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