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Macroeconomic fluctuations, and the traditional Keynesian theory

Nikolina Kosteletou

Keynesian theories: open economy

National and Kapodistrian University of AthensDepartment of EconomicsMaster Program in Applied EconomicsUADPhilEcon

outline

• Open economy• Fleming- Mundell model• Overshooting• Imperfect capital mobility

Open economy

• Free trade of goods• Free flows of capital• Demand:• Y = E• E = C+I+G+NE• NE= X-M• NE = NE)

Nominal ε

• ε: price of a unit of foreign currency in terms of domestic currency – [1$ → 0,81€] – (in euro area: 1 € → 0,24 $)

• ε↑: devaluation – depreciation (foreign currency is more expensive…(exports cheaper, imports more expensive)

• ε↓: overvaluation - appreciation

Real exchange rate )

• Real devaluation:• ε↑• P* ↑• P↓• Domestically produced goods cheaper

(exports ↑, imports ↓)• NE ↑ = X-M• P*: exogenous

E = E(Y, (i-πe), G, T, ) )

• Assumptions about the effect of changes of determinants of components, on expenditure:

• 0<EY<1,• Ei-πe <0,• EG>0,• ET<0,• E>0

Exchange rates

• Regime: – fixed – floating

• Expectations: – static – rational

• Flows of capital:– Perfect capital mobility– Imperfect capital mobility

Perfect capital mobility

• Capital flows → yield is greater• Yield: expected rate of return• i• i + • expected rate of depreciation of the domestic

currency.• If expectations are static: =0 and• i = i*

Perfect capital mobility

• Assumptions:• Perfect information

(about yields – investment opportunities – exchange rates)

• No transaction costs• =0 and• i = i* any time

The keynesian model

• E=E(Y, (i-πe), G, T, )• E=Y• (M/P)=L(i,Y)• i=i*• Exchange rate: does not interfere with the money

market• ⇒LM vertical• ⇒money market and monetary policy very

important in determining output - employment

The Fleming – Mundell model

• Assumptions:• short run: prices constant• Static expectations• Free trade (perfect commodity arbitrage

(perfect information, no transportation and other transaction costs)

• Perfect capital mobility, i=i*• Freely floating exchange rates

• E=E(Y, (i-πe), G, T, )• E=Y• (M/P)=L(i,Y)• i=i*• exogenous: πe, G, T, P*, i*, M, P• endogenous: E, Y, I, ε

The Fleming – Mundell model

• The money market:• LM* (ε,Y)• (M/P)=L(i,Y)

The Fleming – Mundell model

ε

Y

LM*

• The goods market:• IS* (ε,Y)• E=E(Y, (i-πe), G, T, )• E=Y• IS* has a positive slope

The Fleming – Mundell model

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ε

Y

IS*

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ε

Y

IS*LM*

Output – employment determined in the money market

Fiscal policy: ineffective

• Suppose G increases:• E↑, → Y ↑, → demand for money increases , i

tends to increase, inflow of foreign capital, supply of foreign money increases in the country:

• Appreciation of the domestic currency• The appreciation absorbs the initial increase in

output.

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ε

Y

IS*LM*

Fiscal expansion

IS*’

Monetary policy

• Increase in Ms,→ Y increases• Demand for goods increases• Demand for foreign goods increases• Demand for foreign currency increases• Depreciation of domestic currency• This allows an increase in output

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ε

Y

IS*

LM*

Monetary expansion

LM*’