Embed Size (px)
Citation preview
Introduction IS LM IS-LM
ECON2123-Tutorial 6Open Economy
Ding Dong
Department of EconomicsHKUST
November 21, 2018
Ding Dong Department of EconomicsHKUST
ECON2123-Tutorial 6 Open Economy 1 / 18
Introduction IS LM IS-LM
Opening the Economy: Goods Market
In a closed economy:
Y = C (Y − T ) + I (Y , i) + G
C=consumption on domestic goods(service);I=investment with domestic goods(service);G=government spending on domestic goods(service).
In an open economy:
Y = C + I + G + X − IM
New Problems: Two-Economy ⇒ Y and Y ∗
Two-Currency ⇒ Nominal Exchange Rate (E)Two-Price Level ⇒ Real Exchange Rate (ε)
Ding Dong Department of EconomicsHKUST
ECON2123-Tutorial 6 Open Economy 2 / 18
Introduction IS LM IS-LM
Exchange Rate
Definition: Nominal Exchange Rate (E)E= The price of the domestic currency in terms of foreigncurrency. i.e., 1 HKD=0.13 USD ⇒ E=0.13.
Definition: Real Exchange Rate (ε) : ε = EPP∗
ε= The price of domestic goods in terms of foreign goods.
Nominal appreciation (E ↑): An increase in the price of thedomestic currency in terms of a foreign currency.
Real appreciation ( ε ↑): An increase in the real exchangerate, i.e., an increase in the relative price of domestic goods interms of foreign goods.
Ding Dong Department of EconomicsHKUST
ECON2123-Tutorial 6 Open Economy 3 / 18
Introduction IS LM IS-LM
Goods Demand
Demand for Domestic Goods (ZZ curve)
Z = C + I + G − IM/ε + X
Domestic Demand for Goods (DD curve)
D = C + I + G
Now we unpack each component:(a) C=C(Y-T).(b) I=I(Y,i).(c) IM ? X?
Ding Dong Department of EconomicsHKUST
ECON2123-Tutorial 6 Open Economy 4 / 18
Introduction IS LM IS-LM
Goods Demand
(a) C=C(Y-T).(b) I=I(Y,i).(c) IM = IM( Y︸︷︷︸
+
, ε︸︷︷︸+
)
(d) X = X ( Y ∗︸︷︷︸+
, ε︸︷︷︸−
)
(e) NX = X (Y ∗, ε)− IM(Y , ε)/ε = NX ( Y︸︷︷︸−
, Y ∗︸︷︷︸+
, ε︸︷︷︸?
)
Marshall-Lerner condition: A real depreciation leads to an increasein net exports. ⇒
NX = NX ( Y︸︷︷︸−
, Y ∗︸︷︷︸+
, ε︸︷︷︸−
) (1)
⇒ NX is a downward sloping curve of output.
Ding Dong Department of EconomicsHKUST
ECON2123-Tutorial 6 Open Economy 5 / 18
Introduction IS LM IS-LM
Goods Demand
Demand for Domestic Goods (ZZ curve)
Z = C (Y − T ) + I (Y , i) + G + X (Y ∗, ε)− IM(Y , ε)/ε︸ ︷︷ ︸NX (Y ,Y ∗,ε)
(2)
Domestic Demand for Goods (DD curve)
D = C (Y − T ) + I (Y , i) + G (3)
⇒ DD curve is steeper than ZZ curve.
The gap between DD and ZZ is the trade balance (NX)⇒ When D=Z, NX=X-IM/ε=0
Supply: 45 degree line.
Ding Dong Department of EconomicsHKUST
ECON2123-Tutorial 6 Open Economy 6 / 18
Introduction IS LM IS-LM
Goods Market Equilibrium
The goods market equilibrium condition is derived at theintersection of ZZ curve and the 45-degree line:
Y = C (Y − T ) + I (Y , i) + G + NX (Y ,Y ∗, ε) (4)
And Trade balance:
NX = NX ( Y︸︷︷︸−
, Y ∗︸︷︷︸+
, ε︸︷︷︸−
) (5)
Policy/Shocks:Change in G/T: Shift ZZ: Yes; Shift NX: No. (policy)Change in ε: Shift ZZ: Yes; Shift NX: Yes. (policy)Change in Y ∗: Shift ZZ: Yes; Shift NX: Yes.
Ding Dong Department of EconomicsHKUST
ECON2123-Tutorial 6 Open Economy 7 / 18
Introduction IS LM IS-LM
Goods Market Equilibrium
Ding Dong Department of EconomicsHKUST
ECON2123-Tutorial 6 Open Economy 8 / 18
Introduction IS LM IS-LM
Goods Market Equilibrium: Government Spending
Ding Dong Department of EconomicsHKUST
ECON2123-Tutorial 6 Open Economy 9 / 18
Introduction IS LM IS-LM
Goods Market Equilibrium: Foreign Income
Ding Dong Department of EconomicsHKUST
ECON2123-Tutorial 6 Open Economy 10 / 18
Introduction IS LM IS-LM
Goods Market Equilibrium: Policy Target
In some cases the policy goals are more complicated:
Reduce trade deficit without affecting output:(a) Depreciate currency (ε ↓): Y ↑ and NX ↑(b) Decrease Gov Spending (G ↓): Y ↓ and NX ↑Increase output without affecting trade balance:(a) Depreciate currency (ε ↓): Y ↑ and NX ↑(b) Increase Gov Spending (G ↑): Y ↑ and NX ↓
Ding Dong Department of EconomicsHKUST
ECON2123-Tutorial 6 Open Economy 11 / 18
Introduction IS LM IS-LM
Interest Rate Parity Condition
Return of saving at home:Return(home)=1+i
Return of saving abroad:Return(abroad)=Et(1 + i∗) 1
E et+1
No Arbitrage Condition: Return(home)=Return(abroad)1 + i = Et(1 + i∗) 1
E et+1
or equivalently,
Et =1 + i
1 + i∗E e (6)
This implies an positive correlation b/w interest rate andexchange rate.
Ding Dong Department of EconomicsHKUST
ECON2123-Tutorial 6 Open Economy 12 / 18
Introduction IS LM IS-LM
Interest Rate Parity Condition
Ding Dong Department of EconomicsHKUST
ECON2123-Tutorial 6 Open Economy 13 / 18
Introduction IS LM IS-LM
Open Economy IS
Original IS:
Y = C (Y − T ) + I (Y , i) + G + NX (Y ,Y ∗, ε) (7)
Assume that ε = E , and from interest parity: condition
E =1 + i
1 + i∗E e (8)
IS in the Open Economy:
Y = C (Y −T ) + I (Y , i) +G +NX ( Y︸︷︷︸−
, Y ∗︸︷︷︸+
,1 + i
1 + i∗E e︸ ︷︷ ︸
−
) (9)
Ding Dong Department of EconomicsHKUST
ECON2123-Tutorial 6 Open Economy 14 / 18
Introduction IS LM IS-LM
Open Economy IS-LM
IS in the Open Economy:
Y = C (Y −T )+I (Y , i)+G +NX ( Y︸︷︷︸−
, Y ∗︸︷︷︸+
,1 + i
1 + i∗E e︸ ︷︷ ︸
−
) (10)
Open Economy LM:i = i (11)
Ding Dong Department of EconomicsHKUST
ECON2123-Tutorial 6 Open Economy 15 / 18
Introduction IS LM IS-LM
Open Economy IS-LM
Ding Dong Department of EconomicsHKUST
ECON2123-Tutorial 6 Open Economy 16 / 18
Introduction IS LM IS-LM
Open Economy IS-LM: Monetary Policy
Ding Dong Department of EconomicsHKUST
ECON2123-Tutorial 6 Open Economy 17 / 18
Introduction IS LM IS-LM
Open Economy IS-LM: Fiscal Policy
Ding Dong Department of EconomicsHKUST
ECON2123-Tutorial 6 Open Economy 18 / 18
