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# 302-12b - CHAPTER CharlesEngel 12...

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C H A P T E R The Open Economy Revisited:   the Mundell-Fleming Model and  the Exchange-Rate Regime University of Wisconsin Charles Engel 12

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CHAPTER 12.02 slide 2 In this chapter, you will learn… the Mundell-Fleming model ( IS-LM for the small open economy) causes and effects of interest rate differentials arguments for fixed vs. floating exchange rates how to derive the aggregate demand curve for a small open economy
CHAPTER 12.02 slide 3 The Mundell-Fleming model Key assumption: Small open economy with perfect capital mobility. r = r* Goods market equilibrium – the IS* curve: ( ) ( ) ( ) * Y C Y T I r G NX e = - + + + where e = nominal exchange rate = foreign currency per unit domestic currency

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CHAPTER 12.02 slide 4 The  IS*  curve:  Goods market eq’m The IS* curve is drawn for a given value of r * . Intuition for the slope: Y e IS * ( ) ( ) ( ) * Y C Y T I r G NX e = - + + + e NX Y ⇒ ↑ ⇒ ↑ We could derive this using the “Keynesian cross”. See Ch. 12. Remember, the IS curve incorporates the multiplier effect.
CHAPTER 12.02 slide 5 The  LM*  curve:  Money market eq’m The LM* curve is drawn for a given value of r * . is vertical because: given r* , there is only one value of Y that equates money demand with supply, regardless of e . Y e LM * ( , ) * M P L r Y =

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CHAPTER 12.02 slide 6 Equilibrium in the Mundell-Fleming model Y e LM * ( , ) * M P L r Y = IS * ( ) ( ) ( ) * Y C Y T I r G NX e = - + + + equilibrium exchange rate equilibrium level of income
CHAPTER 12.02 slide 7 Floating & fixed exchange rates In a system of floating exchange rates , e is allowed to fluctuate in response to changing economic conditions. In contrast, under fixed exchange rates , the central bank trades domestic for foreign currency at a predetermined price. Next, policy analysis – first, in a floating exchange rate system then, in a fixed exchange rate system

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CHAPTER 12.02 slide 8 Fiscal policy under floating exchange  rates Y e ( , ) * M P L r Y = ( ) ( ) ( ) * Y C Y T I r G NX e = - + + + Y 1 e 1 1 * LM 1 * I S 2 * I S e 2 At any given value of e , a fiscal expansion increases Y , shifting IS* to the right. Results: e > 0, Y = 0
CHAPTER 12.02 slide 9 Lessons about fiscal policy In a small open economy with perfect capital mobility, fiscal policy cannot affect real GDP. “Crowding out” closed economy: Fiscal policy crowds out investment by causing the interest rate to rise. small open economy: Fiscal policy crowds out net exports by causing the exchange rate to appreciate.

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CHAPTER 12.02 slide 10 Monetary policy under floating  exchange rates Y e e 1 Y 1 1 * LM 1 * I S Y 2 2 * LM e 2 An increase in M shifts LM* right because Y must rise to restore eq’m in the money market. Results: e < 0, Y > 0 ( , ) * M P L r Y = ( ) ( ) ( ) * Y C Y T I r G NX e = - + + +
CHAPTER 12.02 slide 11 Lessons about monetary policy Monetary policy affects output by affecting the components of aggregate demand: closed economy: M ⇒↓ r I Y small open economy: M ⇒↓ e NX Y Expansionary mon. policy does not raise world agg. demand, it merely shifts demand from foreign to domestic products.

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