Short Run Open Economies

Question 1

What is the main difference between the classical and SR open economy models?

Answer 1

Prices P and P* are (exogenously) fixed so changes to ε map one-to-one to changes to e
π^e also assumed exogenously fixed so there is a fixed i* = r* + π^e

Question 2

How is output determined in the SR open economy?

Answer 2

The CB can set M to determine M/P to get a money market eqm but money demand L(i, Y) will change via income to attain the global nominal interest rate so output is given by the intersection of LM curve (from closed economy) and i = i* in (Y, i) space
Y determined without goods market (no IS)

Question 3

What is the effect of a monetary expansion?

Answer 3

Shifts LM downward which increases output
Perfect capital mobility ensures higher M –> higher Y to inflate money demand so that i = i* maintained
Analogous to quantity theory with fixed V = 1/I(i*) and fixed P so M and Y are directly linked

Question 4

What is the role of the IS curve?

Answer 4

Since eqm Y is determined by CB policy and r*, the IS must shift to match this eqm via and adjustment of e
If IS were to the right of this point, there would be upward pressure on r leading to positive NCF, foreign capital attraction to home drives up home currency so e appreciates so NX falls so IS shifts in

Question 5

What is the Mundell-Fleming model?

Answer 5

The SR (Keynesian) model of the open economy, where the money market determines Y for a given M/P, then e adjusts to ensure the goods market eqm is the same as this (as long as e can freely adjust)
Have money market (LM), goods market (IS), and BoP (r = r*) eqm

Question 6

How can the goods market eqm be represented graphically?

Answer 6

On a (Y, e) graph, LM is a vertical line at Y, the intersection with downward sloping IS gives e

Question 7

What would be the effect of a fall in the global interest rate?

Answer 7

From the money market, a contraction along the LM curve would mean a lower Y (fall in r increases money demand so contraction needed to maintain M/P)
In the goods market in (Y, e) space LM shifts left and IS shifts right so there is nominal appreciation (lower r* makes home more attractive to foreign speculators leading to capital inflow which appreciates e which lowers NX so Y falls until it reaches the new money market eqm, could equivalently graph IS with money market eqm)
Consumption falls as Y has fallen, I increases as r* is lower, NX falls because e has appreciated
From IS eqn, |ΔNX|>|ΔI|

Question 8

When does the fixed M and flexible e Mundell-Fleming model apply?

Answer 8

For many OECD economies today (if the Eurozone is considered a single economy) but not the historical cases where e has been pegged or viewing Eurozone as fixing e for members

Question 9

What determines output when e is fixed?

Answer 9

The goods market from IS relation with dependence on r and e
Graphically on (Y, e) plot, there is a horizontal line at e = ē which will intersect any IS at Y*
This means that M must adjust so that the money market eqm is the same
Graphically, LM must shift to meet the intersection of IS and i = i* on a (Y, i) plot

Question 10

What is the implication of the Mundell-Fleming model with pegged e for monetary policy?

Answer 10

Active monetary policy is impossible
If CB wanted to expand M, the fixed Y would mean there is downward pressure on i (no realised change in i = i*) in the money market leading outward capital flow so CB has to buy currency to maintain peg which takes home currency out of the money supply so previous M/P restored

Question 11

What are the pros and cons of a fixed exchange rate?

Answer 11

Allows for imported inflation-fighting credibility (fixed e seen as commitment to watching π, some Euro countries saw improved π after joining Euro possibly by “inheriting” credibility, but Argentina’s currency board failure shows risks) and stable prices can promote trade (but global trade increased after end of Bretton Woods) but devaluation can only come through price cuts which is particularly important if ε overvalued when peg initiated

Question 12

How would you analyse overvaluation in the Mundell-Fleming model with a pegged exchange rate?

Answer 12

On a (Y, e) graph, ē may be pegged at some level above the ẽ which would bring output to full capacity (so NX external deficit likely), if prices are slow to adjust this situation will persist, fiscal expansion can remove output gap in SR but won’t fix trade deficit (internal but not external balance)

Question 13

What are the crisis risks associated with a pegged e when it comes with a CA deficit?

Answer 13

Plot of budget surpluses against CA surpluses suggests Eurozone countries replaced deficient NX with high G which could have led to Eurozone debt crisis
There could also be a currency crisis as a CA deficit requires a NCF surplus and investors fearing devaluation may require a risk premium (r = r* + θ) which can worsen a negative output gap (by IS relation) which can increase the actual risk of a devaluation as there is political and fiscal pressure to raise Y

Question 14

What do changes to the Mundell-Fleming model imply about the relative effectiveness of monetary and fiscal policy?

Answer 14

When e is floating, M is controllable so the CB can determine Y in the money market (monetary expansion increases Y by entire horizontal shift in (Y, e) LM curve, greater than closed economy, which will raise C, depreciate e, and leave I unchanged meaning monetary policy works solely through an exchange rate channel in a small fixed-price open economy) and the goods market must adjust to meet this so fiscal policy will only impact e (ΔG = -ΔNX) unless the CB accommodates the fiscal expansion
When e is fixed, monetary policy can’t be used actively but fiscal expansion raises Y by ΔG/(1 - c) so only G and C increase, with M adjusting to restore money market eqm

Question 15

How could a government allow for fixed e and active monetary policy?

Answer 15

Instituting capital restrictions so that BoP can be attained at different values of r

Question 16

What is the impossible trinity?

Answer 16

The idea that the government can choose any two from fixed exchange rate, monetary activism, and free capital flows
UK, US, Japan don’t have fixed e, Denmark, Bulgaria, Eurozone (ish) don’t have monetary independence, China doesn’t have free capital mobility

Question 17

How do capital controls work?

Answer 17

They restrict the FDI and PI components of NCF so that official sector flows are a policy tool
Because of the restriction on NCF, the CB can set r ≠ r*

Question 18

Under what conditions are capital mobility restrictions more effective?

Answer 18

When NX > 0 so gov should fix ē to get this and then can control r as desired, effectively leaving IS-MP/LM model
NX > 0 (and therefore NCF ≤ 0 via official sector) needed because this ensures foreign capital is coming in so the CB can endlessly save up foreign reserves (like PBOC recycling trade surpluses as official-sector capital outflows 2000-2010 as exporters exchanged forex earnings for domestic currency at the CB which can then invest abroad)
If NX < 0, the CB is losing reserves until they have none

Question 19

How would the effects of capital restrictions vary between an undervalued and overvalued exchange rate?

Answer 19

Undervalued ē => NX surplus, CB probably sets r > r* to keep Y close to Ȳ despite high NX so they accumulate reserves and sustain undervaluation at cost of unrealised investment so MPK > MPK*
Overvalued ē => NX deficit, CB probably sets r < r* to keep Y close to Ȳ despite low NX so reserves deplete to exhaustion at which point the peg must be abandoned or capital inflows must be allowed which would lead to r increasing

Question 20

What are the issues with capital controls?

Answer 20

By the second international accounting identity not every country can have a “sufficiently depreciated” e
There are risks of competitive devaluation and episodic crises

Question 21

How can barriers to trade be included in the Mundell-Fleming model?

Answer 21

Summarising tariffs, quotas, and product standards in a parameter of NX so that greater import restrictions correspond to greater ζ which lowers NX, allowing NX schedule to be shifted for fixed e

Question 22

What are the effects of using trade barriers?

Answer 22

With a floating exchange rate, any increase in NX from an increase in ζ will be offset by an appreciation, with lower imports and exports but no net change, since Y is fixed in the money market
With a fixed exchange rate, tariffs can increase output by ΔNX/(1-c), which is particularly helpful for a country with an overvalued peg (when capital controls are unsustainable)
However when adding a foreign response variable ζ* the effect on trade becomes ambiguous
LR effects on Ȳ need to be considered