ECON 671 – International Economics

Aggregate Demand & Supply

in the Open Economy

Short Run IS-LM-BP Model and Aggregate Demand

3

Open Economy SR Equilibrium:IS-LM-BP Model

IS-LM-BP Model described by 3 equations(IS)(IS) Y = C (Y-T, W) + I(i) + G + NX(e, Y, YROW, W)

(LM)(LM) Ms/P= a(DR + IR)/P= f(Y, i, W, E())

(BP)(BP) BOP0 = NX(e, Y, YROW, W) + (i, i*+ xa)

IS-LM-BP with Fixed Exchange Rate RegimeFixed Exchange Rate Regime:• Endogenous VariablesEndogenous Variables: Y, i, MY, i, M (BOP=IR)

• Exogenous VariablesExogenous Variables: G, T, DR, W, P, e

IS-LM-BP with Flexible Exchange Rate RegimeFlexible Exchange Rate Regime:• Endogenous VariablesEndogenous Variables: Y, i, eY, i, e• Exogenous VariablesExogenous Variables: G, T, M (BOP=0), W, P

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Effect of Domestic Price Level Look at effects of riserise in domestic prices, P.

Direct EffectsDirect Effects– Rise in P lowers NX which shifts IS and BP Curves inwards.

– Also lowers real money supply so LM Curve shifts back.

– New internal equilibrium where new IS Curves intersect. Y decreases at new intersection. This is new overall equilib.!!

– This result occurs regardless of fixed or flexible EXR.

Aggregate DemandAggregate Demand

– AD Curve shows relationship between Domestic Price Level and Output for Open Economy.

Demonstrated this is downward-sloping regardless of EXR regime.

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Increase in Domestic Prices

InterestRate

Income, Output

LM(Ms/P0)

IS(e0, P0)

BP(e0, P0)

IS(e1, P1)

P >0P >0

P >0P >0

BP(e1, P1)

LM(Ms/P1)

P >0P >0

Y0

i0

Y1

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Open Economy AD Curve

Begin at Price Level P1 with IS1, BP1, and LM*

1.

1. Increase Price level to P2.

- All 3 curves shift inward.

2. Lower level of real GDP, Y2, at higher Price level P2.

3. AD Curve summarizes relationship of P and Y.

4. Anything that shifts IS, BP, or LM Curve (with Price level fixed) will shift AD Curve.

i

i1

YY1

BP1

IS1

Y1

P2

1.

Y

PriceLevel

P

P1 AD(G,T,M,i*)

3.

LM1

Y2

LM2

2.

BP2

2.

IS2

2.

Y2

i2

Shifts in Aggregate Demand under

Different EXR Regimes

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AD Curve Shifts & Fixed EXR Fiscal PolicyFiscal Policy

– Shifts in IS Curve lead to shifts in AD Curve because Y changes.– Adjustments to equilibrium depend on degree of capital mobility.– Higher the degree of capital mobility, the more effective is fiscal policy.

When capital immobile, IR adjustment shifts LM in & increases i, Y fixed. When capital mobile, IR adjustment shifts LM out & increases Y, i fixed.

Monetary PolicyMonetary Policy– Shifts in LM Curve do not affect AD curve because Y does not change.– Adjustment to equilibrium does not depend on degree of capital mobility.– Monetary policy is not effective in changing Y.

Change in Domestic Reserves brings changes in i & Y affecting FX market. FX market disequilibrium, requires Central Bank to change Int’l Reserves by

amount exactly offsetting original change in Domestic Reserves.

Exchange Rate PolicyExchange Rate Policy– Devaluation shifts both IS & BP curves, increasing Y, shifts AD curve out.

Central Bank intervention to achieve new fixed EXR brings about change.

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AD Curve Shifts & Flexible EXR Fiscal PolicyFiscal Policy

– Shifts in IS affect AD Curve only to extent Y changes..

– How much shift in IS changes Y depends on degree of capital mobility.

– Higher the degree of capital mobility, the less effective is fiscal policy. When capital immobile, EXR adjustment mostly shifts BP & increases Y. When capital mobile, EXR adjustment mostly shifts IS & decreases Y.

Monetary PolicyMonetary Policy– Shifts in LM Curve lead to shifts in AD Curve because Y changes.

– Shift in AD Curve does not depend on degree of capital mobility.

– Monetary policy is very effective in changing Y & shifting AD Curve. Most effective when capital perfectly mobile, keeps domestic i = i*. Effect on interest rate uncertain in most cases, depends on relative shifts and

slopes of IS and BP curves.

Short Run and Long Run Aggregate Supply

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Short Run Aggregate Supply Use standard model of SRAS. All variations of

this model have a common theme.

(SRAS) (SRAS) Y = YY = YLRLR + + (P- P(P- Pee) with ) with > 0 > 0

In SR, output deviates from LR level if actual price level deviates from expected price level.• This behavior arises from imperfection in a market.• Each of the four models focuses on slightly different

rationale for imperfection. These models imply a tradeoff between inflation

and unemployment - but only a temporary one.• Called the Phillips Curve

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Sticky Wage Model of SRAS In labor market, nominal wage often sticky in SR.

• Why? Unions, long term contracts, social norms.

If nominal wage, W, assumed fixed then;• Rise in Price level will reduce real wage, W/P.• Labor cheaper, firms hire more labor, increase output.• Higher Price level brings higher output = SRAS.

Nominal wage fixed by expected Price, Pe.• Bargain W = Target Real Wage W = Target Real Wage xx P P ee or W = W = xxPPee

• Receive Actual real wage = W/P = Actual real wage = W/P = xxPPee/P) /P) • If P > PP > Pee actual real wage lowerlower than target real wage.

Leads to SRAS: Y = YY = YLRLR + + (P- P(P- Pee) ) > 0 > 0

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Worker Misperception Model In labor market assume Nominal wage varies but

workers confuse real & nominal wages. Firms know Price level: LLdd = L = Ldd(W/P).(W/P). Workers do not know Price level: L Lss = L = Lss(W/P(W/Pee))

• rewrite Labor Supply as LLss = L = Lss(W/P (W/P xx P/P P/Pee) )

• Ls depends on real wage & worker misperceptions of P.

Unexpected increase in Price Level increases P/Pe.

• Any real wage now associated with higher nom. wage.

• Workers interpret as higher real wage. Ls shifts out.

Leads to SRAS: Y = YY = YLRLR + + (P- P(P- Pee) ) > 0 > 0

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Imperfect Information Model Focus on misperceptions of price in output market.

• No-one in economy knows true average price level.• Supplier observes only price of single good they sell.• How much of price change in good due to inflation?

How much from increase in relative demand? If price change due to entirely inflation, real price unchanged

– Supplier should not increase output., real profits same. If price change from increased demand, real price increased.

– Supplier should increase output because real profit higher.

Unexpected rise in price level for given expected price “fools” suppliers into increasing output.

Leads to SRAS: Y = YY = YLRLR + + (P- P(P- Pee) ) > 0 > 0

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L

Misperception Model of SRAS

L

Ld(W/P)

W/PY Y

Labor Market

AggregateSupply

Production

F(K0, L)

L1 L1

Y1

Y1

3. Higher L results in higher output Y.

Y2

3.

Y23.

Y=YLR + (P-Pe)

4.

4. Relationship between P and YSummarized by upward sloping SRAS.

(W/P)1

P1

1. Increase in Price level fools workers. P2 1.

LS1

L2

2.

Result is fall in Real wage, increase in L.

L2

2.

(W/P)2

2. LS shifts out given workers’ fixed Pe.

LS2

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Short Run Aggregate Supply

Price LevelP

Income, Output, YY1

LRAS2. LRAS vertical

Pe = P in LR equilib.P1

1. SRAS upward sloping- depends on price expectations

Y = YLR + (P - Pe1)Pe

- increase in Pe shifts SRAS up.

P2

3. Change in expected price

1

SR vs. LR Effects in an Open Economy AD-AS Model

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Shift in AD Curve: SR vs LR

Price LevelP

Income, Output, Y

LRAS

P1LR

SRAS1

AD1

3.Pe

- increase in Pe shifts SRAS up. 3. Change in expected price

SRAS2

AD2

1. AD Curve shifts out- Price expectations fixed

1.

YSR

2. In SR: Higher YSR and PSR

PSR 2.

P2LR

4.4. In LR: back to YLR at

higher Price level.

YLR