Core Macroeconomics, Hilary Term 2014

Week 5: The open economy

This week we focus on the Carlin & Soskice model of a small open economy. This combines the Mundell-Fleming model you studied last year with the C&S supply side story of the labour market. It has the important property that the equilibrium unemployment rate is not unique, due to the exchange rate's impact on the purchasing power of wages.

Readings

Carlin & Soskice Chapters 9, 10

Your favourite first year macro text such as Blanchard or Mankiw will cover the Mundell-Fleming model, and this would be a good place to start.

You might find it useful to look at Krugman & Obstfeld, International Economics: Theory and Policy, Part III "Exchange rates and open-economy macroeconomics". The chapters in this section review the international material you learned last year as well as covering most of the topics in C&S in a different, and possibly more readable way. However, this treatment does not feature a dependence of the equilbrium unemployment rate on the real exchange rate.

Assignment

Please write an essay answering the following questions.

i. Use macroeconomic theory (in particular the model underlying the Swan diagram) to evaluate the implications for the real exchange rate and the trade balance of increases in public and private sector borrowing in southern European countries in the years after the formation of the Eurozone.
ii. Now suppose that lenders doubt the solvency of southern European countries and that austerity is imposed such that the AD line is forced back to its position at the time of the formation of the Eurozone. Evaluate the consequences for output and employment in both the short-run and the medium-run. What determines the size of the differences in output and employment across the short-run and the medium-run? What determines the length of time needed for the adjustment, and what sorts of reforms might help to reduce this period? How would nominal exchange rate flexibility help?
iii. In the long-run, what combination of policies might help to return these countries to the levels of output achieved during the period of high borrowing, without a loss of national competitiveness and the emergence of unsustainable trade deficits?

Inevitably, the interpretation developed here will be partial and incomplete. I am interested in knowing your thoughts about what the model leaves out or gets wrong, but first demonstrate your understanding of how it works. You should make an effort to confront the model's predictions with a few "stylised facts" about European economies over the last few years.