Lecture 19 Econ: 2470

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Lecture 19 Econ 2470
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World Influence on Aggregate Demand

• Chapter 8

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IRP

• In the open economy, there are three equilibrium
  conditions.
• The IS curve
• The LM curve
• Interest rate parity
• Interest parity is the equality of the ROR
  obtainable from lending in either domestic or
  foreign currency. This implies,
• Domestic ROIForeign ROIExpected rate of
  Depriciation of Domestic currency

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• In case of fixed exchange rate,
• Thus interest parity implies that under fixed
  exchange rates, the domestic interest rate is
  equal to the given foreign interest rate.

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Equilibrium in the Open Economy
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Fiscal Policy with a Fixed ER
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Fiscal Policy with a Flexible ER

• Initial GDP is 800 and the ROI is 5, NX is 0
• Fiscal policy, ISo shifts to IS1.
• ROI increases and real GDP increases.
• NX decreases to NX1.
• NX decreases, because of increase in Real GDP and
  increase in Exchange rate (as ROI increases)

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Crowding Out in the Open Economy

• Increase in govt. expenditure, i.e. expansionary
  fiscal policy leads to an increase in ROI.
• Thus there is crowding out effect.
• Crowding out occurs because of 2 reasons.
• Higher the interest rate, investment decreases-
  typical crowding out phenomenon.
• Higher ROI induces higher exchange rate, which
  decreases NX, thus fiscal policy crowds out NX.

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Twin Deficits

• It is the govt. budget deficit and Canadas
  deficit with the ROW.
• Say initially budget is balanced and NX is zero
  and then theres a shift in the IS curve.
• IS shifts cause govt. expenditure increases
  without increase in tax.
• Thus budget deficit occurs.
• When IS shifts right, NX becomes negative.
• Thus we have twin deficit.

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Monetary Policy

• Increase in the money supply in the flexible
  exchange rate. LM shifts right to LM1.
• ROI falls to r1 and GDP increases to 1000.
• As ROI falls, thus exchange rate falls too.
• NX shifts right
• Full effect is ambiguous.
• Higher GDP increases import.
• But exchange rate increases export.
• In the figure GDP effect is larger but in the
  reality exchange rate effect could be larger.