ECON 208 - Week 6

• Assumes a small open economy with perfect mobility. Interest rate in this economy is determined by the world interest rate r=r*

• The goods market is represented by   Y = C(Y-T) + T(r) + G + NX(e)

• e = the nominal exchange rate. The amount of foreign currency per unity of domestic currency e.g. 100 yen per euro.

• E = real exchange rate. Relative prices of goods at home and abroad. e.g. price of mars bars in Tokyo per price of a mars bar in Frankfurk. 

NX(E) = S - I(r*). 

S or I don't depend on E. So net capital outflow is vertical.

E adjusts to equal NX with net capital outflow

Demand: foreigners needs pounds to buy UK exports.

Supply: the net capital outflow (S-I) is the supply of pounds to be invested abroad. 

IS

Goods market equlibrium

Y= C(Y-T) + I(r*) + G + NX(e). 

Downward sloping because as e falls, NX increases and Y increases

LM

Money market equlibirum

M/P = L(r*, Y)

Vertical because the exchange rate isn't in the equarion. Given r*, there is only one value of Y that equated money supply with demand. 

• The central bank increases the money supply. Price level is fixed so this means an increase in real money balances.
• Shifts LM* to the right.
• Raises income
• Lowers exchange rate. 
• Output must rise to restore equilibirum in the money market. 

Expansionary monetary policy does not raise world aggregate demand, it shifts demand from foreign to domestic products. The increase in income and employment at home comes at the expense of losses abroad. 

Suppose the government imposes an import tariff which reduces the demand for imported goods:

• Increase in imports
• IS* shifts to the right
• e apperiates 
• Y is the same. 

Import restrictions cannot reduce a trade deficit . Even though NX is unchanged there is less trade - an appreciation in e reduces exports (SPICED). Import restrictions save some jobs in domestic producing industries but destory jobs in export-producing sectors. Failing to increase total employment and it creates 'sectoral shifts' which causes frictional unemployment.

Suppose the government increases public spending.

• IS* curves shifts to the right.
• e appreciates 
• Y is the same because it does not effect GDP.

Fiscal policy crowds out net exports by causing the exchange rate to appreciate. 

• Expansionary shifts IS* to the right.
• To keep e stable, the central bank increase money supply 
• Output increases

Central bank wants to increase the money supply - buying bonds from the public. 

• LM* curve shifts to the right.
• To reduce the downward pressure on e - bank will have to reduce the money supply

By fixing the exchange rate, the central bank gives up control of the money supply.

The government implements import restrictions.

• Shifts IS* to the left
• To stop e increasing, LM* must shift to the right.
• Increases output
• Increases NX.
• Gains come at the expsense of other countries