CHAPTER ShortRun Fluctuations in an Open Economy

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CHAPTERShort-Run Fluctuations in an
Open Economy
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Short-Run Fluctuations in an Open Economy

• The Open Economy Short-Run Macro Model
• The Balance of Payments (BP) Curve
• Policy Analysis with the IS/LM Model and the BP
  Curve
• Monetary and Fiscal Policy
• Policies That Directly Affect the Balance of
  Payments

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• Policy in a Small Open Economy the Mundell
  Fleming Model
• Fixed Exchange Rates
• Flexible Exchange Rates
• International Policy Coordination
• International Organizations
• A Common Currency for Europe

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Open-Economy Short-Run Macro Model

• The current account balance is the difference
  between exports and imports.
• The private capital account balance is the
  difference between private capital inflows and
  outflows.
• The balance of payments is in equilibrium when
  the current account and private capital account
  balances sum to zero.

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Private Balance of Payments Deficit

• If the private balance of payments is in deficit,
• current account private capital account lt 0
• supply of currencygtdemand for currency
• With a flexible exchange rate, the currency
  depreciates until
• current account private capital account 0
• demand for currency supply of currency
• With a fixed exchange rate, the country must buy
  up the excess supply of its currency.

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Private Balance of Payments Surplus

• If the private balance of payments is in surplus,
• demand for currencygtsupply of currency
• current account private capital account gt 0
• With a flexible exchange rate, the currency
  appreciates until
• demand for currency supply of currency
• current account private capital account 0
• With a fixed exchange rate, the country must sell
  its currency to eliminate the excess demand.

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The Balance of Payments Curve

• The balance of payments (BP) curve represents
  combinations of interest rates and income levels
  at which the private balance of payments is in
  equilibrium.
• On the BP curve income and interest rates are
  directly related because of their effect on the
  current account and the private capital account.

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The BP Curve

• Current Account
• Exports - Imports
• Exports are Exogenous
• Imports Increase as Income Increases
• Private Capital Account
• Capital Inflows - Capital Outflows
• Capital Inflows Increase as Interest Rates
  Increase
• For BP equilibrium, interest rates must increase
  with income so that a deficit in the current
  account is offset with a capital account surplus.

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Deriving the BP Curve
capital account
C
B
A
Current account deficit/surplus 0
A
Capital account deficit/surplus 0
Aggregate Output
r1
Y2
Y0
Y1
rw
r2
Real interest rate ()
B
A decline in income re- quires a decline in the
interest rate.
C
current account
B
r1
Real interest rate ()
A
rw
A rise in in- come requires a rise in the
interest rate.
C
r2
Aggregate Output
Y1
Y2
Y0
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Deriving the BP Curve A Numerical Example
E
A
40
B
D
Current account deficit/surplus
20
C
C
Capital account deficit/surplus
0
0
Aggregate Output
10
8
6
14
12
500
400
200
300
100
-20
Real interest rate ()
B
D
-40
A
E
Point G BP surplus
BP Curve
Real Balance Real Interest of
Point Output Rate Payments
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Real interest rate ()
E
G
12
D
10
C
A 100 6 0 B 200 8 0
C 300 10 0 D
400 12 0 E 500 14 0
H
8
B
6
Point H BP deficit
A
500
400
300
200
100
Aggregate Output
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Slope of the BP Curve

• The responsiveness of capital flows to
  differences between domestic and world interest
  rates
• The BP curve is flatter if capital flows are more
  responsive to interest rate differences.
• The responsiveness of imports to income
• The BP curve is steeper if imports are more
  responsive to changes in income.

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Policies that Shift the BP Curve

• Exchange Rate Policies
• Import Controls
• Export Drives
• Capital Controls

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Exchange Rate Policy Depreciation of a Currency
Starting at A, depreciation causes the BP curve
to shift down and/or right.
BP0
BP1
Real Interest Rate ()
At C, the same interest rate requires a
higher income for equilibrium.
C
A
r0
At B, the same income requires at lower interest
rate for equilibrium.
B
r1
Y1
Aggregate Output
Y0
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The J-Curve
Initially a depreciation of a countrys currency
can worsen the trade deficit until people adjust
their buying patterns.
Trade balance in dollars
Trade balance improves
Time in years
T1
T2
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Import Controls

• Import controls are policies that forbid or
  discourage the importing of goods.
• Tariffs are taxes on imports.
• Quotas are quantitative limits on imports.
• Voluntary restraint agreements are informal
  agreements to limit exports.
• Import controls create surpluses and shift the BP
  curve to the right.

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Export Drives

• An export drive is a policy that promotes a
  countrys exports using
• subsidies
• international appeals to buy its exports
• Export drives shift the BP curve to the right.

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Capital Controls

• Capital outflow controls are policies that limit
  the amount of capital that can leave the country.
• Capital controls are meant to reduce the demand
  for foreign currency and keep the domestic
  currency from depreciating.
• If the capital controls do not affect capital
  inflows, the BP curve will shift to the right.

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Policy Analysis with the IS/LM Model and the BP
Curve

• When the government achieves its short-run goals
  for interest rates and output, the economy is in
  internal balance.
• When the government achieves its goals for its
  trade balance or balance of payments, it is in
  external balance.
• If all goals are met simultaneously, the country
  is in internal and external balance.

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Monetary and Fiscal Policy with the BP Curve
1. If the economy is below potential output at
A, ex pansionary monetary and fiscal policy shift
the IS and LM curves to B. With flexible
exchange rates, the currency depreciates,
shifting the BP to point B.
LM0
LM1
Real Interest Rate ()
A
B
2. If the exchange rate is fixed, the country
must buy the excess supply of its currency to
maintain the rate.
r0
BP0
IS1
BP1
IS0
Aggregate Output
Y1potential
Y0
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Monetary and Fiscal Policy with a Balance of
Payments Constraint
1. If the economy is below potential output at
A, expansionary fiscal policy shifts the IS curve
to B.
LM1
Real Interest Rate ()
LM0
2. If the exchange rate is fixed and the country
doesnt have enough reserves to buy the
excess supply of its currency, it must
decrease its money supply, which shifts the LM
curve to the left to C.
C
r2
r1
B
A
r0
3. At C interest rates have risen enough to
increase the capital account balance and reduce
income so the current account increases to
achieve equilibrium.
BP0
IS1
IS0
Y1potential
Y0
Y2
Aggregate Output
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Achieving External Balance
1. If the economy is below potential output at
A, ex pansionary monetary and fiscal policy shift
the IS and LM curves to B, where internal balance
occurs.
LM0
LM1
Real Interest Rate ()
2. External balance remains at A, where there is
a balance of payments deficit.
A
B
r0
3. The government can buy its surplus currency
or use imports controls and/or export drives to
shift the BP to BP1 and achieve both internal
and external balance.
BP0
IS1
BP1
IS0
Aggregate Output
Yp
Y0
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Policy in a Small Open Economy the Mundell
Fleming Model

• Small, internationally integrated economies
  usually have perfect capital mobility, investors
  can buy and sell assets across countries with no
  additional risk.
• Real interest rates are the same across countries
  because capital flows eliminate differences.
• The Mundell-Fleming Model is an open economy
  model where capital is perfectly mobile.

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Mundell-Fleming Model
2. If income increases to Y1, the current
account decreases. Since capital is prefectly
mobile, capital flows in as interest rates begin
to increase.
1. At A the economy is in balance of payments
equilibrium with the domestic interest rate
rw, the world interest rate.
Real Interest Rate ()
BP Curve
B
A
rw
3. The inflow of capital increases the capital
account to offset the current account decrease
and keeps interest rates at rw.
Real Output, Income ()
Y1
Y0
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Policy in the Mundell-Fleming Model with Fixed
Exchange Rates
LM0
Real Interest Rate ()
LM1
A
B
BP
rw
IS1
IS0
Aggregate Output
Y1
Y0
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Policy in the Mundell-Fleming Model with Fixed
Exchange Rates
LM0
Real Interest Rate ()
LM1
A
BP
rw
IS0
Aggregate Output
Y0
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Policy in the Mundell-Fleming Model with Flexible
Exchange Rates
LM
Real Interest Rate ()
r1
rw
A
B
BP
IS1
IS0
Y1
Y0
Aggregate Output
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Policy in the Mundell-Fleming Model with Flexible
Exchange Rates
LM0
LM1
Real Interest Rate ()
A
B
BP
rw
IS1
IS0
Aggregate Output
Y1
Y0
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Policy Effectiveness in the Mundell-Fleming Model
Fixed Exchange Rate Flexible Exchange
Rate Monetary Ineffective in changing
Effective in changing Policy income by itself
offset income causes net by capital
inflows or exports to change to
outflows. Effective validate
monetary when coordinated policy.
with fiscal policy. Fiscal
Effective in changing Ineffective in
changing Policy income because it income by
itself net forces an accommo- exports
will change to dative monetary
offset it. Effective policy. When
coordinated with accomodative
monetary policy.
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International Organizations
International Finance Organizations Internati
onal Helps coordinate international Monetary
Fund (IMF) financial flows www.imf.org World
Bank Helps developing countries
www.worldbank.org obtain low interest
loans International Trade Organizations World
Trade Works toward free trade in goods
Organization and services and
mediates trade (WTO) disputes among
members www.wto.org
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Regional and Special Issue
Organizations Group of 7 A group of 7 countries
(Britain, Canada, France, Germany, Italy, Japan,
and the U.S.) that promotes trade negotiations
and coordinates economic policies among its
members Organization A group of 13 major oil
exporting countries in the Middle East, of
Petroleum Africa, and South America established
to create greater cooperation and
Exporting coordination among member countries
to help prevent the price of oil Countries from
falling too low (OPEC) Organization A group
of countries from Europe and North America
plus for Economic Japan, New Zealand, Mexico, the
Czech Republic, Korea, Cooperation Hungary,
and Poland that promotes economic
cooperation Development among its
members (OECD) North Established to eliminate
trade barriers among Mexico, American Free the
United States, and Canada Trade Agree- ment
(NAFTA) European Union Seeks to integrate members
by eliminating trade barriers and establishing
a common currency. Members are Belgium,
Italy, Germany, France, Luxembourg, the
Netherlands, Denmark, Ireland, the United
Kingdom, Greece, Spain, Protugal,
Austria, Finland, and Sweden.
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International Policy Coordination
BP
In the early 1970s the U.S. was running
expansionary monetary policy and
slightly expansionary fiscal policy. This
caused a balance of pay- ments deficit and put
pressure on the dollar to de- preciate. Since
exchange rates were fixed, foreign countries were
forced to increase their money supplies to buy up
excess dollars. The expanding money supplies led
to global inflation.
LM0
Real Interest Rate ()
LM1
A
B
r0
IS1
IS0
Y0
Aggregate Output
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European Unions
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Advantages of a Common Currency

• Reduction in exchange rate risk
• Eliminates the risk of exchange rate variability,
  which increases capital market stability
• Reduction in transactions costs
• There is no exchange of currencies among members,
  so transaction costs are reduced
• Economies of scale
• Along with the dollar, the euro may serve as a
  reserve currency, so the EU gets interest free
  loans

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Disadvantages of a Common Currency

• Loss of independent monetary policy
• With a common currency monetary policy is the
  same in all countries because there is one money
  supply and one central bank
• Loss of nationalism
• Losing a national currency may be a loss of
  national identity or heritage

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Optimal Currency Areas

• An optimal currency area is a group of countries
  suitable to adopt a common currency without
  significantly jeopardizing domestic policy goals.
• Criteria for optimal currency areas
• Similar industries
• Significant labor mobility
• Broad range of industries
• Diverse demand shocks