Chapter 13: Essential macroeconomic tools

“The point is that you can’t have it all: A country must pick two out of three.” (1999)

© The McGraw-Hill Companies, 2015 The closed economy: a refresher

The goods market: Y = C + I + G

The IS curve

© The McGraw-Hill Companies, 2015 The closed economy: a refresher

The goods market and role of fiscal policy: expansionary fiscal policy shifts the IS curve:

© The McGraw-Hill Companies, 2015 The closed economy: a refresher

The financial market equilibrium:

© The McGraw-Hill Companies, 2015 The closed economy: a refresher

The financial market equilibrium and

© The McGraw-Hill Companies, 2015 The closed economy: a refresher

The general equilibrium

© The McGraw-Hill Companies, 2015 The open economy: a refresher

The goods market:

The IRP condition

IRP: A trader deciding on investing anywhere in the world: - compare interest rates; - consider fluctuations: if foreign currency appreciates, an investment abroad will also lead to capital gain.

- Thus, financial markets are in equilibrium when:

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Government bond interest rates:

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- Exchange rate regime only matters because nominal exchange rate has real effects in the short run. Non-neutrality arises because prices and wages move slowly (i.e., they are ‘sticky’).

- Regimes: - free floating; - managed floating: central banks buy their own currency when they consider it too weak, and sell it when they see it as too strong, but they refrain from pursuing any particular exchange rate target; - fixed exchange rates or target zones: authorities declare an official parity vis-à-vis another currency or a basket of currencies, with margins of fluctuations around the central parity (i.e., target zone);

© The McGraw-Hill Companies, 2015 The Impossible Trinity

IRP does not necessarily go through point A (i.e., interest rate chosen by the ): central bank must either accept being at B or ‘do something’ about the exchange rate.

© The McGraw-Hill Companies, 2015 The Impossible Trinity Impossible trinity principle: only two of the three following features are compatible with each other: - full capital mobility; - fixed exchange rates; - autonomous monetary policy.

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- The impossible trinity principle is central to European integration: fixing the exchange rate means adopting the foreign interest rate; conversely, maintaining the ability to choose the domestic interest rate requires allowing the exchange rate to float freely.

- Since the EU adopted in 1992 the principle of open capital markets, the choice has been circumscribed to the left or bottom sides of the triangle. One way of escaping the choice between exchange rate stability and monetary policy autonomy is to restrict capital movements. This is one reason why many European countries operated extensive capital controls until the early 1990s when full capital mobility was made compulsory. Likewise, many of the new EU members only abandoned capital controls upon accession.

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- Full capital mobility and fixed exchange rate: Exchange Rate Mechanism: • shallow distinction between such a policy and euro membership.

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- The purchasing power parity (PPP) principle asserts that:

- So, if inflation at home is durably lower than abroad, domestic currency should appreciate (and conversely).

- Real exchange rate (measure of competitiveness): E × P/P*, where E is nominal exchange rate; P and P* are prices of basket of goods at home and abroad.

- When real exchange rate appreciates, competitiveness declines as more baskets of foreign goods would need to be traded for 1 basket of domestic goods.

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Equilibrium exchange rate of countries that enjoy lasting fast growth b/c of catching up from lower level of development follow an appreciation trend

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