Aggregate Demand in the Open Economy CHAPTER TWELVE Aggregate Demand in the Open Economy Chapter 12 covers a lot of material. First, it develops the Mundell-Fleming open-economy IS-LM model for a small open economy with perfect capital mobility. The model is used to analyze the effects of fiscal & monetary policy under floating and flexible exchange rates. Trade policy is also considered. Then, the chapter explores interest rate differentials, or risk premia that arise due to country risk or expected changes in exchange rates. The Mundell-Fleming model is used to analyze the effects of a change in the risk premium. The 1994-95 Mexican Peso Crisis is an important real-world example of this. The chapter summarizes the debate over fixed vs. floating exchange rates. Following that discussion, the Mundell-Fleming model is used to derive the aggregate demand curve for a small open economy. And finally, the chapter discusses how the results it derives would be different in a large open economy. To reinforce this material, I urge you to do some in-class exercises (I’ve suggested several in the lecture notes accompanying some of the slides in this presentation) *and* to assign a homework consisting of several of the “Questions for Review” and “Problems and Applications” starting on p.339 of the text.

주요 내용 The Mundell-Fleming model: 소국개방경제의 IS-LM 분석 고정환율제와 변동환율제 소국개방경제의 총수요 곡선

먼델 – 플레밍 모형 주요가정: 자본의 자유로운 완전이동. r = r* 재화시장- IS* curve: where 주요가정: 자본의 자유로운 완전이동. r = r* 재화시장- IS* curve: In this and the following sections (in which we analyze policies with the M-F model), we assume the price level is fixed---just as we did when we first used the closed economy IS-LM model to do policy analysis in chapter 11. As we learned in chapter 5, NX depends on the real exchange rate. However, with price levels fixed, the real & nominal exchange rates move together. So, for simplicity, we write NX as a function of the nominal exchange rate here. (At the end of this chapter, when we use M-F to derive the aggregate demand curve, we go back to writing NX as a function of the real exchange rate, because the nominal & real exchange rates may behave differently when the price level is changing.) Chapter 5 introduced the notation r* for the world interest rate, and explained why r = r* in a small open economy with perfect capital mobility. Perfect capital mobility means that there are no restrictions on the international flow of financial capital: the country’s residents can borrow or lend as much as they wish in the world financial markets; and because the country is small, the amount its residents borrow or lend in the world financial market has no impact on the world interest rate. Chapter 5 also explained why net exports depend negatively on the exchange rate. where e = 명목환율

IS* 곡선: 재화시장의 균형 IS* 곡선은 주어진 r*에 의해 그려진다. 명목환율과 소득과의 관계: e IS* Y Again, “eq’m” is an abbreviation for “equilibrium.” The text (p.315) shows how the Keynesian Cross can be used to derive the IS* curve. Suggestion: Before continuing, ask your students to figure out what happens to this IS* curve if taxes are reduced. Answer: The IS* curve shifts rightward (i.e., upward). Explanation: Start at any point on the initial IS* curve. At this point, initially, Y = C + I + G + NX. Now cut taxes. At the initial value of Y, disposable income is higher, causing consumption to be higher. Other things equal, the goods market is out of whack: C + I + G + NX > Y. An increase in Y (of just the right amount) would restore equilibrium. Hence, each value of e is associated with a larger value of Y. OR, a decrease in NX of just the right amount would restore equilibrium at the initial value of Y. But the decrease in NX requires an increase in e. Hence, each value of Y is associated with a higher value of e. Rationale: Doing this exercise now will break up your lecture, and will prepare students for the fiscal policy experiment that is coming up in just a few slides.

LM* 곡선: 화폐 시장의 균형 LM*곡선 역시 r*가 주어진 상태에서 수직선: 명목환율 e에 상관 없이 Y는 일정하다. e The text (p.316) shows how the LM curve in (Y,r) space, together with the fixed r*, determines the value of Y at which the LM* curve here is vertical. Suggestion: Before continuing, ask your students to figure out what happens to this LM* curve if the money supply is increased. Answer: LM* shifts to the right. Explanation: The equation for the LM* curve is: M/P = L(r*, Y) P is fixed, r* is exogenous, the central bank sets M, then Y must adjust to equate money demand (L) with money supply (M/P). Now, if M is raised, then money demand must rise to restore equilibrium (remember: P is fixed). A fall in r would cause money demand to rise, but in a small open economy, r = r* is exogenous. Hence, the only way to restore equilibrium is for Y to rise. Rationale: Doing this exercise now will break up your lecture, and will prepare students for the monetary policy experiment that is coming up in just a few slides.

먼델-플레밍 모형의 균형 Y e LM* IS* 균형환율 균형소득

변동환율제( floating exchange rates), 명목환율e 는 경제상황에 따라 변하게 된다. 변동환율제도와 고정환율제도 변동환율제( floating exchange rates), 명목환율e 는 경제상황에 따라 변하게 된다. 고정환율제( fixed exchange rates), 중앙은행이 미리 정한 교환비율에 따라 자국화폐와 외환을 거래한다. 양 제도 하에서 재정, 금융, 무역정책의 효과는?

재정정책: 변동환율제 주어진 명목환율 e 에서, 재정확대는 Y 의 증가, IS* 곡선을 우측으로 이동. Results: Intuition for the shift in IS*: At a given value of e (and hence NX), an increase in G causes an increase in the value of Y that equates planned expenditure with actual expenditure. Intuition for the results: As we learned in earlier chapters, a fiscal expansion puts upward pressure on the country’s interest rate. In a small open economy with perfect capital mobility, as soon as the domestic interest rate rises even the tiniest bit about the world rate, tons of foreign (financial) capital will flow in to take advantage of the rate difference. But in order for foreigners to buy these U.S. bonds, they must first acquire U.S. dollars. Hence, the capital inflows cause an increase in foreign demand for dollars in the foreign exchange market, causing the dollar to appreciate. This appreciation makes exports more expensive to foreigners, and imports cheaper to people at home, and thus causes NX to fall. The fall in NX offsets the effect of the fiscal expansion. How do we know that Y = 0? Because maintaining equilibrium in the money market requires that Y be unchanged: the fiscal expansion does not affect either the real money supply (M/P) or the world interest rate (because this economy is “small”). Hence, any change in income would throw the money market out of whack. So, the exchange rate has to rise until NX has fallen enough to perfectly offset the expansionary impact of the fiscal policy on output. Results: e > 0, Y = 0 Y1

재정정책의 효과: 변동환율제도 소국개방경제에서 재정정책은 효과가 없다. “구축효과” 재정정책의 효과: 변동환율제도 소국개방경제에서 재정정책은 효과가 없다. “구축효과” 소국개방경제: 재정확대는 명목환율의 상승을 가져와 순수출을 감소시킴으로써 총소득의 증가효과를 상쇄하게 된다.

금융정책: 변동환율제도 통화량의 증가는 LM* 곡선을 우측으로 이동시킨다. 총소득 Y가 증가. Results: Suggestion: Treat this experiment as an in-class exercise. Display the graph with the initial equilibrium. Then give students 2-3 minutes to use the model to determine the effects of an increase in M on e and Y. Intuition for the rightward LM* shift: At the initial (r*,Y), an increase in M throws the money market out of whack. To restore equilibrium, either Y must rise or the interest rate must fall, or some combination of the two. In a small open economy, though, the interest rate cannot fall. So Y must rise to restore equilibrium in the money market. Intuition for the results: Initially, the increase in the money supply puts downward pressure on the interest rate. (In a closed economy, the interest rate would fall.) Because the economy is small and open, when the interest rate tries to fall below r*, savers send their loanable funds to the world financial market. This capital outflow causes the exchange rate to fall, which causes NX --- and hence Y --- to increase. e2 Results: e < 0, Y > 0 Y2

금융정책의 효과: 변동환율제도 금융정책은 총소득의 증가를 가져온다: M  e  NX  Y 통화팽창정책은 환율의 하락으로 국내물품의 가격을 낮추어 수입품의 소비를 줄이고 국내 상품의 소비를 촉진한다. 이에 따른 국내고용과 소득이 증가한다. Suggestion: Before revealing the text on this slide, ask students to take out a piece of paper and answer this question: “Contrast the way in which monetary policy affects output in the closed economy with the small open economy.” Or something to that effect.

무역정첵: 변동환율제도 주어진 명목환율 e1, 관세의 인상과 수입제한은 NX를 증가, IS* 곡선의 우측이동 . Y e e1 Y1 주어진 명목환율 e1, 관세의 인상과 수입제한은 NX를 증가, IS* 곡선의 우측이동 . e2 Intuition for results: At the initial exchange rate, the tariff or quota shifts domestic residents’ demand from foreign to domestic goods. The reduction in their demand for foreign goods causes a corresponding reduction in the supply of the country’s currency in the foreign exchange market. This causes the exchange rate to rise. The appreciation reduces NX, offsetting the import restriction’s initial expansion of NX. How do we know that the effect of the appreciation on NX exactly cancels out the effect of the import restriction on NX? There is only one value of Y that allows the money market to clear; since Y, C, I, and G are all unchanged, NX = Y-(C+I+G) must also be unchanged. Or looking at it differently: As we learned in chapter 5, the accounting identities say that NX = S - I. The import restriction does not affect S or I, so it cannot affect the equilibrium value of NX. Results: e > 0, Y = 0

(보호)무역정책의 효과 보호무역정책은 무역적자를 감소시키지 못한다. NX 가 결과적으로 변하지 않더라도 이는 무역량의 감소를 가져온다 : 보호무역은 수입의 감소 환율평가절상에 따른 수출의 감소 결과적으로 무역량의 감소 Import restrictions cause a sectoral shift, a shift in demand from export-producing sectors to import-competing sectors. As we learned in chapter 6, sectoral shifts contribute to the natural rate of unemployment, because displaced workers in declining sectors take time to be matched with appropriate jobs in other sectors.

고정환율제도 고정환율제도하에서는 중앙은행이 일정한 환율에 자국통화을 해외통화와 거래하게 된다. Mundell-Fleming model, 중앙은행은 LM* 곡선을 이동시킬 것이 요구된다. 명목환율 e 를 유지하기 위해서. 고정된 명목환율을 유지하더라도 장기적으로는 가격이 변화함에 따라 실질환율은 변하게 된다.

재정정책: 고정환율제도 e = 0, Y > 0 Under floating rates, a fiscal expansion would raise e. 변동환율제도에서 재정정책은 효과가 없었으나, 고정환율제에서는 , 효과적이다. Y e To keep e from rising, the central bank must sell domestic currency, which increases M and shifts LM* right. e1 Results: e = 0, Y > 0 Y1 Y2

금융정책: 고정환율제도 An increase in M would shift LM* right and reduce e. 반면 변동환율제도에서 효과적이던 금융정책은 고정환율제도에서는 효과가 (소득의 증가) 없다. Y e Y1 e1 To prevent the fall in e, the central bank must buy domestic currency, which reduces M and shifts LM* back left. The monetary expansion puts downward pressure on the exchange rate. To prevent it from falling, the central bank starts buying domestic currency in greater quantities to “prop up” the value of the currency in foreign exchange markets. This buying removes domestic currency from circulation, causing the money supply to fall, which shifts the LM* curve back. Another way of looking at it: To keep the exchange rate fixed, the central bank must use monetary policy to shift LM* as required so that the intersection of LM* and IS* always occurs at the desired exchange rate. Unless the IS* curve shifts right (an experiment we are not considering now), the central bank simply cannot increase the money supply. Results: e = 0, Y = 0

무역정책: 고정환율제도 e = 0, Y > 0 변동환율제도, 보호무역정책은 Y or NX 불변. 고정환율제도, Y and NX 증가 이는 결국 국내물품의 상대 가격을 통화정책을 통해 유지 함으로써 상대국의 수입을 차단하고 상대국의 소득을 줄여 얻는 이득이다. A restriction on imports puts upward pressure on e. Y e Y1 e1 To keep e from rising, the central bank must sell domestic currency, which increases M and shifts LM* right. Suggestion: Assign this experiment as an in-class exercise. Give students 3 minutes to work on it before displaying the answer on the screen. Results: e = 0, Y > 0 Y2

이자율 차이 이자율 차이의 두가지 이유 (r 과 r*) 국가위험 (country risk) 환율기대(expected exchange rate changes)

먼델-플레밍 모형에서의 이자율차이  는 위험할증(risk premium). R를 IS* and LM* equations에 대입: The first equation says that a country’s interest rate equals the world interest rate plus a risk premium (whose size depends on investors’ perceptions of the political & economic risk of holding that country’s assets and on the expected rate of depreciation or appreciation of the country’s currency. We can now use the M-F model to analyze the effects of a change in the risk premium. The next few slides present this analysis, then discuss an important real-world example (the Mexican peso crisis).

위험할증의 증가 Results: e < 0, Y > 0 IS* 좌측이동    r  I LM* 곡선의 우측이동    r  (M/P )d, so Y 증가. Intuition: If prospective lenders expect the country’s currency to depreciation, or if they perceive that the country’s assets are especially risky, then they will demand that borrowers in that country pay them a higher interest rate (over and above r*). The higher interest rate reduces investment and shifts the IS* curve to the left. But it also lowers money demand, so income must rise to restore money market equilibrium. Why does the exchange rate fall? The increase in the risk premium causes foreign investors to sell some of their holdings of domestic assets and pull their ‘loanable funds’ out of the country. The capital outflow causes an increase in the supply of domestic currency in the foreign exchange market, which causes the fall in the exchange rate. Or, in simpler terms, an increase in country risk or an expected depreciation makes holding the country’s currency less desirable. e2 Results: e < 0, Y > 0 Y2

위험할증()의 증가 결과 : 통화의 평가절하 국가 위험도 (country risk)의 증가 혹은 예기된 평가절하 (an expected depreciation)는 더 이상 그 통화의 보유가 유리하지 않게 된다 . Note: 예견된 통화의 평가 절하는 자기 성취적 (self-fulfilling prophecy)이다. Y의 증가는 순수출 NX의 증가 때문 으로 (from the depreciation) 투자(I) 의 감소를 상쇄시키고도 남을 만큼 (from the rise in r ).

그러나 현실은 중앙은행의 환율 방어를 위한 통화량 축소 통화의 평가 절하는 수입품 가격의 상승으로 전반적인 가격 수준을 높이고 결국 실질 통화 공급을 축소 하게 된다. 소비자 들 역시 위험에 대비 통화를 보유하려는 성향이 강해 진다. 때문에 LM* 곡선이 왼쪽으로 이동(leftward). The result that income rises when the risk premium rises seems counter-intuitive and inaccurate. This slide explains why the increase in the risk premium may cause other things to occur that prevent income from rising, and may even cause income to fall.

CASE STUDY: The Mexican Peso Crisis Mexico’s central bank had maintained a fixed exchange rate with the U.S. dollar at about 29 cents per peso.

CASE STUDY: The Mexican Peso Crisis In the week before Christmas 1994, the central bank abandoned the fixed exchange rate, allowing the peso’s value to “float.” Then, in just one week, the peso lost nearly 40% of its value, and fell further during the following months.

The Peso Crisis 는 Mexico문제만은 아님 U.S. 상품이 멕시코 사람들에게 비싸짐으로 미국 기업의 수입 감소 멕시코 국경 근처의 미국 시민들의 파산. 멕시코의 자산가치 하락으로 미국 시민들의 은퇴 후를 위한 투자의 가치 급락 The purpose of this slide is to motivate the topic. Even though this occurred in another country some years ago, it was very important for the U.S. The parents of many of your students probably held Mexican assets (indirectly through mutual funds in their 401k accounts and pension funds, which viewed Mexico very favorably prior to the crisis) and took losses when the crisis occurred.

1994년 멕시코 정부는 달러의 고갈 사실을 감추고 있었음. 멕시코 중앙은행의 달러 보유고 December 1993 ……………… $28 billion August 17, 1994 ……………… $17 billion December 1, 1994 …………… $ 9 billion December 15, 1994 ………… $ 7 billion Defending the peso in the face of large capital outflows was draining the reserves of Mexico’s central bank. (August 17, 1994 was the date of the presidential election.) Ask your students if they can figure out why Mexico’s central bank didn’t tell anybody it was running out of reserves. The answer: If people had known that the reserves were dwindling, then they would also have known that the central bank would soon have to devalue or abandon the fixed exchange rate altogether. They would have expected the peso to fall, which would have caused a further increase in Mexico’s risk premium, which would have put even more downward pressure on Mexico’s exchange rate and made it even harder for the central bank to “defend the peso.” Source (not only for the data on this slide, but some of the other information in this case study): Washington Post National Weekly Edition, pp8‑9, Feb 20‑26 1995, various issues of The Economist in Jan & Feb '95. 1994년 멕시코 정부는 달러의 고갈 사실을 감추고 있었음.

 the disaster  (fixes e at 25 cents instead of 29 cents) Dec. 20: 멕시코 정부는 페소를 13% 평가 절하함 (fixes e at 25 cents instead of 29 cents) 투자자들의 충격 shocked ! ! ! …중앙은행의 달러 잔고 고갈을 알게됨… , 멕시코 페소의 투매. Dec. 22: 중앙은행의 고정환율제 포기 일주일 사이 페소는 30%추가 하락.

구제금융 1995: 미국과 IMF의 50억 대출. 멕시코 경제의 신뢰 회복. 1995년 이후 안정적 성장 지속. The case study on pp.330-331 gives more detail on the peso crisis.

변동환율제도 vs. 고정환율제도 변동환율제도 (floating rates): 통화정책이 환율안정이라는 목적이외의 다양한 목표로 (stable growth, low inflation)사용될 수 있다. 고정환율제도(fixed rates): 불확실성과 변동성을 피함으로써 국제간 거래의 안정성 확보 억제된 통화정책으로 과잉 통화공급 및 초 인플레이션을 막을수 있음.

Mundell-Fleming 모형과 총 수요곡선 먼델-플레밍 모형은, 이제껏 P 가 고정되어 있음을 가정. Next: 총수요곡선을 도출하기 위해 가격변화가 M-F model에 미치는 영향 분석. We now write the M-F equations as: Net exports really depend on the real exchange rate, not the nominal exchange rate. Earlier in the chapter, we wrote NX as a function of the nominal rate, because the price level was assumed fixed, so the nominal & real rates always moved together. But now, with the price level changing also, we need to write NX as a function of the real exchange rate. (Earlier in this chapter, P was fixed, so we could write NX as a function of e instead of .)

Deriving the AD curve  Y 왜 AD 곡선은 negative slope를 가지는가: 2 1 P LM*(P2) LM*(P1) 왜 AD 곡선은 negative slope를 가지는가: IS* 2 1 P  (M/P )  LM shifts left Y2 Y1 Y P   P2 Like figure 12-12 on p.336, except here we are showing what happens to Y when P increases (not falls). The derivation of the open economy AD curve is very similar to that of the closed economy AD curve (see chapter 11).  NX P1  Y AD Y2 Y1

장기. 단기 분석   가격하락 압력이 발생한다. 1 2 시간이 지남에 따라 p 가 하락 (M/P ) NX  Y  IS* AD LRAS LM*(P2) P2 SRAS2 LM*(P1) 가격하락 압력이 발생한다. 1 2 시간이 지남에 따라 p 가 하락 (M/P )   NX  Y  P1 SRAS1 Figure 12-13 on p.337. Suggestion: Have your students draw the two panels of the diagram on this screen, with the economy in an initial equilibrium with output equal to its natural rate. Then, have them use their diagrams to analyze the short-run and long-run effects of a negative IS* shock.

대국개방경제 많은 국가들이 폐쇄 경제와 소국 개방경제의 중간이다. 통화팽창정책: Like in a closed economy, M > 0  r  I (though not as much) Like in a small open economy, M > 0    NX (though not as much) For more details, see the Appendix to chapter 12 (not included in this PowerPoint presentation).

Chapter summary the IS-LM model for a small open economy. 1. Mundell-Fleming model the IS-LM model for a small open economy. takes P as given can show how policies and shocks affect income and the exchange rate 2. Fiscal policy affects income under fixed exchange rates, but not under floating exchange rates.

Chapter summary affects income under floating exchange rates. 3. Monetary policy affects income under floating exchange rates. Under fixed exchange rates, monetary policy is not available to affect output. 4. Interest rate differentials exist if investors require a risk premium to hold a country’s assets. An increase in this risk premium raises domestic interest rates and causes the country’s exchange rate to depreciate.

Chapter summary 5. Fixed vs. floating exchange rates Under floating rates, monetary policy is available for can purposes other than maintaining exchange rate stability. Fixed exchange rates reduce some of the uncertainty in international transactions.