OPEN ECONOMY (PART 2)
x A brief review of what we have learned for an open economy.
x Discuss the effectiveness of monetary and fiscal policies under flexible exchange rate.
x Discuss the effectiveness of monetary and fiscal policies under fixed exchange rate.
x Wrap up the course!
Open Economy—A Brief Review
The AE Model in Generic Form—the Full Version
Consumption: C = C0 + c1DI, where DI = Y – T + TR
Investment: I = I0 – d (r – r1), where r1 is a constant
Government sector: G
T = T
0 + tr1Y
TR = TR0 – tr1Y
Foreign sector: X = X0 – x1 (E – E1), where E1 is a constant
IM = IM0 + im1Y + im2 (E – E1), where E1 is a constant
x The AE function: AE = C + I + G + X – IM
AE = C0 + c1 [Y – (T0 + tr1Y) + (TR0 – tr1Y)] + [I0 – d (r – r1)] + G + [X0 – x1 (E – E1)] – [IM0 + im1Y + im2 (E – E1)]
AE = C0 + I0 + G + X0 – IM0 – c1T0 + c1TR0 – d (r – r1) – (x1 + im2) (E – E1) + [c1 (1 – t1 – tr1) – im1] Y
AE = AE0 + cYY,
where AE0 = C0 + I0 + G + X0 – IM0 – c1T0 + c1TR0 – d (r – r1) – (x1 + im2) (E – E1)
Y = c1 (1 – t1 – tr1) – im1
where r1 and E1 is a constant
*** These two terms show how a change in interest rates and exchange rates change the AE function and equilibrium level of output.
x Equilibrium level of output (equating Y = AE):
x Holding all else constant, a change in E would affect both exports and imports, which then affects AE (via a change in AE0) and Y.
o When C$ appreciates (E increases), Canadian goods become more expensive Æ X decreases and IM increases Æ AE
decreases Æ Y decreases.
x 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 Æ I decreases Æ 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 Æ foreigners buy more Canadian assets Æ capital inflows.
Demand for C$ increases Æ C$ appreciates (E increases).
x 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 Æ C$ appreciates (E increases) Æ X decreases and IM increases Æ AE decreases Æ 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:
x Suppose the central bank buys bonds, MS increases.
x At r0, people find that they have too much liquidity (excess supply of money), and they will try to get rid of the excess liquidity by
x bond prices increase and interest rate decreases (r decreases)
x r decreases Æ cost of borrowing decreases Æ I increases Æ AE increases Æ Y increases
x The SMALL modification:
x Y increases Æ L (r, Y) increases by a small amount