# MGEA06H3 Lecture Notes - Fixed Exchange-Rate System, Fiscal Policy, Monetary Policy

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OPEN ECONOMY (PART 2)

Outline

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)

c

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):

Observations

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

buying bonds.

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

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x overall, r decreases to r1 (pt B in the money market diagram)

x AD shifts to the right to AD1

x The BIG modification: When r (interest rate) decreases, Canadian assets become less attractive Æ Canadians buy more foreign

assets Æ capital outflows.

x SC$ shifts to the right to S1C$ in the foreign exchange market

x C$ depreciates to E1 (E decreases) Æ X increases, IM decreases Æ AE increases further Æ AD shifts further to the right to AD2

x Y increases further due to all these increases

x The first increase in AD is due to an increase in MS

x The second increase in AD is due to an increase in NX

x Conclusion: Monetary policy is effective (it can be used to affect Y) under flexible exchange rate. Because the effect of an

expansionary monetary policy is reinforced by an increase in NX.

Numerical Example

C = 20 + 7/8 DI

T = (2/7) Y – 20

TR = 220 – (1/7) Y

I = 100 – 500 (r – 0.05)

G = 250

X = 120 – 1000 (E – 0.85); E = # of US$ per C$

IM = 1/8 Y + 750 (E – 0.85)

x If r = 0.05 (i.e., 5%) and E = 0.85:

o AE function: AE = 700 + 3/8 Y

o Equilibrium: Y* = 1120

Week 8—No Change in E When MS Changes:

x Now, suppose the central bank increases the money supply, and the interest rate falls to 3% (r = 0.03) and E remains at 0.85:

o AE function: AE = 710 + 3/8 Y

o Equilibrium: Y* = 1136 (Y increases by 16)

Week 12—Change in E When MS Changes:

x Now, suppose the central bank increases the money supply and the interest rate falls to 3% (r = 0.03) and C$ depreciates to 0.83 (E

decreases to 0.83):

AE = (230 + ½ Y) + [100 – 500 (0.03 – 0.05)] + 250 + [120 – 1000 (0.83 – 0.85)] – [1/8 Y + 750 (0.83 – 0.85)]

AE = 230 + ½ Y + 110 + 250 + 140 – 1/8 Y – (–15)

AE = 745 + 3/8Y

AE0 increased because I increased by 10, X increased by 20, and IM decreased by 15 (from the initial case)

Equilibrium: Y = 745 + 3/8Y

Y* = 1192 (Y* increases by 72)

AE function Y*

Initial case, r = 0.05, E = 0.85 AE = 700 + 3/8 Y 1120

MS increases, r = 0.03, E = 0.85 AE = 710 + 3/8 Y 1136

MS increases, r = 0.03, E = 0.83 AE = 745 + 3/8 Y 1192

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