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• Open economy macroeconomics Short-run open-economy output determination (Mundell Fleming model) • International financial system • The rise, crisis, and (fall?) of the Euro

Open Economy Macro

Tree of Macroeconomics

long run Classical

IS-MP, dynamic AS-AD

Closed economy Short run or long run?

(full adjustment of capital, expectations, etc.) short run Classical or non-classical?

(sticky wages and prices, rational expectations, etc.)

Keynesian model (sticky wages and prices, upward-sloping AS

Non-classical Open economy

Mundell-Fleming; small open economy and large open economy

The output decline in the Great Recession (real GDP) Percent change from prior year Good reading: IMF,

World Economic Outlook

Unemployment during the Great Recession Percent of labor force 4

The sharp decline in world trade during the Great Recession (Note that trade change is > output change.) Percent change from prior three months at annual rate 5

The growth in the public debt around the world Debt/GDP ratio (%) 6

The risk premium on corporate securities in the US and Europe 7

Housing bubble: The Old and the New world 8

The Mundell-Fleming Model for Open Economy

Mundell-Fleming (MF) model is short run Keynesian model for open economy.

Hybrid of IS-MP and open-economy classical model.

It derives the impacts of policies and shocks in the short run for an open economy.

Usual stuff for domestic sectors: - Price and wage stickiness, unemployment - Standard determinants for domestic industries (C, I, G, financial markets, etc.) Open economy aspects: - Small open economy would have r d = r w - Large open economy financial flows (CF) determined by r d and r w - Net exports a function of real exchange rate, NX = NX(R) - We consider primarily a flexible exchange rate.

Goods market

Start with usual expenditure-output equilibrium condition.

New wrinkle is the NX function: (Exp) Y = C(Y - T) + I(r d ) + G + NX(R)

Financial markets

Then the monetary policy equation.

(MP$) r = L (Y)

Mankiw has LM, but there is no difference in the analysis except for monetary policy.

Balance of Payments

Capital flows are determined by domestic and foreign interest rates. This leads to balance of payments: (BP) CF(r d , r w ) = NX(R) Substituting (BP) into (Exp), we get IS$ equation in Y and r d : (IS$) Y = C(Y - T) + I(r d ) + G + CF(r d , r w ) 10

Reminder on Exchange rates

Foreign-exchange rates are the relative prices of different national monies or currencies.

Nominal exchange rate

= e = foreign currency/$

Real exchange rate (R)

R = e × p d / p f = domestic prices/foreign prices in a common currency 11

Real exchange rate of $ relative to major currencies (R)

Appreciation Dollar bubble with high interest rates Dot.com stock bubble Flight to $ safety Depreciation 12

r d CLOSED ECONOMY MP C+I(r d

)+G (IS) Y

r d OPEN ECONOMY

CF=NX=0

MP$

Equilibrium C+I(r d )+G+CF(r d ) (IS$)

C+I(r d

)+G (IS) Y

r d

(IS$) MP$ Tiny open economy Closed economy Y

Special Case I. Fiscal Stimulus

How does openness change the impact of a stimulus plan?

Multiplier is reduced because some of the stimulus spills into imports and stimulates other countries Note that financial crisis and high risk premium is the opposite (IS$ shift to the left) 16

r d

Fiscal Expansion

MP$

IS$ IS$’ Y

r d

Fiscal Expansion

IS IS’

MP$ Open economy Closed economy

IS$ IS$’ Y

Special Case II. Normal Monetary Expansion

How does openness change the impact of a monetary policy?

Double barreled effect of monetary policy

- Lower r → higher I (domestic investment) - Lower r → higher CF → depreciates exchange rate (R) → raises NX (foreign investment) 19

r d

Monetary Expansion

MP$ MP$’ IS$ Y

r d

Monetary Expansion

MP$ MP$’

Open economy Closed economy

IS IS$ Y

Special Case III

What about a liquidity trap?

Note that monetary policy cannot work on either of the two mechanisms in a liquidity trap.

- Interest rates stuck and cannot stimulate domestic investment.

- With no change in interest rates, no change in CF (financial flows), no change exchange rate, no change NX So open economy does not change the basic liquidity trap dilemma!

- Fiscal policy super-effective - Monetary policy super-ineffective 22

r d

IS$

Monetary Expansion in Liquidity Trap

MP$ MP$’

Equilibrium Y

r d

IS$

You do fiscal expansion

MP$

Equilibrium Y

The International Monetary System

What is the international monetary system?

International monetary system denotes the institutions under which payments are made for transactions that cross national boundaries and are made in different currencies. In particular, the international monetary system determines how foreign exchange rates are set and how governments can affect exchange rates. 26

Exchange rate regimes

I. . Fixed exchange rate

A. Currency union: currencies irrevocably fixed - US states (1789 - ) - Eurozone (2001- ?) B. Other fixed exchange rate regimes: – Gold standard (1717 - 1933) – Bretton Woods (1945 - 1971) - Hard and soft fixed rates of different varieties (China)

II. Flexible exchange rates (US, Eurozone, UK pound, BOJ)

- Currencies are market determined - Governments use monetary policies to affect exchange rates 27

What are desirable characteristics of an international financial system?

1. Stability of exchange rates to lower risk and promote trade and capital flows.

2. Openness of financial markets to promote efficient allocation and diffusion of best-practice technologies 3. Adjustment to macroeconomic shocks through monetary

policy

But we will see that these three goals are not compatible in the “fundamental trilemma” 28

Evolution of Exchange Rate Regimes (% of countries) The Evolution of Exchange Rate Systems: # countries

The share of floating has increased sharply (% of world GDP)

100% 80% 60% 40% 20% 0% 1960 1970 1980 1990 2000 30