Open Economy IS-LM

• Open economy IS-LM: Output, Interest rates and exchange rates

• Fiscal and monetary policy.• Policy in the early 1980’s• Policy in the current fiscal expansion:

– Implications for the U.S– Implications for the world

Goods market:

• Equilibrium in the goods market:Y = C(Y-T) + I(Y,r) + G - eIM(Y,e) + X(Y*,e)

• Net exports:NX(Y,Y*,e) = X(Y*,e)- eIM(Y,e)

• Equilibrium in the goods market:Y = C(Y-T) + I(Y,r) + G + NX(Y,Y*,e)

Some simplifications:

• Real vs nominal exchange rate: e = EP*/P. Assume domestic and foreign prices are fixed (at P* = P) so e = E.

• Assume inflation is zero so real and nominal interest rates are equal: i=r.

• Goods market equilibrium is now:Y = C(Y-T) + I(Y,i) + G + NX(Y,Y*,E)

Equilibrium in financial markets:

• Arbitrage in financial markets implies uncovered interest parity:

i(t) = i*(t) + (Ee(t+1)-E(t)) /E(t)• Assume expected future exchange rate is fixed:

Ee(t+1)=Ee

• Solving for E(t):E(t) = Ee/(1+ i(t) – i*(t))

• If domestic interest rates rise relative to foreign interest rates, the exchange rate appreciates.

Intuition:

• U.S. tightens monetary policy. U.S interest rate rises relative to European rate.

• Foreign investors sell Euros and buy $ in order to purchase U.S. bonds.

• Demand for dollars rises and the price of the dollar increases -- E falls(E denotes the amount of $ needed to buy one unit of foreign currency).

How much does $ appreciate?• Holding future expected exchange rate fixed, an

appreciation today implies an expected depreciation over the next year.

• The $ must appreciate enough today so that expected rates of return on U.S. and European bonds are equalized, given the expected depreciation.

• Example: if i=i*=2% and i increases to 5% then exchange rate must appreciate by 3% today in order for it depreciate by 3% over the next year.

Equilibrium in goods and financial markets

• LM Curve:M/P = L(i)Y

• Uncovered interest parity:E = Ee/(1+ i – i*)

• IS Curve:Y = C(Y-T) + I(Y,i) + G + NX(Y,Y*, Ee/(1+ i – i*) )

• Equilibrium in goods and financial markets determines Y,i and E (given M,T,G and Ee ,Y*, i*)

Comments:

• LM Curve is unchanged by open economy considerations.

• IS curve: a fall in the domestic interest rate has two effects:– As interest rate fall, investment rises.– As interest rate fall, currency depreciates and

net-exports increase.– Both go in same direction – a reduction

interest rates increases output and IS curve still downward sloping.

Fiscal and monetary policy:

• An expansionary fiscal policy (increase in govt spending) leads to an increase in output, a rise in the interest rate and an appreciation of the currency.

• A contractionary monetary policy leads to a rise in U.S. interest rates, a reduction in output and an appreciation of the currency.

Budget deficits and trade deficits

• An expansionary fiscal policy causes an appreciation of the $ and a rise in output.– As output increases, imports rise.– As $ appreciates net exports falls.

• Result: budget deficits lead to trade deficits.• Intuition:

– with closed economy, budget deficits crowd out private investment,

– with open economy, we see less crowding out of private investment since we can import goods from abroad to make up for low domestic savings.

Does the model fit the facts?

• Early 1980’s:– Large tightening of monetary policy– Large increase in deficits (increase in

spending combined with tax cuts).• Result: twin deficits.

– Interest rates rise and output falls.– Budget deficit increases.– $ appreciates and trade deficit increases.

Numbers are for fiscal years, which start in October of the previous calendar year. All numbers are expressed as a percentage of GDP.

2.01.61.62.32.6Corporate taxes8.28.89.99.69.4Personal taxes

−−−−5.6

19.425.01983

−−−−4.5

19.223.71984

Table 20-1 The Emergence of Large U.S. Budget Deficits, 1980-1984

−−−−3.5−−−−2.0−−−−1.8Budget surplus

20.520.820.2Revenues24.022.822.0Spending198219811980

Inflation: Rate of change of the CPI. The nominal interest rate is the three-month T-bill rate. The real interest rate is equal to the nominal rate minus the forecast of inflation by DRI, a private forecasting firm. The real exchange rate is the trade-weighted real exchange rate, normalized so that 1973 = 100

−−−−2.7−−−−1.5−−−−0.6−−−−0.4−−−−0.5Trade surplus (% of GDP)

77858999117Real exchange rate5.95.16.04.92.5(real) 9.68.610.614.011.5Interest rate (nominal) 3.93.83.88.912.5Inflation (CPI) (%)7.59.69.77.67.1Unemployment rate (%)6.23.9−−−−2.21.8−−−−0.5GDP Growth (%)

19841983198219811980

Major U.S. Macroeconomic Variables, 1980-1984

Current period:

• See current IMF World economic outlook.• What is impact of current U.S. deficits?

– How big is fiscal stimulus?– How big is fiscal multiplier?– What will be the effect on interest rates?– What will be the effect on investment and the

trade deficit?• Global implications?