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71

N IS,

FIGURE 5.5 The effects of an increase in government purchases

The impact of this change in aggregate demand on output and the price level depends on the aggregate supply curve. If it is vertical, only the price level increases. If it is horizontal, only output increases. And if it is upward-sloping but not vertical, both output and the price level increase.

Thus, incomplete adjustment of nominal prices introduces a new channel through which shocks affect output. For some reason, which we have not yet specified, normnal prices do not adjust fully in the short run. As



The Keynesian View of Fluctuations

The IS-LM model suggests many potential sources of fluctuations: there can be changes in monetary and fiscal policy, shocks to investment demand, shifts in the money demand function, and so on. And in the complete IS-LM-AS model, there can be disturbances to aggregate supply as well. Standard Keynesian accounts of macroeconomic fluctuations (such as descriptions of the macroeconomic history of the United States over the last several decades) typically assign important roles to many different kinds of shocks. Thus, in contrast to the real-business-cycle approach, Keynesian analyses typically do not attribute the bulk of fluctuations to a small number of types of disturbances.

The fact that Keynesian analyses allow for many different shocks means that they generally do not deliver specific predictions about the relative magnitudes of movements in different variables or about how the movements in the variables are related: in the models, different shocks cause different patterns of changes. Because of this, Keynesian models are typically not evaluated using the caUbration approach described in Section 4.9. Instead, they are usually judged by their success in describing the effects of specific kinds of shocks. For example, there is a large literatiue testing the models implications concerning the effects of monetary shocks; we will discuss some of this work in Section 5.6. To give another example, the models are often judged by their success in accounting for the behavior of output and inflation in the United States over the past several decades given the major shocks that appear to have occurred. As we will see in Section 5.5, some versions of Keynesian models seem to be contradicted by this evidence, whereas others appear broadly consistent with it.

5.3 The Open Economy

In most practical applications, the exchange rate and international trade are important to short-run fluctuations. This section therefore extends the IS-LM model to the case of an open economy.

An important exception is the monetarist view that monetary policy shocks are the driving force of most fluctuations.

a result, any change in the demand for goods at a given price level affects output. In contrast, the intertemporal-substitution and wealth effects that drive employment fluctuations in real-business-cycle models would correspond to effects of government purchases on the aggregate supply curve-that is, they would affect not the quantity of output that households and firms want to buy at a given price level, but the quantity that firms want to produce at a given price level.



The Mundell-Fleming Model

The simplest assumptions about capital movements are that there are no barriers to capital mobility and that investors are risk-neutral; we will refer to this case as perfect capital mobility. Barriers to foreign investment in most industrialized countries are small, and many investors appear willing to make large changes in their portfolios in response to small rate-of-return differences. As a result, perfect capital mobility is likely to be a good approximation for many purposes.

The function IS often assumed to take the specific form C(Y - T) + I{i - -n-) + G + NX{eP*/P), where NX denotes net exports.

The Real Exchange Rate and Planned Expenditure

It is simplest to think of the rest of the world as consisting of a single country. Let £ denote the nominal exchange rate-specifically, the price of a unit of foreign currency in terms of domestic currency. With this definition, a rise in the exchange rate means that foreign currency has become more expensive, and therefore corresponds to a weakening, or depreciation, of the domestic currency. Similarly, a fall in a corresponds to an appreciation of the domestic currency. Let P* denote the price level abroad (that is, the price of foreign goods in units of foreign currency). These definitions imply that the real exchange rate-the price of foreign goods in units of domestic goods-is aP* IP.

A higher real exchange rate implies that foreign goods have become more expensive relative to domestic goods. Both domestic residents and foreigners are therefore likely to increase their purchases of domestic goods relative to foreign ones. Thus planned expenditure rises. Mathematically, equation (5.7) becomes

Y = E(Y,i -7T,G,T,aP*/P), (5.12)

with £() increasing in aP* /P. Money demand is likely to be largely unaffected by the exchange rate; thus the LM curve is the same as before.

Since any individual country is small relative to the entire rest of the world, it is reasonable to take the foreign price level as given. But it is not reasonable to take the exchange rate as given. Equations (5.1) and (5.12), together with the AS curve, are thus not a complete model.

At this point one can make different assumptions about the exchange-rate regime (floating or fixed), capital mobility (perfect or imperfect), and exchange-rate expectations (static or rational). What set of assumptions is appropriate depends on the economy being studied and the questions being asked. Here we discuss some of the most important possibilities.



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