WEEK 5 - Macroeconomic Policies in Open Economy

Question 1

What is the objective of open economy macroecon policy?

Answer 1

To reach both internal and external balance

Question 2

What is Internal and External Balance?

Answer 2

Internal Balance:

• Steady growth of economy
• Low unemployment rate
• Mkts in equilibrium
• Resources efficiently used

External Balance:
- Achieve desired trade balance or desired international capital flows

Question 3

What is the IS/LM/BP model also known as?

Answer 3

Mundell-Flemming model

Question 4

What is the IS curve?

Answer 4

-> Goods market equilibrium
The quantity of goods and services supplied is equal to
the quantity demanded

Question 5

What is the LM curve?

Answer 5

-> Money Market Equilibrium

The willingness to hold money is equal to the quantity of money supply

Question 6

What is the BP curve?

Answer 6

->BoP equilibrium

The current account deficit is equal to the capital account surplus, so that the official settlements equals to zero

Question 7

What does the equilibrium in three markets look like?

Answer 7

LOOK AT GRAPH IN NOTES

Question 8

What is the key assumption to the IS-LM-BP (Mundell-Flemming Model)

Answer 8

1. Small open economy so that: i = i* (interest rate = foreign interest rate) (Perfect capital mobility)
2. Perfect substitutability of assets

Question 9

What are the assumptions in deriving the IS Curve?

Answer 9

Income leakages = domestic spending injections
S + T + IM = I + G + X
Savings + Tax + IM = Investment + Govt Spending + Exports
- S depends on income
- With higher income people tend to save more
T arbitrarily set by Govt
IM depends on income
- Higher income => IM up
- Higher Interest => Higher costs of borrowing and hence decrease willingness to invest
- G arbitrarily set by Govt
- X depends on foreign income
-> If people in trading partner countries are wealthier, tend to buy more from us

Question 10

How do we derive the IS Curve?

Answer 10

the various combinations of i and Y that satisfy the equality in the
equation (Income leakages = Domestic spending injections)

• > Every point on the IS curve represents an equilibrium in the goods market.
• > IS curve is downward sloping
• > If interest rate falls, ->investment projects become more profitable.
• > So, investment increases.
• > More investment spending will create more production and generate more income

SEE DERIVATION GRAPH IN NOTES.

Question 11

What are the key elements when deriving the LM Curve?

Answer 11

Money Supply = Money Demand

Ms = Md (i,Y)

Question 12

What are the elements of MS and MD?

Answer 12

MS money supply is fixed (by the central bank, BoE)
->The money supply curve is vertical

MD function of (Y) and interest rate (i). (Downward sloping)
->Higher income: people will hold more cash as the amount of
transactions increases with their income. (Positive Relationship with MD)

-> Higher interest rate: Opp cost of holding cash increase, people less likely to hold cash (Inverse relationship with MD)

Question 13

How do we derive the LM model?

Answer 13

->Suppose that the market is initially in an equilibrium, an increase in income will increase the demand for money.
->But, since the amount of money supplied is fixed, it would cause an excess demand for money at the same interest rate.
->Thus, interest rate must rise to discourage cash holding and bring the
market to a new equilibrium

SEE DERIVATION GRAPH

Question 14

What is the BP curve?

Answer 14

->the combinations of I and Y that yield balance of payments equilibrium.
->the BP curve is drawn for a given domestic price level,
a given exchange rate, and
a given net foreign debt.

Question 15

When does Equilibrium occur?

Answer 15

Occurs when Current A surplus (CS) equal to Capital Account Deficit (KD)

SEE DERIVATION GRAPH IN NOTES

Question 16

How does capital mobility affect the BP curve?

Answer 16

• > If capital perfectly mobile, BP curve horizontal
• > If capital not perfectly mobile then BP curve upward sloping
• > If perfectly immobile then BP vertical

(Higher interest -> Current Account able to sustain higher deficit

Question 17

What variables shift the 3 curves?

Answer 17

IS -> Domestic prices, Exchange Rates, G and T

LM -> Change in MS

BP -> Change in perception of asset substitutability

Question 18

What entails Macroeconomic policy? (Dif Elements of Fiscal Policy)

Answer 18

Fiscal Policy:
G and T
-> When G>T, govt run budget deficit (Expansionary Fiscal Policy
-> When G FISCAL POLICY ADJUSTS THE IS CURVE

Question 19

What entails Macroecnomic Policy? (Dif elements of Monetary Policy)

Answer 19

• > Increase money supply = Expansionary Monetary Policy
• > Decrease Monetary Policy = Contractionary Monetary Policy

-> Monetary Policy shifts LM Curve

Question 20

Why is Monetary Policy ineffective under Fixed Exchange Rates? (Assuming Perfect Capital Mobility)

Answer 20

->Suppose the central bank increases the money supply.
->LM shifts to the right.
->At e’, the good market and the money market are in equilibrium.
->Interest rate falls and income rises.
->Large capital outflow
->Large official settlements deficit
->Pressure the domestic currency to depreciate.
->To peg, the central bank has to buy domestic currency and sell foreign
currency.
->Buying domestic currency will decrease the money supply.
->Move the LM back to its original location.

Making it ineffective

(LOOK AT GRAPH FOR CLEARER VIEW)

Question 21

Why can Fiscal Policy be seen as effective under Fixed Rates? (Assuming Perfect Capital Mobility)

Answer 21

->Suppose that government uses an expansionary Öscal policy.
->IS curve shifts to the right.
->Income rises and interest rate rises (at e’)
->Large capital account surplus (because of higher i)
->Official settlements become a surplus.
->Pressure the domestic currency to appreciate.
->To peg, the central bank has to buy foreign currency and sell domestic
currency.
->Increase the money supply.
->LM shifts to the right.

SEE GRAPH IN NOTES

Question 22

What can be seen by using Monetary Policy under Floating Exchange Rates? (Assuming perfect capital mobility)

Answer 22

• > Suppose the central bank increases money supply.
• > LM shifts to the right.
• > Income rises and interest rate falls (at e’).
• > Large current account deficit
• > Official settlements deficit
• > Domestic currency depreciates.
• > Currency depreciation makes domestic exports become relatively cheaper.
• > An increase in exports shifts the IS curve to the right.
• > New equilibrium (e’): income rises and i = iF

SEE GRAPH IN NOTES

Question 23

Why can fiscal policy be seen to be ineffective under Floating Rates? (Assuming Perfect Capital Mobility)

Answer 23

->Suppose that the government uses an expansionary fiscal policy.
->IS curve shifts to the right.
Income rises and interest rate rises (at e’).
->Capital account surplus (because domestic i > iF).
->Official settlements surplus
->The domestic currency appreciates.
->An appreciation of the domestic currency shifts the IS curve to the left.
->Return to the original equilibrium point.

SEE GRAPH IN NOTES

Question 24

What is the Macroeconomic Trilemma?

Answer 24

Authorities can only choose between one of three things to focus on:

1. Fixed Exchange Rate
2. Free Movement of Capital
3. Monetary Independence

Question 25

APPLYING IS-LM-BP: Asian Financial Crisis )PT 1

Answer 25

• > In 1997, investors perceived that assets in Thailand were riskier than other countries.
• > To defend the fixed exchange rate, the Bank of Thailand had to buy Thai baht and sell dollar reserves.
• > This would reduce the money supply, shifting LM to the left.
• > Domestic interest rate rose sharply - discourage investment -> income falls.
• > Thailand went into a deep recession

SEE GRAPH FOR THIS

Question 26

APPLYING IS-LM-BP: Asian Financial Crisis: PT 2

Answer 26

• > In July 1997, Thai government decided to allow the exchange rate to float.
• > The sharp depreciation of Thai baht improved the country’s competitiveness in exporting goods.
• > The IS curve shifts to the right.
• > The recovery began.
• > Income and employment started to rise

SEE GRAPH FOR THE IMPROVEMENT