G. Mankiw Macroeconomics CH12 slides edited and modified by C. Fuller WEEK 9-10 OPEN ECONOMY IS-LM FRAMEWORK THE ‘MUNDELL-FLEMING’ MODEL G. Mankiw Macroeconomics CH12 slides edited and modified by C. Fuller

Small open economy version LM E LM* IS IS* Y Y IS- LM MODEL Closed economy version Small open economy version IS CURVE Goods market equilibrium Y = C + I + G Y = C + I + G + NX Income = planned spending MAIN DIFFERENCES from closed economy case: LM CURVE Money market equilibrium L(Y, r) = M/P L(Y, r) = M/P Money supply = money demand OVERALL EQUILIBRIUM Determines Y and national interest rate r Determines Y and exchange rate Given world interest rate (r*) determines national level of r CHAPTER 11 Aggregate Demand II

WEEKS 9-10 SUMMARY 0. The Closed Economy IS-LM model 1. The Open Economy IS-LM model (‘Mundell-Fleming’ model) 2. Flexible (floating) exchange rates 3. Using the closed and open IS-LM models CHAPTER 12 The Open Economy Revisited

0.Closed Economy IS-LM model: POLICY MONETARY POLICY FISCAL POLICY LM r r LM r2 r1 LM’ r1 r0 IS’ IS IS Y* Y** Y** Y* Why does expansionary fiscal policy raise interest rates in a closed economy? Government increases G and/or cuts T. This increases planned spending E. If E rises, this causes Y to rise: economy grows towards Y**. The IS curve shifts out right. BUT as Y rises, so the demand for money Md rises (remember, Md depends on Y) If money supply Ms is unchanged, then Md>Ms at r1 and so r will have to rise to r2. Why does expansionary monetary policy increase income in a closed economy? If Ms increases, then this cuts interest rates: r starts to go down below r1. As r goes below r1, then investment (I) starts to rise [remember I = I(r)] As I rises, so planned spending (E) rises As E rises, Y starts to rise too until it gets to Y**. Y Y Shift in Shift in Rise in G Fall in T Predict: Rise in r Rise in Y Rise in money supply Predict: Fall in r Rise in Y IS LM To right To right CHAPTER 12 The Open Economy Revisited

1.The Mundell-Fleming model: Open Economy IS-LM Key assumption: Small open economy (SOE) with perfect capital mobility. r = r* [because SOE forced to accept world r] Goods market equilibrium – the IS* curve: As we learned in the Classical Open Economy model, NX depends on the real exchange rate. However, with price levels fixed, the real & nominal exchange rates move together. To see this, remember E = real exchange rate = e.(Pd/Pf). But since Pd and Pf are assumed fixed in this model, the ratio (Pd/Pf) never changes, so when e goes up[down], E goes up[down] as well. So having e instead of E makes no difference here. So, for simplicity, we write NX as a function of the nominal exchange rate here. where e = nominal exchange rate = foreign currency per unit domestic currency We could use E instead of e as prices are fixed anyway. An exam question might have either – won’t make any difference. CHAPTER 12 The Open Economy Revisited

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.337) 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 equilibrium: 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. CHAPTER 12 The Open Economy Revisited

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 (p.316) 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. CHAPTER 12 The Open Economy Revisited

Equilibrium in the Mundell-Fleming model Y e LM* IS* equilibrium exchange rate equilibrium level of income CHAPTER 12 The Open Economy Revisited

2. Floating exchange rates In a system of floating exchange rates, e is allowed to fluctuate in response to changing economic conditions.  WE FOCUS ON THIS CHAPTER 12 The Open Economy Revisited

FLOATING EXCHANGE RATES: Fiscal policy 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 goes up, no change in Y Y1 WHY IS FISCAL POLICY INEFFECTIVE? CHAPTER 12 The Open Economy Revisited

FLOATING EXCHANGE RATES: Fiscal policy LM r IS’ reminder IS Y e Y Results [from last slide] e goes up, no change inY e2 WHY does e rise? e1 [1] In CLOSED economy: Fiscal expansion  rise in Y , rise in r 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. [2] but In SMALL OPEN economy: A rise of domestic ‘r’ above r*.. Y1 ...causes HUGE CAPITAL INFLOW [3] Big rise in demand for UK currency CHAPTER 12 The Open Economy Revisited

FLOATING EXCHANGE RATES: Lessons about fiscal policy In a small open economy with perfect capital mobility, fiscal policy cannot affect Y. “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. CHAPTER 12 The Open Economy Revisited

FLOATING EXCHANGE RATES: Monetary policy An increase in M shifts LM* right e1 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 falls, Y goes up Y2 WHY IS MONETARY POLICY SO EFFECTIVE? CHAPTER 12 The Open Economy Revisited

FLOATING EXCHANGE RATES: Monetary policy LM r IS reminder Y e Y Y1 Results (from last slide) e falls, Y goes up e1 WHY does e fall? [1] In CLOSED economy Rise in M  rise in Y, fall in r 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 [2] BUT In SMALL OPEN economy.. Y2 If domestic ‘r’ falls below r*.. [3] Big fall in demand for UK currency ...this causes a HUGE CAPITAL OUTFLOW CHAPTER 12 The Open Economy Revisited

FLOATING EXCHANGE RATES: Lessons about monetary policy Monetary policy is very effective at changing Y Monetary policy affects output by affecting the components of aggregate demand: closed economy: M  r  I  Y small open economy: M  e  NX  Y CHAPTER 12 The Open Economy Revisited