Lecture Note on Open Economy

Macroeconomic (MSc/MA Class)

Outline of the Lecture
 (i) Background about Open Econ Theory
 (A) the MF [MFM] Model
 (B) Weeks’ Heterodox Critique of MF model in LDCs
 (ii) Aggregate SS and the Armington Approach
 (iii) Exchange rate Models &The Overshooting Model
 (iv) Application: African and Global Modelling [AFRIMOD]

 Alemayehu Geda
Dept. of Economics,
Addis Ababa University, 2023-2024
web : www.Alemayeh.com
I. Background to the Theories

I. Background to the
Theories
I. Background to the Theories

I. Background to the
Theories
 OPEN ECONOMY
MACROECONOMICS

Prof. Alemayehu Geda

Guest Lecture (UoN)

School of Economics
University of Nairobi

.
Lecture 1
Objectives:

1. Extend the closed economy IS-LM model to include

the external sector.
2. Evaluate the relevance of fiscal and monetary policies
at the disposal of policy makers.
3. Analyze how the domestic economy performs, given
the international macroeconomic conditions.
4. Carry out quantitative analysis of various
polices/shocks to the economy vis-a-vis the extended
IS-LM model.
The international conditions sometimes give us
(domestic economy) opportunities and sometimes,
pose threats to us also.

Therefore, the more an economy is integrated into

the global village (through globalisation), the more
severe these impacts will be. [Being totally closed is
not a viable option for various reasons]

Growing international interdependence implies

booms and recessions in one country spills over to
other country. [When America sneezes, the world
catches cold!]
Economies are linked through trade & financial flows
and changes in interest &exchange rates. [the latter
two, prices, affect both trade accounts and external
debt/capital account flows.]

For example, the Asian Crisis of 1997-99 was limited

to few countries initially but spread to other countries,
affecting global economic growth. Same with the 2008
Global Crisis in the West We call this & also the
COVID-19 2020 effect
We call them “The Contagion effect”

In this lecture, basic facts (empirical evidence) and

models of international economic linkages are
introduced and discussed.
Growth rates in Export, Commodity price, Terms of Trade (ToT) and Real GDP for
Developing African Economies (GDP Growth in Right Axis) [Source: A.Geda, 2016, JAE]

40 c i al 7
Fi nan
l o b al
G is
30
0 0 8 / 9 c C ri s 6
2 mi
The Econo
20 an d
5

10
4

0
2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014
3
-10

2
-20

1
-30

-40 0

Tot Growth Expor Growth (Value) Commodity Price Growth (All) GDP Growth Linear (GDP Growth)
Only under the fixed exchange rate system, there is
accumulation or de-accumulation of foreign exchange
reserve, which changes Money Supply (Ms), LM curve
shifts to restore final equilibrium.

Money supply becomes endogenous – is not under full

control of the Central bank. It is made up of domestic base
money supply + foreign exchange reserves (BOP
surplus) .
Thus C/Bank cannot carry out independent monetary
policy under fixed exchange rate.
A Critique of Such Money Supply definition called
Modern Moneatary Theory (MMT) & the Post-Keynesian
view of Endogenous Money is discussed in Ch 8
 Revision Material: Under Graduate
level derivation of the IS-LM-BP
framework from Mankiew’a Text Book
is given in the next slides
 Derivation of Net Exports and Investment Saving in an Open Economy
Note: AD
AD (a)
(a) Shows reduction in AD
following an increase in ER ΔNX
(b) Shows investment
saving
balance in an open economy
(c) Shows net export as
a function of the exchange Y1 Y2 Y
rate (c)
(Lower rer=> rise dd for dom (b)
goods=> rise Nx nb
e2
e2
rer=e=en*(Pd/pf)
e1
e1 IS*(e)
NX (e)
y1 Y2
27 NX2 NX1
 IS-LM Model in an Open Economy: Mundell-Fleming Model

LM (y, i)
Exchange

Assumption:
Money supply does not
Rate

depend on exchange rate

e*

IS*

o y Output

28
 IS-LM Model in an Open Economy: Mundell-Fleming Model

LM (y, i)
Exchange

Assumption:
Money supply does not
Rate

depend on exchange rate

e*

IS*

o y Output

29
Impact of Fiscal Policy under Fixed and Flexible Exchange Rate Systems

Flexible Exchange Rate System

Fixed Exchange Rate System
LM LM1
LM2

e2
IS*’
e

e1 IS*’
IS* IS*

Y1 Y2
Y
No Impact of Fiscal Policy Full Impact of Fiscal Policy
30
Impact of Monetary Policy under Fixed and Flexible Exchange Rate Syste

Flexible Exchange Rate System Fixed Exchange Rate System

LM LM1
LM2
e2

e
IS*’
e1

IS* IS*

Y1 Y2 Y1 Y2
Full Impact of Monetary Policy
No Impact of Monetary Policy
31
Trade Policy under Flexible Exchange Rate Systems

Flexible Exchange Rate System Fixed Exchange Rate System

LM LM1
LM2
e2

e
IS*’
e1

IS* IS*

Y1 Y2 Y1 Y2
Full Impact of Monetary Policy
No Impact of Monetary Policy
32
 Trade Policy under Fixed Exchange Rate Systems

Flexible Exchange Rate System Fixed Exchange Rate System

LM LM1
LM2
e2

e
IS*’
e1

IS* IS*

Y1 Y2 Y1 Y2
Full Impact of Monetary Policy
No Impact of Monetary Policy
33
Summary of the MF Model Policy Implications
IB. John Weeks’ Heterodox Critique of MF in
LDCs

IB. John Weeks’ Heterodox

Critique of MF in LDCs
 John Weeks’ Critique of MF Model in LDC’s

 The MF model states that ..the standard policy rule under flexible
exchange rate regime, with perfectly elastic capital flow monetary policy
is effective and fiscal policy is not
 According to Weeks, the logical validity of the statement requires that the
domestic price level effect of devaluation be ignored, which makes the
theory to be true.
 Thus, Weeks insists, the Mundell-Fleming analysis of a flexible
exchange rate regime would appear to ignore an obvious, simple and
fundamental economic relationship, the impact of depreciation and
appreciation on the price level [Weeks is right, I found for Ethiopia the
elasticity of inflation wrt depreciation is about 2[1.9]
 The complete story is, thus,…an increase in Ms results in trade deficit,
which leads to depreciation. This raises price level via its impact on
imported goods, as the supply of imported goods will diminish.
 Ms  r<r*  capital out flow  depreciation
X, M  CA shift of IS
John Weeks’ Critique of MF Model in LDC’s
 This price increase lowers the real money supply and hence
the outward shift of LM curve is less than what would be
implied by the increase in nominal Ms. Thus, MP would not
be completely effective
 Under flexible exchange rate regime, with perfectly elastic
capital flow the effectiveness of monetary policy depends
on the values of import share and the sum of trade
elasticities as well as the degree of capital mobility
 The price effect of devaluation makes FP effective by the
same degree it makes MP ineffective
 MF is incorrect in theory as well as in practice (Weeks
show this using data of 129 countries (Read Weeks article
in your reading material folder)
 Critique of the MF model by the New Open Economy
Macroeconomics (NOEM) is a PhD level topic….
II. Aggregate Supply Side Issues & the
Marshall-Learner Condition

II. Aggregate Supply Side

Issues and the Marshall-
Learner Condition
II. Aggregate Supply Side Issues
 The objective of this part of the lecture is to show that the open
economy variables , net exports, affects the aggregate economy not
only directly but also indirectly through the sourcing of absorption
(C+I+G).
 The second objective of this part of the lecture is to derive the
Marshall-Learner condition from the first principle. This is
important to show not only the importance of the magnitude of
export and import elasticities but also the initial level of BoP
deficit to make exchange rare policy effective .
 In MF model we normally assume domestic & foreign prices are
constant (ie. P=P*=1, which is a horizontal supply curve.
 This might be true in the short run but we need to add the supply
side to our Mundel-Fleming Model (Mead-Mundel-Fleming
model) – this will give it a micro foundation.
II. Aggregate Supply Side Issues
 For this purpose we use the model of Argy & Salop (1979),
Armington (1969) and Branson and Rotembert (1980) to show
the importance of the supply side issue.
 We restrict our analysis to the case of perfect capital mobility
and flexible exchange rate.
The Armington Approach
 Since we are now modeling the supply side we need to be
precise about the various price indices as well as the source of
goods that are used in the economy.
 Broadly there are two goods (domestic and foreign) with
corresponding prices (domestic and foreign prices). We assumed
these goods to be imperfect substitutes.
II. Aggregate Supply …Cont’d
 Real HH consumption and Investment are determined
by the usual macro relationships
 Regarding the sourcing of these goods Armington
assumed that these goods, say C is “constructed” out of
domestic and foreign goods through Cobb-Douglass
relationships as:
[1]
 Since HH as rational economic agents want to get C as
cheaply as possible they will stand to optimize their
spending function which is given as:
[2]
II. Aggregate Supply …Cont’d*
 The HH can obtain the optimal ration between
domestic and foreign goods by optimizing the
following objective function as:

 [! To be done: work out the optimization from the lecture

here]

 the first order condition for this will offer the following
solution:
= [3]
 II. Aggregate Supply …Cont’d
 The result in equation [3] shows that sourcing consumption
domestically directly related to the foreign to domestic price ratio
(the converse holds for sourcing from foreign countries)
 Solving Eqn [3] for EP*Cf and inserting the result into the objective
function Eqn [2] (&similar procedure for EP*Cf)yields:

and [4]
 Again substituting this result into the CD formulation (Eqn 1) we
can get an expression for the CPI [Pc]:
=
 II. Aggregate Supply …Cont’d
 This implies the CPI [Pc]:
[5]
Where:
 By substituting [5] into [4] and taking C as C=c(Y), we get:

 [6]

 α/(1- α ) Pc C
 Nb: Y raises both Cd & Cf; while EP*/P determines where to buy
goods to be consumed.
 Similar procedure offers similar equation for I & G as:
 II. Aggregate Supply …Cont’d

 [7]

 Depicting real exports by EX - sold at the same domestic price (P), and
spending on imports being EP*(Cf+If+Gf), the NI identity could be given
by:
 II. Aggregate Supply Side Issues

 [8]
Nominal GDP

Real GDP
 II. Aggregate Supply Side Issues
The main message is that by looking deeper on the
sourcing issue we see that RER affects domestic
absorption [Agg DD] (although the very last equation in
[8] seems to show only domestic production enters the
aggregate production measure for the domestic economy

 [8]
 II. Aggregate Supply …Cont’d
The Marshall-Learner Condition
 Let us assume the real net exports are given by:
 [9]
 If we assume further, as before, the demand for exports
depends on real exchange rare (EP*/P)=Q, we have:
 [10]
 Thus, we can have the net export function as:
[11]
 Where M is based on Eqns [6] and [7]
Absorption
 Note the following that follows from Eqn [11]:
 II. Aggregate Supply …Cont’d
From Eqn [11] follows:
 (1) Domestic absorption, not just aggregate demand, appears in the
net export function or Eq [11]
 (2) Since domestic absorption depends on interest rate and some
investment goods are imported, the BP curve has a positive slop even
under imperfect capital mobility. [eg r  I M of IfNTrade
surplus To restore equilibrium on NTrade Y (& hence M) must
rise [M,Y ]
 Having Eqn [11] we can now be more precise abou the Marshall-
Lerner condition by differentiating Eqn [11] wrt Q and dividing
through by Y, holding A+G constant. This gives:
 II. Aggregate Supply …Cont’d
= [12]
Where:
;
 -are the domestic output share of exports & imports, respectively
 This expression shows that net exports improve as a result of a real
exchange rate depreciation if the following condition holds:
[13]
 Or if the trade balance is initially in equilibrium and thus imports
and exports are of magnitude and hence Wm=Wx equation [13]
could be written as:
same
 II. Aggregate Supply ….Cont’d

 Thus, Eqn [13], ie the condition for the improvement in NX,

will be true only if the above condition [Eqn 14] is satisfied.
 This is what is referred as the Marshall-Learner condition: Only
when the sum of the elasticity of imports and exports is greater than
1 deprecation/devaluation could improve the trade balance not.
 Note that this condition requires initial equilibrium if so we do not

get this result (! Many African countries are in BoP disequilibrium)

 Read John Weeks’ critique of this theory and the MF model (! John

says the theory is wrong and this doesn’t hold in LDCs’ at all)
III. A Brief Look at Exchange rate
Models [& The Dornbusch Model]

Exchange Rate Models/Theories

[& The Dornbusch Model]
IIIB. The Overshooting Model
[The Dornbusch Model]

IIIB. The Overshooting Model [The

Dornbusch Model]
 The Dornbusch/Overshooting..Cont’d*

 l

 T

 * Thus, owing to the goods market price stickiness and the money (exchange rate) market flexibility, the change in
exchange rate overshoots its long run value – and hence the name overshooting model. the Exchange rate
over shoots its long run value
The Dornbusch (Overshooting) Model…
 Thus,
 it is the model of exchange rate behavior under flexible
exchange rate regime aims at showing the presence of efficient
financial market. (Dornbusch, 1976; 1980)
 It also aims to address dynamics of exchange rate movement and
inflation.
 The model is based on the presumption that the financial
markets responds very quickly to news while the goods market
response is sluggish/sticky.
 This will lead to significant amount of exchanger rate volatility
that includes the overshooting of the exchange rate (a temporary
rise or fall in exchanger rate unwarranted by the change in
economic events/ fundamentals)
 The model is an extension of the previous MF model with the
The Dornbusch (Overshooting) Model…
 a) there is the perfect myopic foresight variant of rational expectation
in the market
 b) there is log run money (or policy) neutrality as in the monetary
approach to the BoP
 Thus, it is a capital account approach to the exchange rate
determination (as E responds to inflow/outflows of Capital)
 This means in the short run the goods market respond
slowly to change in the economy which result in the short
run response; while in the long run output returns to its
natural (or non-inflationary) rate which existed prior to the
changes that shocked the economy.
 This means the rise in money supply [due to K-inflow] leads
to equi-proportional increase in domestic prices and
exchange rate, leaving the real exchange rate unchanged
owing to the rise in the money supply.
 The Overshooting Model….Cont’d
 We can get the intuition of the model form the following diagram:
 Price
overvaluation
 PPP
undervaluation
 C G2
 P2 Excess SS
 G1
Excess DD
 P1 A B

 M1 M2

 e1 e0 e2 Exchange rate
 The Overshooting Model….Cont’d
 At the initial equilibrium (A) the MS is give by M1, the domestic
price by P1 and the interest rate by r1 (not shown). The goods market
equilibrium is given by G1 the purchasing power parity condition
which says P=eP* is given by PPP.
 Let us assume unanticipated increase in Ms to M2 at time t1, say by
20%. In the long run every one expects price to go to P2. This enailts
a 20% depreciation of the domestic currency from e1 to e0 to
maintain the long run PPP at C.
 However, the Dornbusch model says things are different in the short
run where prices are sticky and exchanger rate and money market are
not. Thus
 At P1 the increase in MS (from M1 to M2) entails an excess SS of
money that will be willingly be held only if r is lowered from r1 to r2
(not shown)
 The Overshooting Model….Cont’d
 This implies the new domestic interest rate (r2) is lower than r*
  This in turn implies, speculators will require appreciation of the
domestic currency to compensate for the decline in r1 to that of r2
(which is lower than r*).
  For this reason e1 will jump (depreciate) from e1 to e2 at B,
overshooting its long run value of e0 at C…. Why? Because:
  It has to overshoot because it is only by the depreciation by
more than 20% (above e0) that there can be an expected
appreciation of domestic currency to compensate for the lower
interest rate on domestic assets (bonds, the r2).
 There are various forces that bring back the economy back to the
long run point “C” following this monetary policy and short run
event that put the economy at “B”.
 The Overshooting Model….Cont’d
 (1st ) the lower interest rate encourages investment and hence agg
DD
 (2nd ) The depreciation of the exchange rate to e2 encouraged exports
and discourage imports (and hence raises Agg DD)
 This shifts Agg DD from G1 to G2.
 As output is fixed this will lead to a rise in price form P1 to P2; and
also an exchange rate appreciation from e2 to e0.
 (Expected appreciation is matched by actual appreciation)
 Over time the economy movers to C where e0, P2, M2 &G2 prevail.
 In the mean time interest rate rises from r2 to its original level r1 (not
shown in the figure) – so once again there is neither an expected
appreciation nor depreciation of the domestic currency.
[See the summary Figure in the next slide - & End of Lecture]
Illustration of overshooting in the Dutch Disease
Context

Eg of showing overshooting in the Dutch Disease Con

 FF AggDD  Pd= (eP*/Pd)  Exports

 Overshooting Occurs here
 The overshooting occurs before the in Pd. This because goods
price are sticky while asset price is flexible. So the anticipated
rise in Pd entails a sharp rise in “e” until the stick price began
rising –can’t rise fast as it is sticky.
 When the price began to rise it will lead to an increase in output
and thus price eventually decline. In tandem with the price
decline the “e” will began to decline (begin appreciation) from its
overshooted level compensating for the declining price –thus
moving towards its long run value where PPP [P=eP*] will hold.
 Dynamics of the Overshooting (Dornbusch)
Model

You may add in our Textbook to be done:
 Application of OEM: My Global Model

 Its Applications abut the Impact of the 2008/09

Economic Crisis on Africa or for AfDB/ECA

IV Application of Open Economics
Macroeconomics in Developing
Countries/Africa

Application of Open Economy

Macroeconomic Policies and
Models in Developing Countries
and Africa
Refer to the New book for this
Refer to the New book for this
Refer to the New book for this
Refer to the New book for this
Refer to the New book for this
Refer to the New book for this
Refer to the New book for this