open economy issues - sgh warsaw school of economics
TRANSCRIPT
M.Brzoza-Brzezina:
Macroeconomics II – Open
economy
2
Outline
1. Empirical facts about international economic relationships
2. Interest rate parity and the Mundell-Fleming model
Production, interest rate and exchange rate under fixed exchange rates
Production, interest rate and exchange rate under flexible exchange rates
1. Empirical facts about international economic relationships
M.Brzoza-Brzezina:
Macroeconomics II – Open
economy
3
Introduction Economies are open to international flows
of goods, services and capital
This has important implications:
– Foreign shocks and policies are transmitted
to the domestic economy
– Impact of domestic shocks and policies is
modified
Most economies are small and open – we
can ignore their impact on the ROW, but
note vice versa
The impact depends on the ex. rate
regime
M.Brzoza-Brzezina:
Macroeconomics II – Open
economy
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Openness to trade and finance
Most popular measures:
– Trade openness: (M+X)/GDP
– Financial openness: Foreign assets/GDP &
Foreign liabilities/GDP
Smaller economies are more open
Smaller economies are more prone to
international shocks
M.Brzoza-Brzezina:
Macroeconomics II – Open
economy
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Table 11.1
World trade as % of GDP
M.Brzoza-Brzezina:
Macroeconomics II – Open
economy
7 Source: World Bank Database
0
10
20
30
40
50
60
70
1960 1970 1980 1990 2000 2010
International correlation of
business cycles
An important consequence of openness is
that business cycles and inflation rates are
strongly correlated worldwide
Examples of spillovers: – a positive demand shock in Germany boosts German
imports Polish exports to Germany increase
– financial crisis abroad the foreign owner of a Polish bank
faces solvency problems withdraws profits from the Polish
bank Polish bank has lower capital and grants fewer
loans demand in Poland falls GDP declines
M.Brzoza-Brzezina:
Macroeconomics II – Open
economy
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GDP growth rate (y-o-y)
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-8,0
-6,0
-4,0
-2,0
0,0
2,0
4,0
6,0
8,0
10,0
12,019
96Q
1
19
96Q
3
19
97Q
1
19
97Q
3
19
98Q
1
19
98Q
3
19
99Q
1
19
99Q
3
20
00Q
1
20
00Q
3
20
01Q
1
20
01Q
3
20
02Q
1
20
02Q
3
20
03Q
1
20
03Q
3
20
04Q
1
20
04Q
3
20
05Q
1
20
05Q
3
20
06Q
1
20
06Q
3
20
07Q
1
20
07Q
3
20
08Q
1
20
08Q
3
20
09Q
1
20
09Q
3
20
10Q
1
20
10Q
3
20
11Q
1
20
11Q
3
20
12Q
1
20
12Q
3
20
13Q
1
20
13Q
3
20
14Q
1
20
14Q
3
20
15Q
1
20
15Q
3
20
16Q
1
20
16Q
3
20
17Q
1
20
17Q
3
20
18Q
1
20
18Q
3
Euro area Denmark Poland Sweden
Source: Eurostat data
HICP inflation (y-o-y)
M.Brzoza-Brzezina:
Macroeconomics II – Open
economy
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0,0
0,5
1,0
1,5
2,0
2,5
3,0
3,5
4,0
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Euro area Denmark Sweden
Source: Eurostat data
2. Interest rate parity and the
Mundell-Fleming model
M.Brzoza-Brzezina:
Macroeconomics II – Open
economy
11
Interest rate parity
To analyse these issues we need a link
between domestic and foreign interest
rates
Assume there is no risk, home bias or
restrictions on international capital flows
Then (simplified) equilibrium requires
𝑖 = 𝑖∗
M.Brzoza-Brzezina:
Macroeconomics II – Open
economy
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M.Brzoza-Brzezina:
Macroeconomics II –
Open economy
i* IFM
Inte
rest ra
te
International Financial Market Equilibrium
Figure 11.1 (a)
Output
i > i*, capital flows in
i < i*, capital flows out
When domestic and foreign rates of
return are not the same, capital will
flow towards the higher returns until
returns are equalized.
13
Fixed vs. flexible exchange rate
We already discussed some differences
between fixed and variable exchange
rates when analysing monetary policy
Here we go further and look at effects of
various domestic and foreign shocks
Note that we consider short-medium
term developments and ignore long-run
issues (e.g. return to potential)!!! M.Brzoza-Brzezina:
Macroeconomics II – Open
economy
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Model
Our model for this lecture is a variation
of the Mundell-Fleming model
IS curve + Taylor rule + Interest rate
parity (International Financial Markets
curve)
M.Brzoza-Brzezina:
Macroeconomics II – Open
economy
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The model
Under fixed exchange rate interest rates
are always equal
If they deviated, this would result in
apreciation or depreciation of the ex.
rate
This would be inconsistent with the fixed
exchange rate regime
M.Brzoza-Brzezina:
Macroeconomics II – Open
economy
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Demand shocks and fiscal policy
Domestic demand shocks are powerfull
– they are not crowded out by monetary
policy
This is also true for fiscal policy
M.Brzoza-Brzezina:
Macroeconomics II – Open
economy
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M.Brzoza-Brzezina:
Macroeconomics II –
Open economy
i* IFM
Inte
rest ra
te
Demand Shock with Capital Mobility
IS
A
Y‘
Figure 11.5 (a)
B
IS‘
Y Output
Positive demand shock:
IS curve shifts to the right.
At point B, output
has risen to Y‘.
i
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Monetary policy
As we already know monetary policy is
completely ineffective since 𝑖 = 𝑖∗
M.Brzoza-Brzezina:
Macroeconomics II – Open
economy
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Foreign financial shock
Foreign financial shocks have a
contractionary impact on the domestic
economy
M.Brzoza-Brzezina:
Macroeconomics II – Open
economy
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M.Brzoza-Brzezina:
Macroeconomics II –
Open economy
i*
Inte
rest ra
te
Int. Financial Shock: Fixed Exchange Rates
IS
B
Output
Figure 11.6 (a)
IFM‘
i
IFM A
i*‘
Y‘ Y 23
Devaluation
Devaluation makes domestic goods
more competitive
Foreign demand increases, so does
output
M.Brzoza-Brzezina:
Macroeconomics II – Open
economy
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M.Brzoza-Brzezina:
Macroeconomics II –
Open economy
i*
Figure 11.7 (a): Animation 1 (Demand
for Goods)
Inte
rest ra
te
A Devaluation: (b) Shift in Demand for Goods
IS´
B
Output
Figure 11.7 (a)
IFM
IS
A
A devaluation increases the
demand for domestic goods:
IS curve shifts to the right;
output expands from Y to Y‘.
Y Y‘ 25
The model
Under flexible ex. rates domestic
interest rate can deviate temporarily
from international
This generates capital flows that result
in apreciation or depreciation of the
exchange rate
In the model this is represented as
shifts of the IS curve M.Brzoza-Brzezina:
Macroeconomics II – Open
economy
27
Demand shock and fiscal policy
Domestic demand shocks less powerfull
– they are crowded out by monetary
policy and exchange rate apreciation
This is also true for a fiscal stimulus
Timing matters: crowding out is not
immediate so that fiscal policy can have
temporary effects
Note: ignoring risk hides the potential
depreciating effect of expansionary
fiscal policy M.Brzoza-Brzezina:
Macroeconomics II – Open
economy
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M.Brzoza-Brzezina:
Macroeconomics II –
Open economy
i* IFM
Figure 11.9 (a): Animation 1
Inte
rest ra
te
IS‘
Demand Shock Under Flexible Exchange Rates
TR
A
Y
Figure 11.9 (a)
i
IS
B
C
Expansionary
demand shock:
IS curve shifts
to the right.
At point B:
i > i*
capital inflow
appreciation
IS curve
shifts back
i
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Monetary policy
Monetary policy is (as we know)
effective.
It stimulates domestic demand and
affects the exchange rate
This streghtens monetary transmission
M.Brzoza-Brzezina:
Macroeconomics II – Open
economy
30
M.Brzoza-Brzezina:
Macroeconomics II –
Open economy
i* IFM
Figure 11.8 (a): Animation 1 (TR
Curve Shift)
Inte
rest ra
te
Monetary Policy Shock: (b) Shift in TR Curve
TR
IS
A
Figure 11.8 (a)
Output
IS‘
TR‘
B
i
Y Y‘
C
i < i*:
capital
outflow,
depreciation
increases
demand for
domestic
goods.
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Foreign financial shock
Foreign financial shocks have an
expansionary impact on the domestic
economy
But beware: this ignores possible
spillovers through international trade
M.Brzoza-Brzezina:
Macroeconomics II – Open
economy
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M.Brzoza-Brzezina:
Macroeconomics II –
Open economy
i*
Figure 11.6 (b): Animation 2 (Flexible
Exchange Rates)
Inte
rest ra
te
Int. Financial Shock: Flexible Exchange Rates
IS
A
IS´
Output
Figure 11.06
TR
C
Y Y‘
i
i*‘
At point A:
i=i*
i* increases to i*‘:
capital flows out,
exchange rate
depreciates,
demand for
domestic goods
increases,
IS curve shifts
to the right.
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M.Brzoza-Brzezina:
Macroeconomics II –
Open economy
Table 11.3: Mundell-Fleming model:
Summary
The Mundell-Fleming Model: Summary Table 11.3
Fixed exchange rates
Flexible ex. rates
Fiscal policy expansion Increase No effect
Monetary policy expansion No effect Increase
Increase in foreign interest
rate
Decrease Increase
Effect on real GDP
Fixed exchange rates
Flexible ex. rates
Exogen. monetary policy
instrument Exchange rate Interest rate
Endogen. monetary policy
instrument Interest rate Exchange rate
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Takeaways
Effectiveness of monetary and fiscal
policy in an open economy depend
strongly on the exchange rate regime
Under flexible ER monetary policy is
effective, fiscal policy looses power
Under fixed ER monetary policy is
powerless, fiscal policy more powerfull
Under fixed ER foreign financial shocks
are contractionary for the domestic
economy. Under flexible ER they can be
expansionary. M.Brzoza-Brzezina:
Macroeconomics II – Open
economy
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