重访开放经济重访开放经济In this chapter, you will learnthe Mundell-Fleming model (IS-LM for the small open economy)causes and effects of interest rate differentialsarguments for fixed vs. floating exchange rateshow to derive the aggregate demand curve for a small open economy12.1 The Mundell-Fleming modelKey assumption: Small open economy with perfect capital mobility. r = r*Goods market equilibrium the IS* curve:where e = nominal exchange rate = foreign currency per unit domestic currencyThe IS* curve: Goods market eqmThe IS* curve is drawn for a given value of r*. Intuition for the slope:Y eIS*From Keynesian Cross to IS CurveThe LM* curve: Money market eqmThe LM* curveis drawn for a given value of r*.is vertical because:given r*, there is only one value of Y that equates money demand with supply, regardless of e. Y eLM*The LM CurveEquilibrium in the Mundell-Fleming modelY eLM*IS*equilibriumexchangerateequilibriumlevel ofincomeFloating & fixed exchange ratesIn a system of floating exchange rates, e is allowed to fluctuate in response to changing economic conditions.In contrast, under fixed exchange rates, the central bank trades domestic for foreign currency at a predetermined price.Next, policy analysis in a floating exchange rate systemin a fixed exchange rate system12.2 Fiscal policy under floating exchange ratesY eY1 e1 e2 At any given value of e, a fiscal expansion increases Y, shifting IS* to the right. Results: e 0, Y = 0Lessons about fiscal policyIn a small open economy with perfect capital mobility, fiscal policy cannot affect real GDP. “Crowding out”closed economy: Fiscal policy crowds out investment by causing the interest rate to rise. small open economy: Fiscal policy crowds out net exports by causing the exchange rate to appreciate. Monetary policy under floating exchange ratesY ee1 Y1 Y2 e2 An increase in M shifts LM* right because Y must rise to restore eqm in the money market.Results: e 0Lessons about monetary policyMonetary policy affects output by affecting the components of aggregate demand: closed economy: M r I Ysmall open economy: M e NX YExpansionary mon. policy does not raise world agg. demand, it merely shifts demand from foreign to domestic products. So, the increases in domestic income and employment are at the expense of losses abroad. Trade policy under floating exchange ratesY ee1 Y1 e2 At any given value of e, a tariff or quota reduces imports, increases NX, and shifts IS* to the right. Results: e 0, Y = 0Lessons about trade policyImport restrictions cannot reduce a trade deficit. Even though NX is unchanged, there is less trade:the trade restriction reduces imports. the exchange rate appreciation reduces exports.Less trade means fewer “gains from trade.”Lessons about trade policy, cont.Import restrictions on specific products save jobs in the domestic industries that produce those products, but destroy jobs in export-producing sectors. Hence, import restrictions fail to increase total employment. Also, import restrictions create “sectoral shifts,” which cause frictional unemployment. 12.3 Fixed exchange ratesUnder fixed exchange rates, the central bank stands ready to buy or sell the domestic currency for foreign currency at a predetermined rate. In the Mundell-Fleming model, the central bank shifts the LM* curve as required to keep e at its preannounced rate. This system fixes the nominal exchange rate. In the long run, when prices are flexible, the real exchange rate can move even if the nominal rate is fixed.Fiscal policy under fixed exchange ratesY eY1 e1 Under floating rates, a fiscal expansion would raise e. Results: e = 0, Y 0Y2 To keep e from rising, the central bank must sell domestic currency, which increases M and shifts LM* right. Under floating rates, fiscal policy is ineffective at changing output.Under fixed rates,fiscal policy is very effective at changing output. Monetary policy under fixed exchange ratesAn increase in M would shift LM* right and reduce e. Y eY1 e1 To prevent the fall in e, the central bank must buy domestic currency, which reduces M and shifts LM* back left. Results: e = 0, Y = 0Under floating rates, monetary policy is very effective at changing output.Under fixed rates,monetary policy cannot be used to affect output. Trade policy under fixed exchange ratesY eY1 e1 A restriction on imports puts upward pressure on e. Results: e = 0, Y 0Y2 To keep e from rising, the central bank must sell domestic currency, which increases M and shifts LM* right. Under floating rates, import restrictions do not affect Y or NX. Under fixed rates,import restrictions increase Y and NX. But, these gains come at the expense of other countries: the policy merely shifts demand from foreign to domestic goods.Summary of policy effects in the Mundell-Fleming modeltype of exchange rate regime:floatingfixedimpact on:PolicyYeNXYeNXfiscal expansion000mon. expansion000import restriction000Problems and Applications1. Use the MundellFleming model to predict what would happen to aggregate income, the exchange rate, and the trade balance under both floating and fixed exchange rates in response to each of the following shocks:a. A fall in consumer confidence about the future induces consumers to spend less and save more.b. The introduction of a stylish line of Toyotas makes some consumers prefer foreign cars over domestic cars.a. A fall in consumer confidence about the future induces consumers to spend less and save more.floating exchange ratesThe exchange rate falls (depreciates), which causes an increase in the trade balance equal to the fall in consumption.n fixed exchange ratesThe central bank buys the domestic currency that investors seek to exchange, and provides foreign currency. Output fallsThe exchange rate does not change, so the trade balance does not change.b. The introduction of a stylish line of Toyotas makes some consumers prefer foreign cars over domestic cars.floating exchange ratesoutput does not change,while the exchange rate falls (depreciates).The trade balance does not change either, despite the fall in the exchange rate.n fixed exchange ratesThe central bank buys dollars and sells foreign exchange to keep e fixed. As a result, output falls.The trade balance falls, because the shift in the net exports schedule means that net exports are lower for any given level of the exchange rate.12.4 Interest-rate differentialsTwo reasons why r may differ from r*country riskIn some less developed countries, it is plausible to fear that a revolution or other political upheaval might lead to a default on loan repayments.Borrowers in such countries often have to pay higher interest rates to compensate lenders for this risk.expected exchange rate changesIf a countrys exchange rate is expected to fall, then its borrowers must pay a higher interest rate to compensate lenders for the expected currency depreciation.Differentials in the M-F modelwhere is a risk premium, assumed exogenous. Substitute the expression for r into the IS* and LM* equations:The effects of an increase in IS* shifts left, because r IY eY1 e1LM* shifts right, because r (M/P)d,so Y must rise to restore money market eqm.Results: e 0e2Y2 The fall in e is intuitive: An increase in country risk or an expected depreciation makes holding the countrys currency less attractive. Note: an expected depreciation is a self-fulfilling prophecy. The increase in Y occurs because the boost in NX (from the depreciation)is greater than the fall in I (from the rise in r ).The effects of an increase in Why income might not riseThe central bank may try to prevent the depreciation by reducing the money supply.The depreciation might boost the price of imports enough to increase the price level (which would reduce the real money supply).Consumers might respond to the increased risk by holding more money.Each of the above would shift LM* leftward.CASE STUDY: The Mexican peso crisisCASE STUDY: The Mexican peso crisisThe Peso crisis didnt just hurt MexicoU.S. goods more expensive to MexicansU.S. firms lost revenueHundreds of bankruptcies along U.S.-Mexican borderMexican assets worth less in dollarsReduced wealth of millions of U.S. citizensUnderstanding the crisisIn the early 1990s, Mexico was an attractive place for foreign investment. During 1994, political developments caused an increase in Mexicos risk premium ( ):peasant uprising in Chiapas assassination of leading presidential candidateAnother factor: The Federal Reserve raised U.S. interest rates several times during 1994 to prevent U.S. inflation. (r* 0) Understanding the crisisThese events put downward pressure on the peso. Mexicos central bank had repeatedly promised foreign investors that it would not allow the pesos value to fall,so it bought pesos and sold dollars to “prop up” the peso exchange rate. Doing this requires that Mexicos central bank have adequate reserves of dollars. Did it?Dollar reserves of Mexicos central bankDecember 1993 $28 billionAugust 17, 1994 $17 billionDecember 1, 1994 $ 9 billionDecember 15, 1994 $ 7 billionDuring 1994, Mexicos central bank hid the fact that its reserves were being depleted. the disaster Dec. 20: Mexico devalues the peso by 13%(fixes e at 25 cents instead of 29 cents)Investors are SHOCKED!SHOCKED! they had no idea Mexico was running out of reserves. , investors dump their Mexican assets and pull their capital out of Mexico. Dec. 22: central banks reserves nearly gone. It abandons the fixed rate and lets e float.In a week, e falls another 30%. The rescue package1995: U.S. & IMF set up $50b line of credit to provide loan guarantees to Mexicos govt. This helped restore confidence in Mexico, reduced the risk premium. After a hard recession in 1995, Mexico began a strong recovery from the crisis. CASE STUDY:The Southeast Asian crisis 1997-98Problems in the banking system eroded international confidence in SE Asian economies.Risk premiums and interest rates rose.Stock prices fell as foreign investors sold assets and pulled their capital out. Falling stock prices reduced the value of collateral used for bank loans, increasing default rates, which exacerbated the crisis. Capital outflows depressed exchange rates. Data on the SE Asian crisisexchange rate % change from 7/97 to 1/98stock market % change from 7/97 to 1/98nominal GDP % change 1997-98Indonesia-59.4%-32.6%-16.2%Japan-12.0%-18.2%-4.3%Malaysia-36.4%-43.8%-6.8%Singapore-15.6%-36.0%-0.1%S. Korea-47.5%-21.9%-7.3%Taiwan-14.6%-19.7%n.a.Thailand-48.3%-25.6%-1.2% U.S.n.a.2.7%2.3%Floating vs. fixed exchange ratesArgument for floating rates:allows monetary policy to be used to pursue other goals (stable growth, low inflation).Arguments for fixed rates:avoids uncertainty and volatility, making international transactions easier.disciplines monetary policy to prevent excessive money growth & hyperinflation.The Impossible TrinityA nation cannot have free capital flows, independent monetary policy, and a fixed exchange rate simultaneously. A nation must choose one side of this triangle and give up the opposite corner. Free capital flowsIndependent monetary policyFixed exchange rateOption 1(U.S.)Option 3(China)Option 2(Hong Kong)CASE STUDY:The Chinese Currency Controversy1995-2005: China fixed its exchange rate at 8.28 yuan per dollar, and restricted capital flows. Many observers believed that the yuan was significantly undervalued, as China was accumulating large dollar reserves. U.S. producers complained that Chinas cheap yuan gave Chinese producers an unfair advantage.President Bush asked China to let its currency float; Others in the U.S. wanted tariffs on Chinese goods.CASE STUDY:The Chinese Currency ControversyIf China lets the yuan float, it may indeed appreciate. However, if China also allows greater capital mobility, then Chinese citizens may start moving their savings abroad. Such capital outflows could cause the yuan to depreciate rather than appreciate. Mundell-Fleming and the AD curve So far in M-F model, P has been fixed. Next: to derive the AD curve, consider the impact of a change in P in the M-F model.We now write the M-F equations as:(Earlier in this chapter, P was fixed, so we could write NX as a function of e instead of .)Y1Y2Deriving the AD curveY Y PIS*LM*(P1)LM*(P2)ADP1P2Y2Y1 2 1Why AD curve has negative slope:P LM shifts left NX Y (M/P)From the short run to the long runLM*(P1) 1 2then there is downward pressure on prices. Over time, P will move down, causing(M/P ) NX Y P1SRAS1Y Y PIS*ADLRASLM*(P2)P2SRAS2Large: Between small and closedMany countries including the U.S. are neither closed nor small open economies. A large open economy is between the polar cases of closed & small open. Consider a monetary expansion:Like in a closed economy, M 0 r I (though not as much)Like in a small open economy, M 0 NX (though not as much)Chapter Summary1. Mundell-Fleming modelthe IS-LM model for a small open economy.takes P as given.can show how policies and shocks affect income and the exchange rate.2.Fiscal policyaffects income under fixed exchange rates, but not under floating exchange rates. CHAPTER 12 The Open Economy Revisitedslide 49Chapter Summary3.Monetary policyaffects income under floating exchange rates. under fixed exchange rates, monetary policy is not available to affect output.4.Interest rate differentialsexist if investors require a risk premium to hold a countrys assets.An increase in this risk premium raises domestic interest rates and causes the countrys exchange rate to depreciate.CHAPTER 12 The Open Economy Revisitedslide 50Chapter Summary5.Fixed vs. floating exchange ratesUnder floating rates, monetary policy is available for can purposes other than maintaining exchange rate stability.Fixed exchange rates reduce some of the uncertainty in international transactions. CHAPTER 12 The Open Economy Revisitedslide 51