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ECON5002 – Macroeconomic Theory

Week 9: Open economy I – IP curve Reading: Blanchard chapters 18 and 19

Dr Kim Hawtrey

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› open goods market ! so far (Weeks 1-8) we have assumed the economy is ‘closed’ ! we now need to consider the macroeconomics of an open economy

- trade flows (exports, imports) - financial flows (lending, borrowing)

! we can measure the trade openness of an economy in several ways: - ratio of trade (exports and/or imports) to GDP

eg. Australia’s ratio of exports to GDP equals 20% weakness: many domestic import-competing firms are exposed to

international competition even though they are not engaged in trade - ratio of tradable goods (goods that compete with foreign goods either at home or abroad) to GDP

eg. tradables comprise 25% of goods in Australia’s GDP (US = 60%) - restrictions on free trade such as tariffs/quotas, capital controls - openness in factor markets – firms can choose where to locate production, and workers can choose where to work

Open economy

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› open money market ! we can measure the financial openness of an economy in several ways:

- investors are free to diversify their portfolios internationally - to hold both domestic and foreign assets and speculate on foreign interest rate movements

- firms have wide access to a diversity of funding sources internationally – to issue both domestic and foreign securities in debt and equity markets and to make use of bank loans globally

- countries are free to run trade surpluses or deficits, subject only to the rest of the world’s willingness to finance deficits (a country that buys more than it sells must pay for the difference by borrowing from the rest of the world)

! financial openness has expanded dramatically in the past 20 years eg. the Bank for International Settlements reports that daily global volume of foreign-exchange transactions equals over US$4 trillion (quadrupled in a decade)

Open economy

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implications of open economy for our macro model

Open economy

! consumers and firms now need to choose between domestic and foreign goods . . . the choice between domestic goods and foreign goods depends primarily on the exchange rate

! investors and borrowers now need to choose between domestic and foreign assets . . . the choice between domestic and foreign assets/funding depends primarily on their relative rates of return/funding cost, which depend on domestic interest rates and foreign interest rates, and on the expected depreciation/appreciation of the domestic currency

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› nominal exchange rate ! a nominal exchange rate is the raw quoted price between two currencies ! define the nominal exchange rate E as the price of the home currency

(denominator) in terms of foreign currency (numerator) eg. a US$/$A exchange rate of $0.72 (=US$0.72/$A) means it costs 72 US cents to buy one Australian dollar

! a nominal appreciation of the domestic currency is an increase in the price of the domestic currency in terms of the foreign currency and corresponds to an increase in the exchange rate

eg. a 10% appreciation of the $A against the US$ would increase the US$/$A exchange rate from US$0.72 to $0.792 which means it now costs 79.2 US cents to buy one Australian dollar

a nominal depreciation of the domestic currency is a decrease in the price of the domestic currency in terms of the foreign currency, and is a decrease in the exchange rate

International exchange rates

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› real exchange rate ! a real exchange rate is the nominal exchange rate adjusted for the ratio of

prices between the two countries ! it measures the relative price of domestic goods in terms of foreign goods ! let P = price level in the home country and P* = price level in the foreign

country .. then the real exchange rate e is given by e = EP/P*

which gives the price of domestic goods expressed in the foreign currency (EP) in terms of foreign goods expressed in foreign currency (P*)

! an increase in the relative price of domestic goods in terms of foreign goods (­e) is a real appreciation

eg. if the real exchange rate e increases by 10%, this tells us Australian goods are now 10% more expensive relative to US goods

a decrease in the relative price of domestic goods in terms of foreign goods (¯e) is a real depreciation

International exchange rates

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› demand for domestic goods ! until now (Weeks 1-8) we have ignored the overseas sector, and

demand for goods was simply C + I + G ! to derive equilibrium in the goods market we begin with the observation

that in an open economy (ie. with exports and imports) domestic demand for goods ¹ demand for domestic goods

! the revised demand for domestic goods Z is now given by Z = C + I + G – IM/e + X

where IM = imports^, e = real exchange rate, and X = exports notice that we cannot simply subtract the quantity of imports IM – we first need to express the amount of foreign imports in terms of domestic goods .. this is accomplished by using IM/e because 1/e = price of foreign goods in terms of domestic goods no such adjustment is required for X because these are already valued in domestic terms ^ IM = volume of imports in terms of foreign goods. IM/e = volume of imports in terms of domestic goods.

Open economy IS curve

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› demand for domestic goods ! the determinants of C, I and G are unchanged from previously so we write:

domestic demand = C(Y-T) + I(Y,r) + G + (+,-)

which says C depends positively on disposable income, I depends positively on Y and negatively on r, and G is exogenous

! the determinants of imports IM are given by IM = IM(Y, e)

(+,+) which says that imports rise with increased domestic income Y and with an appreciation in the real exchange rate e

! the determinants of exports X are given by X = X(Y*,e)

(+,-) which says that exports rise with increased foreign income Y* and fall with an appreciation in the real exchange rate e

Open economy IS curve

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› demand for domestic goods

Open economy IS curve

chart a - domestic demand (DD) for goods is an increasing function of output charts b+c - demand for domestic goods (ZZ) is obtained by subtracting the value

of IM/e from DD (= panel b) then adding X (= panel c) chart d - the trade balance (NX) is a decreasing function of output

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› demand for domestic goods ! the four curves are

DD = domestic demand = C + I + G AA = domestic demand for domestic goods = C + I + G – IM/e ZZ = demand for domestic goods = C + I + G – IM/e + X NX = net exports = X – IM/e

the distance between DD and AA equals imports IM/e and rises with Y the distance between AA and ZZ equals exports X and is constant

eg. at output level Y, X = AC, IM/e = AB, and NX = BC ! notice that

- the slope of DD is positive but less than one, because some part of additional income is saved rather than spent

- AA is flatter than DD, because as income rises some of the additional spending goes on foreign goods rather than domestic goods

- ZZ is flatter than DD, because AA is flatter than DD ! YTB is the ‘trade balance’ level of output where X = IM/e

Open economy IS curve

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› goods market equilibrium (algebraic) ! equilibrium in the goods market is where domestic output equals demand

– both domestic and foreign – for domestic goods ! collecting the expressions, we have the components of the demand for

domestic goods (RHS), and setting the sum equal to output (LHS): Y = Z [ = C (Y-T) + I(Y, r) + G - IM(Y,e)/e + X (Y*, e) ]

this says that in equilibrium, output must be equal to consumption plus investment plus government spending, minus the value of imports plus exports we can group the two international terms under ‘net exports’

NX (Y, Y*, e) = X (Y*, e) - IM(Y,e)/e and write the equilibrium condition as

Y = C (Y-T) + I(Y, r) + G + NX (Y, Y*, e) ( + ) (+, -) (-, +, -)

Open economy IS curve

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› goods market equilibrium (geometric) Y = Z

= C (Y-T) + I(Y, r) + G - IM(Y,e)/e + X (Y*, e)

^ in the illustration shown here, Ye > YTB and trade is in deficit

Open economy IS curve

The goods market is in equilibrium when production of domestic goods Y is equal to demand for domestic goods Z. Equilibrium is point A. At the equilibrium level of output, the trade balance may show a deficit^ (-) or surplus (+). There is no necessary reason why Ye should equal YTB.

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› how economic shocks affect goods market equilibrium ! experiment A: increase in G assume initially the economy is at point A where TB = 0 suppose the economy is sluggish and policymakers decide to increase government spending Þ demand for domestic goods shifts upwards from ZZ to ZZ’ Þ equilibrium moves from A to A’ Þ output moves from Y to Y’ an increase in government spending leads to an increase in output and to a trade deficit

Open economy IS curve

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› how economic shocks affect goods market equilibrium ! note the similarities of experiment A in the open economy compared with

the same shock in a closed economy: - output still increases - the resulting DY > DG because of the multiplier effect

! BUT also note two differences in the open economy - the multiplier is smaller: the effect on Y of a given DG is now less, because the flatter^ the ZZ curve the smaller^^ is the multiplier.. and as noted (slide 9) ZZ (= DEMAND FOR DOMESTIC GOODS IN OPEN ECONOMY) must be flatter than DD (= DEMAND FOR DOMESTIC GOODS IN CLOSED ECONOMY)

- there is an adverse trade balance effect: the increase in output from Y to Y’ leads to higher imports Þ trade moves from balanced to a deficit equal to vertical distance BC

both have the same cause: an ­demand now falls partly on foreign goods ^ for instance, if the ZZ curve were horizontal the multiplier would equal one

^^ refer to lecture 1 slide 25

Open economy IS curve

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› how economic shocks affect goods market equilibrium ! experiment B: increase in Y* assume initially the economy is at point A where TB = 0 (ie. NX=0 and DD must intersect with ZZ) suppose foreign demand^ rises Þ ­demand for exports by DX Þ NX shifts up from NX to NX’ and ZZ shifts up to ZZ’ Þ equilibrium moves to A’ Þ trade balance must improve as ZZ shifts up but DD does not, so distance DC < DA’ (ie. DNX>0) Þ output moves to Y’ (< new Y’TB)

^ due to ­Y* which could occur for various reasons including foreign policy actions (eg.­G*) or other factors

Open economy IS curve

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› how economic shocks affect goods market equilibrium ! note that experiment B in the open economy – showing that Ddemand in

one country leads to Doutput and Dtrade balance in another country – has two important implications: - cycles tend to be synchronised across countries: downturns in demand in one country affect all other countries .. this ‘domino effect’ was particularly evident during the GFC, when a recession that originated in the US spread rapidly to Europe and elsewhere, as US demand fell .. the closer the trade links between two countries, the stronger will be the effect, and the closer the two economies will move together - policy may need to be synchronised across countries: if one country independently tries to combat recession by increasing its own domestic demand, it may simply worsen its trade deficit .. but if all countries coordinate their macro policies with the aim of jointly stimulating their domestic demands simultaneously (known as ‘policy coordination’^) then trade balances need not deteriorate

^ for example, the G20 economies meet regularly to coordinate, at least in theory

Open economy IS curve

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Case study: GFC output cycles were synchronised

Open economy IS curve

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Open economy IS curve

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› how economic shocks affect goods market equilibrium ! experiment C: fall in e (with ¯G)

^ provided the Marshall–Lerner condition holds

Open economy IS curve

A depreciation is like an increase in foreign demand, since it raises^ net exports. It makes imports more expensive and exports cheaper. Initially, trade deficit = BC. Then suppose e depreciates: Þ NX shifts up from NX to NX’, eliminating the trade deficit Þ but ¯e would also shift ZZ to ZZ’ (because ­NX) .. so policy makers ¯G to keep ZZ unchanged Þ output remains at Y

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› how economic shocks affect goods market equilibrium ! comments on experiment C - recall that net exports equals

NX = X(Y*, e) – IM(Y,e)/e the real exchange rate e enters the RHS of this equation in three places, so a real depreciation (to e’) affects the trade balance via three channels: 1. exports increase (­X) because domestic goods become less expensive

to foreign buyers, raising foreign demand 2. imports decrease (¯IM) because foreign goods become more expensive

to domestic buyers, reducing home demand 3. the relative price of foreign goods in terms of domestic goods increases

(­1/e’) which increases the import bill (­IM/e’) because the same quantity of imports now costs more to buy in terms of domestic goods

for the trade balance (TB) to improve after a depreciation, X must rise and IM must fall by enough to compensate for the higher import price 1/e’ this is called the Marshall-Lerner Condition

Open economy IS curve

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› how economic shocks affect goods market equilibrium ! deriving the Marshall-Lerner Condition:

start with NX = X – IM/e and assume trade is initially balanced, which means that NX = 0 and X = IM/e or equivalently eX = IM .. multiplying both sides by e we can write the equation as eNX = eX – IM now consider a change in the real exchange rate equal to De " the effect on the LHS of the equation is given by (De)NX + e(DNX) and because NX = 0 initially, this reduces to simply e(DNX) " the effect on the RHS of the equation is given by (De)X + e(DX) – (DIM)

setting LHS = RHS gives: e(DNX) = (De)X + e(DX) – (DIM)

dividing both sides by eX and using eX = IM we obtain DNX/X = De/e + DX/X - DIM/IM % change % change % change % change in trade in real in in balance exchange exports imports

(as ratio to X) rate

Open economy IS curve

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› how economic shocks affect goods market equilibrium ! when the M-L Condition is met, the trade balance will improve following a

depreciation eg. suppose a 1% depreciation of e leads to a 0.9% rise in exports and a 0.8% fall in imports .. then DNX/X = -1% + 0.9% -(-0.8%) = 0.7% .. the trade balance improves and the Marshall-Lerner Condition is satisfied

Q: is the M-L condition typically satisfied empirically, in actual economies? A: yes " from now on we will always assume that ¯e results in ­TB

! note that in addition to the trade balance – as illustrated in Experiment C – a depreciation of e also has effects on demand and output " ¯e has similar effects to the ­Y* that we saw in Experiment B (slide 15)

ie. ZZ and NX lines both shift upward " the depreciation (if unchecked by ¯G) leads to an upward shift in both

domestic and foreign demand for domestic goods " ­domestic Y in Experiment C (slide 19) policymakers neutralised this side effect by ¯G

Open economy IS curve

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› how economic shocks affect goods market equilibrium ! other possible experiments involving various exchange rate and fiscal

combinations are listed in the table below, depending on the initial output and trade situation

eg. consider an economy with initially low output and a trade deficit .. policy makers are concerned about high unemployment .. a depreciation will help reduce the trade deficit and boost output .. this may need ‘fine tuning’ by ¯G

Open economy IS curve

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› how economic shocks affect goods market equilibrium ! the dynamics of adjustment after a shock in the open economy now

involve additional dynamic effects relating to X and IM (not only Y, C, I) ! when a depreciation causes ­X and ¯IM this does not happen instantly ..

Open economy IS curve

.. a depreciation may lead to an initial deterioration of the trade balance Þ e decreases, but neither X nor IM quantities adjust very much initially .. mostly prices adjust at first .. so in the early stages

¯e Þ ¯( X - IM/e ) .. eventually, export volumes increase and import volumes decrease .. so that depreciation leads to an improvement of the trade balance (assuming the M–L condition holds)

(↑X, ¯IM, ¯e) Þ ↑(X – IM/e)

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› how economic shocks affect goods market equilibrium ‘J-curve’ dynamics

the J-curve resembles the letter ‘J’

Open economy IS curve

A real depreciation leads initially to a deterioration, then to an improvement of the trade balance. The initial trade deficit = OA The depreciation initially increases the deficit to OB because neither X nor IM falls at first, while imports cost more instantly. Over time, X volumes rise and IM volumes fall Þ the TB ends better than it began.

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› IS relation and international interest rate parity ! recall the equilibrium condition (slide 11)

Y = C (Y-T) + I(Y, r) + G + NX (Y, Y*, e) ! for simplicity we will assume – as we did in the closed economy ISLM

analysis (Week 3) – that P (domestic price level) is given, and also P* (foreign price level) is given together, these imply that the real exchange rate e = EP/P* and the nominal exchange rate E move together: a decrease (increase) in E implies one-for-one a decrease (increase) in e for convenience let P/P* = 1 and therefore e = E and we can replace e by E P given implies inflation is zero, so (nominal) i = r (real) and we can replace r by i the equilibrium equation - using nominal rates - becomes

Y = C (Y-T) + I(Y, i) + G + NX (Y, Y*, E)

IP curve

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› international interest arbitrage condition ! investors face a choice between holding domestic bonds (yielding i in

home currency) versus foreign bonds (yielding i* in foreign currency) ! if these are not equal – after allowing for foreign currency exchange –

investors will continually arbitrage (sell one, buy the other) until: (DOMESTIC RETURN) (1+it) = (Et)(1+i*t)/Eet+1 (FOREIGN RETURN)

! investors will drive the values of i and i* up/down until they are indifferent between investing in domestic or foreign bonds

(1+it) = (Et)(1+i*t)/Eet+1 is called the interest arbitrage condition

IP curve

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› international interest rate parity ! rearranging:

(1+it) = (1+i*t) [Et/Eet+1] or (1+it)/(1+i*t) = [Et/Eet+1] which is known as the interest parity condition this is an arbitrage condition that defines equilibrium between interest rates across countries, given expected changes in exchange rates

! interest parity says the domestic return on investing $1 (=1+it) must be equal to the foreign return on investing $1 (=1+i*t) adjusted for the expected appreciation (if Et/Eet+1<1) or depreciation (if Et/Eet+1>1) of the domestic currency

eg. suppose iAUS = 5% and iUS = 2% .. then (1+it)/(1+i*t) = 1.0294 and so - if you expect the $A to depreciate more than 2.94% you invest in US bond - if you expect the $A to depreciate less than 2.94% you invest in AUS bond

- if you expect the $A to depreciate by exactly 2.94% then interest parity holds

IP curve

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› IS relation and international interest rate parity ! multiplying both sides of the parity condition by Eet+1 gives

Et = [(1+it)/(1+i*t)] Eet+1 for now, we take Eet+1 as given (=Ee) and so

E = [(1+i)/(1+i*)] Ee [= equation of IP curve] this tells us that the nominal exchange rate E will

- rise when the domestic interest rate rises - fall when the foreign interest rate rises - rise when the expected future exchange rate rises

in particular, a ­Ee (expectation) leads to ­E (= current) appreciation eg. assume initially i = 2%, i* = 2%, E = 1 and Ee = 1 (ie. parity holds) .. next, suppose investors now expect E to be 10% higher a year from now, so Ee = 1.10 Þ despite paying the same interest, US bonds are now less attractive than Australian bonds because the $A will be worth 10% more than the US$ a year from now Þ investors will sell US bonds Þ they will buy $A Þ E will appreciate by 10% to E’ = [(1.02)/(1.02)]1.10 = 1.10

IP curve

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› IS relation and international interest rate parity equation of IP curve: E = [(1+i)/(1+i*)] Ee

The interest parity line is drawn for given i* and Ee .. if these change, the line will shift position

IP curve

The relation between the domestic interest rate and the exchange rate implied by interest parity - a lower domestic interest rate leads to a lower exchange rate = a depreciation of the domestic currency - a higher domestic interest rate leads to a higher exchange rate = an appreciation of the domestic currency.

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› IS relation and international interest parity

equation of IP curve: E = [(1+i)/(1+i*)] Ee

IP curve

The relation between the foreign interest rate and the exchange rate implied by interest parity - a lower i* leads to a higher current exchange rate E .. the parity line rotates clockwise (or vice versa)

The relation between the expected exchange rate and the current exchange rate implied by interest parity - a higher Ee leads to a higher current exchange rate E .. the parity line shifts rightward (or vice versa)

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› IS relation and IP ! the open economy equilibrium IS relation – using the interest parity

condition - becomes IS: Y = C (Y-T) + I(Y, i) + G + NX [Y, Y*, ((1+i)/(1+i*))Ee]

this says an increase in the interest rate now has two effects: 1. closed economy effect = the direct effect on investment where an ­i Þ ¯I which leads to a fall in demand for domestic goods and ¯Y

2. open economy effect = the indirect effect through the exchange rate, whereby ­i Þ ­E (appreciation) which makes domestic goods more expensive relative to foreign goods, resulting in a ¯NX and hence a fall in demand for domestic goods and ¯Y

both effects work in the same direction the IS curve continues to be downward sloping in the open economy, since ­i Þ ¯Y (and vice versa)

Open economy IS curve - revisited