Week 11 and 12 chapter notes

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University of Toronto Scarborough
Economics for Management Studies
Jack Parkinson

Chapter 12 The Open Economy Revisited: The Mundell-Fleming Model and the Exchange-Rate Regime Notes N Mundell-Fleming model the IS-LM model for a small open economy 12.1 The Mundell-Fleming Model Components of the Model N Y = C (Y T) + I (r) + G + NX (e) IS, MP = L (r, Y) LM, r = r* N the first equation describes the goods market it states that aggregate supply Y is equal to aggregate demandthe sum of consumption C, investment I, government purchases G, and net exports NX N second equation describes the money market it states that the supply of real money balances, MP, equals the demand L (r, Y) N like IS-LM model, this model takes P as an exogenous variable, so there is no difference between nominal and real interest rates N the third equation states that the world interest rate r* determines the interest rate in this economy The Model on a Y-r Graph N one way to depict is to use a graph in which income Y is on the horizontal axis and the interest rate r is on the vertical axis N the IS curve slopes downward, the LM curve slopes upward, and a horizontal line represents the world interest rate N the equilibrium in this graph is found where the LM curve crosses the line representing the world interest rate N the exchange rate then adjusts and shifts the IS curve so that the IS curve crosses this point as well The Model on a Y-e Graph N the second way to depict is to use a graph in which income is on the horizontal axis and the exchange rate is on the vertical axis N this graph is drawn holding the interest rate constant at the world interest rate N the two equations in this figure are: Y = C (Y T) + I (r*) + G + NX (e) IS*, MP = L (r*, Y) LM* N the IS* curve slopes downward because a higher exchange rate lowers net exports and thus lowers aggregate income N the LM* curve is vertical because the exchange rate does not enter into the LM* equation N given the world interest rate, the LM* equation determines aggregate income, regardless of the exchange rate N the equilibrium for the economy is found where the IS* curve and the LM* curve intersect N this intersection shows exchange rate and level of income at which goods market and money market are both in equilibrium 12.2 The Small Open Economy Under Floating Exchange Rates N floating exchange rates central bank allows to change in response to changing economic conditions and economic policies N in this case, the exchange rate e adjusts to achieve simultaneous equilibrium in the goods market and the money market N when something happens to change that equilibrium, the exchange rate is allowed to move to a new equilibrium value, since the central bank does not intervene in t
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