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