ECON 671 International Economics

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ECON 671 International Economics

• Aggregate Demand Supply
• in the Open Economy

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Short Run IS-LM-BP Model and Aggregate Demand
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Open Economy SR EquilibriumIS-LM-BP Model

• IS-LM-BP Model described by 3 equations
• (IS) Y C (Y-T, W) I(i) G NX(e, Y,
  YROW, W)
• (LM) Ms/P a(DR IR)/P f(Y, i, W, E(p))
• (BP) BOP0 NX(e, Y, YROW, W) j(i, i xa)
• IS-LM-BP with Fixed Exchange Rate Regime
• Endogenous Variables Y, i, M (BOPDIR)
• Exogenous Variables G, T, DR, W, P, e
• IS-LM-BP with Flexible Exchange Rate Regime
• Endogenous Variables Y, i, e
• Exogenous Variables G, T, M (BOP0), W, P

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Effect of Domestic Price Level

• Look at effects of rise in domestic prices, P.
• Direct Effects
• Rise in P lowers NX which shifts IS and BP
  Curves inwards.
• Also lowers real money supply so LM Curve shifts
  back.
• New internal equilibrium where new IS Curves
  intersect.
• Y decreases at new intersection. This is new
  overall equilib.!!
• This result occurs regardless of fixed or
  flexible EXR.
• Aggregate Demand
• AD Curve shows relationship between Domestic
  Price Level and Output for Open Economy.
• Demonstrated this is downward-sloping regardless
  of EXR regime.

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Increase in Domestic Prices
Interest
Rate
BP(e0, P0)
LM(Ms/P0)
i0
IS(e0, P0)
Y0
Income, Output
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Open Economy AD Curve
i

• Begin at Price Level P1 with IS1, BP1, and LM1.
• 1. Increase Price level to P2.
• - All 3 curves shift inward.
• 2. Lower level of real GDP, Y2, at higher Price
  level P2.
• 3. AD Curve summarizes relationship of P and Y.
• 4. Anything that shifts IS, BP, or LM Curve (with
  Price level fixed) will shift AD Curve.

BP1
LM1
i1
IS1
Y
Y1
Price
Level
P
P1
Y1
Y
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Shifts in Aggregate Demand underDifferent EXR
Regimes
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AD Curve Shifts Fixed EXR

• Fiscal Policy
• Shifts in IS Curve lead to shifts in AD Curve
  because Y changes.
• Adjustments to equilibrium depend on degree of
  capital mobility.
• Higher the degree of capital mobility, the more
  effective is fiscal policy.
• When capital immobile, IR adjustment shifts LM in
  increases i, Y fixed.
• When capital mobile, IR adjustment shifts LM out
  increases Y, i fixed.
• Monetary Policy
• Shifts in LM Curve do not affect AD curve because
  Y does not change.
• Adjustment to equilibrium does not depend on
  degree of capital mobility.
• Monetary policy is not effective in changing Y.
• Change in Domestic Reserves brings changes in i
  Y affecting FX market.
• FX market disequilibrium, requires Central Bank
  to change Intl Reserves by amount exactly
  offsetting original change in Domestic Reserves.
• Exchange Rate Policy
• Devaluation shifts both IS BP curves,
  increasing Y, shifts AD curve out.
• Central Bank intervention to achieve new fixed
  EXR brings about change.

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AD Curve Shifts Flexible EXR

• Fiscal Policy
• Shifts in IS affect AD Curve only to extent Y
  changes..
• How much shift in IS changes Y depends on degree
  of capital mobility.
• Higher the degree of capital mobility, the less
  effective is fiscal policy.
• When capital immobile, EXR adjustment mostly
  shifts BP increases Y.
• When capital mobile, EXR adjustment mostly shifts
  IS decreases Y.
• Monetary Policy
• Shifts in LM Curve lead to shifts in AD Curve
  because Y changes.
• Shift in AD Curve does not depend on degree of
  capital mobility.
• Monetary policy is very effective in changing Y
  shifting AD Curve.
• Most effective when capital perfectly mobile,
  keeps domestic i i.
• Effect on interest rate uncertain in most cases,
  depends on relative shifts and slopes of IS and
  BP curves.

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Short Run and Long Run Aggregate Supply
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Short Run Aggregate Supply

• Use standard model of SRAS. All variations of
  this model have a common theme.
• (SRAS) Y YLR a(P- Pe) with a gt 0
• In SR, output deviates from LR level if actual
  price level deviates from expected price level.
• This behavior arises from imperfection in a
  market.
• Each of the four models focuses on slightly
  different rationale for imperfection.
• These models imply a tradeoff between inflation
  and unemployment - but only a temporary one.
• Called the Phillips Curve

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Sticky Wage Model of SRAS

• In labor market, nominal wage often sticky in SR.
• Why? Unions, long term contracts, social norms.
• If nominal wage, W, assumed fixed then
• Rise in Price level will reduce real wage, W/P.
• Labor cheaper, firms hire more labor, increase
  output.
• Higher Price level brings higher output SRAS.
• Nominal wage fixed by expected Price, Pe.
• Bargain W Target Real Wage x P e or W w x Pe
• Receive Actual real wage W/P w x (Pe/P)
• If P gt Pe actual real wage lower than target real
  wage.
• Leads to SRAS Y YLR a(P- Pe) a gt 0

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Worker Misperception Model

• In labor market assume Nominal wage varies but
  workers confuse real nominal wages.
• Firms know Price level Ld Ld(W/P).
• Workers do not know Price level Ls Ls(W/Pe)
• rewrite Labor Supply as Ls Ls(W/P x P/Pe)
• Ls depends on real wage worker misperceptions
  of P.
• Unexpected increase in Price Level increases
  P/Pe.
• Any real wage now associated with higher nom.
  wage.
• Workers interpret as higher real wage. Ls shifts
  out.
• Leads to SRAS Y YLR a(P- Pe) a gt 0

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Imperfect Information Model

• Focus on misperceptions of price in output
  market.
• No-one in economy knows true average price level.
• Supplier observes only price of single good they
  sell.
• How much of price change in good due to
  inflation? How much from increase in relative
  demand?
• If price change due to entirely inflation, real
  price unchanged
• Supplier should not increase output., real
  profits same.
• If price change from increased demand, real price
  increased.
• Supplier should increase output because real
  profit higher.
• Unexpected rise in price level for given expected
  price fools suppliers into increasing output.
• Leads to SRAS Y YLR a(P- Pe) a gt 0

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Aggregate
Misperception Model of SRAS
Supply
P1
Y1
Y
Y
Labor Market
W/P
LS1
F(K0, L)
Y1
(W/P)1
Production
Ld(W/P)
L1
L1
L
L
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Short Run Aggregate Supply
1. SRAS upward sloping
Price Level
- depends on price expectations
P
Y YLR a (P - Pe1)
1
a
Y1
Income, Output, Y
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SR vs. LR Effects in an Open Economy AD-AS Model
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Shift in AD Curve SR vs LR
Price Level
LRAS
P
SRAS1
P1LR
AD1
YLR
Income, Output, Y