1. The open economy

2. The Mundell-Fleming Model
Perfect capital mobility
Static expectations for ε
Consequently:
In floating exchange rate:

3. ε
LM*
IS* Y
An increase in G
Monetary policy only can effect Y

4. In a fixed exchange rate, the LM curve (and monetary policy) disappears
Money supply is endogenous ε
IS* Y

5. Rational exchange rate expectation and overshooting
Dornbusch (1976)
When expectations are not static, PKM does not implies that i=i*
The (uncovered see fn 10) interest rate parity
Consider the effect of an ↑M which implies in the LR ↑P,ε
In the short run, i↓, from 5.19, we see that:
How is that possible?

6. Log ε
jump ε1 ε0 t
The macroeconomic world is full of overshooting

7. i LM IS Y
Overshooting of i in the IS-LM model

8. Imperfect capital mobility is an intermediate case between the Mundell-Fleming model and the close economy model. Do it yourself.
Section 5.4 on the Output-inflation tradeoffs is fundamental.

9. Output-inflation tradeoffs, the Phillips curve, and the natural rate
A permanent output-inflation trade-off in a simple Keynesian model
Consider the following modelling of the supply side:
And consider an ↑ in AD (fiscal or monetary policy)

10. P
AS2
AS0 AS1 P1 P0
AD2
AD1
AD0 Y Y0 Y1

11. Y0 might be viewed as
in figure 5.18 P
LRAS AD Y
Permanent output-inflation trade-off? (Phillips, 1958)
A theory of inflation (the natural rate, Friedman 1968)

12. The Phillips curve π u φ

13. Okun’s law and Phillips curve
Putting the two together lead to the following
aggregate supply curve (figure 5.19)
And the expectations-Augmented Phillips Curve (Friedman-Phelps)

14. LRAS(πe=π) π
AS(πe=π1)
AS(πe=0)
Ln Y

15. When inflationary expectations adjust
no permanent output (unemployment) trade-off
Example: adaptative expectations
But more generally (see Romer section 5.4), modern Keynesians
tend to support the following AS curve:
Where π* is the core or underlying inflation and it is not necessarily
equal to the expected inflation rate. As an example:

16. Canonical New Keynesian Model
Three ingredients in this model: New Keynesian IS curve, New Keynesian Phillips curve, interest rate rule
With uncertainty
Phillips curve is based on infrequent adjustment of nominal prices
Bank adjusts interest rates in response to changes in expected future inflation and output

17. The model

18. The Taylor Rule and the modelling of Monetary policy
Controlling money supply or the interest rate
Reaction to a demand shock versus supply shock
In 2009, the i by the FED shoul have been negative according to Taylor

19. Case of white noise disturbance
The general model is usually solved with calibration and simulation (read page )
With white noise disturbances (the rhos in 7.87 to 7.89) there is no force causing agents to expect the economy to depart from its steady state in the future.
The E(y and π) in 7.84 to 7.86 = 0

20. Contractionary (increase ump) monetary policy raises interest rate and lower output and inflation
Positive aggregate demand shock (increase uis) increases output and inflation but does not affect the interest rate (money policy is forward looking and does not respond to the shock).
As the basic RBC model, no internal propagation mechanism (only with the rhos)
Read 7.9