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12 The Open Economy Revisited: The Mundell-Fleming Model and the Exchange-Rate Regime Chapter 12 covers a lot of material. First, it develops the Mundell-Fleming open-economy IS-LM model for a small open economy with perfect capital mobility. The model is used to analyze the effects of fiscal, monetary, and trade policy under floating and flexible exchange rates. Then, the chapter explores interest rate differentials, or risk premia that arise due to country risk or expected changes in exchange rates. The Mundell-Fleming model is used to analyze the effects of a change in the risk premium. The Mexican Peso Crisis is an important real-world example of this. The chapter summarizes the debate over fixed vs. floating exchange rates. Following that discussion, the Mundell-Fleming model is used to derive the aggregate demand curve for a small open economy. And finally, the chapter discusses how the results it derives would be different in a large open economy. To reinforce this material, I strongly recommend you to allow a bit of class time for a few in-class exercises (I’ve suggested several in the lecture notes accompanying some of the slides in this presentation), and that you assign a homework consisting of several of the end-of-chapter “Questions for Review” and “Problems and Applications” in the textbook.

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**In this chapter, you will learn:**

the Mundell-Fleming model (IS-LM for the small open economy) causes and effects of interest rate differentials arguments for fixed vs. floating exchange rates how to derive the aggregate demand curve for a small open economy 1

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**The Mundell-Fleming model**

Key assumption: Small open economy with perfect capital mobility. r = r* Goods market equilibrium – the IS* curve: In this and the following sections (in which we analyze policies with the M-F model), we assume the price level is fixed---just as we did when we first used the closed economy IS-LM model to do policy analysis in chapter 11. As we learned in chapter 5, NX depends on the real exchange rate. However, with price levels fixed, the real & nominal exchange rates move together. So, for simplicity, we write NX as a function of the nominal exchange rate here. (At the end of this chapter, when we use M-F to derive the aggregate demand curve, we go back to writing NX as a function of the real exchange rate, because the nominal & real exchange rates may behave differently when the price level is changing.) Chapter 5 introduced the notation r* for the world interest rate, and explained why r = r* in a small open economy with perfect capital mobility. Perfect capital mobility means that there are no restrictions on the international flow of financial capital: the country’s residents can borrow or lend as much as they wish in the world financial markets; and because the country is small, the amount its residents borrow or lend in the world financial market has no impact on the world interest rate. Chapter 5 also explained why net exports depend negatively on the exchange rate. where e = nominal exchange rate = foreign currency per unit domestic currency

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**The IS* curve: Goods market eq’m**

The IS* curve is drawn for a given value of r*. Intuition for the slope: Y e IS* Again, “eq’m” is an abbreviation for “equilibrium.” The text (p.342) shows how the Keynesian Cross can be used to derive the IS* curve. Suggestion: Before continuing, ask your students to figure out what happens to this IS* curve if taxes are reduced. Answer: The IS* curve shifts rightward (i.e., upward). Explanation: Start at any point on the initial IS* curve. At this point, initially, Y = C + I + G + NX. Now cut taxes. At the initial value of Y, disposable income is higher, causing consumption to be higher. Other things equal, the goods market is out of whack: C + I + G + NX > Y. An increase in Y (of just the right amount) would restore equilibrium. Hence, each value of e is associated with a larger value of Y. OR, a decrease in NX of just the right amount would restore equilibrium at the initial value of Y. But the decrease in NX requires an increase in e. Hence, each value of Y is associated with a higher value of e. Rationale: Doing this exercise now will break up your lecture, and will prepare students for the fiscal policy experiment that is coming up in just a few slides.

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**The LM* curve: Money market eq’m**

is drawn for a given value of r*. is vertical because: given r*, there is only one value of Y that equates money demand with supply, regardless of e. Y e LM* The text (Figure 12-2 on p.344) shows how the LM curve in (Y,r) space, together with the fixed r*, determines the value of Y at which the LM* curve here is vertical. Suggestion: Before continuing, ask your students to figure out what happens to this LM* curve if the money supply is increased. Answer: LM* shifts to the right. Explanation: The equation for the LM* curve is: M/P = L(r*, Y) P is fixed, r* is exogenous, the central bank sets M, then Y must adjust to equate money demand (L) with money supply (M/P). Now, if M is raised, then money demand must rise to restore equilibrium (remember: P is fixed). A fall in r would cause money demand to rise, but in a small open economy, r = r* is exogenous. Hence, the only way to restore equilibrium is for Y to rise. Rationale: Doing this exercise now will break up your lecture, and will prepare students for the monetary policy experiment that is coming up in just a few slides.

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**Equilibrium in the Mundell-Fleming model**

Y e LM* IS* equilibrium exchange rate equilibrium level of income

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**Floating & fixed exchange rates**

In a system of floating exchange rates, e is allowed to fluctuate in response to changing economic conditions. In contrast, under fixed exchange rates, the central bank trades domestic for foreign currency at a predetermined price. Next, policy analysis – first, in a floating exchange rate system then, in a fixed exchange rate system

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**Fiscal policy under floating exchange rates**

At any given value of e, a fiscal expansion increases Y, shifting IS* to the right. e2 e1 Intuition for the shift in IS*: At a given value of e (and hence NX), an increase in G causes an increase in the value of Y that equates planned expenditure with actual expenditure. Intuition for the results: As we learned in earlier chapters, a fiscal expansion puts upward pressure on the country’s interest rate. In a small open economy with perfect capital mobility, as soon as the domestic interest rate rises even the tiniest bit about the world rate, tons of foreign (financial) capital will flow in to take advantage of the rate difference. But in order for foreigners to buy these U.S. bonds, they must first acquire U.S. dollars. Hence, the capital inflows cause an increase in foreign demand for dollars in the foreign exchange market, causing the dollar to appreciate. This appreciation makes exports more expensive to foreigners, and imports cheaper to people at home, and thus causes NX to fall. The fall in NX offsets the effect of the fiscal expansion. How do we know that Y = 0? Because maintaining equilibrium in the money market requires that Y be unchanged: the fiscal expansion does not affect either the real money supply (M/P) or the world interest rate (because this economy is “small”). Hence, any change in income would throw the money market out of whack. So, the exchange rate has to rise until NX has fallen enough to perfectly offset the expansionary impact of the fiscal policy on output. Results: e > 0, Y = 0 Y1

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**Lessons about fiscal policy**

In a small open economy with perfect capital mobility, fiscal policy cannot affect real GDP. “Crowding out” closed economy: Fiscal policy crowds out investment by causing the interest rate to rise. small open economy: Fiscal policy crowds out net exports by causing the exchange rate to appreciate.

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**Monetary policy under floating exchange rates**

An increase in M shifts LM* right because Y must rise to restore eq’m in the money market. e1 Suggestion: Treat this experiment as an in-class exercise. Display the graph with the initial equilibrium. Then give students 2-3 minutes to use the model to determine the effects of an increase in M on e and Y. Intuition for the rightward LM* shift: At the initial (r*,Y), an increase in M throws the money market out of whack. To restore equilibrium, either Y must rise or the interest rate must fall, or some combination of the two. In a small open economy, though, the interest rate cannot fall. So Y must rise to restore equilibrium in the money market. Intuition for the results: Initially, the increase in the money supply puts downward pressure on the interest rate. (In a closed economy, the interest rate would fall.) Because the economy is small and open, when the interest rate tries to fall below r*, savers send their loanable funds to the world financial market. This capital outflow causes the exchange rate to fall, which causes NX --- and hence Y --- to increase. e2 Results: e < 0, Y > 0 Y2

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**Lessons about monetary policy**

Monetary policy affects output by affecting the components of aggregate demand: closed economy: M r I Y small open economy: M e NX Y Expansionary mon. policy does not raise world agg. demand, it merely shifts demand from foreign to domestic products. So, the increases in domestic income and employment are at the expense of losses abroad. Suggestion: Before revealing the text on this slide, ask students to take out a piece of paper and answer this question: “Contrast the way in which monetary policy affects output in the closed economy with the small open economy.” Or something to that effect.

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The Rise in the Dollar, 1979–1982 Early 1980s the U.S. experienced a combination of tight monetary policy and loose fiscal policy. Fed’s goal: reduce the high inflation rate Reagan: cut taxes and raise defense spending. Mundell–Fleming model prediction: dollar appreciation. 1979: 1$=218yen(1.83M) 1982: 1$=248yen(2.42M) Imported goods less expensive U.S. firms loss competitivity (auto industry) European vacations more affordable!

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**Trade policy under floating exchange rates**

At any given value of e, a tariff or quota reduces imports, increases NX, and shifts IS* to the right. e2 Intuition for results: At the initial exchange rate, the tariff or quota shifts domestic residents’ demand from foreign to domestic goods. The reduction in their demand for foreign goods causes a corresponding reduction in the supply of the country’s currency in the foreign exchange market. This causes the exchange rate to rise. The appreciation reduces NX, offsetting the import restriction’s initial expansion of NX. How do we know that the effect of the appreciation on NX exactly cancels out the effect of the import restriction on NX? There is only one value of Y that allows the money market to clear; since Y, C, I, and G are all unchanged, NX = Y-(C+I+G) must also be unchanged. Or looking at it differently: As we learned in chapter 5, the accounting identities say that NX = S - I. The import restriction does not affect S or I, so it cannot affect the equilibrium value of NX. Results: e > 0, Y = 0

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**Lessons about trade policy**

Import restrictions cannot reduce a trade deficit. Even though NX is unchanged, there is less trade: the trade restriction reduces imports. the exchange rate appreciation reduces exports. Less trade means fewer “gains from trade.”

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**Lessons about trade policy, cont.**

Import restrictions on specific products save jobs in the domestic industries that produce those products, but destroy jobs in export-producing sectors. Hence, import restrictions fail to increase total employment. Also, import restrictions create “sectoral shifts,” which cause frictional unemployment. Import restrictions cause a sectoral shift, a shift in demand from export-producing sectors to import-competing sectors. As we learned in chapter 6, sectoral shifts contribute to the natural rate of unemployment, because displaced workers in declining sectors take time to be matched with appropriate jobs in other sectors.

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**Chapter Summary the IS-LM model for a small open economy.**

1. Mundell-Fleming model the IS-LM model for a small open economy. takes P as given. can show how policies and shocks affect income and the exchange rate. 2. Fiscal policy affects income under fixed exchange rates, but not under floating exchange rates. 15

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**Chapter Summary affects income under floating exchange rates.**

3. Monetary policy affects income under floating exchange rates. under fixed exchange rates, monetary policy is not available to affect output. 16

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