🗊Презентация The is–lm model in an open economy

CHAPTER 6: THE IS–LM MODEL IN AN OPEN ECONOMY

The IS–LM Model in an Open Economy Openness has three distinct dimensions: Openness in goods markets. Free trade restrictions include tariffs and quotas. Openness in financial markets. Capital controls place restrictions on the ownership of foreign assets. Openness in factor markets. The ability of firms to choose where to locate production, and workers to choose where to work.

A good index of openness is the proportion of aggregate output composed of tradable goods—or goods that compete with foreign goods in either domestic or foreign markets. A good index of openness is the proportion of aggregate output composed of tradable goods—or goods that compete with foreign goods in either domestic or foreign markets.

The main factors behind differences in export ratios are geography and country size: The main factors behind differences in export ratios are geography and country size: Distance from other markets. Size also matters: The smaller the country, the more it must specialize in producing and exporting only a few products and rely on imports for other products.

When goods markets are open, domestic consumers must decide not only how much to consume and save but also whether to buy domestic goods or foreign goods. When goods markets are open, domestic consumers must decide not only how much to consume and save but also whether to buy domestic goods or foreign goods. Central to the second decision is the price of domestic goods relative to foreign goods, or the real exchange rate.

Nominal exchange rates between two currencies can be quoted in one of two ways: Nominal exchange rates between two currencies can be quoted in one of two ways: As the price of the domestic currency in terms of the foreign currency. As the price of the foreign currency in terms of the domestic currency.

The nominal exchange rate is the price of the foreign currency in terms of the domestic currency. The nominal exchange rate is the price of the foreign currency in terms of the domestic currency. An appreciation of the domestic currency is a decrease in the price of the foreign currency in terms of the domestic currency, which corresponds to a decrease in the exchange rate. A depreciation of the domestic currency is an increase in the price of the foreign currency in terms of the domestic currency, or a increase in the exchange rate.

When countries operate under fixed exchange rates, that is, maintain a constant exchange rate between them, two other terms used are: When countries operate under fixed exchange rates, that is, maintain a constant exchange rate between them, two other terms used are: Revaluations, rather than appreciations, which are decreases in the exchange rate, and Devaluations, rather than depreciations, which are increases in the exchange rate.

Note the two main characteristics of the figure: Note the two main characteristics of the figure: The trend decrease in the exchange rate—there was a depreciation of the pound vis-à-vis the euro over the period. The large fluctuations in the exchange rate—there was a very large appreciation of the pound at the end of the 1990s, followed by a large depreciation in the following decade.

Let’s look at the real exchange rate between Kazakhstan and USA. Let’s look at the real exchange rate between Kazakhstan and USA. If the price of a Ford in USA is $50,000 and dollar is worth 350 tenge, then the price of a Ford in tenge is $50,000 X 350 = KZT17.5 millions. If the price of a Chevrolet in the Kazakhstan is KZT 5 millions, then the price of a Ford in terms of Chevrolet would be KZT 17.5 millions/KZT5 millions = 3.5. To generalize this example to all of the goods in the economy, we use a price index for the economy, or the GDP deflator.

Like nominal exchange rates, real exchange rates move over time. Given that real exchange rate is price of foreign good in terms of domestic good: Like nominal exchange rates, real exchange rates move over time. Given that real exchange rate is price of foreign good in terms of domestic good: An decrease in the relative price of foreign goods in terms of domestic goods is called a real appreciation, which corresponds to a decrease in the real exchange rate, . A increase in the relative price of foreign goods in terms of domestic goods is called a real depreciation, which corresponds to an increase in the real exchange rate, .

Note the two main characteristics of Figure 6.4: Note the two main characteristics of Figure 6.4: The large nominal and real appreciation of the pound at the end of the 1990s and the collapse of the pound in 2008–2009. The large fluctuations in the nominal exchange rate also show up in the real exchange rate.

Bilateral exchange rates are exchange rates between two countries. Multilateral exchange rates are exchange rates between several countries. Bilateral exchange rates are exchange rates between two countries. Multilateral exchange rates are exchange rates between several countries. For example, to measure the average price of UK goods relative to the average price of goods of UK trading partners, we use the UK share of import and export trade with each country as the weight for that country, or the multilateral real UK exchange rate.

Equivalent names for the relative price of foreign goods vis-á-vis Kazakhstan goods are: Equivalent names for the relative price of foreign goods vis-á-vis Kazakhstan goods are: The real multilateral Kazakhstan exchange rate. The Kazakhstan trade-weighted real exchange rate. The Kazakhstan effective real exchange rate.

6.2 Openness in Financial Markets The purchase and sale of foreign assets implies buying or selling foreign currency—sometimes called foreign exchange. Openness in financial markets allows: Financial investors to diversify—to hold both domestic and foreign assets and speculate on foreign interest rate movements. Allows countries to run trade surpluses and deficits. A country that buys more than it sells must pay for the difference by borrowing from the rest of the world.

6.2 Openness in Financial Markets (Continued) The balance of payments account summarizes a country’s transactions with the rest of the world. It consists of current account and capital account. The current account balance and the capital account balance should be equal, but because of data gathering errors they aren’t. For this reason, the account shows a statistical discrepancy.

6.2 Openness in Financial Markets (Continued) record payments to and from the rest of the world are called current account transactions: The first two lines record the exports and imports of goods and services. UK residents receive investment income on their holdings of foreign assets and vice versa. Countries give and receive foreign aid; the net value is recorded as net transfers received.

6.2 Openness in Financial Markets (Continued) The sum of net payments in the current account balance can be positive, in which case the country has a current account surplus, or negative—a current account deficit. A positive current account balance indicates that the nation is a net lender to the rest of the world, while a negative current account balance indicates that it is a net borrower from the rest of the world.

6.2 Openness in Financial Markets (Continued) A capital account shows the net change in physical or financial asset ownership for a nation. The capital account balance, also known as net capital flows, can be positive (negative) if foreign holdings of US assets are greater (less) than US holdings of foreign assets, in which case there is a capital account surplus (deficit). Negative net capital flows are called a capital account deficit. The numbers for current and capital account transactions are constructed using different sources; although they should give the same answers, they typically do not. The difference between the two is called the statistical discrepancy.

6.2 Openness in Financial Markets (Continued) The decision or whether to invest abroad or at home depends not only on interest rate differences but also on your expectation of what will happen to the nominal exchange rate.

6.2 Openness in Financial Markets (Continued) If both UK bonds and US bonds are to be held, they must have the same expected rate of return, so that the following arbitrage relation must hold:

6.2 Openness in Financial Markets (Continued) The assumption that financial investors will hold only the bonds with the highest expected rate of return is obviously too strong, for two reasons: It ignores transaction costs. It ignores risk.

The relation between the domestic nominal interest rate, the foreign nominal interest rate and the expected rate of depreciation of the domestic currency is stated as: The relation between the domestic nominal interest rate, the foreign nominal interest rate and the expected rate of depreciation of the domestic currency is stated as:

This is the relation you must remember: Arbitrage implies that the domestic interest rate must be (approximately) equal to the foreign interest rate plus the expected depreciation rate of the domestic currency. This is the relation you must remember: Arbitrage implies that the domestic interest rate must be (approximately) equal to the foreign interest rate plus the expected depreciation rate of the domestic currency. If , then

Should you hold UK bonds or US bonds? Should you hold UK bonds or US bonds? It depends whether you expect the pound to depreciate vis-á-vis the dollar over the coming year. If you expect the pound to depreciate by more than 3.0%, then investing in UK bonds is less attractive than investing in US bonds. If you expect the pound to depreciate by less than 3.0% or even to appreciate, then the reverse holds, and UK bonds are more attractive than US bonds.

6.3 The IS Relation in an Open Economy (Continued)  

6.3 The IS Relation in an Open Economy (Continued)

6.4 The LM Relation in an Open Economy

6.5 Putting Goods and Financial Market Together in an Open Economy Figure 6.11 The IS–LM model in an open economy An increase in the interest rate reduces output both directly and indirectly (through the exchange rate): the IS curve is downward sloping. Given the real money stock, an increase in output increases the interest rate: the LM curve is upward sloping.