LECTURE 6: MACROECONOMIC INTERDEPENDENCE

(I) Interdependence: Y depends on Y*.

(II) The two-country model, to be used for a country big enough to affect world income Y*.

• Simultaneous determination of Y & Y*.• Implication of repercussion effects for the multiplier.

(III) International transmission under fixed vs. floating exchange rates

• of a disturbance originating domestically.• of a disturbance originating abroad .

ITF-220 Prof.J.Frankel, HKS

Re-endogenizing Exports

ms

MYmXAY

**

**YmXX ms

MXAY

}=>

I.e., Y depends on Y*.

“When the US sneezes, Canada catches cold.”

GICA where

ITF-220 Prof.J.Frankel, HKS

Y depends on Y*.

ms

MYmXAY

**

For every $1 of foreign income,

how much is spent on our goods?

For every $1 of demand for our exports, how much does our income rise?

ITF-220 Prof.J.Frankel, HKS

The other equation of the two-country model: Y* depends on Y

ms

MYmXAY

**

Instead of deriving the equation for Y* from scratch,use equation for Y,

and substitute foreign for domesticand domestic for foreign:

**

**

ms

XmYMAY

For every $1 of domestic income,

how much is spent on foreign goods?

For every $1 of demand for foreign goods, how much does foreign income rise?

Fiscal expansion shifts Y to D

in small-country Keynesian model

(too small to affect Y*),

Combine two simul-taneous relationships:=> equilibrium at B .

but further, to D´,in large-country

model.

FIGURE 17.A.1

2-COUNTRY MODEL

ITF-220 Prof.J.Frankel, HKS

•••

of which m is leakageabroad through imports,

m/(s*+m* )is the multiplier effect of our imports on Y* ,and m* [m /(s*+m* )]

is the repercussion effect: how much comes back

as demand for our goods.

In two-country model,multiplier is increased

by subtraction fromdenominator of

m*m /(s*+m* ),

ITF-220 Prof.J.Frankel, HKS

•••

The same result -- fiscal expansion raises Y to D

in small-country Keynesian model, but further, to D´,in large-country model --

can be shown in our traditional graph.

The X-M line is flatter now, because it captures the

repercussion effect on TB:Beyond Y↑ => IM↑,

also X*↑ =>Y*↑ => X↑

BIG-COUNTRY VS. SMALL-COUNTRY MODEL

FIGURE 17.5

● D’’

ITF-220 Prof.J.Frankel, HKS

• ••

ITF-220 Prof.J.Frankel, HKS

adverse trend in TB (D´´ lies above TB=0 line,which is deficit territory)

A is rising faster than ,*A

But this model may not work in the long run, when growth is supply-drivenrather than demand-driven.

)(Y

FIG.17.A.1

or m>m*(TB=0 line is flat).

If both countries expand:

••

can result if either:

Fix

International Transmission

↓I ↓X

Floating increases effect on Y Floating decreases effect on Y

=> appreciation

=> depreciation

= “insulation.”

• ••

Float

Fix

Float

• ••= “bottling up” of disturbance.

ITF-220 Prof.J.Frankel, HKS

Conclusions regarding transmission(with no capital mobility)

• (i) Trade makes economies interdependent (at a given exchange rate).

– TB can act as a safety valve, releasing pressure from expansion: .

– Disturbances are transmittedfrom one country to another:

.XmsY ))/(1(

AmsY ))/(1(

ITF-220 Prof.J.Frankel, HKS

Conclusions regarding transmission(with no capital mobility), continued

• (ii) Floating exchange rates work to isolate effects of demand disturbances within the country where they originate:

– Effects of a domestic disturbance tendto be “bottled up” within the country. In the extreme, floating reproduces the closed economy multiplier: . .

– The floating rate tends to insulate the domestic economy from effects of foreign disturbances. In the extreme, floating reproduces a closed economy: . .

AsY )/1(

0Y

ITF-220 Prof.J.Frankel, HKS

End of Lecture 6: InternationalTransmission