Chapter 12

Chapter 12 - CHAPTER 12 The Open Economy Revisited The...

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Chapter Twelve 1 ® CHAPTER 12 The Open Economy Revisited: The Mundell-Fleming Model and the Exchange-rate Regime A PowerPoint Tutorial To Accompany MACROECONOMICS, 6th. ed. N. Gregory Mankiw By Mannig J. Simidian
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Chapter Twelve 2 Introducing… e Income, output, Y LM * IS * Equilibrium exchange rate Equilibrium income 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.
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Chapter Twelve 3 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 economy’s 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 adopts—floating or fixed. This model will help answer the question of which exchange rate regime should a nation adopt?
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Chapter Twelve 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.
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The price level is exogenously fixed since the model is used to analyze curve will be vertical because the exchange rate does not enter IS*: Y = C(Y-T) + I(r*) + G + NX(e) Let’s start with two equations (notice the asterisk next to IS and LM to remind us that the equations hold the interest rate constant): The Small Open Economy Under Floating Exchange Rates LM*: M/P = L (r*,Y)
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Chapter Twelve 6 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. Income, output, Y IS * Exchange rate, e
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Income, output, Y Y=E Planned expenditure, E = C + I + G + NX (a) (c) (b)
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8 Income, output, Y Income, output, Y r = r *
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Chapter Twelve 9 e Income, output, Y LM * IS * e Income, output, Y LM * IS * IS *' LM *' 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 – NX ). The – NX offsets the expansionary fiscal policy and the effect on Y.
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This note was uploaded on 04/02/2008 for the course ECON 420 taught by Professor Hill during the Fall '08 term at UNC.

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Chapter 12 - CHAPTER 12 The Open Economy Revisited The...

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