lecture12 - Lecture XII Economics 202A Fall 2007 Exam...

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1 Lecture XII Economics 202A Fall 2007 Exam: October 23. No class this Thursday. Maury will continue with international next Tuesday. It will be in the same mode as previous exams. Today we will go over the theory of exchange rates. Today I am going to go over the Mundell-Fleming model and the Dornbusch model. Both of them serve as the basis for the determination of macroeconomic equilibrium with flexible exchange rates. The Dornbusch model builds on Mundell-Fleming. First, let me review the Mundell-Fleming model. We are going to use IS-LM analysis. To remind you the IS curve is the locus of income and the interest rate such that planned savings equals planned investment (or, equivalently so that sales equals production). The LM curve is the locus of income and the interest rate such that the demand for money equals the supply of money. Consider economies in which wages and prices are fixed, at least in the short-run which we will be considering. r LM r*
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2 IS income Suppose we have an IS and an LM curve. Let us suppose, however, also that investors will not tolerate an interest rate in New York that is different from an international interest rate, which I will call r*. And suppose further that there are flexible exchange rates. We start in an initial equilibrium. <NOW PICTURE IT> In that equilibrium the IS and the LM curve intersect at r*. (In what follows I will show why in fact that is the characteristic of an equilibrium). Suppose the U.S. tries to shift the IS curve. The IS curve shifts to IS N at the old exchange rate. r LM r* IS(e o ) IS N (e 0 ) Y Then the interest rate in the U.S. will rise relative to the international interest rate in London, and investors will buy dollars to take advantage of the higher U.S. interest rates. Because investors are buying dollars the dollar will appreciate. That appreciation will cause people to want to buy fewer U. S. goods. As a result the demand for U.S. net exports will fall.
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3 And the IS curve will be driven back as the dollar appreciates. The net result of the initial shift of the IS curve, however, will be an appreciated dollar and an increased trade deficit. So shifts in the IS curve in this model have no effect on income. A rise in U.S. government spending will only appreciate the dollar and increase the deficit in the balance of payments. Now let°s see what happens with shifts in the LM curve. We will see that expansionary monetary policy will increase output. r LM LM N r* E E N IS(e 0 ) Income First we shall picture the initial equilibrium. Then the LM curve shifts outward to LM N . The interest rate in the US is now low. <point> People sell dollars. That depreciates the dollar. And that depreciation makes imports from the U.S. attractive to the rest of the
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4 world, which shifts out the IS curve.
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