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ECON303 Topic 3

# ECON303 Topic 3 - TOPIC 3 The MundellFleming model under f...

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TOPIC 3 The Mundell Fleming model under flexible exchange rates (AA DD model) & sticky prices 1

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Introduction L d l f l h ll i f i d Long run models are useful when all prices of inputs and outputs have time to adjust. I th h t i f i t d t t t In the short run, some prices of inputs and outputs may not have time to adjust, due to labour contracts, costs of adjustment or imperfect information about market demand. 2
Determinants of Aggregate Demand 1. consumption expenditure – depends on: ( ) di bl i Y T a. (+) disposable income, Y T b. possibly ( ) interest rate, R and (+) wealth C = C(Y T) 2. investment expenditure – depends on: a. possibly ( ) R b. possibly (+) Y I = I 0 (exogenous for now) 3. government purchases – exogenous G = G 0 4. net expenditure by foreigners : the current account depends on: a. (+) real exchange rate EP*/P (Marshall Lerner condition) b. ( ) Y T c. possibly (+) Y* T* CA = CA(EP*/P, Y T) 3

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How Real Exchange Rate Changes Affect the Current Account The current account measures the value of exports relative to the value of imports: CA = EX – IM (+nfi) Wh h l h EP*/P i h i When the real exchange rate rises, the prices of foreign products rise relative to the prices of domestic products. h l f h b h b f 1. The volume of exports that are bought by foreigners rises. 2. The volume of imports that are bought by domestic residents falls. 3. The value of imports in terms of domestic products rises: the value/price of imports rises, since foreign products are more valuable/expensive. Marshall Lerner condition : for short run equilibrium (approx 1 year) volume effects dominate value effect Therefore, we assume that a real depreciation leads to an increase in the current account 4
Determinants of Aggregate Demand (cont.) Aggregate demand is therefore expressed as: D = C ( Y T ) + I + G + CA ( EP */ P , Y T ) Investment and government purchases, both Current account as a function of the real exchange rate and Consumption as a function of disposable Or more simply: exogenous disposable income. income D = D ( EP */ P , Y T , I , G ) 5

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