Open Economy AS/AD Model

Prof. Lutz Hendricks

Econ520

November 13, 2013

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Objectives

In this section you will learn:

1

how to analyze an open economy in the medium run (AS/AD model)

how the effects of policies and shocks differ from the short run

why the medium run outcomes under floating and pegging are similar

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Short vs Medium Run

Short run:
P is fixed.
Any adjustment of the real exchange rate must work through the
nominal exchange rate:
= EP/P
(1)

Medium run:
P adjusts
Any change in E can be mimicked by a change in P
same effect on
no other real effects of money in the medium run

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Fixed Exchange Rates

Fixed Exchange Rate Model

We need to clear these markets:
1
2

Foreign exchange: UIP with fixed E implies: i = i

Money:
M/P = YL(i )

(2)

Endogenous: M/P, Y
Goods:
1

demand:
P/P )
Y = C(Y T) + I(Y, i e ) + G + NX(Y, Y , E

(3)

P = Pe (1 + m)F(1 Y/L, z)

(4)

supply:

Endogenous: Y, P (really also e , but lets set that aside)

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Market Clearing

Short run:
Pe fixed
AS is upward sloping

Medium run:
Pe = P
vertical AS curve determines Yn by itself:
1 = (1 + m)F(1 Yn /L, z)

(5)

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Irrelevance of Money

We show:
The goods market determines Y and P
The money market determines M
so that i = i holds at all times

The Fed has no control over the money supply

This is true in short run and medium run
Key assumption: high capital mobility (UIP holds).

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Aggregate Demand
Start from IS with i = i :
P/P )
Y = C(Y T) + I(Y, i e ) + G + NX(Y, Y , E

(6)

P/P , G, T
Y =Y E

(7)

Simplify:

Negative slope: P = Y
this works through the real exchange rate and NX
New shifters: Y , i , P , E

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Aggregate Demand

M/P no longer shifts AD

Why not?

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Analyzing the Model

We can forget about the money market and UIP and just analyze
AS:
P = Pe (1 + m)F(1 Y/L, z)

(8)

P/P , G, T
Y =Y E

(9)

AD:

Short run: Pe is given.

Medium run: Pe = P.
Transition: Pe P shifts AS.

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Analysis: Medium Run

P = Pe : AS is vertical and determines Yn :

1 = (1 + m) F (1 Yn /L, z) Yn

P adjusts to get the right real exchange rate, such that AD = Yn :

P/P , G, T P
Yn = Y E

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AS/AD Graph

Price level, P

AS

Short run: Pe is fixed.

Output is not at the natural
rate.

AD

Yn

Output, Y

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Adjustment Over Time

Price level, P

AS

AS !

Initially: Pe > P.
W/P too high.
Pe falls over time.
AS shifts down

AD

Yn

Output, Y

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What Differs From Closed Economy?

Closed economy:
P = M/P = i = I

Open economy:
P = NX

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Devaluation

Instead of waiting for P to fall, why not simply lower E?

The effect on the real exchange rate and on demand is the same.
Avoid the painful period of unemployment.

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Devaluation

AS

Price level, P

"E < 0

AD!

AD

Yn

Output, Y
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A Free Lunch?

Now fixed exchange rates look like a free lunch.

Avoid exchange rate volatility
Gain instant adjustment to full employment through devaluation.
Whats the catch?

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Example: Fiscal expansion

Shock: G
Medium run:
Short run:
Process:

Pe

AD

Yn

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Example: Increase in i

Shock: i
Medium run:
Short run:
Process:

Pe

AD

Yn

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Currency Crises

Currency Crises

Under the peg: UIP implies i = i

But what happens if investors doubt the peg?
UIP:
it = it xt
E e Et
xt = t+1
Et

(10)
(11)

In general, the depreciation term xt can be positive or negative.

But the peg offers insurance to those to bet against the peg: xt can
never be positive.

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Currency Crises

Example:
25% chance of 20% devaluation over the next month
xt = 0.75 0 + 0.25 0.2 = 0.05
investors demand an interest premium of 5% per month to
compensate for this risk

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Policy Options

Raise i by 60%
major recession as borrowing shuts down

Raise i by less than 60%

capital outflows
CB must sell FX and eventually runs out of reserves

Devalue the currency

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Lessons

Fixed exchange rates are fragile

1

2
2

they can only be sustained as long as investors remain utterly

convinced that a peg will hold
betting against a peg is insured by the government

Fixed exchange rates can collapse without reason

If many investors believe the peg will fail, it will fail.

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Crisis Examples

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Crisis Examples
1.05

1.00

1992:1=1.00

0.95

0.90

0.85

0.80

0.75

FINLAND
SWEDEN
UK
ITALY
SPAIN
FRANCE
PORTUGAL

0.70
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

1992

1993

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Which Exchange Rate Regime Is Best?

The costs of fixing the exchange rate

Loss of monetary autonomy.

Import the U.S. inflation rate

Risk of speculative attacks.

Volatile interest rates.

Loss of automatic adjustment to certain shocks.

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Benefits of fixing the exchange rate

Loss of monetary autonomy.

Import the U.S. inflation rate

Incentives for fiscal discipline.

Cannot print money to finance budget deficits.

Stable exchange rate

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The Impossible Trinity

Exchange rate regimes pursue 3 goals:

1
2
3

Stable exchange rates

Monetary autonomy
Free capital flows.

Only 2 of the 3 goals are attainable.

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The Impossible Trinity

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Which regime is best?

The answer depends on the characteristics of the country.

Large, relatively closed countries can handle volatile currencies - they
usually float.
Small countries with a major trading partner may want to peg
But beware of pegging against the wrong country (Argentina).

Countries with questionable central banks may want to peg

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Example: Regime Choice

USA vs rest of the world

Canada vs USA

Argentina vs USA vs Brazil

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Currency Unions

If the exchange rate is fixed, why not get rid of it?

Main example: Euro
Benefits:
lower transactions costs
credibility
speculative attacks no longer possible.

Costs:
irreversible: cannot devalue in response to shocks
loss of monetary policy

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Reading

Blanchard / Johson, Macroeconomics, 6th ed., ch. 21

Additional reading:
Jones, Macroeconomics, ch. 15.

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