AGGREGATE DEMAND IN AN

OPEN ECONOMY
Chapter 4
Outline
• International flows of goods & Capital
• Saving and Investment in the Small Open
Economy
• Exchange rates
• The Mundell-Fleming model
• fiscal and monetary policies in an open
economy with perfect capital mobility
– Fixed exchange rate
– Floating exchange rate
Saving – Investment = Net Exports
• In Chs. 3, we had assumed a closed economy
(that is, NX = 0)
• Consequently, we had S = I
• That’s no longer true in an open economy
 Perfect Capital Mobility
• Assumption: people are free to lend to or
borrow from anyone anywhere in the world
• Assumption: lending to foreign borrowers is in
no way different from lending to domestic
borrowers

• The real interest rate is r for domestic loans and

r* for loans to foreigners
• Our two assumptions imply r = r*
 Real Interest Rate: predictions
• r* is assumed exogenous
• Therefore, we already have a complete (and
trivial!) theory of the domestic real interest
rate

Predictions Grid
r* r r
r* +
 “Small Country”
• The assumption that the foreign real interest
(r*) rate is exogenous and that it determines
the domestic real interest rate (r = r*)
represents the idea that the domestic
economy is affected by the foreign economy
and is unable to affect the foreign economy
• In other words, we assume that the domestic
economy is a “small country”
 Investment and the real interest rate
• Assumption: investment spending is inversely
related to the real interest rate
• I = I(r), such that r↑⇒ I↓
r

r* r
I
I(r)

I (r )

I
Investment and the real interest rate
r Investment is still a
downward-sloping function
of the interest rate,
but the exogenous
world interest rate…
r*
…determines the
country’s level of
investment.
I (r )

I (r* ) I
 NX = S – I
• Remember that in open economy: NX = S – I
 If the economy were closed…

r S
…the
…the interest
interest
rate
rate would
would
adjust
adjust to
to
equate
equate
investment
investment
and
and saving:
saving: rc
I (r )

I(rc) = S
S, I
 But in a small open economy…
r
the
the exogenous
exogenous S
world
world interest
interest
rate
rate determines
determines
investment… NX
investment…
r*
…and
…and thethe
difference
difference rc
between
between saving
saving
and
and investment
investment
I (r )
determines
determines netnet
capital
capital outflow
outflow I1 S, I
and
and net
net exports
exports
Nominal and Real

EXCHANGE RATES
 The nominal exchange rate

e = nominal exchange rate,

the relative price of
domestic currency
in terms of foreign currency
(e.g. Birr per Dollar)
 The real exchange rate

ε = real exchange rate,

the relative price of
the lowercase domestic goods
Greek letter
epsilon
in terms of foreign goods
(e.g. American bread per
Ethiopian bread)
 Example:
• A cup of coffee
• price in the U.S.:
P* = 2 USD
• price in Ethiopia:
P = 40 Birr
• nominal exchange rate
e = 0.02 USD/Birr To
Tobuy
buyananEthiopian
Ethiopiancup
cupof
of
coffee,
coffee,someone
someonefrom
fromAmerica
America
would
wouldhave
havetotopay
payan
anamount
amount
𝑒× 𝑃 that
thatcould
couldbuy
buy0.4
0.4American
American
𝜀= ∗ cup
cupof
ofcoffee.
coffee.
𝑃
Understanding the units of ε
e P
ε 
P *

¿¿¿
( 𝑈𝑆𝐷 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 𝐸𝑡h𝑖𝑜. 𝑔𝑜𝑜𝑑𝑠 )
¿
𝑈𝑆𝐷 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 𝑈 . 𝑆 . 𝑔𝑜𝑜𝑑𝑠

¿𝑢𝑛𝑖𝑡 𝑈 .𝑆.𝑔𝑜𝑜𝑑𝑠𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 𝐸𝑡h𝑖𝑜.𝑔𝑜𝑜𝑑𝑠

 ε in the real world & our model
• In the real world:
We can think of ε as the relative price of
a basket of domestic goods in terms of a
basket of foreign goods
• In our macro model:
There’s just one good, “output.”
So ε is the relative price of one country’s
output in terms of the other country’s output
 Purchasing Power Parity
• This is the simplest theory of the real
exchange rate ε

• PPP assumption: ε = 1 ε=1

NX

• That’s it! NX

• The PPP assumption is also called the Law of

One Price (LOOP)
 Purchasing Power Parity
• Nothing can affect the real exchange rate,
under PPP
• because it is always ε = 1 under PPP
 How NX depends on ε: approach 2

ε  Ethiopian goods become more

expensive relative to foreign goods
 EX, IM
 NX
 The NX curve for Ethiopia
ε

so Ethiopian
When ε is net exports
relatively low, will be high
Ethiopian goods
are relatively ε1
inexpensive
NX (ε)
0
NX(ε1) NX
The NX curve for Ethiopia
ε At high enough
values of ε,
ε2 Ethiopian goods
become so
expensive that we
export less than
we import

NX (ε)
NX(ε2) 0 NX
 The Net Exports Function
• The net exports function reflects this inverse
relationship between NX and ε :
NX = NX(ε )
 The Mundell-Fleming Model
• Key assumption:
Small open economy with perfect capital mobility.
r = r*
• Goods market equilibrium---the IS* curve:

Y  C (Y  T )  I (r *)  G  NX (e )
where
e = nominal exchange rate
= foreign currency per unit of domestic
currency
 The IS* curve: Goods Market Eq’m
Y  C (Y  T )  I (r *)  G  NX (e )

The IS* curve is drawn for e

a given value of r*.
Intuition for the slope:

 e   NX   Y

IS*
Y
 Deriving IS curve using Keynesian Cross
E=Y
E
3. … causing planned spending E = C + I(r*) + G + NX2
curve shifts upward……
E = C + I(r*) + G + NX1
1. When ∆NX
exchange rate
falls,… 45
° Y1 Y2 Y
e1 e1 4. … for given
P, income will
e2
increase
e2
IS
NX(r)
NX1 NX2
Y Y1 Y2 Y
2. … NX increases…
 The LM Curve
LM 1. The money
market equi.
Interest rate, e r
condition…
r = r*
2. … and the
world interest
rate…
Income, Output, Y
LM*
Exchange rate, e

3. … determine the
level of income.

Y* Income, Output, Y
The LM* curve: Money Market Eq’m
M P  L (r *,Y )
The LM* curve
• is drawn for a given e LM*
value of r*
• is vertical because:
given r*, there is
only one value of Y
that equates money
demand with supply, Y
regardless of e.
Equilibrium in the Mundell-Fleming model
Y  C (Y  T )  I (r *)  G  NX (e )
M P  L (r *,Y )
e LM*

equilibrium
exchange
rate

IS*
equilibrium Y
level of
income
Floating Vs fixed exchange rates
 Floating & fixed exchange rates
• In a system of floating exchange rates,
e is allowed to fluctuate in response to changing
economic conditions.
• In contrast, under fixed exchange rates, the
central bank trades domestic for foreign currency
at a predetermined price.
• We now consider fiscal, monetary, and trade
policy: first in a floating exchange rate system,
then in a fixed exchange rate system.
 Fiscal policy under floating exchange rates
Y  C (Y  T )  I (r *)  G  NX (e )
M P  L (r *,Y )
e LM 1*
At any given value of e, e2
a fiscal expansion increases Y,
shifting IS* to the right. e1
IS 2*
Results: IS 1*
e > 0, Y = 0 Y
Y1
 Lessons about fiscal policy
• In a small open economy with perfect capital
mobility, fiscal policy cannot affect real GDP.
• “Crowding out”
• closed economy:
Fiscal policy crowds out investment by causing
the interest rate to rise.
• small open economy:
Fiscal policy crowds out net exports by causing
the exchange rate to appreciate.
Mon. policy under floating exchange rates
Y  C (Y  T )  I (r *)  G  NX (e )
M P  L (r *,Y )
e LM 1*LM 2*
An increase in M shifts
LM* right because Y must
rise to restore eq’m in the
e1
money market.
e2
Results: IS 1*
e < 0, Y > 0 Y
Y1 Y2
 Lessons about monetary policy
• Monetary policy affects output by affecting
one (or more) of the components of aggregate
demand:
closed economy: M  r  I  Y
small open economy: M  e  NX  Y

• Expansionary mon. policy does not raise world

aggregate demand, it shifts demand from foreign to
domestic products.
Thus, the increases in income and employment
at home come at the expense of losses abroad.
Trade policy under floating exchange rates
Y  C (Y  T )  I (r *)  G  NX (e )
M P  L (r *,Y )
e LM 1*
At any given value of e,
a tariff or quota reduces e2
imports, increases NX,
e1
and shifts IS* to the right.
IS 2*
Results: IS 1*
e > 0, Y = 0 Y
Y1
 Lessons about trade policy
• Import restrictions cannot reduce a trade deficit.
• Even though NX is unchanged, there is less trade:
– the trade restriction reduces imports
– the exchange rate appreciation reduces exports
Less trade means fewer ‘gains from trade.’
• Import restrictions on specific products save jobs in the
domestic industries that produce those products, but
destroy jobs in export-producing sectors.
Hence, import restrictions fail to increase total
employment.
• Worse yet, import restrictions create “sectoral shifts,”
which cause frictional unemployment.
 Fixed exchange rates
• Under a system of fixed exchange rates, the country’s
central bank stands ready to buy or sell the domestic
currency for foreign currency at a predetermined
rate.
• In the context of the Mundell-Fleming model,
the central bank shifts the LM* curve as required to
keep e at its preannounced rate.
• This system fixes the nominal exchange rate.
In the long run, when prices are flexible, the real
exchange rate can move even if the nominal rate is
fixed.
How does A Fixed-exchange-rate System
Works
• If central bank announces to fix the exchange rate
below the Forex market, arbitrageurs will find it
profitable to buy USD in Forex market & sell it to the
central bank.
• When a central bank buys Birr, it will cause an
increase in money supply.
• When the money supply increases, LM* curve will
shift to the right.
• When LM* shifts to the right, the exchange rate will
fall to the predetermined level.
 Example:
• Forex market: 1 Birr = 0.02 USD
• National bank of Ethiopia (NBE) wants to fix the exchange
rate as 1 Birr = 0.01 USD.
• Birr is expensive in Forex market
• Arbitrageurs buy Birr from NBE and sell it in Forex market
for profit.
– Same as: Arbitrageurs sell dollar to NBE after buying it in Forex
market.
• When NBE sells Birr, the money supply of Ethiopia will
automatically increase.
• This will push down the equ. exchange rate until it reaches
at the predetermined level.
 Example…

Exchange
rate, e

𝑳𝑴 ∗𝟏𝑳𝑴 ∗𝟐
Equi.
exchange
rate
0.02

0.01
Fixed
exchange
rate Y1 Y2 𝒀
 How A fixed Exchange Rate Governs The
Money Supply
• Equi e > the fixed e
Exchange
rate, e • Arbitrageurs will buy
foreign currency in
𝑳𝑴 ∗𝟏𝑳𝑴 ∗𝟐 forex markets and sell
Equi. it to the central bank
exchange for a profit.
• Mss rises
rate
• LM* shifts to the right
• e falls

Fixed
exchange
rate 𝑰𝒏𝒄𝒐𝒎𝒆, 𝑶𝒖𝒕𝒑𝒖𝒕,𝒀
 How A fixed Exchange Rate Governs The
Money Supply
Exchange
rate, e • Equi e < the fixed e

𝑳𝑴 ∗𝟐 𝑳𝑴 ∗𝟏 • Arbitrageurs will buy

Fixed Birr in forex markets
and sell it to the
exchange central bank for a
rate profit.
• Mss falls
• LM* shifts to the left
• e rises
Equi.
exchange
rate 𝒀
 Fiscal policy under fixed exchange rates

Under floating
Under floatingrates,
rates,a
fiscal policy ineffective
fiscal expansion would
at changing
raise e. output. e LM 1*LM 2*
To
Under e from
keepfixed rising,
rates,
the central
fiscal policybank must
is very
effective at changing
sell domestic currency,
output.
which increases M e1
and shifts LM* right. IS 2*
Results: IS 1*
Y
e = 0, Y > 0 Y1 Y2
 Mon. policy under fixed exchange rates

An increase
Under in Mrates,
floating would shift
monetary
LM* policy
right and is very
reduce e.
effective at changing e LM 1*LM 2*
To prevent the fall in e,
output.
the central bank must
Under fixed rates,
buy domestic currency,
monetary policy cannot be
which reduces M and e1
used to affect output.
shifts LM* back left.
Results: IS 1*
Y
e = 0, Y = 0 Y1
 Trade policy under fixed exchange rates

Under floating
A restriction on rates,
imports puts
import
upward restrictions
pressure on do
e. not
affect Y or NX.
e LM 1*LM 2*
Under fixede rates,
To keep from rising,
import restrictions
the central bank must
increase Y and NX.
sell domestic currency,
But, these gains come e1
which increases M at
the expense of other IS 2*
and shifts LM* right.
countries, as the policy
Results:
merely shifts demand from
IS 1*
Y
foreignto
e =domestic
0, Y goods.
>0 Y1 Y2
 M-F: summary of policy effects

type of exchange rate regime:

floating fixed
impact on:
Policy Y e NX Y e NX

fiscal expansion 0    0 0

mon. expansion    0 0 0

import restriction 0  0  0 
 Floating vs. Fixed Exchange Rates

Argument for floating rates:

• allows monetary policy to be used to pursue
other goals (stable growth, low inflation)
Arguments for fixed rates:
• avoids uncertainty and volatility, making
international transactions easier
• disciplines monetary policy to prevent
excessive money growth & hyperinflation
 Mundell-Fleming and the AD curve
• So far in M-F model, P has been fixed.
• Next: to derive the AD curve, consider the impact
of a change in P in the M-F model.
• We now write the M-F equations as:

(IS* ) Y  C (Y  T )  I (r *)  G  NX (ε )

(LM* ) M P  L (r *,Y )
 Deriving the AD curve
 LM*(P2) LM*(P1)
Why AD curve has
2
negative slope:
1
P  (M/P )
IS*
 LM shifts left Y2 Y1 Y
P
 
P2
 NX P1
 Y AD
Y2 Y1 Y
From the short run to the long run
If Y1  Y ,  LM*(P1) LM*(P2)
then there is
1
downward pressure on
prices. 2
IS*
Over time, P will
move down, causing Y1 Y Y
P LRAS
(M/P )
P1 SRAS1

P2 SRAS2
NX 
Y AD
Y1 Y Y
 Large: between small and closed
• Many countries - including the U.S. - are neither closed
nor small open economies.
• A large open economy is in between the
polar cases of closed & small open.
• Consider a monetary expansion:
• Like in a closed economy,
M > 0  r  I (though not as much)
• Like in a small open economy,
M > 0    NX (though not as much)
 Chapter summary
1. Mundell-Fleming model
 the IS-LM model for a small open economy.
 takes P as given
 can show how policies and shocks affect income
and the exchange rate
2. Fiscal policy
 affects income under fixed exchange rates, but not
under floating exchange rates.
 Chapter summary
3. Monetary policy
 affects income under floating exchange rates.
 Under fixed exchange rates, monetary policy is not
available to affect output.
4. Fixed vs. floating exchange rates
 Under floating rates, monetary policy is available
for can purposes other than maintaining exchange
rate stability.
 Fixed exchange rates reduce some of the
uncertainty in international transactions.