Open Economy Macroeconomics Lecture Notes

Part 2

Ozan Hatipoglu

Department of Economics, Bogazici University

Spring 2015

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 1 / 72

Monetarist/Neoclassical Long-Run

w W= P1 e g(N)

w1 W= P0 e g(N)

w0
W= P1 f(N)

W= P0 f(N)
N
N0
Y= f(K,N)
Y

N
P N0
AS

y
y0

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 2 / 72

Extreme Keynesian Short-Run

w1 W= P0 e g(N) = P1 e g(N))

w0
W= P1 f(N)

W= P0 f(N)
N
N0
Y= f(K,N)
Y

N
P N1

AS

y
y0 y1

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 3 / 72

Short Run vs. Long Run

P
LR AS
MR AS

Extreme
SR AS

AD1
AD0
y

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 4 / 72

Monetary Model of Floating Rates
Assumptions:
1 Perfect foresight in labor markets, i.e. P 0 (P ) = 1

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 5 / 72

Monetary Model of Floating Rates
Assumptions:
1 Perfect foresight in labor markets, i.e. P 0 (P ) = 1
2 Aggregate Demand is determined only by the monetary conditions.
Money demand is given by M d = kPy = kY

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 5 / 72

Monetary Model of Floating Rates
Assumptions:
1 Perfect foresight in labor markets, i.e. P 0 (P ) = 1
2 Aggregate Demand is determined only by the monetary conditions.
Money demand is given by M d = kPy = kY
3 PPP holds, i.e. Q = 1 =⇒ SP ∗ = P

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 5 / 72

Monetary Model of Floating Rates
Assumptions:
1 Perfect foresight in labor markets, i.e. P 0 (P ) = 1
2 Aggregate Demand is determined only by the monetary conditions.
Money demand is given by M d = kPy = kY
3 PPP holds, i.e. Q = 1 =⇒ SP ∗ = P
4 We will ignore the domestic goods market which is always in eq.

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 5 / 72

Monetary Model of Floating Rates
Assumptions:
1 Perfect foresight in labor markets, i.e. P 0 (P ) = 1
2 Aggregate Demand is determined only by the monetary conditions.
Money demand is given by M d = kPy = kY
3 PPP holds, i.e. Q = 1 =⇒ SP ∗ = P
4 We will ignore the domestic goods market which is always in eq.

Definition
The equilibria in this economy is given by (y , P ) pairs such that AS=AD
and where AD is given by (y , P ) pairs such that M s = kPy = kSP ∗ y or
Ms
S = kP ∗y

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 5 / 72

Monetary Model of Floating Rates
Assumptions:
1 Perfect foresight in labor markets, i.e. P 0 (P ) = 1
2 Aggregate Demand is determined only by the monetary conditions.
Money demand is given by M d = kPy = kY
3 PPP holds, i.e. Q = 1 =⇒ SP ∗ = P
4 We will ignore the domestic goods market which is always in eq.

Definition
The equilibria in this economy is given by (y , P ) pairs such that AS=AD
and where AD is given by (y , P ) pairs such that M s = kPy = kSP ∗ y or
Ms
S = kP ∗y

Corollary
∆Ms ∆P
Assumptions 1 → vertical AS, therefore Ms = P

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 5 / 72

Monetary Model of Floating Rates

P P AS

P=SP*
under-compe ve

P>SP*
P0 P0
over-compe ve

P<SP*
AD

S y
S0 Y0

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 6 / 72

Monetary Model of Floating Rates

Theorem
A given percentage increase in domestic M s leads to a depreciation of the
domestic currency at the same proportion

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 7 / 72

Monetary Model of Floating Rates

Theorem
A given percentage increase in domestic M s leads to a depreciation of the
domestic currency at the same proportion

Proof.
M s = kPy , taking logs, ln M s = ln k + ln P + ln y
s dy
taking derivatives: dM dP
Ms = P + y
dM s dP ∗ dP ∗
but dy ∗ dS
y = 0 Since Q = 1, P = SP and M s = S + P ∗ and P∗
= constant

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 7 / 72

Policy Analysis. A Money Supply Increase

P P AS

P=SP*
P1

P0 AD1

AD0

S y
S0 S1 Y0

An increase in M s creates excess demand but y is fixed so P ↑ . Since

PPP holds S ↑ . Inflation and Depreciation.

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 8 / 72

Policy Analysis. An Increase in Real Income

P P AS

P=SP*
A a
P1 b

B
P0
c AD

S y
S0 S1 y0 y1

M s = kPy . Since Ms is constant P ↓ . If P were constant there will be an

excess demand for money at b.Since PPP holds, a decrease in domestic
prices causes the currency to appreciate. Deflation, Appreciation.

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 9 / 72

Two Country Model

M s = kPy (home)

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 10 / 72

Two Country Model

M s = kPy (home)
M s ∗ = k ∗ P ∗ y ∗ (foreign)

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 10 / 72

Two Country Model

M s = kPy (home)
M s ∗ = k ∗ P ∗ y ∗ (foreign)
Ms kPy
Ms∗ = k∗P∗y ∗

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 10 / 72

Two Country Model

M s = kPy (home)
M s ∗ = k ∗ P ∗ y ∗ (foreign)
Ms kPy
Ms∗ = k∗P∗y ∗
P
Under PPP P∗ = S therefore

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 10 / 72

Two Country Model

M s = kPy (home)
M s ∗ = k ∗ P ∗ y ∗ (foreign)
Ms kPy
Ms∗ = k∗P∗y ∗
P
Under PPP P∗ = S therefore
Ms
Ms∗ = S kky
∗y ∗

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 10 / 72

Two Country Model

M s = kPy (home)
M s ∗ = k ∗ P ∗ y ∗ (foreign)
Ms kPy
Ms∗ = k∗P∗y ∗
P
Under PPP P∗ = S therefore
Ms
Ms∗ = S kky
∗y ∗

k ∗y ∗ Ms
   
S=
ky Ms∗
| {z } | {z }
relative real money demand relative money supply

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 10 / 72

Monetary Model of Fixed Rates

Assumptions:
1 y , P ∗ given

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 11 / 72

Monetary Model of Fixed Rates

Assumptions:
1 y , P ∗ given
2 Under fixed rates money supply is endogenous and since rates are
fixed, given ∆M s = ∆FX + ∆DC , the only policy variable is DC . The
adjustments are through changes in FX .

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 11 / 72

Monetary Model of Fixed Rates

Assumptions:
1 y , P ∗ given
2 Under fixed rates money supply is endogenous and since rates are
fixed, given ∆M s = ∆FX + ∆DC , the only policy variable is DC . The
adjustments are through changes in FX .
3 S is fixed by authorities.

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 11 / 72

Increase in Money Supply

P P AS Ms

Ms=FX+DC 1
P=SP*
A
P1 b
M1s=kPy
Ms=FX+DC 0
B c
P0
a
M0s=kPy
DC 1

FX
DC 0
S y
S0

An increase in DC will increase M s (and P as a result of excess money

supply), rendering domestic economy uncompetitive. There is a BOP
deficit at A and reserves fall. As a result M s will decrease to its original
level and so is P

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 12 / 72

Increase in Money Supply

Demand: M d = kPy = k S P ∗ y

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 13 / 72

Increase in Money Supply

Demand: M d = kPy = k S P ∗ y
Supply: M s = FX + DC

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 13 / 72

Increase in Money Supply

Demand: M d = kPy = k S P ∗ y
Supply: M s = FX + DC
Equilibrium: k S P ∗ y = FX + DC

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 13 / 72

Increase in Money Supply

Demand: M d = kPy = k S P ∗ y
Supply: M s = FX + DC
Equilibrium: k S P ∗ y = FX + DC
FX = k S P ∗ y − DC

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 13 / 72

Increase in Money Supply

Demand: M d = kPy = k S P ∗ y
Supply: M s = FX + DC
Equilibrium: k S P ∗ y = FX + DC
FX = k S P ∗ y − DC

Theorem
Under fixed exchange rates changes in domestic credit are neutralized by
changes in reserves. Any change in domestic credit will change the
composition of money supply.

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 13 / 72

Increase in Money Supply

The above mechanism is an auto-stabilization, because reserves act as

a buffer to equilibrium distortions.

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 14 / 72

Increase in Money Supply

The above mechanism is an auto-stabilization, because reserves act as

a buffer to equilibrium distortions.
Suppose the authorities insist on increasing in M s . They can do so by
further increasing DC , to offset the effect of the decline in reserves:

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 14 / 72

Increase in Money Supply

The above mechanism is an auto-stabilization, because reserves act as

a buffer to equilibrium distortions.
Suppose the authorities insist on increasing in M s . They can do so by
further increasing DC , to offset the effect of the decline in reserves:
Definition
Sterilization is neutralizing the effects of BOP deficit(surplus) by creating
(cancelling) extra domestic credit to offset the decrease(increase) in
foreign reserves.

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 14 / 72

Increase in Money Supply

The above mechanism is an auto-stabilization, because reserves act as

a buffer to equilibrium distortions.
Suppose the authorities insist on increasing in M s . They can do so by
further increasing DC , to offset the effect of the decline in reserves:
Definition
Sterilization is neutralizing the effects of BOP deficit(surplus) by creating
(cancelling) extra domestic credit to offset the decrease(increase) in
foreign reserves.

Q: Can sterilization work under fixed rate systems?

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 14 / 72

Domestic Income and Foreign Price Increase

Theorem
Under fixed rates, an increase in real income will increase reserves. Prices will
return to PPP levels.

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 15 / 72

Domestic Income and Foreign Price Increase

Theorem
Under fixed rates, an increase in real income will increase reserves. Prices will
return to PPP levels.

Theorem
Under fixed rates, an increase in foreign prices will increase reserves. Prices will
increase. A small open economy will import foreign inflation under this scenario.

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 15 / 72

Mundell-Fleming Model Assumptions

AS is flat. Prices are fixed:

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 16 / 72

Mundell-Fleming Model Assumptions

AS is flat. Prices are fixed:

Only y adjusts. Since prices are fixed Q ∼ S

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 16 / 72

Mundell-Fleming Model Assumptions

AS is flat. Prices are fixed:

Only y adjusts. Since prices are fixed Q ∼ S
B (Q, y ) = X (Q ) − M (Q, y ) ≈ X (S ) − M (S, y )

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 16 / 72

Mundell-Fleming Model Assumptions

AS is flat. Prices are fixed:

Only y adjusts. Since prices are fixed Q ∼ S
B (Q, y ) = X (Q ) − M (Q, y ) ≈ X (S ) − M (S, y )
Since prices are fixed, PPP does not necessarily hold

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 16 / 72

Mundell-Fleming Model Assumptions

AS is flat. Prices are fixed:

Only y adjusts. Since prices are fixed Q ∼ S
B (Q, y ) = X (Q ) − M (Q, y ) ≈ X (S ) − M (S, y )
Since prices are fixed, PPP does not necessarily hold
m (y , r ) = ky − lr ( 6= kPy )

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 16 / 72

Mundell-Fleming Model Assumptions

AS is flat. Prices are fixed:

Only y adjusts. Since prices are fixed Q ∼ S
B (Q, y ) = X (Q ) − M (Q, y ) ≈ X (S ) − M (S, y )
Since prices are fixed, PPP does not necessarily hold
m (y , r ) = ky − lr ( 6= kPy )
Exchange Rate expectations are static

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 16 / 72

Mundell-Fleming Model Assumptions

AS is flat. Prices are fixed:

Only y adjusts. Since prices are fixed Q ∼ S
B (Q, y ) = X (Q ) − M (Q, y ) ≈ X (S ) − M (S, y )
Since prices are fixed, PPP does not necessarily hold
m (y , r ) = ky − lr ( 6= kPy )
Exchange Rate expectations are static
Capital mobility is less than perfect:

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 16 / 72

Mundell-Fleming Model Assumptions

AS is flat. Prices are fixed:

Only y adjusts. Since prices are fixed Q ∼ S
B (Q, y ) = X (Q ) − M (Q, y ) ≈ X (S ) − M (S, y )
Since prices are fixed, PPP does not necessarily hold
m (y , r ) = ky − lr ( 6= kPy )
Exchange Rate expectations are static
Capital mobility is less than perfect:
r 6= r ∗ in SR

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 16 / 72

Mundell-Fleming Model Assumptions

AS is flat. Prices are fixed:

Only y adjusts. Since prices are fixed Q ∼ S
B (Q, y ) = X (Q ) − M (Q, y ) ≈ X (S ) − M (S, y )
Since prices are fixed, PPP does not necessarily hold
m (y , r ) = ky − lr ( 6= kPy )
Exchange Rate expectations are static
Capital mobility is less than perfect:
r 6= r ∗ in SR
0
Non-zero Capital Account Balance: K (r ) = k (r − r ∗ ) with K ≥ 0, r ∗
exogenously given.

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 16 / 72

Mundell-Fleming Model with Floating Rates

Define the BOP eq as: F (S, y , r ) = B (S, y ) + K (r ) = 0

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 17 / 72

Mundell-Fleming Model with Floating Rates

Define the BOP eq as: F (S, y , r ) = B (S, y ) + K (r ) = 0

Where

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 17 / 72

Mundell-Fleming Model with Floating Rates

Define the BOP eq as: F (S, y , r ) = B (S, y ) + K (r ) = 0

Where
∂F (S,y ,r )
∂S >0

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 17 / 72

Mundell-Fleming Model with Floating Rates

Define the BOP eq as: F (S, y , r ) = B (S, y ) + K (r ) = 0

Where
∂F (S,y ,r )
∂S >0
∂F (S,y ,r )
∂y <0

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 17 / 72

Mundell-Fleming Model with Floating Rates

Define the BOP eq as: F (S, y , r ) = B (S, y ) + K (r ) = 0

Where
∂F (S,y ,r )
∂S >0
∂F (S,y ,r )
∂y <0
∂F (S,y ,r )
∂r >0

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 17 / 72

Mundell-Fleming Model with Floating Rates

Define the BOP eq as: F (S, y , r ) = B (S, y ) + K (r ) = 0

Where
∂F (S,y ,r )
∂S >0
∂F (S,y ,r )
∂y <0
∂F (S,y ,r )
∂r >0
Can express BOP equilibrium in:

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 17 / 72

Mundell-Fleming Model with Floating Rates

Define the BOP eq as: F (S, y , r ) = B (S, y ) + K (r ) = 0

Where
∂F (S,y ,r )
∂S >0
∂F (S,y ,r )
∂y <0
∂F (S,y ,r )
∂r >0
Can express BOP equilibrium in:
(S, r ) or (y , r ) plane

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 17 / 72

BOP eq. in Mundell-Fleming Model
r r

r0 A r0 A

FF(y1>y0)

FF(y0) FF(y0)
S S
S0 S0
OR
r r
BP(S0) BP(S0) BP(S1>S0)

CA surplus A
A
r0 r0
CA deficit

y y
y0 y0

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 18 / 72

Summary of Mundell-Fleming Assumptions

An increase in S

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 19 / 72

Summary of Mundell-Fleming Assumptions

An increase in S
IS shifts right, BP shifts right, FF does not shift,

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 19 / 72

Summary of Mundell-Fleming Assumptions

An increase in S
IS shifts right, BP shifts right, FF does not shift,
An increase in y

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 19 / 72

Summary of Mundell-Fleming Assumptions

An increase in S
IS shifts right, BP shifts right, FF does not shift,
An increase in y
BP does not shift, FF shifts right.

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 19 / 72

Summary of Mundell-Fleming Assumptions

An increase in S
IS shifts right, BP shifts right, FF does not shift,
An increase in y
BP does not shift, FF shifts right.
If capital is perfectly mobile, BP and FF curves are flat.

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 19 / 72

Mundell-Fleming Model
r r
LM(M0)
BP(S0)

A
r0

IS(S0)
FF(y0)
S y
S0
y0
y CA Eq: B(y,s) =0 r
450 line

y0 y0
A
S y
S0
y0
Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 20 / 72
Increase in Money Supply (with floating rates)
!" !"
,-&-$(" 2<&#$("

,-&-)("
*
"!$""

"!)""

+#&#$("
%%&'$("
#" '"
"#$""
'$" ')"
'" .*"/01"2&'34("5$" !"
67$"89:;"

'$" '$"
*
#" '"
"#$""
'$"

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 21 / 72

Increase in Money Supply(with floating rates)
!" !"
./&/$(" +=&#$("

./&/,("
* +=&#,("
"!$""
+
"!)""
"!,""
-#&#,("

%%&',(" -#&#$("
%%&'$("
#" '"
"#$"" "#,""
'$" ',"
'" 0*"123"+&'45("6$" !"
78$"9:;<"

'," + ',"

'$" '$"
*
#" '"
"#$"" "#,""
'$" ',"
Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 22 / 72
Summary of Monetary Policy Intermediate Effects

An increase in Ms

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 23 / 72

Summary of Monetary Policy Intermediate Effects

An increase in Ms
LM shifts right, since AS is flat, real income y ↑ . To have money
market eq. r has to come down.

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 23 / 72

Summary of Monetary Policy Intermediate Effects

An increase in Ms
LM shifts right, since AS is flat, real income y ↑ . To have money
market eq. r has to come down.
As a result: y ↑, r ↓⇒ F (S, y , r ) < 0 because K (r ) ↓ (capital
account deficit)and B (S, y ) ↓ .(current account deficit).

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 23 / 72

Summary of Monetary Policy Intermediate Effects

An increase in Ms
LM shifts right, since AS is flat, real income y ↑ . To have money
market eq. r has to come down.
As a result: y ↑, r ↓⇒ F (S, y , r ) < 0 because K (r ) ↓ (capital
account deficit)and B (S, y ) ↓ .(current account deficit).
To retain BOP eq. S ↑

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 23 / 72

Summary of Monetary Policy Intermediate Effects

An increase in Ms
LM shifts right, since AS is flat, real income y ↑ . To have money
market eq. r has to come down.
As a result: y ↑, r ↓⇒ F (S, y , r ) < 0 because K (r ) ↓ (capital
account deficit)and B (S, y ) ↓ .(current account deficit).
To retain BOP eq. S ↑
If S ↑ then S (y , r ) − I (r ) < (G − T ) + B (S, y ) So IS shifts right
such that r ↑ to bring the capital account deficit down.

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 23 / 72

Summary of Monetary Policy Intermediate Effects

An increase in Ms
LM shifts right, since AS is flat, real income y ↑ . To have money
market eq. r has to come down.
As a result: y ↑, r ↓⇒ F (S, y , r ) < 0 because K (r ) ↓ (capital
account deficit)and B (S, y ) ↓ .(current account deficit).
To retain BOP eq. S ↑
If S ↑ then S (y , r ) − I (r ) < (G − T ) + B (S, y ) So IS shifts right
such that r ↑ to bring the capital account deficit down.
The adjustment through the goods market prevents a steep decrease in
r (i.e. r → r2 and r2 > r1 )

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 23 / 72

Summary of Monetary Policy Final Effects

An increase in Ms

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 24 / 72

Summary of Monetary Policy Final Effects

An increase in Ms
a depreciation of the currency

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 24 / 72

Summary of Monetary Policy Final Effects

An increase in Ms
a depreciation of the currency
increase in real income

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 24 / 72

Summary of Monetary Policy Final Effects

An increase in Ms
a depreciation of the currency
increase in real income
decrease in domestic interest rates assuming capital is not perfectly
mobile

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 24 / 72

Summary of Monetary Policy Final Effects

An increase in Ms
a depreciation of the currency
increase in real income
decrease in domestic interest rates assuming capital is not perfectly
mobile
improvement in current account and a deterioration in capital account,
no effect on BOP eq.

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 24 / 72

Summary of Monetary Policy Final Effects

An increase in Ms
a depreciation of the currency
increase in real income
decrease in domestic interest rates assuming capital is not perfectly
mobile
improvement in current account and a deterioration in capital account,
no effect on BOP eq.
How about the effects of monetary policy if there is perfect capital
mobility?

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 24 / 72

Fiscal Expansion with floating rates
r r
LM(M0)
BP(S0 )

A
r0

IS(S0)
FF(y0)
S y
S0
y0
y CA Eq: B(y,s) =0 r
450 line

y0 y0
A
S y
S0
y0

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 25 / 72

Fiscal Expansion with floating rates
r r
B LM(M0)
r1 BP(S0)

r0
A

IS(G1,S0)

FF(y1)
FF(y0) IS(G0,S0)
S y
S0
y0 y1
y CA Eq: B(y,s) =0 r
450 line

y0 A y0

S y
S0
y0

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 26 / 72

Fiscal Expansion with floating rates
r r BP(S1)
B LM(M0)
r1 BP(S0)
r2

r0
A

IS(G1,S0)

FF(y1) IS(G1,S1)
FF(y0) IS(G0,S0)
S y
S1 S0
y0 y2 y1
y CA Eq: B(y,s) =0 r
450 line

y2
B

y0 A y0

S y
S1 S0
y0 y2

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 27 / 72

Summary of Fiscal Policy Intermediate Effects

An increase in G

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 28 / 72

Summary of Fiscal Policy Intermediate Effects

An increase in G
IS shifts right, since AS is flat, real income y ↑ . To have money market
eq. r has to increase since money supply is fixed. r has to increase due
to higher equilibrium borrowing requirement of the government.

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 28 / 72

Summary of Fiscal Policy Intermediate Effects

An increase in G
IS shifts right, since AS is flat, real income y ↑ . To have money market
eq. r has to increase since money supply is fixed. r has to increase due
to higher equilibrium borrowing requirement of the government.
As a result: y ↑, r ↑⇒ A capital account surplus (K (r ) ↑) and a
current account deficit (B (S, y ) ↓) .. Since funds flows much faster
than goods and services it must be the case that K (r ) dominates
B (S, y ), K (r1 ) > B (S, y1 ) such that F (S, y , r ) > 0

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 28 / 72

Summary of Fiscal Policy Intermediate Effects

An increase in G
IS shifts right, since AS is flat, real income y ↑ . To have money market
eq. r has to increase since money supply is fixed. r has to increase due
to higher equilibrium borrowing requirement of the government.
As a result: y ↑, r ↑⇒ A capital account surplus (K (r ) ↑) and a
current account deficit (B (S, y ) ↓) .. Since funds flows much faster
than goods and services it must be the case that K (r ) dominates
B (S, y ), K (r1 ) > B (S, y1 ) such that F (S, y , r ) > 0
To retain BOP eq. S ↓

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 28 / 72

Summary of Fiscal Policy Intermediate Effects

An increase in G
IS shifts right, since AS is flat, real income y ↑ . To have money market
eq. r has to increase since money supply is fixed. r has to increase due
to higher equilibrium borrowing requirement of the government.
As a result: y ↑, r ↑⇒ A capital account surplus (K (r ) ↑) and a
current account deficit (B (S, y ) ↓) .. Since funds flows much faster
than goods and services it must be the case that K (r ) dominates
B (S, y ), K (r1 ) > B (S, y1 ) such that F (S, y , r ) > 0
To retain BOP eq. S ↓
If S ↓ then S (y , r ) − I (r ) > (G − T ) + B (S, y ) So IS shifts left such
that r ↓ to bring the capital account surplus down.

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 28 / 72

Summary of Fiscal Policy Intermediate Effects

An increase in G
IS shifts right, since AS is flat, real income y ↑ . To have money market
eq. r has to increase since money supply is fixed. r has to increase due
to higher equilibrium borrowing requirement of the government.
As a result: y ↑, r ↑⇒ A capital account surplus (K (r ) ↑) and a
current account deficit (B (S, y ) ↓) .. Since funds flows much faster
than goods and services it must be the case that K (r ) dominates
B (S, y ), K (r1 ) > B (S, y1 ) such that F (S, y , r ) > 0
To retain BOP eq. S ↓
If S ↓ then S (y , r ) − I (r ) > (G − T ) + B (S, y ) So IS shifts left such
that r ↓ to bring the capital account surplus down.
The adjustment through the goods market prevents a steep increase in
r (i.e. r → r2 and r2 < r1 )

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 28 / 72

Summary of Fiscal Policy Final Effects

An increase in G

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 29 / 72

Summary of Fiscal Policy Final Effects

An increase in G
an appreciation of the currency

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 29 / 72

Summary of Fiscal Policy Final Effects

An increase in G
an appreciation of the currency
increase in real income

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 29 / 72

Summary of Fiscal Policy Final Effects

An increase in G
an appreciation of the currency
increase in real income
increase in domestic interest rates assuming capital is not perfectly
mobile

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 29 / 72

Summary of Fiscal Policy Final Effects

An increase in G
an appreciation of the currency
increase in real income
increase in domestic interest rates assuming capital is not perfectly
mobile
improvement in capital account and a deterioration in current account,
no effect on BOP in eq.

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 29 / 72

Summary of Fiscal Policy Final Effects

An increase in G
an appreciation of the currency
increase in real income
increase in domestic interest rates assuming capital is not perfectly
mobile
improvement in capital account and a deterioration in current account,
no effect on BOP in eq.
crowding out of private investment I (r ) ↓

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 29 / 72

Summary of Fiscal Policy Final Effects

An increase in G
an appreciation of the currency
increase in real income
increase in domestic interest rates assuming capital is not perfectly
mobile
improvement in capital account and a deterioration in current account,
no effect on BOP in eq.
crowding out of private investment I (r ) ↓
How about the effects of fiscal policy if there is perfect capital
mobility?

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 29 / 72

Mundell-Fleming: Increase in Money Supply (with fixed
rates)
!" !"
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Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 30 / 72

Summary of Monetary Policy Effects: with Fixed Rates

Ms ↑: In SR a fall in r and an increase in real income, y . Since

F (r ) < 0 and B (S, y ) < 0 there is a BOP deficit.

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 31 / 72

Summary of Monetary Policy Effects: with Fixed Rates

Ms ↑: In SR a fall in r and an increase in real income, y . Since

F (r ) < 0 and B (S, y ) < 0 there is a BOP deficit.
Since S is fixed the CB has to sell FX to counter the flight from
domestic currency. And LM shifts back. Decrease in FX , no change
in r , y or S.

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 31 / 72

Fiscal Expansion with fixed rates
r r
LM(M0)
BP(S0 )

A
r0

IS(S0)
FF(y0)
S y
S0
y0
y CA Eq: B(y,s) =0 r
450 line

y0 y0
A
S y
S0
y0

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 32 / 72

Fiscal Expansion with fixed rates
r r LM(DC0, FX0 )
B
BP(S0 )
r1

r0
A

IS(G1)
FF(y0 ) IS(G0)
FF(y1 )
S y
S0
y0 y1
y CA Eq: B(y,s) =0 r
450 line

y1

y0 A y0

S y
S0
y0 y1

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 33 / 72

Fiscal Expansion with fixed rates
r r LM(DC0, FX1 )
LM(DC0, FX0 )
B
BP(S0 )
r1
r2
r0
A

IS(G1)
FF(y2 )
FF(y0 ) IS(G0)
FF(y1 )
S y
S0
y0 y1 y2
y CA Eq: B(y,s) =0 r
450 line

B
y2
y1

y0 A y0

S y
S0
y0 y1 y2

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 34 / 72

Summary of Fiscal Policy Effects

G ↑:an increase in r and an increase in real income, y . F (r ) > 0

and B (S, y ) < 0. In SR capital account dominates current account
and there is a BOP surplus.

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 35 / 72

Summary of Fiscal Policy Effects

G ↑:an increase in r and an increase in real income, y . F (r ) > 0

and B (S, y ) < 0. In SR capital account dominates current account
and there is a BOP surplus.
Since S is fixed the CB has to buy FX to counter the effects of hot
money inflows. (i.e. to prevent appreciation) And LM shifts right
(Increase in FX ) r decreases and y increases even further
deteriorating CA deficit even more.

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 35 / 72

Summary of Fiscal Policy Effects

G ↑:an increase in r and an increase in real income, y . F (r ) > 0

and B (S, y ) < 0. In SR capital account dominates current account
and there is a BOP surplus.
Since S is fixed the CB has to buy FX to counter the effects of hot
money inflows. (i.e. to prevent appreciation) And LM shifts right
(Increase in FX ) r decreases and y increases even further
deteriorating CA deficit even more.
Higher r , higher y , BOP eq, significant CA deficit.

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 35 / 72

Impulse Response Functions (M-F model: Mont. Policy
with floating Rates)
r y

r0 y0

t t
S0
CA, CPA S

CA
S0
t
CPA

t
Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 36 / 72
Dornbusch Model

Some weaknesses of preceding models:

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 37 / 72

Dornbusch Model

Some weaknesses of preceding models:

Monetary Model: exchange rates are far more volatile than monetary
variables (and prices) than implied by data

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 37 / 72

Dornbusch Model

Some weaknesses of preceding models:

Monetary Model: exchange rates are far more volatile than monetary
variables (and prices) than implied by data
M-F Model: with fixed prices policy conclusions are valid only in short
run,

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 37 / 72

Dornbusch Model

Some weaknesses of preceding models:

Monetary Model: exchange rates are far more volatile than monetary
variables (and prices) than implied by data
M-F Model: with fixed prices policy conclusions are valid only in short
run,
Dornbusch (1976) hybrid:

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 37 / 72

Dornbusch Model

Some weaknesses of preceding models:

Monetary Model: exchange rates are far more volatile than monetary
variables (and prices) than implied by data
M-F Model: with fixed prices policy conclusions are valid only in short
run,
Dornbusch (1976) hybrid:
Short run properties of Keynesian models

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 37 / 72

Dornbusch Model

Some weaknesses of preceding models:

Monetary Model: exchange rates are far more volatile than monetary
variables (and prices) than implied by data
M-F Model: with fixed prices policy conclusions are valid only in short
run,
Dornbusch (1976) hybrid:
Short run properties of Keynesian models
Long run properties of Monetary Model

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 37 / 72

Dornbusch Model

Empirical observation: financial markets adjust to shocks far more

rapidly than goods markets

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 38 / 72

Dornbusch Model

Empirical observation: financial markets adjust to shocks far more

rapidly than goods markets
Consequence for the model: in the short run, financial markets have
to overadjust in order to compensate for sluggish goods markets
(OVERSHOOTING)

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 38 / 72

Dornbusch Model

Empirical observation: financial markets adjust to shocks far more

rapidly than goods markets
Consequence for the model: in the short run, financial markets have
to overadjust in order to compensate for sluggish goods markets
(OVERSHOOTING)
With prices fixed in the short run, any change in the nominal money
supply changes real balances, requiring the interest rate to adjust to
clear the money market (Liquidity Effect).

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 38 / 72

Dornbusch Model

Empirical observation: financial markets adjust to shocks far more

rapidly than goods markets
Consequence for the model: in the short run, financial markets have
to overadjust in order to compensate for sluggish goods markets
(OVERSHOOTING)
With prices fixed in the short run, any change in the nominal money
supply changes real balances, requiring the interest rate to adjust to
clear the money market (Liquidity Effect).
In the long run, prices adjust fully, returning all real variables to their
pre-shock levels, but leaving the nominal exchange rate at the new
equilibrium level predicted by the simple Monetary Model

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 38 / 72

Dornbusch Model Assumptions
1 Small open economy (so P ∗ , r ∗ exogenous)

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 39 / 72

Dornbusch Model Assumptions
1 Small open economy (so P ∗ , r ∗ exogenous)
2 Initially, equilibrium inflation and exchange rate depreciation zero and
aggregate demand is determined by the standard open economy
IS-LM mechanism.

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 39 / 72

Dornbusch Model Assumptions
1 Small open economy (so P ∗ , r ∗ exogenous)
2 Initially, equilibrium inflation and exchange rate depreciation zero and
aggregate demand is determined by the standard open economy
IS-LM mechanism.
3 Price level is sticky: AS is horizontal in SR (impact phase),
increasingly steep in MR (adjustment phase) and vertical in LR.

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 39 / 72

Dornbusch Model Assumptions
1 Small open economy (so P ∗ , r ∗ exogenous)
2 Initially, equilibrium inflation and exchange rate depreciation zero and
aggregate demand is determined by the standard open economy
IS-LM mechanism.
3 Price level is sticky: AS is horizontal in SR (impact phase),
increasingly steep in MR (adjustment phase) and vertical in LR.
4 Financial markets adjust instantaneously. UIRP holds immediately
and the in LR

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 39 / 72

Dornbusch Model Assumptions
1 Small open economy (so P ∗ , r ∗ exogenous)
2 Initially, equilibrium inflation and exchange rate depreciation zero and
aggregate demand is determined by the standard open economy
IS-LM mechanism.
3 Price level is sticky: AS is horizontal in SR (impact phase),
increasingly steep in MR (adjustment phase) and vertical in LR.
4 Financial markets adjust instantaneously. UIRP holds immediately
and the in LR
5 Investors are risk neutral, so that UIRP holds always: r = r ∗ + ∆S e

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 39 / 72

Dornbusch Model Assumptions
1 Small open economy (so P ∗ , r ∗ exogenous)
2 Initially, equilibrium inflation and exchange rate depreciation zero and
aggregate demand is determined by the standard open economy
IS-LM mechanism.
3 Price level is sticky: AS is horizontal in SR (impact phase),
increasingly steep in MR (adjustment phase) and vertical in LR.
4 Financial markets adjust instantaneously. UIRP holds immediately
and the in LR
5 Investors are risk neutral, so that UIRP holds always: r = r ∗ + ∆S e

Theorem
Investors’ exchange rate expectations formed adaptively i.e. by
∆Ste = θ (S − St ) where θ > 0 is the sensitivity of market expectations to
over- or undervaluation of currency from equilibrium level, S, therefore
UIRP can be written as r = r ∗ + θ (S − St )

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 39 / 72

Dornbusch Model: Expectations

If St > S then ∆Ste < 0 and f St < S then ∆Ste > 0

r r

r1
r* r*

r1

RP ( S 1 > S 0 )
RP ( S 0 )
RP ( S 1 )
S S
S0 S1 S1 S 1

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 40 / 72

Dornbusch Model
r r
L M (M 0 / P 0 )

A
r0

RP ( S 0 )
IS(G0, Q0)
S y
S0 y0
P P
Q0 = SP0* / P
AS(LR)

AS(SR)
P0 y0
A
AD (G 0 , M 0 , S0 P0* )
S y
S0
Ozan Hatipoglu (Bogazici Economics)
y0
Open Economy Macroeconomics Spring 2015 41 / 72
Dornbusch Model: Monetary Expansion

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Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 42 / 72
Dornbusch Model: Monetary Expansion Long Run Effects

Long Run effects:

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 43 / 72

Dornbusch Model: Monetary Expansion Long Run Effects

Long Run effects:

AS is vertical which means that in LR there is no change in eq. real
income y0 and P ↑ such that to acommodate the increase in money
supply such that we have eq in both money ( an increase in money
demand to match the increase in money supply) and goods markets(
an increase in interest rates r starting from the initial lower rates that
result from an increase in Ms ).

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 43 / 72

Dornbusch Model: Monetary Expansion Long Run Effects

Long Run effects:

AS is vertical which means that in LR there is no change in eq. real
income y0 and P ↑ such that to acommodate the increase in money
supply such that we have eq in both money ( an increase in money
demand to match the increase in money supply) and goods markets(
an increase in interest rates r starting from the initial lower rates that
result from an increase in Ms ).
In LR PPP holds, i.e. Q = SP ∗ /P, since prices are higher therefore S
↑ in the long run. RP curve shifts right

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 43 / 72

Dornbusch Model: Monetary Expansion Long Run Effects

Long Run effects:

AS is vertical which means that in LR there is no change in eq. real
income y0 and P ↑ such that to acommodate the increase in money
supply such that we have eq in both money ( an increase in money
demand to match the increase in money supply) and goods markets(
an increase in interest rates r starting from the initial lower rates that
result from an increase in Ms ).
In LR PPP holds, i.e. Q = SP ∗ /P, since prices are higher therefore S
↑ in the long run. RP curve shifts right
We have current account equilibrium due to instantaneous adjustment
of CPA and PPP.

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 43 / 72

Dornbusch Model: Monetary Expansion Long Run Effects

Long Run effects:

AS is vertical which means that in LR there is no change in eq. real
income y0 and P ↑ such that to acommodate the increase in money
supply such that we have eq in both money ( an increase in money
demand to match the increase in money supply) and goods markets(
an increase in interest rates r starting from the initial lower rates that
result from an increase in Ms ).
In LR PPP holds, i.e. Q = SP ∗ /P, since prices are higher therefore S
↑ in the long run. RP curve shifts right
We have current account equilibrium due to instantaneous adjustment
of CPA and PPP.
IS and LM are in original positions

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 43 / 72

Dornbusch Model: Monetary Expansion Impact Effects

Impact Effects:

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 44 / 72

Dornbusch Model: Monetary Expansion Impact Effects

Impact Effects:
r ↓ (liquidity effect)

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 44 / 72

Dornbusch Model: Monetary Expansion Impact Effects

Impact Effects:
r ↓ (liquidity effect)
S ↑ : Starting from r = r ∗ + θ (S 0 − St ), r ↓, r0 → r1 where r1 < r0 .
And due to LR effects on prices we haveS ↑, S 0 → S 1 where S 1 > S 0 .
As a result r1 < r ∗ + θ (S 1 − St ). It must be the case that current
exchange rate St > S 1 , to have interest rate parity equilibrium
immediately.e. even higher than the long-run depreciated rate. This is
called overshooting. It results in over-competitiveness at least in SR.

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 44 / 72

Dornbusch Model: Monetary Expansion Impact Effects

Impact Effects:
r ↓ (liquidity effect)
S ↑ : Starting from r = r ∗ + θ (S 0 − St ), r ↓, r0 → r1 where r1 < r0 .
And due to LR effects on prices we haveS ↑, S 0 → S 1 where S 1 > S 0 .
As a result r1 < r ∗ + θ (S 1 − St ). It must be the case that current
exchange rate St > S 1 , to have interest rate parity equilibrium
immediately.e. even higher than the long-run depreciated rate. This is
called overshooting. It results in over-competitiveness at least in SR.
LM and IS shifts right.

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 44 / 72

Dornbusch Model: Monetary Expansion Adjustment Effects

Adjustment Effects:

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 45 / 72

Dornbusch Model: Monetary Expansion Adjustment Effects

Adjustment Effects:
P ↑: Prices start to increase as workers adjust their expectations.
Inflation starts to shift LM back. At the same time the because of
inflation the real exchange falls which starts to shift the IS curve back.

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 45 / 72

Dornbusch Model: Monetary Expansion Adjustment Effects

Adjustment Effects:
P ↑: Prices start to increase as workers adjust their expectations.
Inflation starts to shift LM back. At the same time the because of
inflation the real exchange falls which starts to shift the IS curve back.
r ↑, As real money stock falls interest rates rise reducing the money
demand which leads to an appreciation of the domestic currency up to
the new eq S 1 . As S ↓ IS shifts further back

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 45 / 72

Dornbusch Model: Monetary Expansion Adjustment Effects

Adjustment Effects:
P ↑: Prices start to increase as workers adjust their expectations.
Inflation starts to shift LM back. At the same time the because of
inflation the real exchange falls which starts to shift the IS curve back.
r ↑, As real money stock falls interest rates rise reducing the money
demand which leads to an appreciation of the domestic currency up to
the new eq S 1 . As S ↓ IS shifts further back
AD shifts back but still to the right of the original.

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 45 / 72

Dornbusch Model: Monetary Expansion Adjustment Effects

Adjustment Effects:
P ↑: Prices start to increase as workers adjust their expectations.
Inflation starts to shift LM back. At the same time the because of
inflation the real exchange falls which starts to shift the IS curve back.
r ↑, As real money stock falls interest rates rise reducing the money
demand which leads to an appreciation of the domestic currency up to
the new eq S 1 . As S ↓ IS shifts further back
AD shifts back but still to the right of the original.
Realn income back to its original level, y0 but prices remain higher.

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 45 / 72

Dornbusch Model
r r
LM ( M 0 / P 0 )

A C r0
r0
LM ( M 1 / P 0 )

r1
B r1

1
RP ( S ) IS(G0, Q1)
RP ( S 0 ) IS(G0, Q0)
S y
S1
S 0 S1 y0 y1
P P
Q0 = SP0* /P
AS(LR) 450 line

C
P1

AS(SR)
P0 B y0 AD (G0 , M 0 , S1P0* )

A AD (G0 , M 0 , S1 P0* )
AD (G0 , M 0 , S 0P0*)
S y
S0 S1 S1
y0 y1

itbpF4.3993in3.0147in0inFigure
Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 46 / 72
Portfolio Balance Model: Assumptions

How do people diversify their portfolios?

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 47 / 72

Portfolio Balance Model: Assumptions

How do people diversify their portfolios?

Risk aversion: How do people choose between two assets with
different returns and risks.

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 47 / 72

Portfolio Balance Model: Assumptions

How do people diversify their portfolios?

Risk aversion: How do people choose between two assets with
different returns and risks.
With utility maximization investors diversify their holdings of risk
assets.

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 47 / 72

Portfolio Balance Model: Assumptions

Demand for money generalised to demand for assets i.e. proportions

of wealth allocated to three markets

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 48 / 72

Portfolio Balance Model: Assumptions

Demand for money generalised to demand for assets i.e. proportions

of wealth allocated to three markets
Money market M/W

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 48 / 72

Portfolio Balance Model: Assumptions

Demand for money generalised to demand for assets i.e. proportions

of wealth allocated to three markets
Money market M/W
domestic currency bonds market B/W

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 48 / 72

Portfolio Balance Model: Assumptions

Demand for money generalised to demand for assets i.e. proportions

of wealth allocated to three markets
Money market M/W
domestic currency bonds market B/W
foreign currency bonds market SF /W

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 48 / 72

Portfolio Balance Model: Assumptions

Demand for money generalised to demand for assets i.e. proportions

of wealth allocated to three markets
Money market M/W
domestic currency bonds market B/W
foreign currency bonds market SF /W
Risk aversion

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 48 / 72

Portfolio Balance Model: Assumptions

Demand for money generalised to demand for assets i.e. proportions

of wealth allocated to three markets
Money market M/W
domestic currency bonds market B/W
foreign currency bonds market SF /W
Risk aversion
Investors diversify their holdings of risk assets. Portfolio share of a
particular asset will increase as its return relative to competing assets
increase.

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 48 / 72

Portfolio Balance Model: Assumptions

Imperfect capital mobility (as in M-F), so risk aversion prevents UIRP

Current account surplus/deficit →capital in/outflow +

increasing/decreasing stock of FX assets + changing equilibrium wealth
allocation

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 49 / 72

Portfolio Balance Model: Assumptions

Imperfect capital mobility (as in M-F), so risk aversion prevents UIRP

Sticky prices (as in Dornbusch), so balance of payments in temporary
disequilibrium
Current account surplus/deficit →capital in/outflow +
increasing/decreasing stock of FX assets + changing equilibrium wealth
allocation

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 49 / 72

Portfolio Balance Model: Assumptions

M, B are exogenous (issued by domestic government)

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 50 / 72

Portfolio Balance Model: Assumptions

M, B are exogenous (issued by domestic government)

r ∗ is exogenous (set in the rest of the world)

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 50 / 72

Portfolio Balance Model: Assumptions

M, B are exogenous (issued by domestic government)

r ∗ is exogenous (set in the rest of the world)
r , S are endogenous (determined within the model in the SR)

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 50 / 72

Portfolio Balance Model: Assumptions

M, B are exogenous (issued by domestic government)

r ∗ is exogenous (set in the rest of the world)
r , S are endogenous (determined within the model in the SR)
F , P, W are exogenous in the short run (fixed by past current account
imbalances)

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 50 / 72

Portfolio Balance Model: Assumptions

M, B are exogenous (issued by domestic government)

r ∗ is exogenous (set in the rest of the world)
r , S are endogenous (determined within the model in the SR)
F , P, W are exogenous in the short run (fixed by past current account
imbalances)
F , P, W are endogenous in the long run (determined by current and
future current account imbalances)

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 50 / 72

Portfolio Balance Model: Assumptions

Domestic investors hold foreign assets, but not vice versa i.e.
foreigners hold no domestic assets

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 51 / 72

Portfolio Balance Model: Assumptions

Domestic investors hold foreign assets, but not vice versa i.e.
foreigners hold no domestic assets
Other forms of wealth (e.g. equity, human capital) can be ignored: all
wealth is allocated to money, domestic or foreign bonds

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 51 / 72

Portfolio Balance Model: Assumptions

Domestic investors hold foreign assets, but not vice versa i.e.
foreigners hold no domestic assets
Other forms of wealth (e.g. equity, human capital) can be ignored: all
wealth is allocated to money, domestic or foreign bonds
Bonds short term – so capital gains/losses resulting from interest rate
changes are negligible

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 51 / 72

Portfolio Balance Model: Assumptions

Risk averse agents will take account of both risk and return,
diversifying their asset portfolio to attain best (i.e utility-maximising)
risk-return combination

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 52 / 72

Portfolio Balance Model: Assumptions

Risk averse agents will take account of both risk and return,
diversifying their asset portfolio to attain best (i.e utility-maximising)
risk-return combination
Equilibrium in asset markets involves different (expected) rates of
return to compensate for risk differences between assets

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 52 / 72

Portfolio Balance Model: Assumptions

Risk averse agents will take account of both risk and return,
diversifying their asset portfolio to attain best (i.e utility-maximising)
risk-return combination
Equilibrium in asset markets involves different (expected) rates of
return to compensate for risk differences between assets
Given risks associated with each asset class, small increase in return
on asset j (relative to competing assets) increases demand for j

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 52 / 72

Portfolio Balance Model: Assumptions

Risk averse agents will take account of both risk and return,
diversifying their asset portfolio to attain best (i.e utility-maximising)
risk-return combination
Equilibrium in asset markets involves different (expected) rates of
return to compensate for risk differences between assets
Given risks associated with each asset class, small increase in return
on asset j (relative to competing assets) increases demand for j
Given wealth is fixed in short run, increase in demand for j implies fall
in demand for other assets cet par.

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 52 / 72

Portfolio Balance Model: Asset Markets

The nominal wealth, W, can be written as W = M + B + SF where

bars denote exogenous variables.

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 53 / 72

Portfolio Balance Model: Asset Markets

The nominal wealth, W, can be written as W = M + B + SF where

bars denote exogenous variables.
Equilibrium in each market is defined as follows:

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 53 / 72

Portfolio Balance Model: Asset Markets

The nominal wealth, W, can be written as W = M + B + SF where

bars denote exogenous variables.
Equilibrium in each market is defined as follows:
M
W = m(r , r ∗ + ∆s e ), m1 < 0, m2 < 0,

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 53 / 72

Portfolio Balance Model: Asset Markets

The nominal wealth, W, can be written as W = M + B + SF where

bars denote exogenous variables.
Equilibrium in each market is defined as follows:
M
W = m(r , r ∗ + ∆s e ), m1 < 0, m2 < 0,
B
W = b (r , r ∗ + ∆s e ), b1 > 0, b2 < 0,

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 53 / 72

Portfolio Balance Model: Asset Markets

The nominal wealth, W, can be written as W = M + B + SF where

bars denote exogenous variables.
Equilibrium in each market is defined as follows:
M
W = m(r , r ∗ + ∆s e ), m1 < 0, m2 < 0,
B
W = b (r , r ∗ + ∆s e ), b1 > 0, b2 < 0,
SF
W = f (r , r ∗ + ∆s e ), f1 < 0, f2 > 0,

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 53 / 72

Portfolio Balance Model: Asset Markets

The nominal wealth, W, can be written as W = M + B + SF where

bars denote exogenous variables.
Equilibrium in each market is defined as follows:
M
W = m(r , r ∗ + ∆s e ), m1 < 0, m2 < 0,
B
W = b (r , r ∗ + ∆s e ), b1 > 0, b2 < 0,
SF
W = f (r , r ∗ + ∆s e ), f1 < 0, f2 > 0,
b1 + b2 > 0, f1 + f2 > 0, (own returen effects dominate cross return
effects)

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 53 / 72

Portfolio Balance Model: Asset Markets

The nominal wealth, W, can be written as W = M + B + SF where

bars denote exogenous variables.
Equilibrium in each market is defined as follows:
M
W = m(r , r ∗ + ∆s e ), m1 < 0, m2 < 0,
B
W = b (r , r ∗ + ∆s e ), b1 > 0, b2 < 0,
SF
W = f (r , r ∗ + ∆s e ), f1 < 0, f2 > 0,
b1 + b2 > 0, f1 + f2 > 0, (own returen effects dominate cross return
effects)
In SR, W is constant→ m1 + b1 + f1 = 0 and m2 + b2 + f2 = 0

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 53 / 72

Portfolio Balance Model: Asset Markets

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 54 / 72

Open Market Purchase of Dom. Bonds

Buy domestic bonds→excess supply of money and excess demand for

bonds. Price of bonds↑ and rates↓ . Foreign assets become more
attractive: S ↑ . How about open market purchase of foreign bonds?
how about an increase in the stock of FX assets?

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 55 / 72

Portfolio Balance Model: Long Run Effects

Similar to monetary model

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 56 / 72

Portfolio Balance Model: Long Run Effects

Similar to monetary model

i.e. rate of inflation=percentage change in money supply

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 56 / 72

Portfolio Balance Model: Long Run Effects

Similar to monetary model

i.e. rate of inflation=percentage change in money supply
but rate of depreciation < percentage change in money supply. Why?

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 56 / 72

Portfolio Balance Model: Long Run Effects

Similar to monetary model

i.e. rate of inflation=percentage change in money supply
but rate of depreciation < percentage change in money supply. Why?
Impact effect: S↑ but prices are constant in SR. Therefore there is
real depreciation and current account surplus. A rising foreign
currency stock implies appreciation. And in the adjustment phase
prices increase reducing competitivenes,but CA surplus remains until
long run.

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 56 / 72

Portfolio Balance Model: Microfoundations

Differences in risk between foreign and domestic asset are caused by

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 57 / 72

Portfolio Balance Model: Microfoundations

Differences in risk between foreign and domestic asset are caused by

Tax treatment,

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 57 / 72

Portfolio Balance Model: Microfoundations

Differences in risk between foreign and domestic asset are caused by

Tax treatment,
default risk,

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 57 / 72

Portfolio Balance Model: Microfoundations

Differences in risk between foreign and domestic asset are caused by

Tax treatment,
default risk,
political risk,

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 57 / 72

Portfolio Balance Model: Microfoundations

Differences in risk between foreign and domestic asset are caused by

Tax treatment,
default risk,
political risk,
inflation risk,

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 57 / 72

Portfolio Balance Model: Microfoundations

Differences in risk between foreign and domestic asset are caused by

Tax treatment,
default risk,
political risk,
inflation risk,
exchange rate risks

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 57 / 72

Portfolio Balance Model: Microfoundations

Differences in risk between foreign and domestic asset are caused by

Tax treatment,
default risk,
political risk,
inflation risk,
exchange rate risks
business cycle risks

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 57 / 72

Determinants of Risk Premium

Risk premium exist if

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 58 / 72

Determinants of Risk Premium

Risk premium exist if

both assets are not equally risky

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 58 / 72

Determinants of Risk Premium

Risk premium exist if

both assets are not equally risky
There is no perfect capital mobility

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 58 / 72

Determinants of Risk Premium

Risk premium exist if

both assets are not equally risky
There is no perfect capital mobility
Investors are risk averse

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 58 / 72

Determinants of Risk Premium

Risk premium exist if

both assets are not equally risky
There is no perfect capital mobility
Investors are risk averse
Definition
Risk is defined as the variance of capital gains(losses). A riskless asset has
a small variance and a low probability of capital loss, a risky asset has a
high variance and a high probability of capital loss.

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 58 / 72

Money vs. Bonds vs. Shares

Money is a low risk asset in the short run. The associated risks are:

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 59 / 72

Money vs. Bonds vs. Shares

Money is a low risk asset in the short run. The associated risks are:
Inflation risk.

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 59 / 72

Money vs. Bonds vs. Shares

Money is a low risk asset in the short run. The associated risks are:
Inflation risk.
Bond is a low risk asset. The associated risks are

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 59 / 72

Money vs. Bonds vs. Shares

Money is a low risk asset in the short run. The associated risks are:
Inflation risk.
Bond is a low risk asset. The associated risks are
Price risk (if one buys and sells on a secondary market)

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 59 / 72

Money vs. Bonds vs. Shares

Money is a low risk asset in the short run. The associated risks are:
Inflation risk.
Bond is a low risk asset. The associated risks are
Price risk (if one buys and sells on a secondary market)
Default risk

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 59 / 72

Money vs. Bonds vs. Shares

Money is a low risk asset in the short run. The associated risks are:
Inflation risk.
Bond is a low risk asset. The associated risks are
Price risk (if one buys and sells on a secondary market)
Default risk
Shares are high risk assets: The associated risks are

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 59 / 72

Money vs. Bonds vs. Shares

Money is a low risk asset in the short run. The associated risks are:
Inflation risk.
Bond is a low risk asset. The associated risks are
Price risk (if one buys and sells on a secondary market)
Default risk
Shares are high risk assets: The associated risks are
Dividend Risk

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 59 / 72

Money vs. Bonds vs. Shares

Money is a low risk asset in the short run. The associated risks are:
Inflation risk.
Bond is a low risk asset. The associated risks are
Price risk (if one buys and sells on a secondary market)
Default risk
Shares are high risk assets: The associated risks are
Dividend Risk
Price Risks (Market Risks)

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 59 / 72

A simple model

Assume investor can invest in two assets: Money or bonds. Assume

money is riskless and bonds are risky. Bonds pay a return of i on the
capital invested at the maturity. Let γ be the share of the individual’s
portfolio invested in bonds. Let π be the capital gain (or loss), i.e.
gain obtained by changes in the price of the bond.The rate of return,
r on the portfolio is given by

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 60 / 72

A simple model

Assume investor can invest in two assets: Money or bonds. Assume

money is riskless and bonds are risky. Bonds pay a return of i on the
capital invested at the maturity. Let γ be the share of the individual’s
portfolio invested in bonds. Let π be the capital gain (or loss), i.e.
gain obtained by changes in the price of the bond.The rate of return,
r on the portfolio is given by
r = γ (i + π )

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 60 / 72

A simple model

Assume investor can invest in two assets: Money or bonds. Assume

money is riskless and bonds are risky. Bonds pay a return of i on the
capital invested at the maturity. Let γ be the share of the individual’s
portfolio invested in bonds. Let π be the capital gain (or loss), i.e.
gain obtained by changes in the price of the bond.The rate of return,
r on the portfolio is given by
r = γ (i + π )
Assume E (π ) = 0 then E (r ) = E (γ(i + π )) = γE (i ) = γi because
i is fixed at the maturity.

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 60 / 72

A simple model

Assume investor can invest in two assets: Money or bonds. Assume

money is riskless and bonds are risky. Bonds pay a return of i on the
capital invested at the maturity. Let γ be the share of the individual’s
portfolio invested in bonds. Let π be the capital gain (or loss), i.e.
gain obtained by changes in the price of the bond.The rate of return,
r on the portfolio is given by
r = γ (i + π )
Assume E (π ) = 0 then E (r ) = E (γ(i + π )) = γE (i ) = γi because
i is fixed at the maturity.
The variance of the rate of the return on bonds

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 60 / 72

A simple model

Assume investor can invest in two assets: Money or bonds. Assume

money is riskless and bonds are risky. Bonds pay a return of i on the
capital invested at the maturity. Let γ be the share of the individual’s
portfolio invested in bonds. Let π be the capital gain (or loss), i.e.
gain obtained by changes in the price of the bond.The rate of return,
r on the portfolio is given by
r = γ (i + π )
Assume E (π ) = 0 then E (r ) = E (γ(i + π )) = γE (i ) = γi because
i is fixed at the maturity.
The variance of the rate of the return on bonds
E (r − E (r ))2 = σr2 = γ2 σπ2

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 60 / 72

A simple model

Assume investor can invest in two assets: Money or bonds. Assume

money is riskless and bonds are risky. Bonds pay a return of i on the
capital invested at the maturity. Let γ be the share of the individual’s
portfolio invested in bonds. Let π be the capital gain (or loss), i.e.
gain obtained by changes in the price of the bond.The rate of return,
r on the portfolio is given by
r = γ (i + π )
Assume E (π ) = 0 then E (r ) = E (γ(i + π )) = γE (i ) = γi because
i is fixed at the maturity.
The variance of the rate of the return on bonds
E (r − E (r ))2 = σr2 = γ2 σπ2
because r − E (r ) = γπ and (r − E (r ))2 = γ2 π 2

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 60 / 72

A simple model

Assume investor can invest in two assets: Money or bonds. Assume

money is riskless and bonds are risky. Bonds pay a return of i on the
capital invested at the maturity. Let γ be the share of the individual’s
portfolio invested in bonds. Let π be the capital gain (or loss), i.e.
gain obtained by changes in the price of the bond.The rate of return,
r on the portfolio is given by
r = γ (i + π )
Assume E (π ) = 0 then E (r ) = E (γ(i + π )) = γE (i ) = γi because
i is fixed at the maturity.
The variance of the rate of the return on bonds
E (r − E (r ))2 = σr2 = γ2 σπ2
because r − E (r ) = γπ and (r − E (r ))2 = γ2 π 2
E (γ2 π 2 ) = γ2 E (π 2 ) = γ2 σπ2

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 60 / 72

A simple model

or σr = γσπ Given the capital riskiness the higher you invest in

bonds ( higher γ ) the higher the risk you are taking

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 61 / 72

A simple model

or σr = γσπ Given the capital riskiness the higher you invest in

bonds ( higher γ ) the higher the risk you are taking
How do the individual determines γ optimally? Assume the
individual tries to maximize

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 61 / 72

A simple model

or σr = γσπ Given the capital riskiness the higher you invest in

bonds ( higher γ ) the higher the risk you are taking
How do the individual determines γ optimally? Assume the
individual tries to maximize
U (r ) = E (r ) − 1/2ρvar (r ) where ρ is the relative risk aversion given
the relative return-riskiness of asset, i.e. E (r )/σr = γi /γσπ = i /σπ

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 61 / 72

A simple model

!"#$&!
σr

!
"#$%&!

γ
%! γ0 '!
Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 62 / 72
A simple model

U (r ) = E (r ) − 1/2ρvar (r ) where ρ is the relative risk aversion given

the relative return-riskiness of asset, i.e. E (r )/σr = γi /γσπ = i /σπ

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 63 / 72

A simple model

U (r ) = E (r ) − 1/2ρvar (r ) where ρ is the relative risk aversion given

the relative return-riskiness of asset, i.e. E (r )/σr = γi /γσπ = i /σπ
max E (r ) − 1/2ρvar (r ) s.t. E (r )/σr = i /σπ
γ

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 63 / 72

A simple model

U (r ) = E (r ) − 1/2ρvar (r ) where ρ is the relative risk aversion given

the relative return-riskiness of asset, i.e. E (r )/σr = γi /γσπ = i /σπ
max E (r ) − 1/2ρvar (r ) s.t. E (r )/σr = i /σπ
γ

max γi − 1/2ργ2 σπ2

γ

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 63 / 72

A simple model

U (r ) = E (r ) − 1/2ρvar (r ) where ρ is the relative risk aversion given

the relative return-riskiness of asset, i.e. E (r )/σr = γi /γσπ = i /σπ
max E (r ) − 1/2ρvar (r ) s.t. E (r )/σr = i /σπ
γ

max γi − 1/2ργ2 σπ2

γ
i
FOC: i − ργσπ2 = 0 γ= ρσπ2

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 63 / 72

A simple model

U (r ) = E (r ) − 1/2ρvar (r ) where ρ is the relative risk aversion given

the relative return-riskiness of asset, i.e. E (r )/σr = γi /γσπ = i /σπ
max E (r ) − 1/2ρvar (r ) s.t. E (r )/σr = i /σπ
γ

max γi − 1/2ργ2 σπ2

γ
i
FOC: i − ργσπ2 = 0 γ= ρσπ2
i2
E (r ) = E (γi ) = ρσπ2

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 63 / 72

A simple model:Domestic vs. foreign bonds.

r = (1 − γ)(π + i ) + γ(π ∗ + i ∗ )

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 64 / 72

A simple model:Domestic vs. foreign bonds.

r = (1 − γ)(π + i ) + γ(π ∗ + i ∗ )
E (r ) = (1 − γ)i + γi ∗

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 64 / 72

A simple model:Domestic vs. foreign bonds.

r = (1 − γ)(π + i ) + γ(π ∗ + i ∗ )
E (r ) = (1 − γ)i + γi ∗
var (r ) = σr2 = E (r − E (r ))2 = (1 − γ)2 σπ2 + γ2 σπ2 ∗ + 2γ(1 − γ)σπ,π ∗
where σπ,π ∗ = covariance between capital losses (gains) in domestic
and foreign bonds

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 64 / 72

A simple model:Domestic vs. foreign bonds.

r = (1 − γ)(π + i ) + γ(π ∗ + i ∗ )
E (r ) = (1 − γ)i + γi ∗
var (r ) = σr2 = E (r − E (r ))2 = (1 − γ)2 σπ2 + γ2 σπ2 ∗ + 2γ(1 − γ)σπ,π ∗
where σπ,π ∗ = covariance between capital losses (gains) in domestic
and foreign bonds
If σπ,π ∗ < 0 Capital loss in one asset is offset by the other reducing
overall risk.

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 64 / 72

A simple model:Domestic vs. foreign bonds.

r = (1 − γ)(π + i ) + γ(π ∗ + i ∗ )
E (r ) = (1 − γ)i + γi ∗
var (r ) = σr2 = E (r − E (r ))2 = (1 − γ)2 σπ2 + γ2 σπ2 ∗ + 2γ(1 − γ)σπ,π ∗
where σπ,π ∗ = covariance between capital losses (gains) in domestic
and foreign bonds
If σπ,π ∗ < 0 Capital loss in one asset is offset by the other reducing
overall risk.
If σπ,π ∗ > 0 Capital loss in one asset is reinforced by the other

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 64 / 72

A simple model:Domestic vs. foreign bonds.

Empirical evidence σπ,π ∗ is lower than the covariance between

domestic assets which implies that international diversification
reduces the riskiness of portfolios.

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 65 / 72

A simple model:Domestic vs. foreign bonds.

Empirical evidence σπ,π ∗ is lower than the covariance between

domestic assets which implies that international diversification
reduces the riskiness of portfolios.
If σπ2 = σπ2 ∗ then σr2 = 2γ(1 − γ)σπ,π ∗

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 65 / 72

Present value model

Consider the following standard present value model with risk neutral
agents:

1
Pt = Et (Pt +1 + dt )
1 + rt
Pt :the real stock price at time t
Dt : the real dividend paid at time t
rt : required rate of return

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 66 / 72

Present value model

Consider the following standard present value model with risk neutral
agents:

1
Pt = Et (Pt +1 + dt )
1 + rt
Pt :the real stock price at time t
Dt : the real dividend paid at time t
rt : required rate of return
The solution to the above equation is given by

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 66 / 72

Present value model

Consider the following standard present value model with risk neutral
agents:

1
Pt = Et (Pt +1 + dt )
1 + rt
Pt :the real stock price at time t
Dt : the real dividend paid at time t
rt : required rate of return
The solution to the above equation is given by
 2
Pt = 1+1rt Et (Pt +2 + Dt +1 )) + 1+1rt Dt = ... =
 i  i
∑i∞=0 1+1rt Et Dt +i + lim 1+1rt Et (Pt +i ) (1)
i →∞
Fundamentals % - Bubble

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 66 / 72

Intrinsic Rational Bubbles

 i
If the transversality conditions hold, i.e. lim 1+1rt Et (Pt +i ) = 0 or
i →∞
 i
if Et (Pt +i )/Pt ≤ 1 + rt then Pt = ∑i∞=0 1+1rt Et Dt +i .

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 67 / 72

Intrinsic Rational Bubbles

 i
If the transversality conditions hold, i.e. lim 1+1rt Et (Pt +i ) = 0 or
i →∞
 i
if Et (Pt +i )/Pt ≤ 1 + rt then Pt = ∑i∞=0 1+1rt Et Dt +i .
 i
Uncertainty about fundamentals:∑i∞=0 1+1rt Et Dt +i . Froot and
Obstfeld (1991) assumption of a constant random walk with drift is
shown to be invalid by Driffill and Sola (1998)

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 67 / 72

Intrinsic Rational Bubbles

 i
If the transversality conditions hold, i.e. lim 1+1rt Et (Pt +i ) = 0 or
i →∞
 i
if Et (Pt +i )/Pt ≤ 1 + rt then Pt = ∑i∞=0 1+1rt Et Dt +i .
 i
Uncertainty about fundamentals:∑i∞=0 1+1rt Et Dt +i . Froot and
Obstfeld (1991) assumption of a constant random walk with drift is
shown to be invalid by Driffill and Sola (1998)
 i
Uncertainty about bubbles: Is lim 1+1rt Et (Pt +i ) exogenous or
i →∞
intrinsic?

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 67 / 72

Intrinsic Rational Bubbles

 i
If the transversality conditions hold, i.e. lim 1+1rt Et (Pt +i ) = 0 or
i →∞
 i
if Et (Pt +i )/Pt ≤ 1 + rt then Pt = ∑i∞=0 1+1rt Et Dt +i .
 i
Uncertainty about fundamentals:∑i∞=0 1+1rt Et Dt +i . Froot and
Obstfeld (1991) assumption of a constant random walk with drift is
shown to be invalid by Driffill and Sola (1998)
 i
Uncertainty about bubbles: Is lim 1+1rt Et (Pt +i ) exogenous or
i →∞
intrinsic?
For each time the hypothesis of bubbles is not rejected, there might
be other fundamental processes that explain the price volatility.

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 67 / 72

Intrinsic Rational Bubbles
8 200%

7
150%

6
100%

5
50%

0%
3

Ͳ50%
2

Ͳ100%
1
Actual Price
% Bubbles
0 Ͳ150%
1871

1879

1887

1896

1904

1912

1921

1929

1937

1946

1954

1962

1971

1979

1987

1996

2004
Figure : Prices and bubble percentages: USA.

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 68 / 72

Intrinsic Rational Bubbles
7 400%

300%
6

200%
5
100%

4 0%

3 Ͳ100%

Ͳ200%
2
Ͳ300%

1
Ͳ400%
Actual Price
% Bubbles
0 Ͳ500%
1989

1991

1993

1994

1996

1998

1999

2001

2003

2004

2006

2008
Figure : Prices and bubble percentages: Turkey.

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 69 / 72

Intrinsic Rational Bubbles
8 100%

50%
6

5
0%

Ͳ50%
3

2
Ͳ100%

1
Actual Price
% Bubbles
0 Ͳ150%
1973

1975

1978

1980

1983

1985

1988

1990

1993

1995

1998

2000

2003

2005

2008
Figure : Prices and bubble percentages: World.

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 70 / 72

Intrinsic Rational Bubbles

7 200% 6.6 40%

30%
6 150% 6.4
20%
5 100% 6.2 10%
4 50% 6 0%
-10%
3 0% 5.8 -20%
2 -50% 5.6 -30%
-40%
1 -100% 5.44
-50%
0 -150% 5.2 -60%
1925 1926 1927 1928 1929 1930 1931 1932 1933 1934 1935 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978

6.5 30% 7.6 30%

6.4 20% 20%
7.4
74
6.3 10%
7.2 10%
6.2 0%
6.1 0%
-10% 7
6 -10%
-20% 6.8
5.9 -20%
5.8 30%
-30%
6.6 -30%
5.7 -40%
-50% 6.4 -40%
5.6
5.5 -60% 6.2 -50%
1985 1986 1987 1988 1989 2004 2005 2006 2007 2008 2009 ActualPrice
Bubble

Figure : Crises in US.

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 71 / 72

Intrinsic Rational Bubbles

6 300% 7 300%
200% 6 200%
5
100% 5 100%
4
0%
4 0%
3 -100%
3 -100%
-200%
2
2 -200%
-300%
1 1 -300%
-400%
0 -500% 0 -400%
1993 1993 1993 1994 1994 1995 1999 2000 2001 2002

6.4 150% 6.6 150%

6.4 100%
6.2 100%
6.2 50%
6 50% 6 0%
5.8 -50%
5.8 0%
5.6 -100%
5.6 -50% 5.4 -150%
5.2 -200%
5.4 -100%
5 -250%
5.2 -150% 4.8 -300%
2005 2005 2006 2006 2006 2008 2008 2008 2009 !"#$%&'()*"+'
,$--&+'

Figure : Crises in Turkey.

Ozan Hatipoglu (Bogazici Economics) Open Economy Macroeconomics Spring 2015 72 / 72