2010 OEM Chapter 7

2010 OEM Chapter 7 - Chapter 7: The Mundell-Fleming Model...

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Chapter 7: The Mundell-Fleming Model 7.1 Introduction We now turn to develop a complete model of an open macro economy. This model will allow us to consider how a variety of possible events might influence output levels, interest rates, the current account balance, and the exchange rate. The model we develop is the open economy IS- LM model, otherwise known as the Mundell-Fleming model. This model was first developed in 1 the early 1960s, and it remains the workhorse open economy macro model to this day. It is a remarkably useful model for understanding how economic policies as well as various types of economic shocks might influence an economy and how openness to the international economy impacts events at home. The Mundell-Fleming model extends the standard IS-LM model by adding, wherever appropriate, international components that affect equilibrium conditions in the goods and assets markets. It also includes an additional curve that, depending upon the exchange rate regime in place for the country, identifies the equilibrium condition for a stationary value for the exchange rate or for a zero balance in the overall balance of payments. This curve is called the BB curve. Solving the overall model will involve deriving the behavior of each of the three curves and finding a point of common intersection that will determine the equilibrium values for each of the endogenous variables in the model. In what follows we will build an algebraic model as well as a graphical 2 The model was first developed by Robert Mundell, now at Columbia University, and the late J. Marcus 1 Fleming, while both were staff economists at the International Monetary Fund. In 1999, Mundell won the Nobel Prize in Economics for his work on this model. A fourth macro-economy market, the labor market, can easily be added to this setup. That market would 2 determine the overall level of full employment, and allow for a discussion of how the price level might change in response to tightness in the output or (equivalently) the labor market. For the time being we will assume that prices are fixed and ignore this market.
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representation of these equilibrium conditions, and then we will consider a variety of experiments to see how the model works. The first version of the model that we consider will be of a small, open economy with perfectly flexible exchange rates. In this version of the model, the endogenous variables are national output, Y, the interest rate, i, and the exchange rate, E. These variables will be determined by market forces in order to achieve equilibrium in the goods and assets markets as well as a zero overall balance of payments. We will then show how the model changes if we have fixed rates instead of flexible. In this version of the model, the exchange rate is set by the government and ceases to be an endogenous variable. Instead, the overall balance of payments is determined by macroeconomic activity, although in the long run it must be the case that the overall balance of payments converges to zero. Finally, we will consider two extensions. In the first, we will relax the assumption made in
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This note was uploaded on 04/17/2011 for the course ECON 1510 taught by Professor Stevenhusted during the Spring '11 term at Pittsburgh.

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2010 OEM Chapter 7 - Chapter 7: The Mundell-Fleming Model...

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