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CHAPTER 12 The Open Economy Revisited: The Mundell-Fleming Model and the Exchange-rate Regime A PowerPoint Tutorial To Accompany MACROECONOMICS, 7th. – PowerPoint PPT presentation

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Title: The Open Economy Revisited: The Mundell-Fleming Model and the Exchange-rate Regime


1
CHAPTER 12 The Open Economy Revisited The
Mundell-Fleming Model and the Exchange-rate Regime
2
Introducing
The Mundell-Fleming Model
This model is a close relative of the IS-LM
model both stress the interaction between the
goods market and the money market. Price levels
are fixed, and both show short-run fluctuations
in aggregate income. The Mundell-Fleming Model
assumes an open economy in which trade
and finance are added the IS-LM assumes a
closed economy.
LM
e
Equilibrium exchange rate
IS
Income, output, Y
Equilibrium income
3
The Mundell-Fleming Model
This model, often described as the dominant
policy paradigm for studying open-economy
monetary and fiscal policy, makes one important
and extreme assumption the economy being studied
is a small open economy and there is perfect
capital mobility, meaning that it can borrow or
lend as much as it wants in world financial
markets, and therefore, the economys interest
rate is controlled by the world interest rate,
mathematically denoted as r r. One key lesson
about this model is that the behavior of an
economy depends on the exchange rate regime it
adoptsfloating or fixed. This model will help
answer the question of which exchange rate regime
should a nation adopt?
4
Under a system of floating exchange rates, the
exchange rate is set by market forces and is
allowed to fluctuate in response to
changing economic conditions. The exchange rate
e, adjusts to achieve simultaneous equilibrium
in the goods market and the money market. When
something changes that equilibrium, the exchange
rate is allowed to adjust to a new rate.
5
Building the Mundell-Fleming Model
The Small Open Economy Under Floating Exchange
Rates
Lets start with two equations (notice the
asterisk next to IS and LM to remind us that the
equations hold the interest rate constant)
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.
6
The IS Curve
The IS curve slopes downward because a higher
exchange rate reduces net exports (since a
currency appreciation makes domestic goods more
expensive to foreigners), which in turn, lowers
aggregate income.
Exchange rate, e
IS
Income, output, Y
7
Deriving the Mundell-Fleming IS Curve
The Keynesian Cross
An 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.
(b)
YE
Planned expenditure, E C I G NX
Expenditure, E
Income, output, Y
(c)
(a)
The IS Curve
The NX Schedule
Exchange rate, e
Exchange rate, e,
NX(e)
IS
Income, output, Y
Net exports, NX
8
Deriving the Mundell-Fleming LM Curve
The LM Curve
LM
Interest rate, r
r r
Income, output, Y
The LM Curve
LM
Exchange rate, e
Income, output, Y
9
The Mundell-Fleming Model Under Floating
Exchange Rates
Expansionary Monetary Policy
Expansionary Fiscal Policy
e
LM
LM'
LM
e
DG, or DT ? De, no DY
DM ? -De, DY
IS
IS'
IS
Income, output, Y
Income, output, Y
When income rises in a small open economy, due
to the fiscal expansion, the interest rate tries
to rise but capital inflows from abroad put
downward pressure on the interest rate. This
inflow causes an increase in the demand for the
currency pushing up its value and thus making
domestic goods more expensive to foreigners
(causing a DNX). The DNX offsets the
expansionary fiscal policy and the effect on Y.
When the increase in the money supply puts
downward pressure on the domestic interest rate,
capital flows out as investors seek a higher
return elsewhere. The capital outflow prevents
the interest rate from falling. The outflow
also causes the exchange rate to depreciate,
making domestic goods less expensive relative to
foreign goods, and stimulates NX. Hence,
monetary policy influences the e rather than r.
10
Fixed Exchange Rates
Under a fixed exchange rate, the central bank
announces a value for the exchange rate and
stands ready to buy and sell the
domestic currency at a predetermined price to
keep the exchange rate at its announced level.
Fixed exchange rates require a commitment of a
central bank to allow the money supply to adjust
to whatever level will ensure that the
equilibrium exchange rate in the market for
foreign- currency exchange equals the announced
exchange rate. Most recently, China fixed the
value of its currency against the U.S. dollar,
which has resulted in a lot of tension between
the two nations. It is important to realize that
this exchange-rate system fixes the nominal
exchange rate. Whether it fixes the real exchange
rate depends on the time horizon.
11
The Mundell-Fleming Model Under Fixed Exchange
Rates
Expansionary Monetary Policy
Expansionary Fiscal Policy
DG, or DT? DY
DM ? no DY
e
LM
LM
LM'
e
IS
IS'
IS
Income, output, Y
Income, output, Y
A fiscal expansion shifts IS to the right. To
maintain the fixed exchange rate, the Fed must
increase the money supply, thus increasing LM to
the right. Unlike the case with flexible
exchange rates, there is no crowding out effect
on NX due to a higher exchange rate.
If the Fed tried to increase the money supply
by buying bonds from the public, that would put
down- ward pressure on the interest rate.
Arbitragers respond by selling the domestic
currency to the central bank, causing the money
supply and the LM curve to contract to their
initial positions.
12
Fixed vs.
Exchange Rate Conclusions
Floating
Fixed Exchange Rates
Floating Exchange Rates
  • Fiscal 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 influence aggregate income under
floating exchange rates. A fiscal
expansion causes the currency to appreciate,
reducing net exports and offsetting the usual
expansionary impact on aggregate demand. The
Mundell-Fleming model shows that monetary policy
does not influence aggregate income under fixed
exchange rates. Any attempt to expand the money
supply is futile, because the money supply must
adjust to ensure that the exchange rate stays at
its announced level.
13
Policy in the Mundell-Fleming Model A Summary
The 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.
14
Devaluation Revaluation
A country with fixed exchange rates can, however,
conduct a type of monetary policy by deciding to
change the level at which the exchange rate is
fixed. A reduction in the official value of the
currency is called a devaluation, and an
increase in the value is called a revaluation.
15
Interest Rate Differentials the International
Flow of Capital
What if the domestic interest rate were above
the world interest rate?
The higher return will attract funds from the
rest of the world, driving the domestic interest
rate back down. And, if the domestic interest
rate were below the world interest rate, r,
domestic residents would lend abroad 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.
16
Country Risk and Exchange Rate Expectations
Why doesnt this logic always apply? There are
two reasons why interest rates differ across
countries 1) Country Risk when investors buy
U.S. government bonds, or make loans to U.S.
corporations, they are fairly confident that they
will be repaid with interest. By contrast, in
some less developed countries, it is plausible to
fear that political upheaval may lead to a
default on loan repayments. Borrowers in such
countries often have to pay higher interest rates
to compensate lenders for this risk. 2) Exchange
Rate Expectations suppose that people expect the
French franc to fall in value relative to the
U.S. dollar. Then loans made in francs will be
repaid in a less valuable currency than loans
made in dollars. To compensate for the expected
fall in the French currency, the interest rate
in France will be higher than the interest rate
in the United States.
17
Differentials in the Mundell-Fleming Model
To incorporate interest-rate differentials into
the Mundell-Fleming model, we assume that the
interest rate in our small open economy is
determined by the world interest rate plus a risk
premium q. r r q The risk
premium is determined by the perceived political
risk of making loans in a country and the
expected change in the real interest rate. Well
take the risk premium q as exogenously
determined. For any given fiscal policy,
monetary policy, price level, and risk premium,
these two equations determine the level of income
and exchange 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)
18
Now suppose that political turmoil causes the
countrys 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 reduces investment. 2)
LM shifts to the right, because the higher
interest rate reduces the demand for money, and
this allows a higher level of income for
any given money supply. These two shifts cause
income to rise and thus push down the
equilibrium exchange rate on world markets. The
important implication expectations of the
exchange rate are partially self-fulfilling. For
example, suppose that people come to believe that
the French franc will not be valuable in the
future. Investors will place a larger risk
premium on French assets q will rise in France.
This expectation will drive up French interest
rates and will drive down the value of the
French franc. Thus, the expectation that a
currency will lose value in the future causes it
to lose value today. The next slide
will demonstrate the mechanics.
19
An Increase in the Risk Premium
LM
LM'
e
IS
IS'
Income, output, Y
An increase in the risk premium associated with a
country drives up its interest rate. Because the
higher interest rate reduces investment, the IS
curve shifts to the left. Because it also
reduces money demand, the LM curve shifts to the
right. Income rises, and the exchange rate
depreciates.
20
There are three reasons why, in practice, such a
boom in income does not occur. First, the
central bank might want to avoid the large
depreciation of the domestic currency and
therefore, may respond by decreasing the money
supply M. Second, the depreciation of
the domestic currency may suddenly increase the
price of domestic goods, causing an increase in
the overall price level P. Third, when some
event increase the country risk premium q,
residents of the country might respond to the
same event by increasing their demand for money
(for any given income and interest rate), because
money is often the safest asset available. All
three of these changes would tend to shift the
LM curve toward the left, which mitigates the
fall in the exchange rate but also tends to
depress income.
21
Should Exchange Rates Be Floating or Fixed?
Fixed Pros
  • Exchange-rate volatility
  • creates uncertainty and
  • makes trade more difficult.
  • 2) Tempers overuse of
  • monetary authority.

Floating Pros
  • Allows monetary policy to be used
  • for other purposes such as stabilizing
  • employment or prices.

Fixed Cons
Floating Cons
  • Monetary policy is committed
  • to the single goal of maintaining
  • the announced level.
  • 2) May lead to greater volatility in
  • income and employment.
  • More speculation and
  • volatility expected.

22
Speculative Attacks, Currency Boards,
and Dollarization
A speculative attack is a case where a change in
investors perceptions makes a fixed rate
untenable. To avoid these kinds of attacks, some
economists suggest the use of a currency board,
an arrangement by which the central bank
holds enough foreign currency to back each unit
of the domestic currency. The next for a nation
is to consider dollarization, a plan in which the
domestic currency is abandoned and the U.S.
dollar is used instead.
23
The Impossible Trinity
It is impossible for a nation to have free
capital flows, a fixed exchange rate, and
independent monetary policy.
Free capital flows
Option 1 United States
Option 2 Hong Kong
Independent Monetary Policy
Fixed Exchange Rates
Option 3 China
24
Chinas Currency Situation
By January 2009, the exchange rate had moved to
6.84 yuan per dollar a 21 appreciation of the
yuan. Despite this large change in the exchange
rate, Chinas critics continued to complain about
that nations intervention in foreign-exchange
markets. In January 2009, the new Treasury
Secretary Timothy Geithner said, President
Obama backed by the conclusions of a broad range
of economistsbelieves that China is manipulating
its currency. So, President Obama had pledged to
use aggressively all diplomatic avenues open to
him to seek change in Chinas currency practices.
25
The Mundell-Fleming Model with a Changing Price
Level
Recall the two equations of the Mundell-Fleming
model
IS YC(Y-T) I(r) G NX(e)
LM
LM'
e
LM M/PL (r,Y)
When the price level falls, the LM curve shifts
to the right. The equilibrium 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,Y
P
AD
Income, output,Y
26
The Short-run and Long-run Equilibria in a Small
Open Economy
LM
LM'
Real exchange rate
Point K in both panels shows the
equilibrium under the Keynesian assumption that
prices are fixed at P1. Point C in both diagrams
shows the equilibrium under the classical
assumption that the price level adjusts
to maintain income at its natural level Y.
e1
K
C
e2
IS
Income, output,Y
P
K
SRAS1
P1
SRAS2
P2
C
AD
Income, output,Y
27
Key Concepts of Chapter 12
Mundell-Fleming Model Floating exchange
rates Fixed exchange rates Devaluation Re
valuation
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