Unformatted text preview: esult, the economy’s interest rate is determined by the world interest rate. The three components that make up the model are: Y = C(Y – T) + I(r) + G + NX(e) IS M/P = L(r, Y) LM r = r* The first equation describes the goods market, the second equation describes the money market, and the third equation states that the world interest rate determines the interest rate in this economy. The Mundell Fleming model assumes that prices are fixed. In a small open economy, the domestic interest rate might right by a little bit for a short time, but as soon as it did, foreigners would see the higher interest rate and start lending to this country. The capital inflow would drive the domestic interest rate back toward r*, and similarly if the domestic rate were below the world interest rate. Thus, we can assume that r = r*. There are deviations of the Canadian interest rate to the world interest rate. One form is a risk premium that depends on such factors as international concern about political instability in Canada. Another reason for departures from r = r* is that it takes some time for international lenders to react to yield differentials. We view r = r* as representing full equilibrium, and we can consider temporary deviations from this while discussing the time sequence in the model. Page 39 of 52 Jessica Gahtan Prof: Mokhles Hossain Macroeconomics ECON2000 Fall 2013 The Mundell Fleming model can be depicted on a graph with the LM curve, the IS curve, and the new r = r* curve which is a horizontal line at the world rate of interest. The IS curve is drawn for a given value of the exchange rate, so a change in the exchange rate shifts the IS curve. Thus, we label IS curve IS(e). The exchange rate adjusts to ensure that all three curves pass through the same point. The equilibrium is found where the LM curve crosses the line representing the world interest rate, and the exchange rate then adjusts and shifts the IS curve so that the IS curve crosses this point as well. The model can also be depicted on a graph which uses income on the horizontal axis and the exchange rate on the vertical axis. This graph holds the interest rate constant at the world interest rate. The two equations in this figure are: Y = C(Y – T) + I(r*) + G + NX(e) IS* M/P = L(r*, Y) LM...
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 Fall '10
 Henriques
 Economics, Macroeconomics

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