CHAPTER 4:AGGREGATE DEMAND IN AN OPEN

ECONOMY
No country is in autarky situation as it cannot be self sufficient in every thing and countries need to
trade.

Thus, the demand management policies in an open economy depends on the interaction of the economy
with the rest of the world.

Any economy is linked to the rest of the world through two broad channels: trade (in goods and
services) and finance.

In open economy, country’s spending in any given year need not be equal to the goods and services
produced within the country.

A country may borrow from the rest of the world and spend more than its production or it may lend to
1
 Open-Economy Multipliers

The assumptions underlying basic multiplier analysis are:

both domestic prices and the exchange rate are fixed, so real interest rate equal with

nominal interest rate.

So the planned expenditure PE=C+I+G+X-M ,Where C=M=Y.

Export(X) assumed as exogenous variables as it depend on the income of the trading partner

or foreign country.

So ∆ + T+ ∆I+ ∆G+- ∆ - Y, collecting similar terms together

2
- Y= ∆ T+ ∆I+ ∆G +- ∆
(1 - + )=∆ T+ ∆I+ ∆G +- ∆ solve for
=(∆ T+ ∆I+ ∆G +- ∆ )
Now we can derive
A)Govt expenditure multiplier = >0 ,where 1 - =s

The value of the open-economy multiplier is less than the closed-economy

multiplier which is given by 1/s.

The reason for this is that increased expenditure is spent on both domestic and
foreign goods rather than domestic goods alone, and the expenditure on foreign
goods raises foreign rather than domestic economy.

3
C)Trade balance multiplier:
Trade balance can be defined as the difference between export earning and import
expenditure.
CA=X- - Y so = X- -Y
But (∆ T+ ∆I+ ∆G +- ∆ )

= X- -((∆ T+ ∆I+ ∆G +- ∆ ))
= < 0 so an increase in the government expenditure has the deteriorating effect on the
current account balance.

=1- > 0
an increase in exports leads to an improvement in the current account balance that is less than
its effect on aggregate income.
The explanation for this is that part of the increase in income resulting from the additional
exports is offset to some extent by increased expenditure on imports( X Y but Y M
CA). 4
 Recall that the national income identity can be presented as:

(1)
By rearranging equation # 1
) (2)
Equation # 2 states that net export equals output less domestic spending.
The net export stands for current account balance which is composed of trade
balance (goods balance) and service balances.
If output exceeds domestic spending, we export the difference: net exports are
positive.
If output falls short of domestic spending, we import the difference: net exports are
negative.
5
 4.1.international flows of capital goods
Net foreign investment /Net capital outflow/:refers to the purchase of foreign assets by
domestic residents minus the purchase of domestic assets by foreigners.
When a foreign resident buys a bond issued by the Ethiopian government, the purchase
reduces the Ethiopian net foreign investment or net capital outflow and vice versa.
 Financial/Capital markets and goods markets are closely related.

Begin with the identity: .

Subtract C and G from both sides to obtain:

6
Note:National saving is the income of the nation that is left after paying for current
consumption and government purchases:
Y - C - G = I + NX
•National saving (S) =Y - C -G which is the sum of private saving(Y-T-C) and public
saving(T-G)

• Net capital outflow reflects the international flow of funds to finance capital
accumulation.

• The national income accounts identity shows that net capital outflow always equals
7
 is termed as net capital outflow/net foreign investment (domestic saving less
domestic investment).

o If net capital outflow is positive, our saving exceeds our investment, and we are
lending the excess to foreigners /I.e., When , the country is a net lender

o If the net capital outflow is negative, our investment exceeds our saving, and we
are financing this extra investment by borrowing from abroad /I.e., When , the
country is a net borrower/.

•The national income account’s identity shows that the international flow of funds
to finance capital accumulation and the international flow of goods and services are
8
two sides of the same coin.
if our saving exceeds our investment, the saving that is not invested domestically is
used to make loans to foreigners.

if our investment exceeds our saving, the extra investment must be financed by
borrowing from abroad.

These foreign loans enable us to import more goods and services than we export.

Factors that Influence Net Foreign Investment

 The real interest rates being paid on foreign assets.

 The real interest rates being paid on domestic assets.

 The perceived economic and political risks of holding assets abroad.

9
 4.2.Saving and investment in the small open economy.
Small open economy: an economy too small to affect the world real interest rate.
World real interest rate (rw): the real interest rate that prevails in the international
capital market.

Assumptions

a. Domestic & foreign bonds are perfect substitutes (same risk, maturity, etc.)

b. Perfect capital mobility: no restrictions on international trade in assets or the

capital are freely mobile without any hindrance.

c. Economy is small: cannot affect the world interest rate, denoted r*

10
Residents of the small open economy need never borrow at any interest
rate above r*, because they can always get a loan at r* from abroad.

Similarly, residents of this economy need never lend at any interest rate
below r * because they can always earn r * by lending abroad. Thus, the
world interest rate determines the interest rate in our small open
economy.

11
 r, S
where refers world real interest rate
r r refers domestic interest rate
i(r)

S,I
If the economy were closed interest rate would adjust to equilibrate saving and
investment.
But in small open economy investment is determined by the world real interest rate().
The difference between saving and investment determines the trade balance at the
world real interest rate.
When saving falls short of investment, investors borrow from abroad.
when saving exceeds investment, the excess is lent to other countries.
12
 4.3.Exchange rate(E)
Exchange rate refers the rate at which one country currency exchanged for another
country currency.
The exchange rate quoted in two ways
o domestic currency per unit of foreign currency: Here, whenever E rises the home
currency gets weaker; it depreciates. Conversely, when E falls, the domestic currency
gets stronger, it appreciates.
Foreign currency per unit of domestic currency: If E rises, the home currency gets
stronger, and vice versa. in this session this quotation will be employed.

When the domestic currency appreciates, it buys more of the foreign currency; when it
depreciates or devaluates , it buys less.
An appreciation or revaluation is sometimes called a strengthening of the currency, and a
depreciation or devaluation is sometimes called a weakening of the currency.
13
 4.3.1. Nominal and Real Exchange Rates
 The Nominal Exchange Rate (e) is the relative price of the currency of two
countries.
 For example, if the exchange rate between the Ethiopian birr and the U.S dollar is
40 birr per dollar, then you can exchange one dollar for 40 birr in the world
markets for foreign currency.
 The real exchange rate(Rer) is the relative prices of the goods of two countries.
 The real exchange rate describes how many of goods and services in one country
can be exchanged for the goods and services in another countries.
Algebraically, the real exchange rate is the same as the nominal exchange rate (e)
times the ratio of the relative prices of the two countries.
Rer=e.,where foreign country price level and
Refers domestic price level. Here e is quoted in domestic per foreign.
14
Accordingly if the values of the Rer are greater than unity

 domestic prices are cheaper than foreign prices.

 export is greater than import and thereby trade balance will be improved.
4.3.1.Exchange rate regimes

In an economy of exchange they are two broad types of exchange rate regime ie

Floating(flexible) exchange rate regime and fixed(pegged) exchange rate regime.

A)flexible(floating) exchange rate regime

Under this system the exchange rate is completely market- determined, without any
interference from government authorities (the central bank).

 balance of payments disequilibria are self correcting(how ?). 15

 B)fixed(pegged) exchange rate regime
o Here the rate of exchange is a policy parameter fixed by the authorities.
o They have to meet excess demand for a foreign currency (not financed by sales in
that foreign country) from their reserves of foreign currency.
o there is no self-correcting mechanism to balance of payments disequilibria.
o These two exchange rate regimes are the two polar extremes in the economics of
exchange rate.
o In reality we have a pastiche of arrangement, somewhere in between the two.
Even with flexible rates, central banks do interfere with the market-determined
exchange rate, often in an internationally concerted fashion.
o This is known as a managed float (consider the Ethiopian case).
16
 How fixed exchange rate works
A) When the equilibrium exchange rate is above official exchange rate

In this situation the government sell domestic currency to the arbitrageurs and buy foreign
currency.

This process leads to an increase in the domestic currency supply.

The increase in the domestic currency supply causes the exchange rate to return back to its
pegged level.

Suppose that in the foreign exchange market the values of yen against birr is 200 and the
officially pegged values of yen against birr is 100.in this case arbitrageur buy 200 yen for 1 birr
and sell it to the govt for 2 birr, making profit of 1birr.when govt buy yen from arbitrageur the birr
it pays for them automatically increases the money supply. 17
 e
e

IS

When the market exchange rate(e) is greater than official exchange rate()the govt sell

domestic currency in exchange for foreign currency.

This action increases the money supply (shift LM curve from to ).

18
B)When equilibrium exchange rate is below the official exchange rate.
In this case the government buy the domestic currency from arbitrageur in an exchange for
foreign currency.

This process leads to the decrease in the domestic money supply.

The decrease in the domestic currency supply causes the exchange rate to increase.

This process continues until it reaches its pegged level.

19
 e

e IS

When the market exchange rate(e) is below the official exchange rate ) then the
government buys domestic currency in an exchange for the foreign currency.

This process leads to the decrease in the domestic currency supply(shifts

from )and which in turn puts upward pressure on the exchange rate (shifts from e
to ).
20
 4.4.The Mundell Fleming model.
o is an open-economy version of the model.
o This model owes its origins to papers published by James Fleming and Robert
Mundell.
o Their major contribution was to incorporate international capital movements into
formal macroeconomic models based on the Keynesian IS-LM framework.
o The Mundell–Fleming model makes one important and extreme assumption: it
assumes that the economy being studied is a small open economy with perfect
capital mobility.
o That is, the economy can borrow or lend as much as it wants in world financial
markets and, as a result, the economy’s interest rate is determined by the world
interest rate.
o the international flow of capital is rapid enough to keep the domestic interest
21
rate
 4.4.1.The goods market and IS curve.
Both ISLM and Mundell Fleming model stress the notion of equilibrium in the
goods and money market equilibrium.
Both ISLM and Mundell Fleming model assumes fixed price level and shows what
causes the short term fluctuation in the aggregate demand.
The Mundell Fleming model add another component ie NX to the goods market
equilibrium.
Henceforth the IS equation under Mundell Fleming model algebraically can be
stated
Y = + (Y – T ) + I(r) + G + NX(e).

investment depends negatively on the interest rate and Net exports depend
negatively on the exchange rate e(foreign currency per domestic currency).

22
o The Mundell-Fleming model, however, assumes that the price levels at home and
abroad are fixed, so the real and nominal exchange rates are proportional.
o When the nominal exchange rate appreciates foreign goods become cheaper
compared to domestic goods, and this causes exports to fall and imports to rise,
and lowers the aggregate income.
 The relation of the exchange rate and aggregate income is called thecurve.
 The goods-market equilibrium condition above has two financial variables
affecting expenditure on goods and services (the interest rate and the exchange
rate),
 but the situation can be simplified using the assumption of perfect capital
mobility(r=

23
The IS* curve is derived from the net-exports schedule and the Keynesian cross.
E AE

PE

Y
e e

NX IS
NX( NX() NX Y
The IS* curve slopes downward because a higher exchange rate reduces net
exports, which in turn lowers aggregate income.
24
 4.4.2.The money market and LM curve.
The Mundell–Fleming model represents the money market with an equation
that should be familiar from the IS–LM model.
Once again, we add the assumption that the domestic interest rate equals the
world interest rate, so r = r*:
M/P = L(r*, Y ).
The LM* curve is vertical because the exchange rate does not enter into the LM* equation.
o Since r is fixed by the world interest rate in an open economy, the equation finds a fixed amount
of income Y.
o Hence, the LM curve, which draws the relation of the exchange rate and aggregate income, is
vertical.

25
 a) LM curve
interest rate LM

r=

Y
b) LM curve LM
exchange rate

Y
equilibrium income 26
 4.4.3.The equilibrium(combining ISLM curve).
•According to the Mundell–Fleming model, a small open economy with perfect
capital mobility can be described by two equations:

o The first equation describes equilibrium in the goods market, and the second
equation describes equilibrium in the money market.
o The exogenous variables are fiscal policy G and T, monetary policy M, the price
level, P and the world interest rate, r*.
o The endogenous variables are income Y and the exchange rate e. 27
 e LM

equilibrium in the exchange rate

IS
Y

Both curves are drawn holding the interest rate constant at the world interest rate.

The intersection of these two curves shows the level of income and the exchange
rate that satisfy equilibrium both in the goods market and in the money market.

28
4.5.Fiscal and monetary policy in an small open economy with perfect capital mobility.

4.5.1.A.fiscal policy under floating exchange rate regime

Suppose that the government stimulates domestic spending by increasing government purchases
or by cutting taxes.

Because such expansionary fiscal policy increases planned expenditure, it shifts the IS curve to
the right.
An increase in the income resulting from expansionary fiscal policy causes the domestic
interest rate to increase.

Due to open economy the capital inflow from abroad due to higher interest causes the demand
for domestic currency to increases(appreciation)

The appreciation of domestic currency makes the goods to become expensive for the foreigner
29
The fall in the net export offset the expansionary effects of fiscal policy on the
income.
An increase in government purchases or a decrease in taxes shifts the IS* curve to
the right.
 This raises the exchange rate but has no effect on income.

e LM

30
 4.5.1.B.Monetary policy under floating exchange rate regime.
o Suppose now that the central bank increases the money supply.
o Because the price level is assumed to be fixed, the increase in the money supply
means an increase in real balances.
o An increase in the real money balance puts downward pressure on the domestic
interest rate but because of perfect capital mobility capital flow out of the country
as the investor seek higher return to their capital elsewhere.
o The capital out flow causes the demand for foreign currency to
increases(appreciation of foreign currency).
o The appreciation of the foreign currency makes the domestic goods cheaper for
the foreigner and thereby stimulates net export.

31
 Hence, in a small open economy, monetary policy influences income by altering
the exchange rate.
e MS E NX Y

compare with closed economy TM ?

IS

 An increase in the money supply shifts the LM* curve to the right, lowering the
exchange rate and raising income.
 So expansionary monetary policy raise income by altering e rather than r.
32
 4.5.2.A.fiscal policy under fixed exchange rate regime.
o Suppose that the government stimulates domestic spending by increasing
government purchases or by cutting taxes.
o An increase in the government purchase shifts IS curve to the right and leads to
the increase in the aggregate demand.
o The increase in the aggregate demand leads to the increase in the demand for the
domestic currency which puts upward pressure on the domestic interest rate.
o Because of perfect capital mobility the higher interest rate leads to capital inflow.
o This massive capital inflow leads to the appreciation of the domestic currency
and leads to exchange rate to increase.
o In order to keep the exchange rate at its pegged level the govt buys the foreign
currency with the domestic currency and this leads to monetary expansion.
33
 e

Fixed exchange rate

Y0 Y1 Y
 A fiscal expansion shifts the IS curve to the right.
 To maintain the fixed exchange rate at , the central bank must increase the
money supply, thereby shifting the LM curve to the right.
 Hence, in contrast to the case of floating exchange rates, under fixed exchange
rates a fiscal expansion raises income.

34
 4.5..2.B.Monetary policy under fixed exchange rate regime.

If the government introduces the expansionary monetary policy for example buy
buying bonds from public then the domestic interest rate will decreases.

The decrease in the domestic interest rate will result in massive capital out flow.

The capital outflow puts downward pressure on the exchange rate as the demand for
foreign currency increases associated with its higher rate of return.

In order to maintain the exchange rate at its pegged level the government should
buy domestic currency and sell foreign currency to the private agents.

This action reduces the money supply and the exchange rate backs to its original
level. 35
 e

An increase in the money supply shifts LM curve to the right(to ).

This leads to capital out flow and which in turn causes exchange rate to decrease (to e).
To maintain to exchange rate to its pegged level() the govt buys domestic currency in
exchange for foreign currency.
This action continues until exchange rate backed to its pegged level().

36
 In general the Mundell-Fleming model shows that the effect of almost any
economic policy on a small open economy depends on whether the exchange rate
is floating or fixed.
• To be more specific, the Mundell –Fleming model shows that the power of
monetary and fiscal policy to influence aggregate income depends on the
exchange-rate regime.
 Under floating exchange rates, only monetary policy can affect income.
The usual expansionary impact of fiscal policy is offset by a rise in the value of the
currency.
 Under fixed exchange rates, only fiscal policy can affect income.
The normal potency of monetary policy is lost because the money supply is
dedicated to maintaining the exchange rate at the announced level .
37