1Reference: Froyen (Chapter 15)EXEE1104/ EIA1003 Macroeconomics ILecture 10Monetary and Fiscal Policies in the Open Economy
2THE MUNDELL-FLEMING MODELThe closed economy IS –LM:Money market equilibrium:M = L (Y, r)(1)Goods market equilibrium:S (Y) + T = I(r) + G(2)When IS = LM, the nominal interest rate (r) and the level of real income (Y), with aggregate price constant, is determined.
3In an open economy, the LM will not change:Equation (1) states that real money supply controlled by the domestic policymaker, must in equilibrium equal to the real demand for moneyFrom equation (2), the IS for the goods market equilibrium in a closed economy:C + S + T = C + I + G (3)When C is subtracted from both sides, S + T = I + G(4)The IS relation for an open economy – include imports (Z) and exports (X):S + T = I + G + X – Z (5)Contd.
4The open economy IS relation can be rewritten as: S(Y)+ T + Z(Y, π) = I(r) + G + X(Yf, π) (6)Sand Iare the same as in closed economyImports depend positively on income (Y) and negatively on exchange rate (π).Exchange rate – price of foreign currency.A rise in exchange rate means foreign goods are relatively more expensive.Contd.
5The IS in Figure 10.1 is downward sloping.High r will result in low I.To satisfy equation (6), at such high level of r, Y must be low so that levels of Z and S will be low (high i– income low – Z and S low).In constructing the IS, four variable are held constant: G, T, Yf(foreign income) and π.These are the variables that shift the IS curve.Contd.
6Figure 10.1 – Open Economy IS –LM ModelIn addition to IS and LM, open economy consists of balance of payment schedule, BP.BP: all interest rate – income combinations that result in BOP equilibrium at a given exchange rate.BP equilibrium means that official reserve transaction balance is zero.The BP:X(Yf, π) – Z(Y, π) + F(r – rf) = 0(8)rYISBPLM
7The BP schedule is given as:X(Yf, π) – Z(Y, π) + F(r – rf) = 0(8)The first two terms is the trade balance (net exports)The third item (F) is the net capital inflow (the surplus or deficit in the capital account)The net capital inflow depends positively on the interest rate minus foreign interest rate (r – rf).A rise in the domestic interest rate leads to increased demand for domestic assets (net capital inflow increases);A rise in the foreign interest rate leads to increased demand for foreign assets (net capital outflow increases).Contd.
8The BP schedule is positively sloped.As Y rises, Z increases, X does not. To maintain the BP equilibrium, capital inflow must increase (which will happen if r is higher).Factors that shift BP: Increase in πwill shift BP to the right.