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IS-LM IN OPEN ECONOMY

ECON 2123: Macroeconomics

Prof. Fei DING

The Hong Kong University of Science and Technology

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Ch19: The Goods Market in an Open Economy

LEARNING OBJECTIVES

Define and derive the equilibrium in the goods market in an open economy usingtwo approaches.

Explain the effects of domestic shocks, foreign shocks, and real depreciation ondomestic output and trade balance.

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PREVIOUSLY

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WHATS MISSING?

So far we take exchange rate as exogenous.

But it is not!

How are exchange rates determined in the FOREX

market?

How can policy makers affect exchange rates?

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Ch20: Output, the Interest Rate,

and the Exchange Rate

LEARNING OBJECTIVES

Define and derive the open economy IS and LM relations.

Understand how equilibrium output, interest rate, and exchange rate are jointlydetermined in open economies.

Explain the pros, cons, and policy roles under flexible and fixed exchange rates.

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THE DEPRECIATION OF YEN AND WON

Fri May 10, 2013 (Reuters) The yen weakened past 100

per dollar (now 1 USD 122 Yens), giving Japanese PrimeMinister Shinzo Abe a symbolic victory for his easy money

policies, with markets bracing for further declines in the

currency that could raise tensions with trading partners.

9 May 2013 (BBC News) Bank of Korea cuts interest rates

to spur economy. South Korea has cut interest rates in a

surprise move aimed at boosting growth and countering the

weak Japanese yen. Its central bank, the Bank of Korea,lowered its benchmark rate from 2.75% to 2.5%, the first cut

in seven months.

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QUOTE OF THE DAY

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IS-LM MODEL IN AN OPEN ECONOMY

The exchange rate in an open economy plays an

important role, linking goods and financial markets.

In Ch19, exchange rate was taken as a policy

tool/instrument controlled by the government.

Now we study how exchange rate is endogenously

determined in the goods and financial markets.

Can the exchange rate be controlled by the government?

If yes, how? If no, why not?

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THE IS RELATION IN OPEN ECONOMY

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IS relation: goods market equilibrium How

different demands affect the equilibrium Y.

In an open economy,

plays a role in the IS

relation.

Both the Real Interest Rate (r) and Real Exchange

Rate ( ) affect the demand for domestic goods.

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The IS-LM focuses on the short-run situations and

assumes exogenous/fixed (domestic and foreign)price levels.

Real and nominal exchange rates and interest

rates move one-for-one.

Therefore, Yis determined by nominal and :

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THE LM RELATION IN OPEN ECONOMY

Money vs. bonds in a closed economy:

How about in an open economy?

Good news! Same

The LM helps to determine the iin the economy.

In an open economy, there is an additional choicebetween domestic and foreign assets (bonds).

The exchange rate matters again!

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DOMESTIC VS. FOREIGN BONDS

Compare the expected return when choosing

between domestic vs. foreign bonds. At theequilibrium, UIP holds.

Rearrange the terms and assume exogenous

(given) expected exchange rate:

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E (current exchange rate) depends on domestic

interest rate, foreign interest rate, and expected

future exchange rate.

EXAMPLE: domestic interest rate

Eif unchanged

Why?

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For example, the Fed adopts contractionary monetary

policy, so iin the US increases.

Given higher return on US bonds, investors switch

from foreign bonds to US bonds.

This means investors switch from foreign currency to

USD, so USD must appreciate.

Given unchanged i* and expected E, changes in i

lead to immediate changes in E. 14

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Numeric example

Return on HK/US bonds = 2%; E= 7.8 (1 USD for 7.8 HKD)

Sudden increase in US bonds return = 5%

Switch from HK to US bonds and sell HKD for USD.

E= (1.05/1.02)7.8 8.03 (immediate 3% appreciation of USD)

Why would a current 3% USD appreciation bring back the

equilibrium?

Recall: How can different interest rates co-exist in the market?

Investors must expect 3% USD deprecation next period!

assumed unchanged (at 7.8), how can USD depreciate?

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EXAMPLE (2): Expect exchange rate increases (so

domestic currency will be more expensive).

Based on the equation: Emust increase.

Why?

Investors switch away from foreign bonds.

More domestic currency is wanted as a result.

Given unchanged iand i*, expectations about future

appreciation will lead to current appreciation.

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Numerical example

Returns on US bonds and Japanese bonds = 2%

E= 100 (1 USD for 100 Yens)

Now expect USD to appreciate by 10% (to 110).

Investors shift away from Japanese bonds to US

bonds and sell yens to buy USD:

E = (1.02/1.02) 110 = 110

To maintain the same interest rates, current E must

reflect future expectations on E.

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RELATION BETWEEN I AND E

Given and

When

Why a linear curve?

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OPEN ECONOMY IS-LM MODEL

Open economy IS relation is more complicated with

the NXterm and one more variable .

One more condition for the exchange rate (based on

the interest parity condition).

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The IS curve: When iincreases, how would Ychange?

Direct effect: same as in a closed economy

Increase in ilowers investment lower demand.

Indirect effect: additional NX effect for open economy

Increase in i appreciation in E decrease in NX

Luckily, both work in the same direction IS curve is

still downward slopping!

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Fi g u r e 2 0 - 2 The ISLM Model in the Open Economy


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FISCAL POLICY IN AN OPEN ECONOMY

EXAMPLE 1: Increase in G

Which curve(s) shift: IS? LM? Interest parity?

Shift right of the IS curve ONLY

Why?

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FISCAL POLICY IN AN OPEN ECONOMY

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CHANGE OF VARIOUS COMPONENTS

C

I ambiguous (same as in closed economy)

NX, why?

Although Yincreases, both government budget

and trade balance deteriorate!

Twin Deficit

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MONETARY POLICY IN AN OPEN ECONOMY

EXAMPLE 2: Monetary contraction

Which curve(s) shift: IS? LM? Interest parity?

Shift up of the LM curve ONLY

Change of various components:

C ?

I ?

NX ?

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MONETARY POLICY IN AN OPEN ECONOMY

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FIXED EXCHANGE RATE

Fiscal or monetary policy no only changes Yand i,

but also allows Eto freely adjust. Government can even use fiscal or monetary

policy to affect the E.

Allowing Eto freely adjust Flexible exchange

US, UK, Japan, etc.

On the other hand Fixed exchange rate

Example: HK (peg) and China (capital control)

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FIXED EXCHANGE RATE

Fixed does not mean never change.

Government can change the fixed rate when it

is necessary.

Usually, changes are rare.

Consequence of a government changing its fixed rate

often?

Devaluation (fixed) vs. Depreciation (flexible)

Revaluation (fixed) vs. Appreciation (flexible)

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EXAMPLES FIXED EXCHANGE RATE

Peg: 1 USD to 7.8 HKD

Crawling Peg: Try to maintain constant real exchangerate by allowing Eto adjust bit-by-bit slowly.

if domestic inflation consistently higher or lower

than foreign inflation, what happens?

Bands: allow Eto adjust within a certain range/band.

When Emoves outside the band, the central bank will actto put it back.

Example: European Monetary System (EMS)

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HOW TO IMPLEMENT FIXED EXCHANGE RATES?

Cannot just announce the value of E!

What must be done to keep the Eat the level

chosen by the government?

Again, the Interest Rate Parity:

Peg Eat a certain level

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Domestic interest rate must follow foreign interest

rate (assuming perfect capital mobility). HK must follow US interest rate.

So the money market equilibrium becomes

Under fixed exchange rate system, the government

(and its central bank) gives up its monetary policy

EXAMPLE: Expansionary fiscal policy under fixed E

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EXCHANGE RATE: FIXED OR FLEXIBLE?

Fixed exchange rate no monetary policy

Lose a policy tool to adjust the economy!

Fiscal policy becomes more powerful (because it

triggers monetary accommodation).

No control of domestic interest rate, only follow

foreign interest rate.

What happens when one economy is overheating and

the other is slowing down?

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No control of domestic interest rate, only follow

foreign interest rate. What happens when one economy is overheating and

the other is slowing down?

Early 1990s in Europe see FOCUS box p.458

HK economy in the early 90s was good, but US economy

was not that good.

US lowered its interest rate to stimulate economy, and HK had to

follow.

What happened to HK? Inflation, stock and property prices shot up!

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We talked about fiscal policy becoming more

powerful under fixed exchange rate.

But if a country wants to decrease its budget

deficit, it cannot use monetary policy to offset the

adverse effect on Y.

Monetary accommodation would amplify the effect of

fiscal policy! Can you draw me the IS-LM graph to show this?

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i i

EY

i

Y


ISIS

LM

LM

LM

Y could have stayed the same with the correct monetary policy mix.

But instead, things are made worse to maintain fixed exchange rate.

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TRILEMMA IN INTERNATIONAL FINANCE

The impossible trinity!

1. A fixed exchange rate

2. Free capital movement (absence of capital controls)

3. An independent monetary policy (monetary autonomy)

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a: Hong Kong

b: US

c: China

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With all the abovementioned costs, some countries

still adopt fixed exchange rate system. Usually, these are small and open economies.

Trade activities (export and import) are very important for

their economies.

Fixed exchange rate means less uncertainty from E

fluctuations.

Beneficial and encouraging trade!

For Europe, there are also symbolic and political

reasons.

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REFRESH

1. Which of the following represents the domestic

demand for goods?A) C + I + G

B) C + I + G + X

C) C + I + G - IM/

D) C + I + G + X - IM/

E) C + I + G + X + IM

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REFRESH

2. Which of the following occurs when the goods market

is in equilibrium?A) domestic output (Y) equals the demand for domestic goods.

B) Y equals the domestic demand for goods.

C) Y equals the domestic demand for domestic goods.

D) net exports equals 0.

E) demand for domestic goods equals the domestic demand

for goods.

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REFRESH

3. Which of the following must occur in an open

economy?A) demand for domestic goods will be equal to the domestic

demand for goods

B) demand for domestic goods will be greater than thedomestic demand for goods

C) demand for domestic goods will be less than the domestic

demand for goods

D) S + T = I + G

E) none of the above

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TRUE, FALSE, OR UNCERTAIN?

1. The national income identity implies that budget

deficits cause trade deficits.

2. A fiscal expansion tends to increase net export.

3. Fiscal policy has a greater effect on output in an

economy with fixed exchange rates than in an economy

with flexible exchange rates.

4.

Other things being equal, the interest parity conditionimplies that the domestic currency will appreciate in

response to an increase in the expected exchange rate.

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5. If financial investors expect the dollar to depreciate

against the yen over the coming year, one-year interest

rates will be higher in the US than in Japan.

6. If the Japanese interest rate is equal to zero, foreigners

will not want to hold Japanese bonds.

7. Under fixed exchange rates, the money stock must be

constant.

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1. Opening the economy to trade tends to increase the

multiplier because an increase in expenditure leads to

more exports.

2. The reduction in foreign demand leads to a

deterioration of the homes trade balance because itreduces domestic demand for goods, including

imported goods.

3. Ignoring the difference between trade balance andcurrent account balance, a trade deficit implies that

the country is lending to the rest of the world.

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NOW WE ARE DONE!

Assigned reading:

Textbook, Chap. 20 (Appendix is optional)

Suggested exercises for Ch. 20:

Textbook end-of-chapter questions 1-6

Have a good study break. Good luck on the

final exam!

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