Chapter 7: Output, Exchange Rates and Macroeconomic
Policy
Goals: Study the open-economy IS-LM-FX model
In the short run, demand determines output. Many factors affect
demand, from consumer confidence, to fiscal and monetary
policy.
7.1 Demand in open economy
For simplicity, we assume NFIA = NUT = 0, CA = TB
Our main objective is to understand how output (income) is
determined in the home country in the short run during which
price is sticky. First we see how the four components of total
expenditure (consumption, investment, government expenditure
and net export) are determined in short run.
Consumption,𝐶, is positively related to the disposable income,
𝑌 − 𝑇̅, and the consumption function is given by
𝐶 = 𝐶(𝑌 − 𝑇̅)
A typical consumption function looks like
The consumption curve slops upward: consumption goes up as
disposable income rises.
The slope of the consumption line is marginal propensity to
consume (MPC), which satisfies 0<MPC<1.
Exercise: A fall in the income tax 𝑇̅ will shift the consumption
line (up or down)
Exercise: A bull stock market will shift the consumption line (up
or down)
Investment is negatively related to real interest rate, 𝑟, (or
nominal interest rate, 𝑖, since we assume sticky price and thus
zero expected inflation)
𝐼 = 𝐼(𝑖)
The investment curve slopes downward: as the real cost of
borrowing falls, more investment are undertaken.
Exercise: what happens to the investment curve if the
government offers companies investment tax credit?
Both the tax, 𝑇, and government expenditure, 𝐺, are set
exogenously at some fixed levels.
𝑇 = 𝑇̅, 𝐺 = 𝐺̅
Fiscal policy can change 𝑇̅ and 𝐺̅ .
The trade balance, TB, (net export) is positively related to real
exchange rate, 𝑞 =
𝐸𝑃∗
𝑃
.
As real exchange rate increases, home currency (depreciates or
appreciates). As a result home goods or services become (more
or
less) expensive relative to foreign goods or services, and
so net export (falls or rises)
Reminder 1: home currency depreciates when 𝑞 rises.
Reminder 2: net export of home country rises when home
currency depreciates.
A rise in home country’s income will increase import and
decrease TB.
A rise in foreign country’s income will increase export and
increase TB.
Empirically, TB is mostly (not perfectly) positively correlated
with real exchange rate; see the graph below
Discuss: what happens to the year 2000 and later years?
7.2 Goods market equilibrium: The Keynesian Cross
The total demand (or planned expenditure) is
𝐷 = 𝐶 (𝑌 − 𝑇̅) + 𝐼(𝑖 ) + 𝐺̅ + 𝑇𝐵(𝑞, 𝑌 − 𝑇̅, 𝑌 ∗ − 𝑇̅ ∗ )
When the goods market is in equilibrium, total demand = total
supply
𝐷=𝑌
Mathematically, we can solve the following equation
𝑌 = 𝐶 (𝑌 − 𝑇̅) + 𝐼 (𝑖 ) + 𝐺̅ + 𝑇𝐵(𝑞, 𝑌 − 𝑇̅, 𝑌 ∗ − 𝑇̅ ∗ )
for the equilibrium 𝑌. The above equation also defines an
implicit function for 𝑌
𝑌 = 𝑌(𝑖, 𝑇̅, 𝐺̅ , 𝑞, 𝑌 ∗ , 𝑇̅ ∗ )
Graphically we can use Keynesian Cross to show the
equilibrium in goods market:
If we put demand, 𝐷, on the vertical axis, and output (income),
𝑌, on the horizontal axis, the total demand curve is upward
𝑑𝐷
sloping because 𝑑𝑌 = ___________________
The equilibrium condition 𝐷 = 𝑌 can be represented by a 45degree line.
The market is in equilibrium where the two lines cross (point 1).
At point 3, demand (>
(up or down)
or <) supply, and inventory will go
At point 2, demand (>
(up or down)
or <) supply, and inventory will go
An increase of 𝐺̅ will shift 𝐷 curve (up or down)
An increase of 𝑖 will shift 𝐷 curve (up or down)
An increase of 𝐸 will shift 𝐷 curve (up or down)
An increase of 𝑌 ∗ will shift 𝐷 curve (up or down)
We can see the shift in 𝑌 is greater in magnitude than the shift in
the demand curve. This fact illustrates the multiplier effect.
7.3 Goods and Foreign exchange market equilibriums: IS curve
The IS curve shows combinations of output 𝑌 and interest rate 𝑖
for which the goods and foreign exchange market are both in
equilibriums.
A fall in the interest rate will (increase or
decrease) the
investment, and thus total demand. As a result, the 𝐷 line in the
Keynesian Cross will shift (up or down), and 𝑌 will (rise
or fall). In short, when goods market is in equilibrium, interest
rate and 𝑌 move in (the same or opposite) direction. In other
words, the IS curve is downward sloping.
Uncovered interest parity (UIP) states that when the foreign
exchange market is in equilibrium domestic interest rate and
nominal exchange rate are negatively related:
𝐸𝑒 − 𝐸
𝐸𝑒
∗
𝑖=𝑖 +
=𝑖 +
−1
𝐸
𝐸
∗
A fall in the interest rate will cause 𝐸 rise (depreciation of home
currency) as the supply of home currency increases when
investors switch to foreign asset which offers higher rate. Due to
the depreciation of home currency and rising net export, the 𝐷
line will shift up further.
Lesson: in open economy falling 𝑖 will increase total demand
directly by boosting investment, and indirectly by boosting net
export.
Exercise: show what happens to IS curve if 𝐸 𝑒 goes up
Exercise: the IS curve in open economy is (flatter or steeper)
than the one in closed economy.
Exercise: show what happens to IS curve if 𝐺̅ goes up
Any factor which increases demand 𝐷 at a given interest rate 𝑖
must cause the demand curve to shift up, leading to higher
output 𝑌 and, as a result, an outward shift in the IS curve.
Mathematically, we can write this observation using notation
𝐼𝑆 = 𝐼𝑆(𝐺, 𝑇, 𝑖 ∗ , 𝐸 𝑒 , 𝑃, 𝑃∗ , 𝑌 ∗ , 𝑇 ∗ )
7.4 Money market equilibrium: LM curve
The LM curve depicts the combination of 𝑌 and 𝑖 which ensures
the equilibrium at the money market.
An increase in real income or output shifts the demand curve for
real money balance to the right, then the interest rate must rise if
the money supply is fixed.
In short, the LM curve is upward sloping.
Exercise: show what happens to LM curve if money supply rises.
Mathematically, we can write this observation using the notation
𝑀
𝐿𝑀 = 𝐿𝑀 ( )
𝑃̅
7.5 The short-run IS-LM-FX model of an open economy
We can use this model to analyze macroeconomic policy.
Monetary policy under floating exchange rates
Monetary policy is highly effective under floating exchange
rates.
Discuss: how does the expansionary monetary policy (or
quantitative easing, QE) in US affect the economy of UK?
The effect on UK investment is_______________________
The effect on UK net export is _________________________
Discuss: how does the QE in US affect the economy of China if
the IS curve of US is vertical?
What causes vertical IS curve:________________________
The effects on US income and interest rate
are___________________________
The effect on world stock market
is__________________________
The effect on the value of China-held US treasury bond
is___________________
Monetary policy with fixed exchange rate
Monetary policy is ineffective with fixed exchange rate. So for
country using fixed exchange rate (and imposing no restriction
on capital mobility), autonomous monetary policy is not an
option.
Discuss: Can governments in Hong Kong and China use
monetary policy effectively?
Read page 144 on Trilemma
Trilemma means that a country cannot fulfill the following three
goals all at once. The country must drop one of the three:
(1) Fixed exchange rate
(2) International capital mobility
(3) Monetary policy autonomy
Fiscal policy under floating exchange rates
In open economy fiscal policy is less effective than closed
economy. Fiscal expansion will increase interest rate, which
crowds out not only investment, but also net export.
If the economy is hit by a temporary adverse shock, policy
makers could use expansionary monetary (and / or fiscal) policy
to prevent a deep recession. This is the essence of stabilization
policy: