Presentation on theme: "mankiw's macroeconomics modules"— Presentation transcript:
1 mankiw's macroeconomics modules A PowerPointTutorialto Accompany macroeconomics, 5th ed.N. Gregory MankiwMannig J. SimidianCHAPTER TWELVEAggregate Demand in the Open Economy
2 The Mundell-Fleming Model Introducing…The Mundell-Fleming ModeleLM*Equilibriumexchange rateIS*Income, Output, YEquilibrium Income
3 Building the Mundell-Fleming Model Start with these two equations:IS*: Y = C(Y-T) + I(r*) + G + NX(e)LM*: M/P = L (r*,Y)Assumption 1:The domestic interest rate is equal to the world interest rate (r = r*).Assumption 2:The price level is exogenously fixed since the model is used to analyze the short run (P). This implies that the nominal exchange rate is proportional to the real exchange rate.Assumption 3:The money supply is also set exogenously by the central bank (M).Assumption 4:Our LM* curve will be vertical because the exchange rate does not enter into our LM* equation.
4 Deriving the Mundell-Fleming IS* Curve The Keynesian CrossAn increase in the exchange rate, lowers net exports, which shifts planned expenditure downward and lowers income. The IS* curve summarizes these changes in the goods market equilibrium.(c)EY=EPlanned Expenditure,E = C + I + G + NXIncome, Output, Y(a)(b)eThe NX SchedulerThe IS* CurveNX(e)IS*Net Exports, NXIncome, Output, Y
5 Deriving the Mundell-Fleming LM* Curve The LM CurverLMThe LM curve andthe world interestrate together determinethe level of income.r = r*Income, Output, YThe LM* CurveeLM*Income, Output, Y
6 The Mundell-Fleming Model Under Floating Exchange Rates Expansionary Monetary PolicyExpansionary Fiscal PolicyeLM*LM*'eLM*+DG, or –DT +De, no DY+DM -De, +DYIS*'IS*IS*Income, Output, YIncome, Output, YWhen income rises in a small open economy, due tothe fiscal expansion, the interest rate tries to rise butcapital inflows from abroad put downward pressureon the interest rate.This inflow causes an increase inthe demand for the currency pushing up its valueand thus making domestic goods more expensiveto foreigners (causing a –DNX). The –DNX offsetsthe expansionary fiscal policy and the effect on Y.When the increase in the money supply puts downwardpressure on the domestic interest rate, capital flows outas investors seek a higher return elsewhere. The capitaloutflow prevents the interest rate from falling. Theoutflow also causes the exchange rate to depreciatemaking domestic goods less expensive relative toforeign goods, and stimulates NX. Hence, monetarypolicy influences the e rather than r.
7 The Mundell-Fleming Model Under Fixed Exchange Rates Expansionary Monetary PolicyExpansionary Fiscal Policy+DG, or –DT + DY+DM no DYeLM*eLM*LM*'IS*'IS*IS*Income, Output, YIncome, Output, YA fiscal expansion shifts IS* to the right. To maintainthe fixed exchange rate, the Fed must increase themoney supply, thus increasing LM* to the right.Unlike the case with flexible exchange rates, there is nocrowding out effect on NX due to a higher exchangerate.If the Fed tried to increase the money supply bybuying bonds from the public, that would put down-ward pressure on the interest rate. Arbitragers respondby selling the domestic currency to the central bank,causing the money supply and the LM curveto contract to their initial positions.
8 Exchange Rate Conclusions Floating Exchange Rates Fixed vs. FloatingExchange Rate ConclusionsFixed Exchange RatesFloating Exchange RatesFiscal Policy is Powerful.Monetary Policy is Powerless.Fiscal Policy is Powerless.Monetary Policy is Powerful.Hint: (Fixed and Fiscal sound alike).Hint: (Think of floating money.)The Mundell-Fleming model shows that fiscal policy does not influenceaggregate income under floating exchange rates. A fiscal expansioncauses the currency to appreciate, reducing net exports and offsettingthe usual expansionary impact on aggregate demand.The Mundell –Fleming model shows that monetary policy does notinfluence aggregate income under fixed exchange rates. Any attemptto expand the money supply is futile, because the money supplymust adjust to ensure that the exchange rate stays at its announced level.
9 Policy in the Mundell-Fleming Model: A SummaryThe Mundell-Fleming model shows that the effect of almost any economic policy on a small open economy depends on whether the exchange rate is floating or fixed.The Mundell-Fleming model shows that the power of monetary and fiscal policy to influence aggregate demand depends on the exchange rate regime.
10 Interest Rate Differentials What if the domesticinterest rate were abovethe world interest rate?The higher return will attract funds from the rest of the world, driving the US interest rate back down. And, if the interest rate were below the world interest rate, domestic residents would lendabroad to earn a higher return, driving the domestic interest rate back up. In the end, the domestic interest rate would equal the world interest rate.
11 Country Risk and Exchange Rate Expectations Why doesn’t this logic always apply? There are two reasons why interestrates differ across countries:1) Country Risk: when investors buy US government bonds, or makeloans to US corporations, they are fairly confident that they will berepaid with interest. By contrast, in some less developed countries, itis plausible to fear that political upheaval may lead to a default on loanrepayments. Borrowers in such countries often have to pay higherinterest rates to compensate lenders for this risk.2) Exchange Rate Expectations: suppose that people expect the Frenchfranc to fall in value relative to the US dollar. Then loans made in francswill be repaid in a less valuable currency than loans made in dollars. Tocompensate for the expected fall in the French currency, the interest ratein France will be higher than the interest rate in the US.
12 Differentials in the Mundell-Fleming Model To incorporate interest-rate differentials into the Mundell-Flemingmodel, we assume that the interest rate in our small open economyis determined by the world interest rate plus a risk premium q.r = r* + qThe risk premium is determined by the perceived political risk ofmaking loans in a country and the expected change in the real interestrate. We’ll take the risk premium q as exogenously determined.For any given fiscal policy, monetary policy, price level, and riskpremium, these two equations determine the level of income andexchange rate that equilibrate the goods market and the money market.IS*: Y = C(Y-T) + I(r* + q) + G + NX(e)LM*: M/P = L (r* + q,Y)
13 Now suppose that political turmoil causes the country’s risk premium q to rise. The most direct effect is that the domestic interest rate r rises.The higher interest rate has two effects:1) IS* curve shifts to the left, because the higher interest rate reducesinvestment.2) LM* shifts to the right, because the higher interest rate reduces thedemand for money, and this allows a higher level of income for anygiven money supply.These two shifts cause income to rise and thus push down the equilibriumexchange rate on world markets.The important implication: expectations of the exchange rate are partiallyself-fulfilling. For example, suppose that people come to believe that theFrench franc will not be valuable in the future. Investors will place alarger risk premium on French assets: q will rise in France. Thisexpectation will drive up French interest rates and will drive down thevalue of the French franc. Thus, the expectation that a currency will losevalue in the future causes it to lose value today. The next slide willdemonstrate the mechanics.
14 An Increase in the Risk Premium Is this really is where the economy ends up? In the next slide, we’ll see thatincreases in country risk are not desirable.eLM*LM*'IS*IS*'Income, Output, YAn increase in the risk premium associated with a country drives upits interest rate. Because the higher interest rate reduces investment,the IS* curve shifts to the left. Because it also reduces moneydemand, the LM* curve shifts to the right. Income rises, and theexchange rate depreciates.
15 There are three reasons why, in practice, such a boom in income does not occur. First, the central bank might want to avoid the largedepreciation of the domestic currency and, therefore, may respondby decreasing the money supply M. Second, the depreciation of thedomestic currency may suddenly increase the price of domestic goods,causing an increase in the overall price level P. Third, when some eventincrease the country risk premium q, residents of the country mightrespond to the same event by increasing their demand for money (forany given income and interest rate), because money is often thesafest asset available. All three of these changes would tend to shiftthe LM* curve toward the left, which mitigates the fall in the exchangerate but also tends to depress income.
16 The Mundell-Fleming Model with a Changing Price Level Recall the two equations of the Mundell-Fleming model:IS*: Y=C(Y-T) + I(r*) + G + NX(e)eLM*LM*'LM*: M/P=L (r*,Y)When the price level falls the LM*curve shifts to the right. Theequilibrium level of income rises.The second graph displays the negative relationship between P and Y, which is summarized by the aggregate demand curve.IS*Income, Output,YPADIncome, Output,Y
17 Key Concepts of Ch. 12 Mundell-Fleming Model Floating exchange rates Fixed exchange ratesDevaluationRevaluation