Exchange Rates
In panel (a) in the IS-LM diagram, the goods and money markets are initially inequilibrium at point 1. In panel (b), the forex market is initially in equilibrium atpoint 1′.
A temporary monetary expansion that increases the money supply from M 1 to M 2
would shift the LM curve down in panel (a).
5 The Short-Run IS-LM-FX Model of an Open Economy
5 The Short Run IS LM FX Model of an Open Economy
8/9/2019 Feenstra and Taylor Chapter 18
48/62
48 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C h a p t e r 1 8 : O u t p u t , E x c h a n g
e R a t e s , a n d M a c r o e c o n o m i
c P o l i c i e s i n t h e S h o r t R u n
Monetary Policy under Fixed Exchange RatesFIGURE 18-14 (2 of 2)
5 The Short-Run IS-LM-FX Model of an Open Economy
Monetary Policy under Fixed Exchange Rates (continued)
In panel (b), the lower interest rate would imply that the exchange rate mustdepreciate, rising from E 1 to E 2. This depreciation is inconsistent with the peggedexchange rate, so the policy makers cannot move LM in this way.
They must leave the money supply equal to M 1. Implication: under a fixed
exchange rate, autonomous monetary policy is not an option.
5 The Short Run IS LM FX Model of an Open Economy
8/9/2019 Feenstra and Taylor Chapter 18
49/62
49 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C h a p t e r 1 8 : O u t p u t , E x c h a n g
e R a t e s , a n d M a c r o e c o n o m i c P o l i c i e s i n t h e S h o r t R u n
Monetary Policy under Fixed Exchange Rates
5 The Short-Run IS-LM-FX Model of an Open Economy
To sum up: monetary policy under fixed exchange rates is
impossible to undertake. Fixing the exchange rate means
giving up monetary policy autonomy.
Countries cannot simultaneously allow capital mobility,
maintain fixed exchange rates, and pursue an autonomous
monetary policy.
5 The Short Run IS LM FX Model of an Open Economy
8/9/2019 Feenstra and Taylor Chapter 18
50/62
50 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C h a p t e r 1 8 : O u t p u t , E x c h a n g
e R a t e s , a n d M a c r o e c o n o m i c P o l i c i e s i n t h e S h o r t R u n
Fiscal Policy under Floating Exchange RatesFIGURE 18-15 (1 of 3)
Fiscal Policy under Floating Exchange Rates
In panel (a) in the IS-LM diagram, the goods and money markets are initially inequilibrium at point 1.
The interest rate in the money market is also the domestic return, DR 1, that prevailsin the forex market. In panel (b), the forex market is initially in equilibrium at point1′.
5 The Short-Run IS-LM-FX Model of an Open Economy
5 The Short Run IS LM FX Model of an Open Economy
8/9/2019 Feenstra and Taylor Chapter 18
51/62
51 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C h a p t e r 1 8 : O u t p u t , E x c h a n g
e R a t e s , a n d M a c r o e c o n o m i c P o l i c i e s i n t h e S h o r t R u n
Fiscal Policy under Floating Exchange RatesFIGURE 18-15 (2 of 3)
Fiscal Policy under Floating Exchange Rates (continued)
A temporary fiscal expansion that increases government spending from G 1 to G 2 would shift the IS curve to the right in panel (a) from IS 1 to IS 2, causing the interestrate to rise from i 1 to i 2.
The domestic return shifts up from DR 1 to DR 2.
5 The Short-Run IS-LM-FX Model of an Open Economy
5 The Short-Run IS-LM-FX Model of an Open Economy
8/9/2019 Feenstra and Taylor Chapter 18
52/62
52 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C h a p t e r 1 8 : O u t p u t , E x c h a n g
e R a t e s , a n d M a c r o e c o n o m i c P o l i c i e s i n t h e S h o r t R u n
Fiscal Policy under Floating Exchange RatesFIGURE 18-15 (3 of 3)
Fiscal Policy under Floating Exchange Rates (continued)
In panel (b), the higher interest rate would imply that the exchange rate mustappreciate, falling from E 1 to E 2.
The initial shift in the IS curve and falling exchange rate corresponds in panel (a) tothe movement along the LM curve from point 1 to point 2. Output expands Y1 to Y2.The new equilibrium corresponds to points 2 and 2’.
5 The Short-Run IS-LM-FX Model of an Open Economy
5 The Short-Run IS-LM-FX Model of an Open Economy
8/9/2019 Feenstra and Taylor Chapter 18
53/62
53 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C h a p t e r 1 8 : O u t p u t , E x c h a n g
e R a t e s , a n d M a c r o e c o n o m i c P o l i c i e s i n t h e S h o r t R u n
Fiscal Policy under Floating Exchange Rates
5 The Short-Run IS-LM-FX Model of an Open Economy
As the interest rate rises (decreasing investment, I) and
the exchange rate appreciates (decreasing the trade
baland), demand falls. This impact of fiscal expansion is
often referred to as crowding out. That is, the increase ingovernment spending is offset by a decline in private
spending.
Thus, in an open economy, fiscal expansion crowds out
investment (by raising the interest rate) and decreases
net exports (by causing the exchange rate to appreciate).Over time, it limits the rise in output to less than the
increase in government spending.
5 The Short-Run IS-LM-FX Model of an Open Economy
8/9/2019 Feenstra and Taylor Chapter 18
54/62
54 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C h a p t e r 1 8 : O u t p u t , E x c h a n g
e R a t e s , a n d M a c r o e c o n o m i c P o l i c i e s i n t h e S h o r t R u n
Fiscal Policy under Floating Exchange Rates
5 The Short-Run IS-LM-FX Model of an Open Economy
To sum up: an expansion of fiscal policy under floating
exchange rates might be temporary effective. It raises
output at home, raises the interest rate, causes an
appreciation of the exchange rate, and decreases the
trade balance. It indirectly leads to crowding out ofinvestment and exports, and thus limits the rise in output
to less than an increase in government spending.
(A temporary contraction of fiscal policy has opposite
effects.)
5 The Short-Run IS-LM-FX Model of an Open Economy
8/9/2019 Feenstra and Taylor Chapter 18
55/62
55 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C h a p t e r 1 8 : O u t p u t , E x c h a n g
e R a t e s , a n d M a c r o e c o n o m i c P o l i c i e s i n t h e S h o r t R u n
Fiscal Policy under Fixed Exchange RatesFIGURE 18-16 (1 of 3)
Fiscal Policy under Fixed Exchange Rates
In panel (a) in the IS-LM diagram, the goods and money markets are initially inequilibrium at point 1. The interest rate in the money market is also the domesticreturn, DR 1, that prevails in the forex market. In panel (b), the forex market isinitially in equilibrium at point 1′.
5 The Short-Run IS-LM-FX Model of an Open Economy
5 The Short-Run IS-LM-FX Model of an Open Economy
8/9/2019 Feenstra and Taylor Chapter 18
56/62
56 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C h a p t e r 1 8 : O u t p u t , E x c h a n g
e R a t e s , a n d M a c r o e c o n o m i c P o l i c i e s i n t h e S h o r t R u n
Fiscal Policy under Fixed Exchange RatesFIGURE 18-16 (2 of 3)
Fiscal Policy under Fixed Exchange Rates (continued)A temporary fiscal expansion on its own increases government spending from G 1 to G 2 and would shift the IS curve to the right in panel (a) from IS 1 to IS 2, causingthe interest rate to rise from i 1 to i 2.
The domestic return would then rise from DR 1 to DR 2.
5 The Short-Run IS-LM-FX Model of an Open Economy
⎯
⎯
5 The Short-Run IS-LM-FX Model of an Open Economy
8/9/2019 Feenstra and Taylor Chapter 18
57/62
57 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C h a p t e r 1 8 : O u t p u t , E x c h a n g e R a t e s , a n d M a c r o e c o n o m i c P o l i c i e s i n t h e S h o r t R u n
Fiscal Policy under Fixed Exchange RatesFIGURE 18-16 (3 of 3)
Fiscal Policy under Fixed Exchange Rates (continued)In panel (b), the higher interest rate would imply that the exchange rate mustappreciate, falling from E to E 2. To maintain the peg, the monetary authority mustnow intervene, shifting the LM curve down, from LM 1 to LM 2. The fiscal expansionthus prompts a monetary expansion.
In the end, the interest rate and exchange rate are left unchanged, and output
expands dramat ical ly from Y 1 to Y 2. The new equilibrium is at to points 2 and 2′.
5 The Short Run IS LM FX Model of an Open Economy
⎯
5 The Short-Run IS-LM-FX Model of an Open Economy
8/9/2019 Feenstra and Taylor Chapter 18
58/62
58 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C h a p t e r 1 8 : O u t p u t , E x c h a n g e R a t e s , a n d M a c r o e c o n o m i c P o l i c i e s i n t h e S h o r t R u n
Summary
5 The Short Run IS LM FX Model of an Open Economy
To sum up: a temporary expansion of fiscal policy under
fixed exchange rates raises output at home by a
considerable amount. (The case of a temporary
contraction of fiscal policy would have similar but opposite
effects.)
6 Stabilization Policy
8/9/2019 Feenstra and Taylor Chapter 18
59/62
59 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C h a p t e r 1 8 : O u t p u t , E x c h a n g e R a t e s , a n d M a c r o e c o n o m i c P o l i c i e s i n t h e S h o r t R u n
• Authorities can use changes in policies to try to keep
the economy at or near its full-employment level of
output. This is the essence of stabilization policy.
• If the economy is hit by a temporary adverse shock,
policy makers could use expansionary monetary
and fiscal policies to prevent a deep recession.
• Conversely, if the economy is pushed by a shockabove its full employment level of output,
contractionary policies could tame the boom.
6 Stabilization Policy
6 Stabilization Policy
8/9/2019 Feenstra and Taylor Chapter 18
60/62
60 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C h a p t e r 1 8 : O u t p u t , E x c h a n g e R a t e s , a n d M a c r o e c o n o m i c P o l i c i e s i n t h e S h o r t R u n
Policy Constraints A fixed exchange rate rules out any
use of monetary policy. Other firm monetary or fiscal
policy rules, such as interest rate rules or balanced-
budget rules, place limits on policy.
Incomplete Information and the Inside Lag It may take
weeks or months for policy makers to fully understand thestate of the economy today. Even then, it will take time to
formulate a policy response (the lag between shock and
policy actions is called the inside lag ).
Policy Response and the Outside Lag It takes time forwhatever policies are enacted to have any effect on the
economy, through the spending decisions of the public
and private sectors (the lag between policyactions and
effects is called the outside lag ).
6 Stabilization Policy
Problems in Policy Design and Implementation
6 Stabilization Policy
8/9/2019 Feenstra and Taylor Chapter 18
61/62
61 of 93Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e.
C h a p t e r 1 8 : O u t p u t , E x c h a n g e R a t e s , a n d M a c r o e c o n o m i c P o l i c i e s i n t h e S h o r t R u n
Long-Horizon Plans If the private sector understands that
a policy change is temporary, then there may be reasons
not to change consumption or investment expenditure.
Similarly, a temporary real appreciation may have little
effect on whether a firm can profit in the long run from
sales in the foreign market.Weak Links from the Nominal Exchange Rate to the Real
Exchange Rate Changes in the nominal exchange rate
may not translate into changes in the real exchange rate
for some goods and services.Pegged Currency Blocs Exchange rate arrangements in
some countries may be characterized—often not as a
result of their own choice—by a mix of floating and fixed
exchange rate systems with different trading partners.
6 Stabilization Policy
Problems in Policy Design and Implementation
6 Stabilization Policy
8/9/2019 Feenstra and Taylor Chapter 18
62/62
a p t e r 1 8 : O u t p u t , E x c h a n g e R a t e s , a n d M a c r o e c o n o m
i c P o l i c i e s i n t h e S h o r t R u n
Weak Links from the Real Exchange Rate to the Trade
Balance Changes in the real exchange rate may not lead
to changes in the trade balance. The reasons for this
weak linkage include transaction costs in trade, and the J
Curve effects.
These effects may cause expenditure switching to be be anonlinear phenomenon: it will be weak at first and then
much stronger as the real exchange rate change grows
larger.
For example: Prices of BMWs in the U.S. barely changein response to changes in the dollar-euro exchange rate.
6 Stabilization Policy
Problems in Policy Design and Implementation