Macro I Cap 4

Chapter Four
Open Economy Macroeconomics

4.1Extensions of the Basic Model
4.1.1 Exchange Rates & Exchange Rate Regimes
4.1.2 The Balance of Payments (BoP)
4.1.3 Some Open Economy Identities
4.1.4 Open Economy Multipliers
4.1.5 The Marshall–Lerner Condition & the J-
Curve Effect
4.2 Macroeconomic Policy in Open Economy
4.2.1 The IS-LM-BP Model
4.2.2 A Small Open Economy with Perfect Capital
Mobility
04/16/2024 1
CHAPTER FOUR: AGGEGATE DEMAND IN AN
OPEN ECONOMY
1. International flows of Capital Goods

2. Saving and Investment in the Small Open
Economy
3. Exchange rates
4. The Mundell-Fleming model
5. fiscal and monetary policies in an open
economy with perfect capital mobility
Fixed exchange rate
Floating exchange rate
6. Limitations of the Mundell-Fleming model

04/16/2024 2
Introduction
 Open economy macroeconomics is the study of
economies in which international transactions play
a significant role.
 Economies are linked via 2 broad channels:
1. Trade in goods and services
◦ Some of a country’s production is exported
to foreign countries  raise dd for domestically
produced goods.
◦ Some goods consumed/invested at home are
produced abroad & imported  a leakage from
the circular flow of income.
2. Finance
◦ Ethiopian residents can hold Ethiopian
assets OR assets in foreign countries.
04/16/2024 3
Cont,…
 Capital goods are the assets used by businesses in the course
of producing their products and services, and can include
buildings, machinery, tools and equipment.
 Capital resources is a higher-level concept, defined slightly
differently by different scholars.
 Some define capital resources as all the elements of capital
goods plus the funding required to start and/or run a business.
 Others define it as only the man-made items that go into
business production (excluding, for example, natural
resources such as oil, minerals and timber).
 Examples of capital resources would be: money to start a
business; buildings; an office’s copying machine (but not the
one in your house); and a garage mechanic’s wrench (but not
the one in your personal garage).
04/16/2024 4
Cont, …
Capital flows are transactions involving

financial assets between international
entities.
The two primary types of capital flows
are;
official capital flows and
private capital flows.
04/16/2024 5
Saving and Investment in the Small Open Economy
 In the open economy model, the national income identity is
changed since a given country has international transaction
with the rest of the world.
 The current account measures a country’s trade in

currently produced goods and services, along with
net transfers between countries.
 The components of the current account balance are:
◦ net export of goods and services;
◦ investment income from assets abroad;
◦ current transfers.
04/16/2024 6
Cont, …..
 Merchandise trade is trade in goods and services

◦ A car brought to Ethiopia from Japan is a merchandise
import for Ethiopia.
◦ It is a debit item for Ethiopia (–).
◦ It is a credit item for Japan (+).
 The trade in services includes, for example,
transportation or tourism:
◦ An Ethiopian tourist in Mexico is an import of tourism
services for Ethiopia.
◦ It is a debit item for Ethiopia (–).
◦ It is a credit item for Mexico (+).
04/16/2024 7
Cont, …
 Investment income is interest payments, dividends and

royalties a country’s residents receive from assets owned
abroad.
 NFP and net investment income from abroad are
equivalent concepts.
Current transfers are payments from one country to
another that do not correspond to the purchase of
any good, service or asset.
A transfer of money by a Ethiopian to someone
abroad (perhaps a family member back home) is a
debit item (–) for Ethiopia.
04/16/2024 8
Current Account Balance
The current account balance is obtained by
adding all the credit items and subtracting all the
debit items.
A current account surplus is a positive current
account balance.
A current account deficit is a negative current
account balance.
04/16/2024 9
The Capital Account
The capital and financial account records trade in

existing assets, either real (direct investment) or
financial (portfolio investment).
The financial account records direct and portfolio
investment.
The capital account records migrants’ funds,
inheritances, transaction of intellectual property,
like patents.
04/16/2024 10
Cont, …
If Ethiopia sells an asset to another country it is a
financial inflow for Ethiopia
◦ a credit item (+) in the capital account.
If Ethiopia buys an asset from abroad it is a

financial outflow for Ethiopia
◦ a debit item (–) in the capital account.
04/16/2024 11
The Capital Account Balance
The capital account balance equals the value of
capital inflows (credit items) minus the value of
capital outflows (debit items).
A capital account surplus is a positive capital
account balance.
A capital account deficit is a negative capital
account balance.
04/16/2024 12
The Official Settlements Balance
 The official settlements balance or the balance

of payments is the net increase (domestic less
foreign) in a country’s official reserve assets.
 The official reserve assets are assets used in

international payments.
 The balance of payments can be in surplus or

in deficit.
04/16/2024 13
The Current and the Capital Accounts
The current account (CA) balance and the

capital account (KA) balance must sum to zero
at each period of time (CA + KA = 0).
The statistical discrepancy is the amount to be

added to the sum of CA and KA balances to
reach its theoretical value of zero.
04/16/2024 14
Net Foreign Assets and the Balance of
Payments
Net foreign assets can change when:
◦ the value of existing foreign assets and foreign
liabilities changes, and
◦ the country acquires new foreign assets or
incurs new liabilities.
The net amount of new foreign assets a
country acquires in period of time equals
its current account surplus.
04/16/2024 15
The National Income Accounting Identity
S = I + CA = I + (NX + NFP)
NX = Y – (Cd + Id + G)
and was derived in Chapter 3.

Spvt = (Y + NFP – T + TR + INT) – C
Sgovt = (T – G – TR – INT)
Y= C + I + G + NX
Remember S = Spvt + Sgovt
National saving (S) is used:
◦ to increase the nation’s stock of assets by funding
investment (I);
◦ to increase (decrease) the nation’s stock of net foreign
assets by lending (borrowing) to (from) foreigners (the
available funds are equal04/16/2024
to CA). 16
The Goods Market Equilibrium
The open-economy goods market equilibrium

condition is:
Sd = Id + CA = Id + (NX + NFP)
In an open-economy, goods market equilibrium –
the desired amount of national saving (Sd) – must
equal the desired amount of domestic investment
(Id) plus the amount lent abroad CA.
These are the uses of national saving.
04/16/2024 17
Cont, ….
 Let’s assume NFP is zero.

 Then the open-economy goods market
equilibrium condition is:
Sd = Id + NX
NX = Y – (Cd + Id + G)
 The term in brackets (Cd + Id + G) is called
absorption – the total spending by domestic
residents.
A small open economy is an economy that is too
small to affect the world real interest rate.
 The world real interest rate is the real interest rate
that prevails in the international
04/16/2024 capital market. 18
To sum up:
 Private disposable income:
 Private saving:
 Net Government (public) income:
 Government (public) Saving:
 National Saving:
04/16/2024 19
A Small Open Economy: Assumptions of the Model
The world real interest rate is fixed for a small
open economy. Small economy has no power to
influence world interest rate.
The markets for financial capital are open to all
savers and borrowers regardless of where they
live.
Thus, for a small open economy, the domestic real
interest rate will adjust in the long run to equal the
(expected) world interest rate.
04/16/2024 20
Cont, ….
Inan open economy, desired national saving need

not equal desired investment and in fact this rarely
happens.
Higher values of the world real interest rate (rw)
imply:
◦ lower levels of desired consumption (people save more);
◦ lower desired investment (higher uc).
The reverse is true for lower levels of rw.
Our saving and investment model can be used to
determine the excess between S and I, which we
know is net exports.
04/16/2024 21
Cont, ….
04/16/2024 22
Cont, ….
04/16/2024 23
Economic Shocks in a Small Open
Economy
A change that increases (decreases) desired national
saving at a given world real interest rate (rw) will:
◦ increase (decrease) net foreign lending;
◦ increase (decrease) the current account balance;
◦ increase (decrease) net exports.
As in the closed economy, we can use our saving and
investment relationships to get at goods market
equilibrium.
The key is that Y, the supply of output, and the world
interest rate (rw) are given. Then assuming that we
know G, we can use:
Sd = Id + NX (where NX = CA)
Which implies goods market equilibrium through
Y = Cd + Id + G + NX04/16/2024 24
Cont, …. Key assumptions
The Sd curve is drawn for given levels of Y, wealth,

G and T, all of which can shift Sd.
Similarly, the Id curve is drawn for given levels of

productivity (which will affect MPKf), effective
tax rates, price of capital goods (which will affect
the user cost) all of which can shift Id.
The Sd and Id diagram can be used to examine the

effects of shocks.
04/16/2024 25
A Temporary Adverse Supply Shock
Asevere drought when the CA is in surplus
will cause:
◦ the investment curve to be unaffected, since the
shock is temporary; it is absorbed by CA, since
the shock is temporary.
◦ current income to fall;
◦ saving to fall at every r (the saving curve shifts

left) as people reduce their saving to smooth
consumption (Cd);
◦ net foreign lending and current account surplus

to shrink. 04/16/2024 26
Cont, …
The gap between S and I is

CA, it is either surplus or
deficit.
Above the intersection of S
& I CA is positive
Below the intersection of S
& I, CA is negative
04/16/2024 27
A Permanent Positive Supply Shock
A technological innovation, when the CA is in

surplus will cause: Positive shock increase domestic
capacity to absorbed GDP
◦ the expected future MPKf to increase;
◦ the saving curve to be unaffected;
◦ the domestic capital stock to increase;
◦ desired investment to rise at every r;
◦ net foreign lending and the current account to shrink
(absorption increases). Domestic capacity in C, I and G
increase. 04/16/2024 28
Cont, …
04/16/2024 29
 Foreign exchange/currency – refers all currencies other
than the domestic currency of a given country.
 The foreign exchange market is the international market
in which one national currency is traded for another.
 Exchange rate – price of one country’s currency in terms
of another country’s currency.
 Exchange rates are quoted as:
 Foreign currency per unit of domestic currency
($0.037/ETB1), or
 Domestic currency per unit of foreign currency
(ETB51/$1).
 Which method is employed is not important.
 But, one must be careful when talking about a rise/fall in
exchange rate as the meaning differs depending upon the
definition used.
04/16/2024 30
 Three different exchange rate systems (ERS):
1. Fixed exchange rate system– when exchange rate
determined by the government (market has no role to
determine it). E.g. in Derg regime; 1$=2.07 ETB
 In a fixed ERS, central banks stand ready to buy &
sell the currencies at a fixed ER.
 No one will buy dollars for more than fixed rate as
one can get them for the fixed rate.
 No one will sell dollars for less than fixed rate as
one can sell them for the fixed rate.
 Central banks hold foreign reserves to sell them
when they have to intervene in the foreign
exchange market.
04/16/2024 31
Cont, ….
2. Floating exchange rate system (FERS);

 Under floating ERS, the forces of demand & supply
determine the exchange rate, and central banks do
not intervene.
 Market is sole determinant of exchange rate
between two currencies.
3. Managed floating Exchange rate system (MFERS)
 Both the government and market are responsible to
determine the exchange rate. Managed floating
exchange rate system is the integration of fixed and floating
(flexible) exchange rate system
 Now Ethiopia is good example.
 Government should set the rate and leave it to the
market, and again re-set when it is necessary and
again leave it to the market. Then the process
continued in this way. s04/16/2024 32
04/16/2024 33
Nominal vs Real exchange rate
 Nominal ER: the rate at which one country’s currency
trades for another.
 Real ER: the rate at which g & s of one country trade for g
& s of another.
 Real ER is price of a domestic basket of g & s relative to
price of a foreign basket of g & s.
 Real ER depends on nominal ER & prices of g & s in the 2
countries measured in a currency.
Nominal ER (in DC/FC)  Foreign Price
Real ER 
Domestic Price
e  P*
E
P
Where p* is foreign price; p is domestic price; e is
nominal exchange rate
04/16/2024 34
Important terminologies
 Appreciation/Revaluation: an increase in the value of a
currency as measured by the amount of foreign currency
it can buy.
 In fixed exchange rate system= Revaluation
 In float exchange rate system= Appreciation
 Depreciation/Devaluation: a decrease in the value of a
currency as measured by the amount of foreign currency
it can buy.
 In fixed exchange rate system= devaluation
 In float exchange rate system= Depreciation
04/16/2024 35
Cont, ….
 Real ER is a key determinant of how much a country

exports and imports.
 An appreciation of the Ethiopian real ER means that
Ethiopian goods are becoming more expensive relative
to foreign goods.
 Appreciation of Birr implies that Ethiopia is losing
competitiveness in the global market.
04/16/2024 36
The Balance of Payments (BoP)
 BoP - a summary of the transactions b/n residents
& non-residents of a country with the rest of the
world over a given period
 It is the record of a country’s transactions in goods,
services & assets as well as unilateral transfers
with the rest of the world (ROW);
 BoP is also the record of a country’s sources
(supply) & uses (demand) of foreign exchange.
 International transactions are classified as credits
(+) or debits (–).
 Credit transactions are those that involve the
receipt of payments from foreigners.
 Debit transactions are those that involve the
making of payments to foreigners.
04/16/2024 37
Cont, …
The BoP statistics are divided into 2 main
sections:
the current account (CA) &
the capital account (KA).
The CA items refer to income flows,
The KA records changes in assets & liabilities.
BoP always balances since each credit in the
account has a corresponding debit elsewhere.
While the overall BoP always balances this does
not mean that each individual account in the BoP
necessarily in balance.
CA can be in surplus while KA is in deficit.
04/16/2024 38
BALANCE OF PAYMENTS
A. CURRENT ACCOUNT (CA)
Goods Exports +
Goods Imports –
(1) Net Export of Goods [Visible Trade Balance] ?
Export of Services +
Import of Services –
(2) Net Export of Services (invisible TB) ?
Interest Income, Dividends & Profits received +
Interest Income, Dividends & Profits Paid –
(3) Net Income from Abroad ?
Unilateral Receipts +
Unilateral paid –
(4) Net Unilateral Receipts ?
Balance on CA 04/16/2024 (1 + 2 + 3 + 4)
39
BALANCE OF PAYMENTS
B. CAPITAL ACCOUNT (KA)
(5) Inward Foreign Investment +
(6) Investment Abroad –
(7) Short, Medium & Long Term Borrowing from ROW +
(8) Short, Medium & Long Term Lending to ROW –
(9) Repayments on Loans to ROW –
(10) Repayments on Loans Received from ROW +
Balance on KA (5+6+7+8+9+10)
(11) Changes in Reserves: rise (-), fall (+)
(12) IMF borrowing from (+) Repayments to (–)
Official Financing Balance (OFB) (11+12)
Statistical Errors & Omissions (SEO) 0 – (CA+KA+OFB)
04/16/2024
Official Settlement Balance (OSB) = – OFB or (CA+KA+SEO)
40
Cont…
 The summation of the current account balance and capital

account balance (plus SEO if it is different from zero) gives
the official settlements balance (OSB).
 The balance on this account is important because it shows
what is about to happen to the country's official reserves or
to its debt from the IMF due to official borrowing.
Any official settlements deficit (i.e., the amount by
which OSB [= CA + KA + SEO] falls short of
zero) has to be covered by the authorities drawing
on the reserves, or borrowing money from the IMF
or foreign central banks.
04/16/2024 41
Cont,…
 This fall in reserves or borrowing is recorded as a plus or

credit item in the accounts. If, on the other hand, there is
an official settlements surplus (i.e., OSB > 0), then this
can be reflected by the government increasing official
reserves or repaying debts to the IMF or other sources
overseas (a minus since money leaves the country).
 The fact that reserve increases are recorded as a minus,
while reserve falls are recorded as a plus in the BoP
statistics is usually a source of confusion.
 It is most easily rationalized by thinking that reserves
increase when the authorities have been purchasing the
foreign currency because the domestic currency is strong.
 This implies that the other items in the BoP are in
surplus, so reserve increases have to be recorded as a
debit to ensure overall balance.
04/16/2024 42
Cont, ….
Conversely, reserves fall when the authorities have

been supporting a currency that is weak, that is, all
other items sum to a deficit so reserve falls must be
recorded as a plus to ensure overall balance.
The official financing balance (OFB) is equal in
magnitude but opposite in sign to the official
settlements balance, i.e., OFB = – OSB. If, for
instance, CA + KA + SEO = – 15 or OSB = – 15, it
means that BoP is in deficit of (inflows are less
than outflows for the private agents by) 15 units.
Consequently, the authorities must generate an
inflow of + 15 units (OFB = +15) which comes
from official borrowing from abroad and/or
running down official reserves.
04/16/2024 43
Why we include statistical
discrepancy?
To ensure that credits equal debits
It is an impossible task to keep track of
all the transactions between domestic
and foreign residents;
Many of the reported statistics are
based on sampling estimates derived
from separate sources
04/16/2024 44
Sources of errors
 Some of the transactions in the capital account

are underreported in order to avoid taxes
 Some dishonest firms may deliberately under-
invoice their exports and over-invoice their imports
so as to artificially deflate their profits.
 ‘Leads and lags'
◦ The balance of payments records receipts and
payments for a transaction between domestic and
foreign residents, but it can happen that a good is
imported but the payment delayed. Since the import is
recorded by the customs authorities and the payment
by the banks, the time discrepancy may mean that
the two sides of the transaction are not recorded in
the same set of figures.
04/16/2024 45
4.1.3 Some Open Economy Identities
An additional injection (export expenditure) & an
additional leakage (import expenditure).
 The basic national income identity is:
 Deducting taxation T from both sides:
 Using S = Yd – C and rearranging:
 Upon rearranging: 04/16/2024 46

 Assumptions underlying multiplier analysis:
1. Both domestic prices & Exchange Rate are fixed
2. The economy is at less than full emp’t so that rises in
demand result in expansion of output (Y), &
3. The authorities adjust the money supply (MS) to changes in
money demand (Md) by pegging the domestic interest rate
(r).
 Rises in Y that lead to rise in money demand (Md)
would with a fixed money supply (Ms) lead to rise in
domestic r; as it is assumed that authorities passively
expand Ms to meet rise in Md, r does not change.
 There is no inflation resulting from rise in Ms as it is
merely a response to rise in Md.
04/16/2024 47
Cont…
 Import expenditure is assumed to be partly autonomous and

partly a positive function of the level of domestic income:
M = M a + mY.
where Ma is autonomous import expenditure and m is the
marginal propensity to import, that is the fraction of any
increase in income that is spent on imports.
In this simple formulation import expenditure is assumed to
be a positive linear function of income. There are several
justifications for this.
On the one hand increased income leads to increased
expenditure on imports and also more domestic production
normally requires more imports of intermediate goods.
Since we have assumed that domestic prices are fixed this
means that income Y also represents real income.
It can be also re-written as: M=Ma+m(Y-T).
04/16/2024 48
Cont….
Ifwe substitute equations and M = M a +

m(Y-T) and into the basic identity Y = C + I
+G + X - M , we obtain:
04/16/2024 49
C  Ca  c(Y  T ) M  M a  m(Y  T )
Y  Ca  cY  cT  I  G  X  M a  mY  mT
(1  c  m)Y  Ca  I  G  X  M a  (m  c)T
1
Y [Ca  I  G  X  M a  (m  c)T ]
sm
1
dY  [dCa  dI  dG  dX  dM a  (m  c)dT ]
sm
dY 1 dY 1
 0  0
dG s  m dX s  m
04/16/2024 50
Cont…
What is current account (CA)?

CA = X - M and M = M a + m(Y-T) , we
have:
CA=X-(Ma+m(Y-T))
CA=X-Ma-mY+mT
Substitute Y in the above equation:
1
Y [Ca  I  G  X  M a  (m  c)T ]
sm
04/16/2024 51
CA  X  M CA  X  M a  mY  mT
1
CA  X  M a  m{ [C a  I  G  X  M a  (m  c)T]}  mT
sm
m
CA  X  M a  [C a  I  G  X  M a  (m  c)T]  mT
sm
m
dCA  dX  dM a  [dC a  dI  dG  dX  dM a  (m  c)dT]  mdT
sm
dCA s smm dCA s
 1   0
dX sm sm dX sm
dCA  m
 0
dG s  m 04/16/2024 52
4.1.5. The Marshall–Lerner Condition & the J-Curve Effect
 In this sub-section, we investigate the relationship

between the exchange rate and the BoP.
 In particular, we will study a model that
investigates the impact of exchange rate changes
on the current account position of a country.
 This approach is popularly known as the elasticity
approach.
 This is one of the models designed to tackle one
of the most important questions in international
economics – will a devaluation (or depredation)
of the exchange rate lead to a reduction of a
current account deficit?
04/16/2024 53
In examining the impact of exchange rate changes

according to the elasticity approach, we assume
that both domestic and foreign prices are fixed.
For simplicity, we shall also ignore the
complications of unilateral transfers and interest,
profit and dividends on the current account
balance and concentrate on the export and import
of goods and services.
The exchange rate is defined as domestic currency
units per unit of foreign currency (Birr/$), so that
a devaluation/depreciation of the currency (Birr) is
represented by a rise in the exchange rate
04/16/2024 54
At the outset, the model makes some
simplifying assumptions; the model focuses
on demand conditions and assumes that the
supply elasticities for the domestic export
good and foreign import good are perfectly
elastic, so that changes in demand volumes
have no effect on prices.
In effect, these assumptions mean that
domestic and foreign prices are fixed so that
changes in relative prices are caused by
changes in nominal exchange rate.
04/16/2024 55
 The central message of the elasticity approach is that there
are two direct effects of a devaluation on the current
balance, one of which works to reduce a deficit, whilst the
other actually contributes to making the deficit worse than
before.
 Let us consider these effects in some detail.
04/16/2024 56
04/16/2024 57
04/16/2024 58
04/16/2024 59
 The net effect depends on whether the price or volume
effect dominates (or the MLC is fulfilled).
 The possibility that a devaluation may lead to a worsening
rather than improvement in the balance of payments led to
much research into empirical estimates of the elasticity of
demand for exports and imports.
 A devaluation may work better for industrialized countries
than for developing countries.
 Many developing countries are heavily dependent upon
imports, and their price elasticity of demand for imports is
likely to be very low, while for industrialized countries that
have to face competitive export markets the price elasticity
of demand for their exports may be quite elastic.
 The implication of the Marshall-Lerner condition is that
devaluation may be a cure for some countries' BoP deficits
but not for others.
04/16/2024 60
Cont, ….
A general consensus accepted by most economists is that

elasticities are lower in the short run than in the long run, in
which case the Marshall-Lerner conditions may not hold in
the short run but may hold in the medium to long run.
 The possibility that in the short run the Marshall-Lerner
condition may not be fulfilled although it generally holds
over the longer run leads to the phenomenon of what is
popularly known as the J-curve effect which is illustrated in
the figure below.
04/16/2024 61
Cont,….
 The idea underlying the J-curve effect is that in
the short run export volumes and import volumes
do not change much so that the country receives
less export revenue and spends more on imports
leading to deterioration in the current balance.
 However, after a time lag export volumes start to
increase and import volumes start to decline, and
consequently the current deficit starts to improve
and eventually moves into surplus.
 The issue then is whether the initial deterioration
in the CA is greater than the future improvement
so that overall devaluation can be said to work.
04/16/2024 62
Cont,…..
 There have been numerous reasons advanced to explain
the slow responsiveness of export and import volumes in
the short run and why the response is far greater in the
longer run; four of the most important are:
1. A time lag in consumer responses. It takes time for
consumers in both the devaluing country and the rest of
the world to respond to the changed competitive
situation. Switching away from foreign imported goods
to domestically produced goods inevitably takes some
time because consumers will be worried about issues
other than the price change, such as the reliability and
reputation of domestic produced goods as compared to
the foreign imports. While foreign consumers may be
reluctant to switch away from domestically produced
goods towards exports of the devaluing country.
04/16/2024 63
Cont, …
2. A time lag in producer responses. Even though a devaluation improves

the competitive position of exports, it will take time for domestic
producers to expand production of exportables. In addition, the orders for
imports are normally made well in advance and such contracts are not
readily cancelled in the short run. Factories will be reluctant to cancel
orders for vital inputs and raw materials. Also, payments for many imports
will have been hedged against exchange risk in the forward market and so
will be left unaffected by the devaluation.
3. Imperfect competition. Building up a share of foreign markets can be a
time consuming and costly business. This being the case, foreign exporters
may be very reluctant to lose their market share in the devaluing country
and might respond to the loss in their competitiveness by reducing their
export prices. To the extent that they do this, the rise in the cost of imports
caused by the devaluation will be partly offset. Similarly, foreign-import-
competing industries may react to the threat of increased exports by the
devaluing country by reducing prices in their home markets, limiting the
amount of additional exports by the devaluing country. These effects rely
upon some degree of imperfect competition which gives foreign firms
some super-normal profit margins enabling them to reduce their prices. If
foreign firms were in a highly competitive environment they would only
be making normal profits and so would be unable to reduce their prices 64
04/16/2024
Cont, ….
4. It is unlikely that the price of exports as

measured in the domestic prices will remain
fixed. Many imports are used as inputs for
exporting industries and the increased price of
imports may lead to higher wage costs as workers
seek compensation for higher import prices, this
will to some extent lead to a rise in export prices
reducing the competitive advantage of the
devaluation
04/16/2024 65
4.1.5 The Marshall–Lerner Condition & the J-Curve
Effect
 Devaluation and CA
 Nominal Exchange Rate (= e) is defined (Birr/$)
 e = Devaluation/depreciation of Birr.
CA  X  eM dCA  dX  (edM  Mde)

dCA  dX  edM  Mde Divide by de
dCA dX dM de
 e M
de de de de
 Introduce price elasticity of X & M:
dX / X de
X   dX   X . . X
de / e 04/16/2024
e 66
4.1.5 The Marshall–Lerner Condition (MLC) & the J-Curve
Effect
dM / M de
M    dM   M . .M
de / e e
dCA  X .de. X  M .de.M
 e M
de e.de e.de
 Assuming balanced trade (X = eM) initially:
dCA  X .e.M
   M .M  M
de e
dCA dCA
  X .M   M .M  M  M ( X   M  1)
de de
dCA
0 iff  X   M  1The MLC
de 04/16/2024 67
4.1.5 The Marshall–Lerner Condition & the J-Curve
Effect
 Devaluation has two effects:
 Price effect (Export becomes cheaper & import
becomes more expensive).
 Volume effect (XV increases & MV falls).
 The CA balance improves only if the volume effect
is stronger than the price effect.
 It takes time for XV to rise and for MV to fall.
 MLC may not be fulfilled in the short run although
it generally holds over the long run.
 Reasons for slow short run responsiveness of X V
& MV & greater long run responsiveness:
 A time lag in consumer responses.
 A time lag in producer responses.
 Imperfect competition.
 Domestic prices of 04/16/2024
exports may not remain68
Effect
04/16/2024 69
Macroeconomic equilibrium: Deriving the IS, LM & BP curves
 We now return to our model of income determination.
 Now we will explore how exchange rates and international trade
interact with the behavior of the economy as a whole.
 To do so, we extend the IS-LM model to allow for trade and
lending among nations.
 Recall that the components of the IS-LM model are the IS curve,
which describes goods market equilibrium; and the LM curve,
which describes asset market equilibrium.
 Our extension here takes the IS-LM model to the Mundell-Fleming
model, which is an IS-LM model developed for the case of an open
economy. 4.2.1 The IS-LM-BP Model We shall now examine the
main implications of the Keynesian model for open economy by
using what is known as IS-LM-BP analysis.
 Firstly, we derive the IS, LM and BP schedules that provide the
framework for the analysis. Then, we use the IS-LM-BP model to
analyze the operation of macroeconomic policies in an open
economy. 04/16/2024 70
Cont, …
IS-Curve …already derived previously.

LM-Curve ….already derived previously
BOP curve:
 The BP schedule shows different combination and
income that are compatible with equilibrium in the
balance of payments.
 When referring to the BoP we divide it up into two
sections; the current account and the capital
account.
 Exports are assumed to be independent of the level
of income and the rate of interest, but imports are
positively related to income (M=Ma+mY).
04/16/2024 71
Cont, ….
 As we saw earlier in the chapter, the overall BoP

is made up of the current account (CA), the
capital account (KA) and the change in the
authorities’ reserves (dR).
 By maintaining balance in the supply and
demand for the currency – that is, the external
balance – we mean that there is no need for the
authorities to have to change their holdings of
foreign exchange reserves.
 This implies that if there is a CA deficit there
needs to be an offsetting surplus in the KA (and
vice versa) so that BoP equilibrium requires no
change in authorities’ foreign
04/16/2024
reserves (dR = 0). 72
Cont,….
04/16/2024 73
Cont,….
 Since exports are determined exogenously and imports are a
positive function of income, the higher the level of national
income the smaller will be any CA surplus or the larger any
CA deficit. Put differently, increases in income lead to a
deterioration of the current account.
 The CA surplus/deficit requires to an equal capital flow of
the opposite sign. With a CA surplus there is a required
capital outflow (K < 0), to ensure BoP equilibrium, while a
CA deficit, requires a capital inflow (K > 0).
 A higher interest rate is needed to encourage a net capital
inflow whereas a lower interest rate encourages a net capital
outflow.
 Hence, the BP schedule is upward-sloping because higher
levels of income cause a deterioration in the CA, which
necessitates a higher capital inflow (or a reduced capital
outflow) requiring a higher interest rate.
04/16/2024 74
Cont, ….
 Every point on the BP schedule shows a combination of
income and rate of interest for which the overall BoP is in
equilibrium.
 At points to the left of the BP schedule (for example, S in
the figure below) the overall BoP is in surplus because for a
given r (and thus for a given amount of capital flows), the
CA is better than that required for equilibrium as the level of
income is lower.
 Conversely, to the right of the BP schedule the overall BoP
is in deficit as the income level is higher than that
compatible with overall equilibrium.
04/16/2024 75
Cont, …..
04/16/2024 76
Cont,….
 At this point it is worth noting that the slope of the BP schedule is

determined by the degree of capital mobility internationally; the higher
the degree of capital mobility then the flatter the BP schedule.
 This is because for a given increase in income which leads to a
deterioration of the current account, the higher the degree of capital
mobility the smaller the required rise in the domestic interest rate to
attract sufficient capital inflows to ensure overall equilibrium.
 When capital is perfectly mobile, the slightest rise in the domestic
interest rate above the world interest rate leads to a massive (infinite)
capital inflow making the BP schedule horizontal at the world interest
rate.
 At the other extreme, if capital is perfectly immobile internationally then
a rise in the domestic interest will fail to attract capital inflows making
the BP schedule vertical at the income level that ensures current account
balance. Between these two extremes, that is, when we have an upward-
sloping BP schedule, we say that capital is imperfectly mobile
04/16/2024 77
04/16/2024 78
Cont,….
 In the figure above, the income level Yl is seen to be less

than that of the full employment level of income Yf ,
implying that there is some unemployment in the economy.
 Although the economy is not in internal equilibrium, the
BoP is in equilibrium because the IS and LM schedules
intersect at a point on the BP schedule.
 If the IS and LM schedules in the figure above intersect
above the BP schedule, there is a BoP surplus. This surplus
comes about because, at a given level of income, the rate
of interest is too high to be compatible with overall
equilibrium.
 Conversely, if the IS and LM schedules intersect below the
BP schedule, there is a BoP surplus since, at a given level
of income, the rate of interest is too low to be compatible
with overall equilibrium.
04/16/2024 79
Macroeconomic Policies in a Small Open Economy with Perfect
Capital Mobility
 In the Mundell-Fleming model we take the prices as fixed as in the
classical IS-LM model. Therefore, our model should be considered a
short-run model. Since the prices are fixed (in the domestic economy
and also in the international markets), the nominal exchange rate moves
in the same direction as the real exchange rate. This implies that an
increase in the nominal exchange rate (measured as Birr/$) will
increase the trade balance, NX, assuming that the MLC holds. Though
the analysis can be easily generalized to other cases, here we will
consider only the case of a small-open economy. Specifically, we make
two main assumptions:
1. Perfect Capital Mobility: there are no restrictions on international
trade in assets. Furthermore, domestic and international bonds are
perfect substitutes. This means that they have the same features in
terms of risk, maturity etc.
 2. Small-Open Economy: a small-open economy is an economy that is
too small to affect the world prices of any good. This implies that the
trade volume is too small compared to the international level.
Furthermore, since a small-open economy cannot affect the world
prices, it cannot affect also the world interest rate
04/16/2024 80
Cont,….
 The first assumption implies that in the domestic country it must be true
that the domestic interest rate equals the world interest rate: r = r*.
 The second assumption implies that a small-open economy takes the
world interest rate as given (= exogenous).
 Any attempt to raise the domestic interest rate leads to a massive capital
inflow to purchase domestic bonds pushing up the price of bonds until
the interest rate returns to the world interest rate.
 Conversely, any attempt to lower the domestic interest rate leads to a
massive capital outflow as international investors seek higher world
interest rates. Such massive bond sales mean that the domestic interest
rate immediately returns to the world interest rate so as to stop the
capital outflow.
 The implication of perfect mobility is that the BP schedule for a small
open economy is a horizontal straight line at r = r*. Let us now consider
the effectiveness of monetary and fiscal policy measures to influence
the level of income under alternative exchange rate regimes.
04/16/2024 81
Deriving the IS, LM & BP curves:
1. IS:
C  C a  c(Y  T) I  I a  br M  M a  mY  mT
Y  Ca  cY  cT  I a  br  G  X  M a  mY  mT
(1  c  m)Y  Ca  (m  c)T  I a  G  X  M a  br
1
r   [(1  c  m)Y  Ca  (c  m)T  I a  G  X  M a ]
b
 Slope of IS curve: dr (1  c  m)

dY b
 Shifters of the IS curve: Ca, Ia, G, X?, T, Ma
04/16/2024 82
2. LM:
 (M/P)S = (M/P)D
M D 1 M
( )  kY  hr r  (kY  )
P h P
dr k
 Slope of LM: 
dY h
 Shifters of the LM curve: M, P?.
3. BP:
 External Balance: balance in the ss of & dd for
the currency with no need for the authorities to
change their holdings of forex reserves.
 This implies that if there is a CA deficit there
needs to be an offsetting surplus in the KA (and
vice versa) so that dR =04/16/2024
0. CA = – KA 83
With exogenous exports & imports a positive
function of Y, higher level of Y implies smaller CA
surplus or larger CA deficit.
 Net capital inflow (K) is a positive function of
domestic interest rate (r).
 Assuming that the rate of interest in ROW (r*) is
fixed, higher r implies greater capital inflow or
smaller capital outflow.
 K > 0 indicates a net inflow of funds, whereas K

< 0 indicates a net outflow of funds.
 BP curve shows various combinations of Y & r
for which BoP is in eqlm:
X  M  K (r  r*)  0
04/16/2024 84
 A CA surplus requires a K outflow to ensure BoP
eqlm; a CA deficit requires a K inflow.
 High r encourages a net capital inflow while low
r encourages a net capital outflow.
 High YCA deficitK inflow neededhigh r.
 At points to the left of the BP schedule the overall
BoP is in surplus since for a given K flow (a given
r) the CA is better than that required for eqlm as
the level of Y is lower.
 To the right of the BP schedule the overall BoP is
in deficit as Y is higher than that compatible with
overall eqlm.
 The slope of the BP schedule is determined by the
degree of K-mobility internationally; higher the
degree of K-mobility, flatter BP schedule.
04/16/2024 85
04/16/2024 86
 This is because for a given increase in Y which
leads to CA deterioration, the higher the degree
of K-mobility the smaller the required rise in r
to attract sufficient K inflows to ensure overall
equilibrium.
 When K is perfectly mobile, slightest rise in r
above r* leads to a massive K-Inflow making
the BP schedule horizontal at r*.
 If K is perfectly immobile, then a rise in r will
fail to attract K inflows making BP curve
vertical at Y that ensures CA balance.
 Between these two extremes, i.e., when we have
an upward-sloping BP schedule, we say that
capital is imperfectly mobile.
04/16/2024 87
CA   KA X  M a  mY   g (r  r*)
1
r  [ M a  mY  gr *  X ]
g
 Shifters of the BP curve: X?, Ma, r*.
04/16/2024 88
Mobility
 Implications of high capital mobility for a small country
that had no ability to influence world interest rates.
 Choice of ER regime has radical implications
concerning effectiveness of monetary & fiscal policy in
influencing economic activity.
 Fixed ER Regime:
 Fiscal Policy is effective.
G  IS shifts right Y r  K dd for domestic
currency increase -> Value of Birr   to prevent appreciation
NBE purchase foreign currency, then sells domestic currency
(Birr)  MS  LM shifts right Y.
 Monetary policy is ineffective.
MS  LM shifts right  r  K  demand for
domestic currency decrease and demand for foreign
currency increase, then Value of Birr   to prevent
depreciation NBE bust sell foreign currency, I,e
buys domestic currency Birr  MS  LM shifts
back  Y unchanged.
04/16/2024 89
Expansionary Fiscal Policy Mobility
under Fixed ER System
04/16/2024 90
Expansionary Monetary Policy Mobility
under Fixed ER System
04/16/2024 91
Mobility
 Flexible ER Regime:
 Fiscal Policy is ineffective.
G  IS shifts right  r  K  Value
of Birr   NX  IS shifts back Y
unchanged.
 Monetary policy is effective.
 MS  LM shifts right  r  K 
Value of Birr   NX  IS shifts right 
Y.
04/16/2024 92
Expansionary Fiscal Policy Mobility
under Floating ER System
04/16/2024 93
Expansionary Monetary Policy Mobility
under Floating ER System
04/16/2024 94

Macro I Cap 4

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Macro I Cap 4

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Chapter Four

Open Economy Macroeconomics

1. International flows of Capital Goods

6. Limitations of the Mundell-Fleming model

Capital flows are transactions involving

 The current account measures a country’s trade in

◦ investment income from assets abroad;

 Merchandise trade is trade in goods and services

 Investment income is interest payments, dividends and

The capital and financial account records trade in

If Ethiopia buys an asset from abroad it is a

 The official settlements balance or the balance

 The official reserve assets are assets used in

 The balance of payments can be in surplus or

The current account (CA) balance and the

The statistical discrepancy is the amount to be

and was derived in Chapter 3.

The open-economy goods market equilibrium

 Let’s assume NFP is zero.

 Private disposable income:

 Net Government (public) income:

 Government (public) Saving:

Inan open economy, desired national saving need

The Sd curve is drawn for given levels of Y, wealth,

Similarly, the Id curve is drawn for given levels of

The Sd and Id diagram can be used to examine the

◦ current income to fall;

◦ saving to fall at every r (the saving curve shifts

◦ net foreign lending and current account surplus

The gap between S and I is

A technological innovation, when the CA is in

2. Floating exchange rate system (FERS);

 Real ER is a key determinant of how much a country

 The summation of the current account balance and capital

 This fall in reserves or borrowing is recorded as a plus or

Conversely, reserves fall when the authorities have

 Some of the transactions in the capital account

 Deducting taxation T from both sides:

 Using S = Yd – C and rearranging:

 Upon rearranging: 04/16/2024 46

 Import expenditure is assumed to be partly autonomous and

Ifwe substitute equations and M = M a +

What is current account (CA)?

 In this sub-section, we investigate the relationship

In examining the impact of exchange rate changes

A general consensus accepted by most economists is that

2. A time lag in producer responses. Even though a devaluation improves

4. It is unlikely that the price of exports as

CA  X  eM dCA  dX  (edM  Mde)

IS-Curve …already derived previously.

 As we saw earlier in the chapter, the overall BoP

 At this point it is worth noting that the slope of the BP schedule is

 In the figure above, the income level Yl is seen to be less

 K > 0 indicates a net inflow of funds, whereas K

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