ch%2012 - MACROECONOMICS CHAPTE R 12 The Ope n Economy Re...

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1 CHAPTER 12 The Open Economy Revisited MACROECONOMICS C H A P T E R The Open Economy Revisited: The Mundell-Fleming Model 12
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2 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: where e = nominal exchange rate = foreign currency per unit domestic currency = - + + + ( ) ( ) ( ) * Y c Y T I r G NX e
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3 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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4 CHAPTER 12 The Open Economy Revisited 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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5 CHAPTER 12 The Open Economy Revisited Equilibrium in the Mundell-Fleming model Y   e LM * IS * equilibrium exchange rate equilibrium level of income ( , ) * M P L r Y = = - + + + ( ) ( ) ( ) * Y c Y T I r G NX e
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6 CHAPTER 12 The Open Economy Revisited § 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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7 CHAPTER 12 The Open Economy Revisited Fiscal policy under floating exchange rates Y   e Y 1 e e At any given value of e , a fiscal expansion increases Y , shifting IS* to the right. Results: e > 0, Y = 0 ( , ) * M P L r Y = = - + + + ( ) ( ) ( ) * Y c Y T I r G NX e 1 * LM 1 * I S 2 * I S
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8 CHAPTER 12 The Open Economy Revisited 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 The Open Economy Revisited Monetary policy under floating exchange  rates Y   e e Y Y 2 e An increase in M shifts LM* right because Y must rise to restore eq’m in the money market. Results:
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This note was uploaded on 11/10/2011 for the course ECON 4610 taught by Professor Xiaohuang during the Fall '11 term at Kennesaw.

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ch%2012 - MACROECONOMICS CHAPTE R 12 The Ope n Economy Re...

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