Lecture 18 - Small Open Economy SR to LR Flashcards
How does the IS curve differ for a small OPEN economy
include NX=NX(ε) and we let NX = ω - μeP/P* = ω-γe
Where ε=eP/P* (same as earlier) , and
P and P* are fixed in SR
y is μP/P*
Since, small and open, r=r, it is no longer a variable to be determined. Use national identity formula, then rearrange to find Y or e
Y = a+d-fr+G-bT+w/(1-b) - y/1-b e
What shifts IS curve in a small open economy
a, d, ω, G* , T* r*.
f determines impact of r*
b determines how large any shift is.
What determines slope of IS
But we rearrange to find e to find slope
-(1-b)/y
so a change in y or b.
An increase in y or b makes slope flatter.
IS and capital flows (reminder from long run equilibrium, but also works in short run)
National saving = I + CF
If S>I excess saving become capital outflows. Which then match level of NX.
LM curve in small open economy
1st graph: LM curve
In a small open r=r, so r=r is represented by a horizontal line.
Y must deliver money market equilibrium
M/P = L(Y,r) (pos correl for Y, neg for r)
LM upward sloping as usual.
Key: Where r and LM intersect creates the SINGLE level of Y to deliver the money market equilibrium
2nd graph: LM* curve (e on y axis rather than r now)
Because of this, the 2nd graph shows LM curve is vertical and at the given level of Y to create the money market equilibrium.
Use the LM* graph to show impact of
a) increase in r*
b) increase in real money supply
(Look at slide 6 for annotations)
a) an increase in r* reduces demand for money (cost of holding increases), and so a higher Y can be achieved. LM schedule shifts to the right.
b) an increase in the real money supply (M/P) increases. Shifts LM curve to the right. Demand for money increases through a higher Y. (Since Md is a function of Y positively - as income increases we demand more money)
So what is this vertical LM* curve for small open economy called
Mundell Fleming Model
e on y axis
Y on x axis. (Income/output)
Where IS* LM* intersect we have equilibrium exchange rate and equilibrium income.
Using what we learnt: what does the LM* (Vertical Mundel) curve shift by
changes in money supply (by adjusting LM to then create a newer LM) or interest rate (adjusting the vertical interest rate associated with a small open economy r=r)
Floating vs fixed exchange rates in the Mundell Fleming.
What if equilibrium exchange rate > or < fixed exchange rate
a) EQe>Fixede so money supply (LM) needs to increase to return to the fixed e. Monetary policy will action this.
b) EQe<Fixede so monetary policy needs to reduce LM1 to LM2 to deliver the higher fixed exchange rate required.
So monetary policy intervene to adjust money supply accordingly to deliver the fixed e.
Why peg/fix the exchange rate? (3)
Reduces exchange rate volatility to help exporters (allows firms to do better)
Reduce short run volatility in capital markets (CI CO)
avoids investors putting in money to make gains since now fixed. Eval: may not be credible
Stabilise the economy (e.g one with high inflation)
Cons of fixed exchange rates (2)
Can increase short run volatility if peg is not credible
May encourage long term large scale international borrowing. Makes collapse of the peg very costly.
Limits policy makers ability to respond to shocks.
We have assumed open capital markets but countries can choose to restrict the interaction between domestic and international financial markets.
(To protect domestic financial institutions or to avoid extra volatility from opening capital markets.)
How do we represent this decision
The Trilemma
The Trilemma options
Countries must choose 2/3 options
Open capital markets (free capital flows)
Fixed exchange rate
Independent monetary policy
UK chose free capital flows and independent monetary policy (exchange rate determined by financial markets)
We can show impact of price adjustment (short run fixed to long run variable)
First recall the ISLM equations.
Mundell Fleming model.
IS Curve: Y=a+b(Y-T)+I(r) +G +NX(ε)
LM Curve: M/P = L(r, Y)
We can see that changes in prices will shift the LM curve and also the real exchange rate ε (EP/P)
(it changes money supply and thus LM curve and the Y that delivers the money market equilibrium, and so LM (vertical) curve moves, which changes the exchange rate e)
Mundell Fleming model showing the SR to LR (prices)
(HINT: 2 DIAGS NEEDED)
Scenario 1: a fall in price
Fall in P increases the real money supply (M/P). So LM increases.
Mundel Fleming: LM shifts right. e depreciates and y increases
AS/AD: Start at SR disequilibrium (recession) fixed prices as SR.
We then have a fall in SRAS as price falls and output increases. Downward sloping AD curve shows this relationship. Over time prices fall till we reach SRAS2 (resources unemployed so costs fall e.g workers willing to work for less) and reside at long run equilibrium.
