Biz cycle open economy outline
In Part 6 we focused on the closed economy. Understanding the workings of the closed
economy before moving on to study the open economy is useful because most of
the key mechanisms in the closed economy are also present in the open economy.
However, in some important respects openness to international trade in goods and capital
does change the way the macroeconomy works. For this reason openness may signillcantly
all'ect the scope lor and the ellects of macroeconomic policy. It is therefore time now
to put the spotlight on the open economy.
One important insight which will emerge from our study of the open economy is that
the short-run macroeconomic dynamics and the effects of monetary and fiscal policy will
depend on the exchange rate regime. In Chapter 24 we will consider a fixed exchange rate
regime where the central bank intervenes in the foreign exchange market to keep the
nominal exchange rate fixed. Chapter 25 will study a llexible exchange rate regime where
the exchange rate is determined by the forces of supply and demand in the foreign
exchange market.
In the present chapter we derive some important economic relationships prevailing
under both exchange rate regimes. The analysis will allow for the possibility that the
exchange rate may change over time, as it typically does under llexible exchange rates
(outside long-run equilibrium). Ifthe exchange rate is actually fixed, one can simply set
the nominal exchange rate equal to a constant in all the relationships presented in this
chapter \<\lith out invalidating any of our conclusions.
We will start by documenting the trend towards increased international economic integration
and by laying out our key assumptions regarding the open economy. Section 2 then
considers the implications of openness for the formation of nominal and real interest rates.
Follm<Ving this, Section 3 explains how international trade and capital mobility allects the
economy's aggregate demand curve. and Section 4 discusses the modelling oft he aggregate
supply side in the open economy. Section 5 confronts the aggregate supply curve with the
aggregate demand curve to characterize the long-nm equilibrium in the open economy.
The analysis in this chapter will set the stage for the next two chapters where we \<Viii
use our AS-AD model lor the open economy to highlight the characteristics of alternative
exchange rate regimes, as a prelude to the discussion ofthe choice of exchange rate regime
in Chapter 26.
This chapter develops a model of aggregate demand and aggregate supply for an open
economy. The economy is assumed to be so small that it cannot significantly affect macroeconomic
conditions in the rest of the world. It is also assumed to be specialized in the sense
that the goods produced domestically are imperfect substitutes for the goods produced
abroad. Tt; is means that the price of domestic goods can vary relative to the price of foreign
goods. A third important assumption is that capital is perfectly mobile across borders.
2. Under perfect capital mobility the arbitrage behaviour of risk neutral investors will enforce
uncovered nominal interest rate parity. This implies that the domestic nominal interest rate will
be equal to the foreign nominal interest rate plus the expected percentage rate of depreciation
of the domestic currency against the foreign currency. If a group of countries moves
towards credibly fixed exchange rates, the interest rate differentials between them will
therefore tend to vanish.
3. In the forward market for foreign exchange investors can buy or sell foreign currency for future
delivery. The arbitrage behaviour in the forward market enforces covered nominal interest rate
parity. This means that the domestic nominal interest rate equals the foreign nominal interest
rate plus the forward foreign exchange premium. The latter is defined as the percentage
difference between the forward exchange rate and the current spot market exchange rate.
Covered and uncovered interest rate parity will hold simultaneously if the forward exchange
premium equals the expected rate of change in the exchange rate over the period considered.
This equal ty must hold if investors are risk neutral.
4. The real exchange rate is the price of foreign goods relative to the price of domestic goods.
The real eY.change rate is inversely related to the international terms of trade. The percentage
change in the real exchange rate equals the percentage rate of depreciation of the nominal
exchange rate plus the difference between the foreign and the domestic rate of producer
price inflation. In long-run equilibrium the real exchange rate must be constant, implying that
relative purchasing power parity (RPPP) must hold. Under RPPP the rate of depreciation of
the nominal exchange rate equals the difference between the domestic and the foreign
inflation rate.
5. When capital is perfectly mobile, relative purchasing power parity implies that in the long run
the domestic real interest rate is tied to the foreign real interest rate. This long-run relationship
is referred to as real interest rate parity and tends to hold empirically.
6. The trade balance is the difference between exports and imports of goods and services, also
denoted net e)ports. When the Marshaii-Lerner condition is met, a depreciation of the real
exchange rate will improve the trade balance. The Marshaii-Lerner condition requires that the
sum of the numerical price elasticities of export and import demand exceeds unity.
7. The short-run aggregate demand curve in the open economy implies a negative relationship
between the rate of domestic producer price inflation and the aggregate demand for
domestic goods. The reason is that higher domestic inflation will, ceteris paribus, erode the
international competitiveness of domestic producers. The higher the price elasticities of
export and import demand, the stronger is the reaction of net exports to a change in the real
exchange rate, and the flatter is the aggregate demand curve in the output-inflation space.
When the economy is out of long-run equilibrium, the short-run aggregate demand curve will
gradually shift as the real exchange rate changes over time.
8. The properties of the short-run aggregate supply curve in the open economy will depend on
whether there is relative wage resistance or real wage resistance. Under real wage resistance
wage setters have a target for the real consumer wage, defined as the nominal wage rate
supply curve will shift when the real exchange rate changes, as workers respond to
changing import prices by adjusting their nominal wage claims. Real wage resistance will exist
when nominal unemployment benefits are indexed to consumer prices.
9. Under relative wage resistance individual wage setters seek to maintain a certain relation
between their own wage rate and the wages set in the rest of the economy. Such behaviour
emerges when nominal unemployment benefits are indexed to nominal wages, and it leads to
an aggregate supply curve of the same form as the SRAS curve for the closed economy. The
specification of aggregate supply adopted here assumes relative wage resistance since
indexation of unemployment benefits to wages is the most common international practice.
10. The open economy's long-run aggregate demand curve (LRAD) shows the relationship
between real output and the real exchange rate which is consistent with long-run equilibrium
in the market for domestic goods. The LRAD curve is upward-sloping in the output-real
exchange rate-space since a real exchange rate depreciation increases total demand for
domestic goods by improving the international competitiveness of domestic producers.
11. Under relative wage resistance the open economy's long-run aggregate supply curve (LRAS)
is vertical at the natural rate of output. The long-run equilibrium level of output is then uniquely
determined by the position of the LRAS curve, and the long-run equilibrium real exchange rate
is found where the LRAD curve intersects the LRAS curve.
12. Our AS-AD model of the open economy implies that the long-run equilibrium values of the real
interest rate, the real exchange rate and real output and employment will be independent of
the exchange rate regime. In the long run the exchange rate regime is thus neutral with
respect to real variables. The proposition that the exchange rate regime is neutral in the long
run should be seen only as an approximation, since the exchange rate regime may have some
influence on the degree of international economic integration.
13. When there are wealth effects on aggregate demand, the accumulation of net foreign assets
via the current account on the balance of payments will influence the evolution of the economy. In a long run equilibrium without secular growth, the current account balance
measured in units of domestic output must then be zero to ensure constancy of the real stock
of net foreign assets. However, the evidence suggests that in practice it takes a very long time
for current account imbalances to adjust via wealth effects of domestic demand, suggesting
that these effects are quite weak. To simplify the analysis, our AS-AD model of the open
economy therefore ignores wealth effects stemming from the current account.
economy before moving on to study the open economy is useful because most of
the key mechanisms in the closed economy are also present in the open economy.
However, in some important respects openness to international trade in goods and capital
does change the way the macroeconomy works. For this reason openness may signillcantly
all'ect the scope lor and the ellects of macroeconomic policy. It is therefore time now
to put the spotlight on the open economy.
One important insight which will emerge from our study of the open economy is that
the short-run macroeconomic dynamics and the effects of monetary and fiscal policy will
depend on the exchange rate regime. In Chapter 24 we will consider a fixed exchange rate
regime where the central bank intervenes in the foreign exchange market to keep the
nominal exchange rate fixed. Chapter 25 will study a llexible exchange rate regime where
the exchange rate is determined by the forces of supply and demand in the foreign
exchange market.
In the present chapter we derive some important economic relationships prevailing
under both exchange rate regimes. The analysis will allow for the possibility that the
exchange rate may change over time, as it typically does under llexible exchange rates
(outside long-run equilibrium). Ifthe exchange rate is actually fixed, one can simply set
the nominal exchange rate equal to a constant in all the relationships presented in this
chapter \<\lith out invalidating any of our conclusions.
We will start by documenting the trend towards increased international economic integration
and by laying out our key assumptions regarding the open economy. Section 2 then
considers the implications of openness for the formation of nominal and real interest rates.
Follm<Ving this, Section 3 explains how international trade and capital mobility allects the
economy's aggregate demand curve. and Section 4 discusses the modelling oft he aggregate
supply side in the open economy. Section 5 confronts the aggregate supply curve with the
aggregate demand curve to characterize the long-nm equilibrium in the open economy.
The analysis in this chapter will set the stage for the next two chapters where we \<Viii
use our AS-AD model lor the open economy to highlight the characteristics of alternative
exchange rate regimes, as a prelude to the discussion ofthe choice of exchange rate regime
in Chapter 26.
This chapter develops a model of aggregate demand and aggregate supply for an open
economy. The economy is assumed to be so small that it cannot significantly affect macroeconomic
conditions in the rest of the world. It is also assumed to be specialized in the sense
that the goods produced domestically are imperfect substitutes for the goods produced
abroad. Tt; is means that the price of domestic goods can vary relative to the price of foreign
goods. A third important assumption is that capital is perfectly mobile across borders.
2. Under perfect capital mobility the arbitrage behaviour of risk neutral investors will enforce
uncovered nominal interest rate parity. This implies that the domestic nominal interest rate will
be equal to the foreign nominal interest rate plus the expected percentage rate of depreciation
of the domestic currency against the foreign currency. If a group of countries moves
towards credibly fixed exchange rates, the interest rate differentials between them will
therefore tend to vanish.
3. In the forward market for foreign exchange investors can buy or sell foreign currency for future
delivery. The arbitrage behaviour in the forward market enforces covered nominal interest rate
parity. This means that the domestic nominal interest rate equals the foreign nominal interest
rate plus the forward foreign exchange premium. The latter is defined as the percentage
difference between the forward exchange rate and the current spot market exchange rate.
Covered and uncovered interest rate parity will hold simultaneously if the forward exchange
premium equals the expected rate of change in the exchange rate over the period considered.
This equal ty must hold if investors are risk neutral.
4. The real exchange rate is the price of foreign goods relative to the price of domestic goods.
The real eY.change rate is inversely related to the international terms of trade. The percentage
change in the real exchange rate equals the percentage rate of depreciation of the nominal
exchange rate plus the difference between the foreign and the domestic rate of producer
price inflation. In long-run equilibrium the real exchange rate must be constant, implying that
relative purchasing power parity (RPPP) must hold. Under RPPP the rate of depreciation of
the nominal exchange rate equals the difference between the domestic and the foreign
inflation rate.
5. When capital is perfectly mobile, relative purchasing power parity implies that in the long run
the domestic real interest rate is tied to the foreign real interest rate. This long-run relationship
is referred to as real interest rate parity and tends to hold empirically.
6. The trade balance is the difference between exports and imports of goods and services, also
denoted net e)ports. When the Marshaii-Lerner condition is met, a depreciation of the real
exchange rate will improve the trade balance. The Marshaii-Lerner condition requires that the
sum of the numerical price elasticities of export and import demand exceeds unity.
7. The short-run aggregate demand curve in the open economy implies a negative relationship
between the rate of domestic producer price inflation and the aggregate demand for
domestic goods. The reason is that higher domestic inflation will, ceteris paribus, erode the
international competitiveness of domestic producers. The higher the price elasticities of
export and import demand, the stronger is the reaction of net exports to a change in the real
exchange rate, and the flatter is the aggregate demand curve in the output-inflation space.
When the economy is out of long-run equilibrium, the short-run aggregate demand curve will
gradually shift as the real exchange rate changes over time.
8. The properties of the short-run aggregate supply curve in the open economy will depend on
whether there is relative wage resistance or real wage resistance. Under real wage resistance
wage setters have a target for the real consumer wage, defined as the nominal wage rate
supply curve will shift when the real exchange rate changes, as workers respond to
changing import prices by adjusting their nominal wage claims. Real wage resistance will exist
when nominal unemployment benefits are indexed to consumer prices.
9. Under relative wage resistance individual wage setters seek to maintain a certain relation
between their own wage rate and the wages set in the rest of the economy. Such behaviour
emerges when nominal unemployment benefits are indexed to nominal wages, and it leads to
an aggregate supply curve of the same form as the SRAS curve for the closed economy. The
specification of aggregate supply adopted here assumes relative wage resistance since
indexation of unemployment benefits to wages is the most common international practice.
10. The open economy's long-run aggregate demand curve (LRAD) shows the relationship
between real output and the real exchange rate which is consistent with long-run equilibrium
in the market for domestic goods. The LRAD curve is upward-sloping in the output-real
exchange rate-space since a real exchange rate depreciation increases total demand for
domestic goods by improving the international competitiveness of domestic producers.
11. Under relative wage resistance the open economy's long-run aggregate supply curve (LRAS)
is vertical at the natural rate of output. The long-run equilibrium level of output is then uniquely
determined by the position of the LRAS curve, and the long-run equilibrium real exchange rate
is found where the LRAD curve intersects the LRAS curve.
12. Our AS-AD model of the open economy implies that the long-run equilibrium values of the real
interest rate, the real exchange rate and real output and employment will be independent of
the exchange rate regime. In the long run the exchange rate regime is thus neutral with
respect to real variables. The proposition that the exchange rate regime is neutral in the long
run should be seen only as an approximation, since the exchange rate regime may have some
influence on the degree of international economic integration.
13. When there are wealth effects on aggregate demand, the accumulation of net foreign assets
via the current account on the balance of payments will influence the evolution of the economy. In a long run equilibrium without secular growth, the current account balance
measured in units of domestic output must then be zero to ensure constancy of the real stock
of net foreign assets. However, the evidence suggests that in practice it takes a very long time
for current account imbalances to adjust via wealth effects of domestic demand, suggesting
that these effects are quite weak. To simplify the analysis, our AS-AD model of the open
economy therefore ignores wealth effects stemming from the current account.
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