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Prof.

Fei DING
The Hong Kong University of Science and Technology

ECON 2123: Macroeconomics

IS-LM IN OPEN ECONOMY

PREVIOUSLY
Ch19: The Goods Market in an Open Economy

LEARNING OBJECTIVES
Define and derive the equilibrium in the goods market in an open economy using
two approaches.

Explain the effects of domestic shocks, foreign shocks, and real depreciation on
domestic output and trade balance.

WHATS MISSING?

So far we take exchange rate as exogenous.

But it is not!

How are exchange rates determined in the FOREX


market?

How can policy makers affect exchange rates?

Ch20: Output, the Interest Rate,


and the Exchange Rate

LEARNING OBJECTIVES

Define and derive the open economy IS and LM relations.

Understand how equilibrium output, interest rate, and exchange rate are jointly
determined in open economies.

Explain the pros, cons, and policy roles under flexible and fixed exchange rates.

THE DEPRECIATION OF YEN AND WON

Fri May 10, 2013 (Reuters) The yen weakened past 100
per dollar (now 1 USD 122 Yens), giving Japanese Prime
Minister Shinzo Abe a symbolic victory for his easy money
policies, with markets bracing for further declines in the
currency that could raise tensions with trading partners.

9 May 2013 (BBC News) Bank of Korea cuts interest rates


to spur economy. South Korea has cut interest rates in a
surprise move aimed at boosting growth and countering the
weak Japanese yen. Its central bank, the Bank of Korea,
lowered its benchmark rate from 2.75% to 2.5%, the first cut
in seven months.
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QUOTE OF THE DAY

IS-LM MODEL IN AN OPEN ECONOMY


The exchange rate in an open economy plays an
important role, linking goods and financial markets.

In Ch19, exchange rate was taken as a policy


tool/instrument controlled by the government.

Now we study how exchange rate is endogenously


determined in the goods and financial markets.
Can the exchange rate be controlled by the government?
If yes, how? If no, why not?
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THE IS RELATION IN OPEN ECONOMY

THE IS RELATION IN OPEN ECONOMY

IS relation: goods market equilibrium How


different demands affect the equilibrium Y.

In an open economy,

plays a role in the IS

relation.

Both the Real Interest Rate (r) and Real Exchange


Rate ( ) affect the demand for domestic goods.
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THE IS RELATION IN OPEN ECONOMY


The IS-LM focuses on the short-run situations and
assumes exogenous/fixed (domestic and foreign)
price levels.

Real and nominal exchange rates and interest


rates move one-for-one.

Therefore, Y is determined by nominal i and E:

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THE LM RELATION IN OPEN ECONOMY


Money vs. bonds in a closed economy:
How about in an open economy?
Good news! Same

The LM helps to determine the i in the economy.


In an open economy, there is an additional choice
between domestic and foreign assets (bonds).
The exchange rate matters again!
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DOMESTIC VS. FOREIGN BONDS


Compare the expected return when choosing
between domestic vs. foreign bonds. At the
equilibrium, UIP holds.

Rearrange the terms and assume exogenous


(given) expected exchange rate:

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DOMESTIC VS. FOREIGN BONDS

E (current exchange rate) depends on domestic


interest rate, foreign interest rate, and expected
future exchange rate.

EXAMPLE: domestic interest rate


E if

unchanged

Why?
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DOMESTIC VS. FOREIGN BONDS

For example, the Fed adopts contractionary monetary


policy, so i in the US increases.

Given higher return on US bonds, investors switch


from foreign bonds to US bonds.

This means investors switch from foreign currency to


USD, so USD must appreciate.

Given unchanged i* and expected E, changes in i


lead to immediate changes in E.
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DOMESTIC VS. FOREIGN BONDS


Numeric example
Return on HK/US bonds = 2%; E = 7.8 (1 USD for 7.8 HKD)
Sudden increase in US bonds return = 5%

Switch from HK to US bonds and sell HKD for USD.


E = (1.05/1.02)7.8 8.03 (immediate 3% appreciation of USD)

Why would a current 3% USD appreciation bring back the


equilibrium?
Recall: How can different interest rates co-exist in the market?
Investors must expect 3% USD deprecation next period!

assumed unchanged (at 7.8), how can USD depreciate?


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DOMESTIC VS. FOREIGN BONDS


EXAMPLE (2): Expect exchange rate increases (so
domestic currency will be more expensive).

Based on the equation: E must increase.


Why?
Investors switch away from foreign bonds.
More domestic currency is wanted as a result.
Given unchanged i and i*, expectations about future
appreciation will lead to current appreciation.
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DOMESTIC VS. FOREIGN BONDS


Numerical example
Returns on US bonds and Japanese bonds = 2%
E = 100 (1 USD for 100 Yens)

Now expect USD to appreciate by 10% (to 110).


Investors shift away from Japanese bonds to US
bonds and sell yens to buy USD:
E = (1.02/1.02) 110 = 110

To maintain the same interest rates, current E must


reflect future expectations on E.
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RELATION BETWEEN I AND E

Given
When

and

Why a linear curve?

OPEN ECONOMY IS-LM MODEL

Open economy IS relation is more complicated with


the NX term and one more variable E.

One more condition for the exchange rate (based on


the interest parity condition).
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OPEN ECONOMY IS-LM MODEL

The IS curve: When i increases, how would Y change?


Direct effect: same as in a closed economy
Increase in i lowers investment lower demand.

Indirect effect: additional NX effect for open economy


Increase in i appreciation in E decrease in NX

Luckily, both work in the same direction IS curve is


still downward slopping!
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OPEN ECONOMY IS-LM MODEL


Figure 20-2 The ISLM Model in the Open Economy

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FISCAL POLICY IN AN OPEN ECONOMY


EXAMPLE 1: Increase in G
Which curve(s) shift: IS? LM? Interest parity?
Shift right of the IS curve ONLY!
Why?

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FISCAL POLICY IN AN OPEN ECONOMY

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CHANGE OF VARIOUS COMPONENTS

C
I ambiguous (same as in closed economy)
NX , why?
Although Y increases, both government budget
and trade balance deteriorate!
Twin Deficit
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MONETARY POLICY IN AN OPEN ECONOMY


EXAMPLE 2: Monetary contraction
Which curve(s) shift: IS? LM? Interest parity?
Shift up of the LM curve ONLY!
Change of various components:
C?
I?
NX ?
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MONETARY POLICY IN AN OPEN ECONOMY

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FIXED EXCHANGE RATE


Fiscal or monetary policy no only changes Y and i,
but also allows E to freely adjust.

Government can even use fiscal or monetary


policy to affect the E.

Allowing E to freely adjust Flexible exchange


US, UK, Japan, etc.

On the other hand Fixed exchange rate


Example: HK (peg) and China (capital control)
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FIXED EXCHANGE RATE


Fixed does not mean never change.
Government can change the fixed rate when it
is necessary.
Usually, changes are rare.
Consequence of a government changing its fixed rate
often?

Devaluation (fixed) vs. Depreciation (flexible)


Revaluation (fixed) vs. Appreciation (flexible)
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EXAMPLES FIXED EXCHANGE RATE


Peg: 1 USD to 7.8 HKD
Crawling Peg: Try to maintain constant real exchange
rate by allowing E to adjust bit-by-bit slowly.

if domestic inflation consistently higher or lower


than foreign inflation, what happens?

Bands: allow E to adjust within a certain range/band.


When E moves outside the band, the central bank will act
to put it back.

Example: European Monetary System (EMS)


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HOW TO IMPLEMENT FIXED EXCHANGE RATES?

Cannot just announce the value of E!


What must be done to keep the E at the level
chosen by the government?

Again, the Interest Rate Parity:

Peg E at a certain level

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HOW TO IMPLEMENT FIXED EXCHANGE RATES?


Domestic interest rate must follow foreign interest
rate (assuming perfect capital mobility).
HK must follow US interest rate.

So the money market equilibrium becomes

Under fixed exchange rate system, the government


(and its central bank) gives up its monetary policy!

EXAMPLE: Expansionary fiscal policy under fixed E


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HOW TO IMPLEMENT FIXED EXCHANGE RATES?

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EXCHANGE RATE: FIXED OR FLEXIBLE?


Fixed exchange rate no monetary policy
Lose a policy tool to adjust the economy!
Fiscal policy becomes more powerful (because it
triggers monetary accommodation).

No control of domestic interest rate, only follow


foreign interest rate.
What happens when one economy is overheating and
the other is slowing down?
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EXCHANGE RATE: FIXED OR FLEXIBLE?


No control of domestic interest rate, only follow
foreign interest rate.

What happens when one economy is overheating and


the other is slowing down?
Early 1990s in Europe see FOCUS box p.458
HK economy in the early 90s was good, but US economy
was not that good.

US lowered its interest rate to stimulate economy, and HK had to


follow.

What happened to HK? Inflation, stock and property prices shot up!
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EXCHANGE RATE: FIXED OR FLEXIBLE?


We talked about fiscal policy becoming more
powerful under fixed exchange rate.

But if a country wants to decrease its budget


deficit, it cannot use monetary policy to offset the
adverse effect on Y.
Monetary accommodation would amplify the effect of
fiscal policy!

Can you draw me the IS-LM graph to show this?


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EXCHANGE RATE: FIXED OR FLEXIBLE?


i

LM
LM

IS

LM

IS

Y could have stayed the same with the correct monetary policy mix.
But instead, things are made worse to maintain fixed exchange rate.
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TRILEMMA IN INTERNATIONAL FINANCE


The impossible trinity!
1.

A fixed exchange rate

2.

Free capital movement (absence of capital controls)

3.

An independent monetary policy (monetary autonomy)

a: Hong Kong
b: US
c: China
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EXCHANGE RATE: FIXED OR FLEXIBLE?


With all the abovementioned costs, some countries
still adopt fixed exchange rate system.

Usually, these are small and open economies.


Trade activities (export and import) are very important for
their economies.

Fixed exchange rate means less uncertainty from E


fluctuations.

Beneficial and encouraging trade!

For Europe, there are also symbolic and political


reasons.
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REFRESH
1. Which of the following represents the domestic
demand for goods?
A) C + I + G
B) C + I + G + X
C) C + I + G - IM/
D) C + I + G + X - IM/
E) C + I + G + X + IM
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REFRESH
2. Which of the following occurs when the goods market
is in equilibrium?
A) domestic output (Y) equals the demand for domestic goods.
B) Y equals the domestic demand for goods.
C) Y equals the domestic demand for domestic goods.
D) net exports equals 0.
E) demand for domestic goods equals the domestic demand
for goods.
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REFRESH
3. Which of the following must occur in an open
economy?
A) demand for domestic goods will be equal to the domestic
demand for goods
B) demand for domestic goods will be greater than the
domestic demand for goods
C) demand for domestic goods will be less than the domestic
demand for goods
D) S + T = I + G
E) none of the above
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TRUE, FALSE, OR UNCERTAIN?


1.

The national income identity implies that budget


deficits cause trade deficits.

2.

A fiscal expansion tends to increase net export.

3.

Fiscal policy has a greater effect on output in an


economy with fixed exchange rates than in an economy
with flexible exchange rates.

4.

Other things being equal, the interest parity condition


implies that the domestic currency will appreciate in
response to an increase in the expected exchange rate.
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TRUE, FALSE, OR UNCERTAIN?


5.

If financial investors expect the dollar to depreciate


against the yen over the coming year, one-year interest
rates will be higher in the US than in Japan.

6.

If the Japanese interest rate is equal to zero, foreigners


will not want to hold Japanese bonds.

7.

Under fixed exchange rates, the money stock must be


constant.

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TRUE, FALSE, OR UNCERTAIN?


1.

Opening the economy to trade tends to increase the


multiplier because an increase in expenditure leads to
more exports.

2.

The reduction in foreign demand leads to a


deterioration of the homes trade balance because it
reduces domestic demand for goods, including
imported goods.

3.

Ignoring the difference between trade balance and


current account balance, a trade deficit implies that
the country is lending to the rest of the world.
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NOW WE ARE DONE!

Assigned reading:

Suggested exercises for Ch. 20:

Textbook, Chap. 20 (Appendix is optional)

Textbook end-of-chapter questions 1-6

Have a good study break. Good luck on the


final exam!

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