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Chapter

Week 11 and 12 chapter notes


Department
Economics for Management Studies
Course Code
MGEB06H3
Professor
Jack Parkinson

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Chapter 12 The Open Economy Revisited: The Mundell-Fleming Model and
the Exchange-Rate Regime Notes
x Mundell-Fleming model Æ the IS-LM model for a small open economy
12.1 The Mundell-Fleming Model
Components of the Model
x Y = C (Y – T) + I (r) + G + NX (e) IS, M/P = L (r, Y) LM, r = r*
x the first equation describes the goods market Æ it states that aggregate supply Y is equal to aggregate demand—the sum of
consumption C, investment I, government purchases G, and net exports NX
x second equation describes the money market Æ it states that the supply of real money balances, M/P, equals the demand L (r, Y)
x like IS-LM model, this model takes P as an exogenous variable, so there is no difference between nominal and real interest rates
x the third equation states that the world interest rate r* determines the interest rate in this economy
The Model on a Y-r Graph
x 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
x the IS curve slopes downward, the LM curve slopes upward, and a horizontal line represents the world interest rate
x the equilibrium in this graph is found where the LM curve crosses the line representing the world interest rate
x 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
x 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
x this graph is drawn holding the interest rate constant at the world interest rate
x the two equations in this figure are:
Y = C (Y – T) + I (r*) + G + NX (e) IS*, M/P = L (r*, Y) LM*
x the IS* curve slopes downward because a higher exchange rate lowers net exports and thus lowers aggregate income
x the LM* curve is vertical because the exchange rate does not enter into the LM* equation
x given the world interest rate, the LM* equation determines aggregate income, regardless of the exchange rate
x the equilibrium for the economy is found where the IS* curve and the LM* curve intersect
x 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
x floating exchange rates Æ central bank allows to change in response to changing economic conditions and economic policies
x in this case, the exchange rate e adjusts to achieve simultaneous equilibrium in the goods market and the money market
x 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 the foreign exchange market
Fiscal Policy
x in a small open economy with a floating exchange rate, a fiscal expansion leaves income at the same level
x in both closed and open economies, the quantity of real money balances supplied M/P is fixed by the central bank (which sets M)
and the assumption of sticky prices (which fixes P), which the quantity demanded (determined by r and Y) must equal
x when the government increases spending or cuts taxes, the appreciation of the exchange rate and the fall in net exports must be
exactly large enough to offset fully the normal expansionary effect of the policy on income
Monetary Policy
x although monetary policy influences income in an open economy, the monetary transmission mechanism is different
x in a small open economy, monetary transmission cannot affect the interest rate because it is fixed by the world interest rate
x in a small open economy, monetary policy influences income by altering the exchange rate rather than the interest rate
12.3 The Small Open Economy Under Fixed Exchange Rates
x fixed exchange rates Æ an exchange rate that is set by the central bank’s willingness to buy and sell the domestic currency for
foreign currencies at a predetermined price
How a Fixed-Exchange-Rate System Works
x under this system, a central bank stands ready to buy or sell the domestic currency for foreign currencies at a predetermined price
x fixed exchange rate dedicates a country’s monetary policy to the single goal of keeping the exchange rate at the announced level
x in other words, the essence of a fixed-exchange-rate system is the commitment of the central bank to allow the money supply to
adjust to whatever level will ensure that the equilibrium exchange rate equals the announced exchange rate
x moreover, as long as the central bank stands ready to buy or sell foreign currency at the fixed exchange rate, the money supply
adjusts automatically to the necessary level
Monetary Policy
x by agreeing to fix the exchange rate, the central bank gives up its control over the money supply
x a country with a fixed exchange rate can, however, conduct a type of monetary policy: it can decide to change the level at which
the exchange rate is fixed, by devaluation or revaluation
x devaluation Æ an action by the central bank to decrease the value of a currency under a system of fixed exchange rates
x revaluation Æ an action undertaken by the central bank to raise the value of a currency under a system of fixed exchange rates
x a devaluation thus expands net exports and raises aggregate income
x conversely, a revaluation shifts the LM* curve to the left, reduces net exports, and lowers aggregate income
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