Ch_12 (1) - LectureNoteChapter12 TheOpenEconomyRevisited:

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1 CHAPTER 12 The Open Economy Revisited Lecture Note-Chapter 12 The Open Economy Revisited:  The Mundell-Fleming Model and  the Exchange- Rate Regime University of Waterloo Department of Economics Spring 2010
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2 CHAPTER 12 The Open Economy Revisited  Introduction Chapter 12 presents the Mundell–Fleming model of a small open economy in the short run. Essentially, it is a synthesis of the IS–LM model and the small open economy model of Chapter 5.
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3 CHAPTER 12 The Open Economy Revisited  Introduction The goals of this chapter are as follows: 1. To introduce students to the distinction between fixed and floating exchange rates. 2. To show how the short-run effects of monetary and fiscal policy depend crucially upon the exchange–rate regime. 3. To consider whether exchange rates should be fixed or floating.
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4 CHAPTER 12 The Open Economy Revisited In this chapter, you will learn: 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.
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5 CHAPTER 12 The Open Economy Revisited 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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6 CHAPTER 12 The Open Economy Revisited The Mundell-Fleming model The interest rate in a small open economy with perfect capital mobility is determined by the world interest rate, r*, so that r = r*. Net exports, NX, are added to the goods market, giving a new equation for the IS curve: Y = C(Y – T) + I(r*) + G + NX(e).
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7 CHAPTER 12 The Open Economy Revisited The Mundell-Fleming model The Mundell–Fleming model assumes that both domestic and overseas inflation are zero, thus there is no difference between the nominal and real exchange rates. The IS* curve is now the combination of the exchange rate and GDP consistent with goods- market equilibrium, given r = r*.
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8 CHAPTER 12 The Open Economy Revisited 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 ⇒ ↑ ⇒ ↑
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9 CHAPTER 12 The Open Economy Revisited The  IS*  curve:  Goods market eq’m Other things being equal, a higher level of income leads to higher saving and thus a greater supply of dollars to the foreign exchange market. This leads to a fall in the exchange rate. The IS* curve thus slopes down.
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10 CHAPTER 12 The Open Economy Revisited
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11 CHAPTER 12 The Open Economy Revisited The  LM*  curve:  Money market eq’m The LM* curve: is drawn for a given value of r * .
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This note was uploaded on 11/25/2010 for the course ECON 202 taught by Professor Angelatrimarchi during the Spring '10 term at Waterloo.

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Ch_12 (1) - LectureNoteChapter12 TheOpenEconomyRevisited:

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