Lecture notes for week 12

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University of Toronto Scarborough
Economics for Management Studies
Iris Au

OPEN ECONOMY (PART 2) Outline N A brief review of what we have learned for an open economy. N Discuss the effectiveness of monetary and fiscal policies under flexible exchange rate. N Discuss the effectiveness of monetary and fiscal policies under fixed exchange rate. N Wrap up the course! Open EconomyA Brief Review The AE Model in Generic Formthe Full Version Consumption: C = C 0 c 1I, where DI = Y T + TR Investment: I = 0 d (r 1 ) where r1is a constant Government sector: G T = T0+ tr1Y TR = TR 0 tr1Y Foreign sector: X = X 0 x (1 E ),1where E is1a constant IM = IM 0 + im 1 + im (2 E ),1where E is1a constant N The AE function: AE = C + I + G + X IM AE = C 0+ c 1Y (T +0tr Y1 + (TR 0r Y)1 + [I 0 (r r )1 + G + [X 0 (E1 E )] 1 [IM + im0Y + i1 (E E2)] 1 AE = C + I + G + X IM c T + c TR d (r r ) (x + im ) (E E ) + [c (1 t tr ) im ] Y 0 0 0 0 1 0 1 0 1 1 2 1 1 1 1 1 AE = AE + 0 Y,Y where AE 0= C 0 I 0 G + X 0M c 0 + 1 0R 1 0 d (r 1 ) 1x + i2 ) (E 1 ) c = c (1 t tr ) im Y 1 1 1 1 where r1 and E1is a constant *** These two terms show how a change in interest rates and exchange rates change the AE function and equilibrium level of output. N Equilibrium level of output (equating Y = AE): Observations N Holding all else constant, a change in E would affect both exports and imports, which then affects AE (via a change in AE ) a0d Y. o When C$ appreciates (E increases), Canadian goods become more expensive X decreases and IM increases AE decreases Y decreases. N A change in interest rate has two affects on the economy: 1) It affects the cost of borrowing and then investment. When r increases, cost of borrowing increases I decreases Y decreases. 2) It also has a significant impact on the exchange rate due to capital movements. When r increases, Canadian assets become more attractive foreigners buy more Canadian assets capital inflows. Demand for C$ increases C$ appreciates (E increases). N A change in interest rate will cause the exchange rate to change; therefore, a change in interest rate has a large effect on X and IM. o r increases C$ appreciates (E increases) X decreases and IM increases AE decreases Y decreases. Effectiveness of Monetary and Fiscal Policies under Flexible Exchange Rate Case 1: Monetary Policy under Flexible Exchange Rate The central bank runs expansionary monetary policy: N Suppose the central bank buys bonds, MS increases. N At r , people find that they havetoo much liquidity (excess supply of money), and they will try to get rid of the excess liquidity by buying bonds. N bond prices increase and interest rate decreases (r decreases) N r decreases cost of borrowing decreases I increases AE increases Y increases N The SMALL modification: N Y increases L (r, Y) increases by a small amount www.notesolution.com
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