International Economics and Financial Markets 2


IS: Equilibrium on product market
LM: Equilibrium on money market
BP: Equilibrium in international transactions

Keynesian cross:


Three identities:
  1. National income/product:
    Y = Y (Income identity = Product identity)
  2. Income identity (income at household level).
    Y = C + S + t + im
  3. Product identity (production at company level):
    Y = C + G + I + X
S = Savings
t = Taxes
I = Investments
im = Imports
X = Exports


Yd: disposable income
Yd = y – t = C + S + iM

Change in disposable income:
ΔYd = ΔC + ΔS + ΔiM
Divide by ΔYd:
ΔYd/ΔYd = (ΔC + ΔS + ΔiM)/ΔYd
⇒ 1 = MPC + MPS + MPiM (~ 0,2; lower short term; 0,0 long term)


MPS = Marginal propensity to save
MPIM = Marginal pr

Disposable income (Yd):
Yd = C + S + im
Or:
Yd = Y - t

Savings (s):
s = -s0 + (MPS * Yd)

Imports (im):
im = im0 + (MPIM * Yd)

Consumption (C):
C = C0 + (MPC * Yd)

Consumption identity

Y = C + S + t + im
We can now take the disposable income function and combine the functions to get another version of the consumption function:
Yd = C + S + im
Yd = C + (-s0 + (MPS * Yd)) + (C0 + (MPC * Yd))
Move C to left of equal sign:
C = Yd - (-s0 + (MPS * Yd)) - (C0 + (MPC * Yd))
C = Yd + s0 + (MPS * Yd) - C0 + (MPC * Yd)
Same as:
C = (s0 - im0) + (I - MPS - MPIM) * Yd
From this, we can see that it's the same as:
C = C0 + MPC * Yd
Because:
c0 = (s0 - im0)
MPC = (I - MPS - MPIM)


Product identity

Y = C + G + I + X

Investments are dependants on interest rates:
I(r)

Rate of return:
rr = r - πe
r = Nominal interest rate
rr = Real interest rate
πe = Expected inflation

Government spendings are fixed.

Exports are based on:
  • Exchange rates (s)
  • World income (Y*). If the other countries increase their income, they will buy more from us, causing us to export more.


We can also call product identity, aggregate expenditures (AE):
Y = AE = C + G + I + X

C = C0 + MPC * Yd
Disposable income:
Yd = Y - t
Combine with C:
C = C0 + (MPC * (Y-t))
C = C0 + MPC * Y - MPC - t
C = C0 - MPC * t + MPC * Y



IS-LM-BP (Mundell–Fleming model)

IS

We can derive the IS-curve by calculating two different equilibriums from the Keynesian cross for two different income levels.

The IS-curve can also shift. How?
  • Changes in government expenditures (ΔG)
  • Changes in export (ΔX)
  • Changes in investments (ΔI). Only when investments change due to changes in future expectations, not due to direct change in interest rate (Δr)
  • Changes in savings (ΔS), imports (Δim), taxes (Δt), consumption (ΔC)
  • M = Multiplier effect. A change in one of the above can cause an even greater change in IS because of the multiplier effect.

LM

Why do people want hold money (compared to buying bonds):
  • Transactions motive: The motive to hold money for use in planned exchanges. A rich economy/income will have more transactions than a poor economy, making the demand for money dependant on income.
  • Precautionary motive: The motive to hold money for use in unplanned exchanges.
  • Portfolio motive: A speculative motive for holding money in which people hold both money and bonds and adjust their holdings of both based on their anticipations concerning interest rate movements. The demand for money is dependant on interest rate.
Wealth constraints:
W = B + M
Wealth = Bond + Money
W => ΔM => -ΔB

Real money demand = money demand / Price level:
Md = M/P

Money supply (Ms)

How can the central bank manipulate the LM-curve?
  • Interest rates (in Sweden, reporänta, repo rate)
  • Open market operations
  • Reserve requirements

Central bank (CB):
Assets
  • Gold and foreign currency reserves (FX)
  • Lending to government (LG), a.k.a. Domestic bonds (DS)
Liabilities
  • Currency issued ('monetary base', MB)
When bonds are bought by CB, Money supply (Ms) goes up

We can derive the LM-curve by calculating two different equilibriums from the money market when income level changes. 

BP

Nominal interest rate (r) vertically
Income (Y) horisontally

CA = Current account
FA = Financial account
OS = Official settlements (should be equal to 0)

BP = CA + FA + OS
Because we assume that OS = 0:
BP = CA + FA

BP curve is upward sloping. Reason:
Income rises -> Imports goes up -> Worsening of the Current Account -> Because we require balance, interest rate must rise -> Financial Account rises

A more upward sloping / steeper slope means a lower capital mobility. A perfect capital mobility would be a perfectly horisontal BP curve: we immediately adjust to equilibrium, no need to change interest rate.

UiRP = Uncovered interest rate parity
R = R* + ASe + P

This can be combined with IS-LM model, creating IS-LM-BP:
From http://www-personal.umich.edu/~alandear/glossary/figs/islmbp/islmbp.html


Fixed exchange rate

Monetary policy


In the short term (provided capital is not completely mobile)
  • A fall in the interest rate
  • A rise in income
  • A detoriation of the balance of payments on both current and capital accounts
In the longer term
  • A fall in the foreign currency reserves
  • No change in income, the interest rate or the BOP

Fiscal policy

The effects of expansionary fiscal policy in IS-LM with fixed exchange rates:
  1. G increases and IS shifts to the right
  2. Y increases so Md shifts to the right.
  3. Interest rate rises.
  4. Investments goes down. This is the so called Crowding out effect.

The effects of expansionary fiscal policy in IS-LM-BP with fixed exchange rates:
  1. G increases and IS shifts to the right
  2. Y increases so Imports increases. Current account (CA) decreases
  3. Interest rate rises. Capital inflow increases and Financial account (FA) increases.
  4. If we end up above the BP line, this means we'll have a BOP surplus (a CA deficit). We want exports to increase as much as imports.
  5. A BOP surplus means a pressure to revalue. Upward pressure on the domestic currency. But this is not accepted because the exchange rate is fixed.
  6. Capital inflow leads to an increase in the  demand for domestic currency.
  7. Central bank (CB) needs to buy more money on the market (forex). Ms increases.
  8. LM shifts to the right and all lines meet at an even higher income level.
The income increase due to increased government spendings is reinforced by CB's need to increase the money supply because the exchange rate is fixed.

There are also occasions when we after the initial income increase end up below the BP line (in step 4). Then the LM curve will shift to the left instead of the right.

The effect of fiscal policy will depend on the slope of the BP line, i.e. the level of capital mobility. With perfect capital mobility, we'll see the largest overall increase in income (Y).

Instead of increasing G, we can also decrease in taxes (t), leading to an increase in disposable income (Yd), increasing imports etc.
Ricardian equivalance - When taxes increases, people 

In the short run:
  • A rise in the interest rate and income
  • An overall surplus on the balance of payments (net reserve gain)
In the long run:
  • A further increase in income
  • A fall in the interest rate
  • A fall in the balance of payments surplus to zero, leading to a substantial current account deficit.

Floating exchange rate


Effects of currency depreciation

IS:
A depreciation of the domestic currency leads to an increase in export (it's cheaper to buy domestic goods). At the same time, imports might decrease, because it's more expensive to buy foreign goods. Net exports increases, so IS shifts to the right.

BP:
Currency depreciation -> Old BP line now represents BOP surplus because exports have risen, but we want BP to represent BOP balance. However, to reach balance, we need an increase in import as well. And because our total income increases (Y) so does imports. BP shifts to the right.

No change in financial accounts because we haven't change interest rates.

Monetary policy

  1. LM shifts to the right
  2. IS shifts to the right to stay aligned with BP. Steps:
    1. Before IS shifts we have (in this example) a BOP deficit, because we end up at a point under the BP line.
    2. CA decreases, imports increases. FA decreases
    3. The BOP deficit leads to currency depreciation as explained above, which causes the IS to shift to the right.
  3. Income level increases in two steps:
    1. Effect of the monetary policy: Lower interest, increase in income.
    2. Effect of the currency depreciation

Summary of effects of monetary expansion:
  • A depreciation in the exchange rate
  • An increase in income
  • A fall in the interest rate, provided capital is not completely mobile
  • An improvement of CA

Fiscal policy

  1. IS shifts to the right (because of G increase)
  2. BP shifts to the left. Steps:
    1. In this example, before LM shifts we have a BOP surplus (because we are at a point above the BP line).
    2. CA decreases, import increase.
    3. FA increases, increased interest rate.
    4. The BOP surplus leads to a currency appreciation, 
  3. Total income rises.
If we have very low capital mobility (end up at a point below the BP line in step 2.1), then BP will shift to the right because we have a BOP deficit.

With perfect capital mobility, G increases, IS shifts out, causing a currency depreciation, causing IS to shift back to its original position because of a decrease in export. Again, a crowding out effect.

Summary of fiscal policy:
  • An appreciation in the exchange rate
  • An increase in income provided capital is not completely mobile
  • A rise in the interest rate provided capital is not completely mobile
  • A detoriation in the CA



Exam questions

18/1 2005

4a)

Use the IS-LM-BP model (M-F model):
Fixed exchange rate
Fiscal policy
Degree of capital mobility - Decides slope of BP line

1) Perfect capital mobility
2) High capital mobility
3) Low capital mobility
4) No capital mobility

Fiscal policy: Changes in government spendings or taxes

Answer
Keynesian cross:
Upward sloping AE (a.k.a. AD) curve
45-degree Y (a.k.a. AS) curve. AE = C + I(r) + G + NX
Because investments are dependant on interest rate, we can transfer it to the IS-LM curve by taking two different versions of AE curve with different interest rates. The two equilibriums (with the 45-degree curve) make two different points on the IS curve.
By increasing government spendings (G), we'll have a shift in AE upwards. This causes an upward shift in the IS-curve.

IS-LM-BP:
Upward sloping LM curve (based on LM diagram, with r certically
Downward sloping IS curve
BP depends on capital mobility.
If IS curve shifts upwards, we'll see different effects depending on the slope of the BP line:
  1. Perfect capital mobility: BP line straight. IS shifts up to a new point when IS=LM above BP line -> Increase in income -> increase in imports -> lower current account -> Interest rate rises -> Capital inflow (foreign capital will enter the domestic market) -> Financial account rises (more than current account) -> BOP surplus -> Supply (qs) of forex increases -> Pressure for revaluation -> Fixed exchange rates so central bank (CB) cannot accept this -> CB buys forex from market with money -> Increases money supply in market -> LM shifts to the right, increasing income further -> New equilibrium where IS = LM = BP
  2. High capital mobility: BP line slightly upward sloping (more straight than LM). Same effects as 1. Still BOP surplus and LM shift, but not as much. Less increase in income, higher interest rate.
  3. Low capital mobility: BP line very upward sloping (steeper than LM). IS shifts up, but this time to a point under BP curve -> BOP deficit -> Demand (qd) for forex increases -> CB must sell forex on market -> Money supply decreases -> LM shifts to the left, decreasing income -> New equilibrium where IS = LM = BP
  4. No capital mobility: Vertical BP line. No financial flows whatsoever. Same as 3, but LM will shift all the way back and reset the effect on income.

4b)

We have X, M, C and G. C and G are stable put price levels (P) fluctuates. Governments seek real income stability. Should they adopt a system of fixed or floating exchange rates?

Answer:
We need to test both fixed and floating exchange rates in the IS-LM-BP model. We want to stay at the same income level (keep Y fixed).
Let's assume high capital mobility.
Because P fluctuates, this means real money supply fluctuates, and thus LM fluctuates.

Example - LM shifts to the left:
LM shifts to the left -> Above BP line -> Income decreases -> Imports decreases -> Capital account (CA) increases -> interest rate increases -> Capital inflow increases, capital outflow decreases -> Financial account (FA) increases -> BOP surplus
The reaction of the market depends on if we have fixed or floating exchange rate:

Fixed exchange rate:
BOP surplus -> Supply (qs) of forex increases -> CB must buy forex -> Ms increases -> LM shifts to the right back to the original equilibrium point, with income and interest rate back at the original levels

Floating exchange rate:
BOP surplus -> Currency will appreciate -> Two effects: on IS and on BP -> Effect on IS: Exports goes down and imports goes up (IS shifts to the left) -> Effect on BP: Because X decreases and M increases, CA decreases. BP is no longer in equilibrium  (BP shifts up)

Balance of Payment (BOP or BP):
BP = Capital account (CA) + Financial account (FA)
CA = X - M
FA = Savings (S) - Investments (I)
S = Y - C
Dependancies of exports and imports:
X(S, Y*) where Y* = Income abroad
M(S, Y)
Can be drawn in diagram with real interest rate (R) vertically and income (Y) horisontally. BP upward sloping, slope decided by capital mobility.
In currency appreciation (change in exchange rate), Export (X) decreases, imports (M) increases. This means CA decreases. To offset this we need an equivalent FA improvement. This can only happen by an increase of real interest rate (R). Thus, this means that BP must shift upwards.

Perfect capital mobility is a special case, a small open economy, when interest rate = world interest rate (R*)

6/6 2005

4)

Demand for money (Md) relatively stable. Exports and imports fluctuate. Government spendings increase. Should they adopt a system of fixed or floating exchange rates?

Answer:
...

5)

Due to the huge revenues from oil production, the Norwegian Krona has been quite strong during recent years. This has lowered the competitiveness of other businesses in Norway that compete on the world market (the so called "Dutch disease"?), and the Norwegian government is anxious about the long-term employment consequences of the strong Norwegian Krona. Due to this, the Norwegian central bank has undertaken repeated monetary policy actions to depreciate the value of the currency. However, the actual long-run consequences of these policy actions depend critically on what the natural rate of output is in the economy.

Use the model by Romer to examine the short- and long-run consequences on consumption, investments, output, inflation, net exports and the exchange rate of these monetary policy actions given that the economy starts from a situation where output is:

a) Below the natural rate
b) At the natural rate

Answer a)
The kr is too strong. Y < natural rate of Y

Four diagrams
1) MP-IS. Same as IS-LM but MP replaces LM.
2) AD-IA Inflation diagram (inflation vertically, Y horisontally. Two curves: decreasing AD and horisontal IA). This is the long-run figure.
3) r and CF (Capital Flow - Same as capital/financial account, depends on interest rate)
4) ε (Exchange rates) and Nx (Net Exports - Same as current account)
CB policy, real interest rate depends on income: r(Y)

Short run:
New CB policy, lower interest rate in relation to income -> MP shifts to the right


  Short run Long run
 C(Yd) Up Up x 2
 I(r) Up Up x 2
 Y Up Up x 2
 π No change Down
 NX Up Up x 2
 ε Depreciates Depreciates more



In the long run:
In AD-IA:
AD curve shifts to the right because of active policy changes -> New equilibrium when AD=IA at higher income -> In this case, still under natural income -> Inflation decreases -> AI shifts down
In MP-IS
MP shifts two times to the right:
First time because of active policy, second time because of reactive policy.

Answer b)
We're at the natural income rate.

Short run:
Active policy, shift in MP to the right -> new equilibrium when MP = IS at higher income and lower interest rate
Same as in a)

Long run:
Active policy: Shift in AD, higher income than natural -> Prices will go up -> Inflation increases -> IA shifts up -> New equilibrium in AD-IA at the original natural income rate, but higher inflation
Reactive policy: MP shifts back to the left to its original position
We see that, in the long run, changes in money supply equals changes in price level (inflation):
ΔM = ΔP

  Short run Long run
 C(Yd) Up No change
 I(r) Up No change
 Y Up No change
 π No change Up
 NX Up No change
 ε Depreciates No change


7/6 2006

6a

Suppose the government in a country with a flexible exchange rate wants to use a combination of monetary and fiscal policies to depreciate the value of the exchange rate (increase S), without changing the country’s real income (Y). What combination of fiscal and monetary policies should the government use? Use the IS-MP model in the discussion.

Answer
IS-MP:
Thre diagrams:
1) Interest rate (r) vertically, Y horisontally. MP upward sloping (replaces LM), IS downward sloping (IS formula doesn't include NX as this is moved into the CF curve).
2) Interest rate (r) vertically, CF horisontally. Downward sloping CF (net capital outflow) line, slope decided by the level of capital mobility. Because it's downward sloping we do not have perfect capital mobility (the model does not hold at perfect capital mobility)
3) Exchange rate (E) vertically, Nx (net exports) horisontally. Downward sloping Nx line

We want exchange rate to decrease (diagram 3) -> This means lower interest rate in 2 and 1
To reach equilibrium in IS-MP we must both shift MP to the right and IS to the left. This can happen by:
Contracionary Fiscal policy -> Government spending decreases
Expansionary monetary policy -> Active change in r(Y)

We need a mix of contracionary Fiscal policy (IS shifts left) and expansionary monetary policy (MP shifts right).

Extra (long run):
In the long run we add the AD-IA curve.
AD curve shifts to the left because of contractionary fiscal policy.
Expansionary monetary policy shifts AD back to the right to its original position.
No change in inflation.


5/6 2008

A country suffered from:
High growth
Low inflation

A couple of possible explanations:
  1. Boom in IT-technology
  2. Booming stock market - High levels of consumer and investment confidence (consumption and investments)
  3. Cheap imports
  4. Lower oil prices
Discuss how to model these explanations in the short and long run in the Romer model.

Answer:
4 diagrams:

Scenario 1: Boom in IT-technology.
Income increases (Y).
Short run: nothing happens.
Long run: IA shifts down so that IA = AD at the higher income -> Lower inflation and higher income -> Reactive policy: CB lowers r, because r(Y) -> MP shifts to the right -> Capital inflow -> Exchange rate decreases

Scenario 2: Booming stock market
Short run: IS shifts to the right (because I and C increases) -> Higher income
Long run: New equilibrium in IS-MP so AD shifts in AD-AI to the new income level. No change in inflation.

In this example, we don't consider which is the natural income level. If, for example, in scenario 2 the initial income was the natural income, inflation would increase, CB adjust money supply and MP would shift to the left.

Scenario 3: Cheap imports
Scenario 4: Lower oil prices
Both have the same effect: Lowers overall price level. A so called positive inflation chock.
Short run: This does not apply, because of fixed price levels (P)
Long run: Inflation decreases -> Shifts IA curve down -> Income increases
Two reactive policies:
1) MP shifts to the right because of the increased Y.
Depending on where we place our natural income level (Y):
Y = Y Inflation constant
Y < Y Inflation goes down
Y > Y Inflation goes up
In this case, we assume that the original position was the natural income level, so Y > Y and inflation rises until it returns to its original position.
2) MP shifts back to the left


Monetary policy and Dornbusch overshooting

Financial markets adjust quicker than goods markets

IS-LM-BP
Short run:
Expansionary monetary policy -> Ms up -> LM shifts right -> BOP deficit -> Currency depreciates -> Exports increases, Imports decreases -> IS shifts to the right -> New equilibrium at higher income

In the long run: ΔMs = ΔP (prices are not fixed)
Because Ms has increased, P also increases -> In the long run, the real money supply (Ms/P) will return to its original value -> IS returns to its original position

Dornbusch Overshooting Model:
When you have an expansionary monetary model, you might see that exchange rates adjust too quickly (financial markets adjust more quickly than goods markets) which might cause an overrated (overshooting in) exchange rate in the short run, before they adjust to they actual PPP values.

From Wikipedia:
"The financial market will initially overreact to a monetary change, achieving an adjusted short-term equilibrium. Over time, goods prices will eventually respond, allowing the financial market to dissipate its overreaction, and the economy to land in a new long-run equilibrium pricing structure."


Monetary unions

Mundell
Emphasizes disadvantages of having too large monetary unions, because labor mobility becomes too low, causing inefficiencies.

What happens when we have a trade surplus in one country (region A) and deficit in another (region B)?
Floating: Exchange rates serve as a chock stabilizer. Depreciation of currency in one region -> Back to balance
Fixed: In the long run, prices will adjust. In the short run we'll have:
Region A: Surplus -> Low unemployment. Region B: Deficit -> High unemployment
Labor mobility decides how large the monetary unions should be to be efficient
If labor mobility is large enough, the labor force will balance automatically
Many consider EU (EMU) too big and that we lack the labor mobility for it to be effective.

McKinnon
Emphasizes disadvantages of having too small monetary unions (or no unions at all), because smaller economies are too dependant on export and imports, causing workers to suffer hard when exchange rates fluctuate, demanding costly compensation (trade unions, unemployment insurence etc).

The monetary union has to be large enough, so that workers don't demand compensation.
If we have a small economy, it could fare better in a monetary union compared to running its own exchange rate with additional trade unions etc.

Both consider US excellent monetary union. Labor mobility is good. It's not a small economy etc.
Why's Sweden not a member of EMU? Maybe because we believe we have a stronger economy than most of the EMU members, and we'll only pay for those who are worse than us rather than gain something.

The liquidity trap / Kink point

The kink point is the point when nominal interest rate (i) = 0
Real interest rate (r) is approximately given by:
r = i - πe
In the case when i = 0 we get:
r = -πe

Normal case:
π down -> Real interest rate (r) down -> Y up

Liquidity trap:
As soon as i = 0, we'll have negative effect on real interest rate:
π down -> r up -> Y down

Expansionary fiscal policy:
In AD-IA (or AD-PA??):
G up -> AD shift to the right -> Inflation shift down
Instead try to go to full employment
Solution for the 1990s Japanese economy

This is why CB's focus on πe: when they say they'll change interest rate, people will react strongly and adjust actual interest rate. This is more sustainable, because when i = 0, you cannot lower it more, and you'll have to use other means to talk down expectations.

Credit channel:
Ensure that there's always enough liquidity in the economy. This could change the slope of the AD curve.



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