International Monetary Economics

Determination of Output
in an Open Economy

Presentation prepared by Francisco Veiga,

based on the slides provided by Pearson Education, Inc.
 International Monetary Economics

3.1
Output and the Exchange
Rate in the Short Run

◼ Bibliography:
⚫ Krugman, Obstfeld & Melitz (2023), Chapter 17.

F.Veiga - International Monetary Economics Chapter 3 - 2

 Introduction

◼ Long-run models are useful when all prices of inputs and

outputs have time to adjust.

◼ In the short run, some prices of inputs and outputs may not
have time to adjust, due to labor contracts, costs of
adjustment, or imperfect information about willingness of
customers to pay at different prices.

◼ This chapter builds on the short-run and long-run models of

exchange rates to explain how output is related to exchange
rates in the short run.
⚫ It shows how macroeconomic policies can affect production,
employment, and the current account.

F.Veiga - International Monetary Economics Chapter 3 - 3

 Determinants of Aggregate
Demand

◼ Aggregate demand is the aggregate amount of

goods and services that people are willing to buy:

1. consumption expenditure
2. investment expenditure
3. government purchases
4. net expenditure by foreigners: the current account

F.Veiga - International Monetary Economics Chapter 3 - 4

 Short-Run Equilibrium for Aggregate
Demand and Output

◼ Aggregate demand:
𝐸𝑃∗
𝐷 = 𝐶 𝑌 − 𝑇 + 𝐼 + 𝐺 + 𝐶𝐴 𝑃
,𝑌 −𝑇

𝐸𝑃∗
𝐷=𝐷 , 𝑌 − 𝑇, 𝐼, 𝐺
𝑃

⚫ Equilibrium is achieved when the value of output and income

from production Y equals the value of aggregate demand D:

𝐸𝑃∗
𝑌=𝐷 , 𝑌 − 𝑇, 𝐼, 𝐺
𝑃

F.Veiga - International Monetary Economics Chapter 3 - 5

 Short Run Equilibrium and the
Exchange Rate: DD Schedule

◼ The DD schedule
⚫ shows combinations of output and the exchange
rate at which the output market is in short run
equilibrium (aggregate demand = aggregate
output).
⚫ slopes upward because a rise in the exchange rate
causes aggregate demand
and aggregate output to rise.

F.Veiga - International Monetary Economics Chapter 3 - 6

 Deriving the
DD Schedule

The D D schedule slopes upward

because a rise in the exchange rate
from E1 to E2 all else equal, causes
output to rise from Y1 to Y2.

F.Veiga - International Monetary Economics Chapter 3 - 7

 Shifting the DD Curve
(to the Right)

1. Changes in G (more government purchases).

2. Changes in T (lower taxes).

3. Changes in I (higher investment).

4. Changes in P relative to P* (lower domestic prices relative

to foreign prices).

5. Changes in C (willingness to consume more and save less).

6. Changes in demand for domestic goods relative to

foreign goods (willingness to consume more domestic
goods relative to foreign goods).

F.Veiga - International Monetary Economics Chapter 3 - 8

 Short Run Equilibrium in
Asset Markets
◼ We consider two asset markets:

1. Foreign exchange market

⚫ interest parity represents equilibrium:
𝐸 𝑒−𝐸
𝑅 = 𝑅∗ +
𝐸
2. Money market
⚫ Equilibrium occurs when real money supply equals real
money demand:
𝑀𝑆
= 𝐿 𝑅, 𝑌
𝑃
⚫ A rise in income and output causes real money demand to
increase.

F.Veiga - International Monetary Economics Chapter 3 - 9

 Short Run
Equilibrium in
Asset Markets

For the asset (foreign exchange

and money) markets to remain
in equilibrium, a rise in output
must be accompanied by an
appreciation of the currency, all
else equal.

F.Veiga - International Monetary Economics Chapter 3 - 10

 Short Run Equilibrium for Assets:
AA Curve (cont.)

Equilibrium exchange
rate in foreign
exchange market;
Equilibrium output in
money market.

The asset market equilibrium schedule (AA) slopes downward because a rise in output
from Y1 to Y2, all else equal, causes a rise in the home interest rate and a domestic
currency appreciation from E1 to E2.

F.Veiga - International Monetary Economics Chapter 3 - 11

 Shifting the AA Curve (Up)

1. Changes in Ms (increase in the money supply).

2. Changes in P (decrease in the domestic price
level).
3. Changes in real money demand (lower real
money demand).
4. Changes in R* (increase in the foreign interest
rates).
5. Changes in Ee (market participants expect the
domestic currency to depreciate in the future).

F.Veiga - International Monetary Economics Chapter 3 - 12

 Short-Run Equilibrium: The
Intersection of DD and AA

The short-run equilibrium of the economy occurs at point 1, where the output market
(whose equilibrium points are summarized by the DD curve) and the asset markets
(whose equilibrium points are summarized by the AA curve) simultaneously clear.

F.Veiga - International Monetary Economics Chapter 3 - 13

 Temporary Changes in
Monetary and Fiscal Policy

◼ Monetary policy: policy in which the central bank

influences the money supply.
⚫ Monetary policy primarily influences asset markets.
◼ Fiscal policy: policy in which governments
(fiscal authorities) influence the amount of
government purchases and taxes.
⚫ Fiscal policy primarily influences aggregate demand
and output.
◼ Temporary policy changes are expected to be
reversed in the near future and thus do not affect
expectations about exchange rates in the long run.

F.Veiga - International Monetary Economics Chapter 3 - 14

 Policies to Maintain
Full Employment

◼ Expansionary policies may be used to restore full employment

after temporary shocks which reduce output.

◼ Policies to maintain full employment may seem easy in theory,

but are hard in practice.
1. We have assumed that prices and expectations do not change, but
people may anticipate the effects of policy changes and modify their
behavior.
2. Economic data are hard to measure and hard to understand.
3. Changes in policies take time to be implemented and take time to
affect the economy.
4. Policies are sometimes influenced by political or bureaucratic
interests.

F.Veiga - International Monetary Economics Chapter 3 - 15

 Permanent Changes in Monetary and
Fiscal Policy

◼ Permanent policy changes modify people’s expectations about

exchange rates in the long run.

◼ A permanent increase in the level of the money supply

⚫ Short-run: Y rises and E overshoots
⚫ Long-run: P rises, Y returns to full employment and E falls
(overall, E rises proportionally with MS and P)

◼ A permanent increase in government purchases

⚫ Short-run: the appreciation of the domestic currency completely crowds
out the increase in government expenditure
⚫ Long-run: no effects, as the economy remained at full employment.

F.Veiga - International Monetary Economics Chapter 3 - 16

 Macroeconomic Policies and the
Current Account

◼ To determine the effect of monetary and fiscal policies on the

current account,
⚫ derive the XX curve to represent the combinations of output and
exchange rates at which the current account is at its desired level.
◼ It slopes upwards, but less than DD:
⚫ As income increases, imports increase and the current account
decreases when other factors remain constant. Then, to keep the
current account at its desired level, the domestic currency must
depreciate.
⚫ When income increases, savings also increase. Thus, aggregate
demand grows less than income and output.

F.Veiga - International Monetary Economics Chapter 3 - 17

 Macroeconomic Policies and the
Current Account

Along the curve XX, the current account is constant at the level CA = X. Monetary
expansion moves the economy to point 2 and thus raises the current account balance.
Temporary fiscal expansion moves the economy to point 3, while permanent fiscal
expansion moves it to point 4; in either case, the current account balance falls.

F.Veiga - International Monetary Economics Chapter 3 - 18

 Value Effect, Volume Effect
and the J-curve

◼ If the volume of imports and exports is fixed in the very short

run, a depreciation of the domestic currency
⚫ will not affect the volume of imports or exports,
⚫ but will increase the value/price of imports in domestic currency
and decrease the current account: CA ≈ EX – IM.
⚫ The value of exports in domestic currency does not change.

◼ The current account could immediately decrease after a

currency depreciation, then increase gradually as the volume
effect begins to dominate the value effect.

F.Veiga - International Monetary Economics Chapter 3 - 19

 Value Effect, Volume Effect
and the J-Curve (cont.)

The J-curve describes the time lag with which a real currency depreciation improves the
current account.

F.Veiga - International Monetary Economics Chapter 3 - 20

 Value Effect, Volume Effect
and the J-curve (cont.)

◼ The Marshall-Lerner condition

⚫ Indicates that, for all else constant, a real depreciation
improves the current account if the sum of the exchange
rate export and import elasticities is greater than 1.
⚫ Demonstration:
The current account, in units of domestic output is:
CA(EP*/P, Y*,Yd) = EX(EP*/P, Y*) - IM(EP*/P, Yd)
With Y* constant and IM= qEX*, we have:
CA(q,Yd) = EX(q) – qEX*(q, Yd)
A change in CA due to Δq=q2-q1 will have the following effect:
ΔCA= CA2-CA1 = (EX2 – q2EX*2)-(EX1 – q1EX*1)
ΔCA= ΔEX - q2ΔEX* - ΔqEX*1

F.Veiga - International Monetary Economics Chapter 3.1 - 21

 Value Effect, Volume Effect
and the J-curve (cont.)

⚫ Demonstration of the Marshall-Lerner condition (cont.):

Dividing by Δq, we have the reaction of CA to the change in q:
ΔCA/Δq= ΔEX/Δq - q2ΔEX*/Δq - ΔqEX*1/Δq
The CA improves when,
ΔEX/Δq - q2ΔEX*/Δq - EX*1 > 0
Multiplying by q1/EX1 and assuming that CA was initially balanced
(EX1=q1EX*1), we have:
(ΔEX/EX1)/(Δq/q1) – (q2/q1)(ΔEX*/EX*1)/(Δq/q1) - 1 > 0
That is,
η + (q2/q1) η* - 1 > 0
For small changes in the real exchange rate (q2  q1), CA improves if the
sum of the export and import elasticities is greater than 1:
η + η* > 1

F.Veiga - International Monetary Economics Chapter 3.1 - 22

 Value Effect, Volume Effect
and the J-curve (cont.)

F.Veiga - International Monetary Economics Chapter 3 - 23

 Value Effect, Volume Effect
and the J-curve (cont.)

◼ Pass through from the exchange rate to import prices

measures the percentage by which import prices rise when the
domestic currency depreciates by 1%.

◼ In the DD-AA model, the pass through rate is 100%: import

prices in domestic currency exactly match a depreciation of the
domestic currency.

◼ In reality, pass through may be less than 100% due to price

discrimination in different countries.
⚫ Firms that set prices may decide not to match changes in the
exchange rates with changes in prices of foreign products
denominated in domestic currency.

F.Veiga - International Monetary Economics Chapter 3.1 - 24

 The Liquidity Trap

◼ When the nominal interest rate hits zero, the economy is in a

liquidity trap.
⚫ It is a trap because the central bank cannot reduce the interest
rate any further by increasing money supply.
◼ Interest parity when 𝑅 = 0:
𝐸 𝑒−𝐸
𝑅 = 0 = 𝑅∗ +
𝑒
𝐸
𝐸
𝐸=
1 − 𝑅∗
⚫ The currency cannot depreciate further because the nominal
interest rate would have to become negative.
⚫ Temporary monetary policy will have no effect. But, permanent or
unconventional monetary policy will still be able to stimulate the
economy.

F.Veiga - International Monetary Economics Chapter 3.1 - 25

 The Liquidity Trap

At point 1, output is below its full

employment level. Because
exchange rate expectations Ee
are fixed, however, a monetary
expansion will merely shift AA to
the right, leaving the initial
equilibrium point the same. The
horizontal stretch of AA gives
rise to the liquidity trap.

F.Veiga - International Monetary Economics Chapter 3.1 - 26

 International Monetary Economics

3.2
Fixed Exchange Rates and
Foreign Exchange Intervention

◼ Bibliography:
⚫ Krugman, Obstfeld & Melitz (2023), Chapter 18.

F.Veiga - International Monetary Economics Chapter 3 - 27

 Introduction

◼ Many countries try to fix or “peg” their exchange rates

to a currency or group of currencies by intervening in
the foreign exchange market.
◼ Many with a flexible or “floating” exchange rate in fact
practice a managed floating exchange rate.
⚫ The central bank “manages” the exchange rate from time to
time by buying and selling currency and assets, especially in
periods of exchange rate volatility.

◼ How do central banks intervene in the foreign

exchange market?

F.Veiga - International Monetary Economics Chapter 3 - 28

 Central Bank Intervention
and the Money Supply

◼ To study the effects of central bank intervention in

the foreign exchange market, first construct a
simplified balance sheet for the central bank.
⚫ This records the assets and liabilities of a central bank.
⚫ Balance sheets use double bookkeeping: each transaction
enters the balance sheet twice.

F.Veiga - International Monetary Economics Chapter 3 - 29

 Central Bank’s Balance Sheet
◼ Assets
⚫ Foreign government bonds (official international reserves)
⚫ Gold (official international reserves)
⚫ Domestic government bonds
⚫ Loans to domestic banks

◼ Liabilities (monetary base)

⚫ Deposits of domestic banks
⚫ Currency in circulation (previously central banks had to give up gold when
citizens brought currency)

F.Veiga - International Monetary Economics Chapter 3 - 30

 Central Bank’s Balance Sheet
(cont.)

◼ Changes in the central bank’s balance sheet lead to changes in

currency in circulation or changes in bank deposits, which lead
to changes in the money supply.
⚫ When the central bank buys (sells) domestic bonds or foreign
bonds, the domestic money supply increases (decreases).
◼ Central banks trade foreign government bonds in the foreign
exchange markets.
◼ The buying and selling of foreign bonds in the foreign exchange
market affects the domestic money supply
⚫ A central bank may want to offset this effect. This offsetting effect
is called sterilization.

F.Veiga - International Monetary Economics Chapter 3 - 31

 Assets, Liabilities
and the Money Supply (cont.)

F.Veiga - International Monetary Economics Chapter 3 - 32

 Fixed Exchange Rates

◼ The foreign exchange market is in equilibrium when

𝐸𝑒 −𝐸
𝑅= 𝑅∗ + 𝐸

◼ When the exchange rate is fixed at some level E0 and the market
expects it to stay fixed at that level, then
𝑅 = 𝑅∗

◼ Thus, the central bank adjusts the money supply until the domestic
interest rate equals the foreign interest rate, given the price level
and real output:
𝑀𝑆
= 𝐿 𝑅∗ , 𝑌
𝑃

F.Veiga - International Monetary Economics Chapter 3 - 33

 Asset Market Equilibrium With a
Fixed Exchange Rate

To hold the exchange rate fixed at

E0 when output rises from Y 1 to Y2,
the central bank must purchase
foreign assets and thereby raise
the money supply from M 1 to M2.

F.Veiga - International Monetary Economics Chapter 3.2 - 34

 Monetary Policy and
Fixed Exchange Rates

◼ When the central bank buys and sells foreign assets

to keep the exchange rate fixed and to maintain
domestic interest rates equal to foreign interest
rates, it is not able to adjust domestic interest rates
to attain other goals.
⚫ In particular, monetary policy is ineffective in influencing
output and employment.

F.Veiga - International Monetary Economics Chapter 3 - 35

 Fiscal Policy and
Fixed Exchange Rates

◼ Temporary and permanent changes in fiscal policy are

more effective in influencing output and employment
in the short run:
⚫ The rise in aggregate demand and output due to
expansionary fiscal policy raises demand for real monetary
assets, putting upward pressure on interest rates and on the
value of the domestic currency.
⚫ To prevent an appreciation of the domestic currency, the
central bank must buy foreign assets, thereby increasing the
money supply and decreasing interest rates.

F.Veiga - International Monetary Economics Chapter 3 - 36

 Exchange Rate Policy

◼ Depreciation and appreciation refer to changes in

the value of a currency due to market changes.

◼ Devaluation and revaluation refer to changes in a

fixed exchange rate caused by the central bank.
⚫ With devaluation, a unit of domestic currency is made less
valuable, so that more units must be exchanged for 1 unit of
foreign currency (E rises).
⚫ Devaluation reduces the value of domestic goods relative to
foreign goods, so aggregate demand and output increase in
the short-run.

F.Veiga - International Monetary Economics Chapter 3 - 37

 Interest Rate Differentials

◼ For many countries, the expected rates of return are not the
∗ 𝐸𝑒 −𝐸
same: 𝑅>𝑅 + 𝐸
Why?

⚫ Default risk:
The risk that the country’s borrowers will default on their loan
repayments. Lenders require a higher interest rate to compensate
for this risk.
⚫ Exchange rate risk (already considered in UIP):
If there is a risk that a country’s currency will depreciate or be
devalued, then domestic borrowers must pay a higher interest rate
𝐸𝑒 −𝐸
to compensate foreign lenders (given by ).
𝐸

F.Veiga - International Monetary Economics Chapter 3 - 38

 Interest Rate Differentials (cont.)

◼ A difference in the risk of domestic and foreign assets is one

reason why expected returns are not equal across countries:
𝐸 𝑒−𝐸
𝑅 = 𝑅∗ + +𝜌
𝐸
where  is called a risk premium, an additional amount needed to
compensate investors for investing in risky domestic assets.

◼ The risk premium depends positively on the stock of government

debt (B), less the domestic assets of the central bank (A):

𝜌 =𝜌 𝐵−𝐴

F.Veiga - International Monetary Economics Chapter 3 - 39

 Interest Rate Differentials (cont.)

An increase in the supply of domestic currency bonds that the private sector must hold
raises the risk premium on domestic currency assets.

F.Veiga - International Monetary Economics Chapter 3 - 40

 Interest Rate Differentials (cont.)

◼ Effects of a sterilized intervention with imperfect asset

substitutability
⚫ A sterilized purchase of foreign assets does not change the
money supply, but it increases the risk-adjusted return that
domestic currency deposits must offer in equilibrium.
⚫ Figure 18-7 shows the effects of a sterilized purchase by the
central bank.
⚫ The purchase of foreign assets is matched by the sale of
domestic assets (A is reduced from A1 to A2).

F.Veiga - International Monetary Economics Chapter 3 - 41

Increase in the
perceived risk of
investing in domestic
assets makes foreign
assets more attractive
and leads to a
depreciation of the
domestic currency.

Chapter 3 - 42
 Interest Rate Differentials (cont.)

◼ Effects of a sterilized intervention

⚫ Empirical data does not corroborate the view that sterilized
intervention has a significant direct effect on exchange rates.

⚫ Signalling effect of foreign exchange intervention

◆ Sterilized intervention may give a signal of the direction in which

the central bank expects (or desires) the exchange rate to move.

◆That signal can change the market’s view of the future and cause
an immediate change in the exchange rate, even when assets are
perfect substitutes.

F.Veiga - International Monetary Economics Chapter 3 - 43

 Economia Monetária Internacional

3.3
Extensions to the Mundell-
Fleming Model (IS-LM-BP)

◼ Bibliography:
⚫ Hallwood and McDonald (2000), Chap. 5
⚫ Marreijwick (2012), Chap. 25.

F.Veiga - International Monetary Economics Chapter 3 - 44

 The Mundell-Fleming Model
(IS-LM-BP)

◼ Assumptions
⚫ Small open economy (does not affect the rest of the world)
⚫ Perfect capital mobility
⚫ Domestic and foreign assets are perfect substitutes
𝐸 𝑒−𝐸
𝑅 = 𝑅∗ +
𝐸
⚫ Static Exchange rate expectations
𝐸 𝑒 = 𝐸 ⟹ 𝑅 = 𝑅∗
⚫ The Marshall-Lerner condition holds
↑ 𝐸 ⟹↑ 𝑞 ⟹↑ 𝐶𝐴

F.Veiga - International Monetary Economics Chapter 3 - 45

 The Mundell-Fleming Model
(IS-LM-BP)

◼ Equations
⚫ Goods and services markets equilibrium
𝑌 =𝐶+𝐼 𝑅 +𝐺+ 𝑋−𝑀
𝐶𝐴 𝑌,𝑌 ∗ ,𝑞

⚫ Monetary and assets markets equilibrium

𝑀𝑆
= 𝐿 𝑌, 𝑅
𝑃
⚫ Balance of Payments equilibrium
𝐵𝑃 = 𝐶𝐴 𝑌, 𝑌 ∗ , 𝑞 + 𝐹𝐴 𝑅 − 𝑅 ∗

F.Veiga - International Monetary Economics Chapter 3 - 46

 The Mundell-Fleming Model
(IS-LM-BP)

◼ Curves
⚫ In the Y-R space, we have:
◆ IS curve (goods and services market equilibrium) slopes
downward: ↑R →↓I →↓Y
◆ LM curve (monetary Market equilibrium) slopes upward:
↑ Y →↑ L(Y,R) →↑ R
◆ BP curve is horizontal: R=R*

⚫ The effects of permanent policies are equal to those

of the DD-AA model.

F.Veiga - International Monetary Economics Chapter 3 - 47

 Modelo Mundell-Fleming
(IS-LM-BP)
Short-run equilibrium: the intersection of IS-LM-BP
Interest
rate, R LM

1
R*

Y1 Product, Y

F.Veiga - International Monetary Economics Chapter 3 - 48

 Extensions to the
Mundell-Fleming Model

◼ Imperfect capital mobility

⚫ With less than perfect capital mobility, interest parity
does not have to hold (BP curve slopes upward)
◆ Smaller effects on the product of monetary policy in flexible
Exchange rates and of fiscal policy in fixed rates.

◆ Fiscal policy affects the product in flexible exchange rates

⚫ Zero capital mobility (BP is a vertical line)

◆ No policy affects the product in fixed exchange rates
◆ Both policies affect the product in flexible exchange rates.

F.Veiga - International Monetary Economics Chapter 3 - 49

 Extensions to the
Mundell-Fleming Model

◼ The case of a big economy

⚫ Changes in the interest rate of a big economy (e.g.,
USA, China, Euro Area) affect the world’s interest rate
◆ Changes in the world’s interest rate shift the BP curve

◆ Under perfect capital mobility, all policies affect the

equilibrium product in both exchange rate regimes

◆ We obtain intermediate results, when compared to the

extreme cases obtained for small open economies.

F.Veiga - International Monetary Economics Chapter 3 - 50

 Extensions to the
Mundell-Fleming Model

◼ The model with two big economies

⚫ Allows the analysis of economic interdependence
among countries
◆ Policies implemented in one country affect the other (or all
the other)

◆ Expansionary fiscal policies benefit the other country(ies)

◆ Expansionary monetary policies tend to hurt the other
country(ies).

F.Veiga - International Monetary Economics Chapter 3 - 51