Esame International macroeconomics, libro consigliato International Macroeconomics

Product of home good consumption

Now, note that this MPC is less than the marginal propensity to consume, which is a 45 degree line. And that gives us an equilibrium. [leggo] What shifts demand? Many things actually shift demand… 233 So, all have an impact and all this shifts the demand curve upwards. Considering the shift in the trade balance function, for instance, the foreign income would be one important component. Now, we are going to be talking about the IS curve and what we need to know for that is the Uncovered Interest Parity. Remember the UIP: domestic interest rate, foreign interest rate and the expected rate of depreciation of the domestic currency. This is the what we need here. 234… And that allows us to derive the IS curve. [ripresa] Why is it important? It's important because, as you see here, the exchange rate matters in this equation: so, changes in the interest rate will actually have an impact on the exchange rate. 235 [rip] Now, let's look at

what's happening if the interest rate falls. In the demand function, the first thing that changes is investment that shifts up, but you must also realize (and this you can actually see only in the lower right-hand graph) that the domestic return falls and, therefore, we are going to have a depreciation of the exchange rate and that also shifts the demand curve upwards. So, for 2 reasons the demand curve shifts upwards. And that brings us from point 1 to point 2. And we can draw these 2 points in the lower-left graph, which is a graph in the interest rate and output, and we see it's a negative slope: as the interest rate falls, domestic GDP goes up... And that's what we can see in this picture here. 236 So, there is 2 effects that derive the IS curve: first is investment (and low interest rates stimulates investment), but there is also a trade balance effect (because the real depreciation leads to lower interest rates and low interest rates lead to a depreciation and

that stimulates external demand, that stimulates exports and reduces imports). And that gives us the IS curve in our economy. 237 And we can then analyze all kinds of policy intuition. For instance, what happens if government expenditures goes up? Demand goes up, the IS curve shifts to the right. And just to give you a review of what shifts the IS curve, it's basically everything we saw before, with the exception that the interest rates are no longer in there because that has become an endogenous variable of the model. 238

So, what we're doing now is we're talking about what is called the LM curve: liquidity demand equals money supply. And, basically, what is defined as real money supply (or real money balance) is M/P, which has to be equal to money demand, which depends on how much transactions you want to have and how much liquidity you want to hold, given the interest rate. 239 Now, we basically assume that the central bank wants to hold real money balances constant: so, we have

A vertical money supply curve. How do we derive from that a LM curve? Basically, what you do is: you change the interest rate from i to i' and you observe that the same money supply can only happen if the money demand shifts upwards: so, you increase income from Y1 to Y2 in order to have an increase in interest rates from i to i'. And you draw that in the LM diagram with interest rate in the vertical axis and you get this positive slope LM curve.

What happens if the central bank decides to increase the money supply? The LM curve will shift downwards, the interest rate would fall, just like if you would start out all together with the central bank controlling the interest rate.

Now, what does that mean for us? It means that will now have the equilibrium in the short-run for the open economy in 2 graphs. One graph is the IS-LM and you would see a downward sloping IS and a positive sloping LM curve and the intersection gives you the domestic interest rate and you draw that in the

foreign exchange market as a horizontal line, the DR line.

And then, there is the foreign exchange rate and, basically, this is downward sloping as it always is because, if the interest rate at home is higher than the interest rate abroad, there must be a depreciation; and vice versa.

And from there we can basically now start to talk about macroeconomics in an open economy and we will do a lot of variations of things that we do. 242

So, the first thing that we look at is monetary policy and we look at it under a floating exchange rate.

So, what does an expansionary monetary policy do is: it reduces your domestic interest rate and, therefore, the DR curve shifts down. And that implies an exchange rate increase or depreciation. And that has a positive impact and output: so, both the interest rate fall and the depreciation of the exchange rate leads to an increase in income from Y to Y'. 243

What's the difference if you do the same thing under fixed exchange rates? Well, you can't, basically,

because what happens is that, if you want to reduce your interest rate, there should be an exchange rate depreciation, but that can't be because you want to have a fixed exchange rate and, so, the central bank must make a "U-turn" and move the interest rate back to where it was. So, there is no chance to have monetary policy under fixed exchanges. How about fiscal policy? Now, fiscal policy, in this context, is different to the system where the central bank would hold the interest rate constant. In this case, a fiscal policy would shift the IS curve to the right, as it often does, but that would lead not only to an increase in output, but also an increase in the interest rate. And that increasing the interest rate would actually lead to an increase of the domestic return: so, it must be the exchange rate falls or the domestic currency appreciates. And this would be a fiscal policy under floating exchange rate and where the central bank follows a quantity goal or holding the.

money supply constant. 245

The central bank would instead follow a policy of holding the interest rate constant it would actually lead to no impact whatsoever on the exchange rate and a much bigger impact on output. This summarizes what happens under fiscal policy and floating exchange rate. 246247

How about on fixed exchange rates? Things are different in this case because the fixed exchange rate basically is the same as if the central bank would run an interest rate objective or try to hold the interest rate constant and what happens is: an expansionary fiscal policy shifts the IS curve to the right (so, there is expansion), that would lead to an increase in the interest rate and, therefore, you would see a fall in the exchange rate or a depreciation, but, then, the central bank, who under a constant under fixed exchange rate cannot allow that to happen, acts by reducing the interest rate or expanding the money supply. And, so, the LM curve would shift to the right and we would be moving from

equilibrium 1 to equilibrium 2 and there will be no impact, whatsoever on the exchange rate under a fixed exchange rate regime because that's what it's all about. So, whether the central bank runs a fixed exchange rate regime or has interest rate target, basically the same applies. 248

This summarizes all the things that can happen under floating and fixed exchange rate regimes, when you have monetary expansion and/or fiscal expansion.

It's really important to see all the 0s under a fixed exchange rate regime: so, basically, under the fixed exchange rate regime:

• monetary policy has no impact whatsoever;
• fiscal policy has no impact on the interest rate, obviously;
• it has no interest impact on the exchange rate, also obviously and, because it has no impact on the interest rate, it has no impact on investment: you can't manipulate domestic investment through interest rate policy;
• it has only an impact on the trade balance: why is that? Because the fiscal expansion

Would increase output and that would increase imports and, so, it deteriorates that and that has an increase on output because of that very reason.

Under a floating exchange rate, you see a lot more effects:

• interest rates move;
• exchange rates move in opposite direction;
• investment moves because interest rate moves;
• the trade balance moves and;
• output increases.

Finally, it's important to note that the fiscal expansion is more pronounced under a fixed exchange rate regime than under a floating: so, that might be one advantage of fixed exchange rate regimes.

This is a nice example of what's happening: this is an example of the financial crisis of 2008, when you would ask yourself: what do you do if the economy is far under what it should be?

2 options: how about if there is a floating exchange rate regime? Or how about a fixed exchange rate regime?

Suppose there is a negative demand shock, the IS curve shifts left and, so, GDP falls and, therefore, we move from

point 1 to point 2 on the left panel and, then, a monetary policy which is expansionary would actually increase money supply and offset the shock: so, you'd move back to your original income in point 3.

So, monetary policy could completely eliminate the negative shock to the IS curve. With however a caveat and that is: you do that by depreciating the exchange rate: so, you have an impact on foreign economies when you do a monetary policy expansion to counteract your problems in demand.

How about if you have a fixed exchange rate?

Things are very different: you still have a demand shock and the demand shock shifts out negative, but, in that case, countries that have a fiscal policy regime they must actually counteract (and that's crucial) the implied fall in the interest rate from left panel from point 1 to point 2 and, so, they would need to run a monetary contraction: so, the opposite of what you'd actually want.

So, we would come from point 1 to point 4.

In this example, they

also talked about adding fiscal austerity into the mix and it basically just aggravates GDP.
The examples here used are the 2 countries in Eastern Europe: Latvia had basically a fixed exchange rate to the euro and Poland didn't.
And you can basically see what happened as the crisis broke out: you see that the Latvia did not move at all, whereas, as the crisis of 2008 broke, there was a large depreciation of the Polish currency.
And you can see that, because Latvia tried to run a balanced budget, they would have government spending driven down, whereas Poland was spent what they had, and you see that the output per person actually changed dramatically: Poland never experienced a crisis and never a recession, but Latvia recession was rather deep and fell by 20% and, so, maybe, that wasn't the time to do it.
There are a few problems with doing policy: the policy constraints.
We can have fixed exchange rate rule, monetary policy.