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Econ 101: Intermediate Macroeconomic Theory Larry Hu Lecture 13: Extension of IS-LM Model to Econ 101: Intermediate Macroeconomic Theory Larry Hu Lecture 13: Extension of IS-LM Model to Open Economy – Mundell-Fleming Model CHAPTER 12 Aggregate Demand in the Open Economy 0

Learning objectives § The Mundell-Fleming model: IS-LM for the small open economy § Causes Learning objectives § The Mundell-Fleming model: IS-LM for the small open economy § Causes and effects of interest rate differentials § Arguments for fixed vs. floating exchange rates CHAPTER 12 Aggregate Demand in the Open Economy 1

The Mundell-Fleming Model § Key assumption: Small open economy with perfect capital mobility. r 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 of domestic currency CHAPTER 12 Aggregate Demand in the Open Economy 2

The IS* curve: Goods Market Eq’m The IS* curve is drawn for a given The IS* curve: Goods Market Eq’m The IS* curve is drawn for a given value of r*. e Intuition for the slope: IS* Y CHAPTER 12 Aggregate Demand in the Open Economy 3

The LM* curve: Money Market Eq’m The LM* curve § is drawn for a The LM* curve: Money Market Eq’m The LM* curve § is drawn for a given e LM* value of r* § is vertical because: given r*, there is only one value of Y that equates money demand with supply, regardless of e. CHAPTER 12 Aggregate Demand in the Open Economy Y 4

Equilibrium in the Mundell-Fleming model e LM* equilibrium exchange rate equilibrium level of income Equilibrium in the Mundell-Fleming model e LM* equilibrium exchange rate equilibrium level of income CHAPTER 12 IS* Aggregate Demand in the Open Economy Y 5

Floating & fixed exchange rates § In a system of floating exchange rates, e Floating & fixed exchange rates § 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 foreign currency at a predetermined price. § We now consider fiscal, monetary, and trade policy: first in a floating exchange rate system, then in a fixed exchange rate system. CHAPTER 12 Aggregate Demand in the Open Economy 6

Fiscal policy under floating exchange rates At any given value of e, a fiscal Fiscal policy under floating exchange rates At any given value of e, a fiscal expansion increases Y, shifting IS* to the right. e e 2 e 1 Results: e > 0, Y = 0 CHAPTER 12 Y 1 Aggregate Demand in the Open Economy Y 7

Lessons about fiscal policy § In a small open economy with perfect capital mobility, Lessons about fiscal policy § In a small open economy with perfect capital mobility, fiscal policy is utterly incapable of affecting 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. CHAPTER 12 Aggregate Demand in the Open Economy 8

Mon. policy under floating exchange rates e An increase in M shifts LM* right Mon. policy under floating exchange rates e An increase in M shifts LM* right because Y must rise to restore eq’m in the money market. Results: e < 0, Y > 0 CHAPTER 12 e 1 e 2 Y 1 Y 2 Aggregate Demand in the Open Economy Y 9

Lessons about monetary policy § Monetary policy affects output by affecting one (or more) Lessons about monetary policy § Monetary policy affects output by affecting one (or more) of the components of aggregate demand: closed economy: M r I Y small open economy: M e NX Y § Expansionary mon. policy does not raise world aggregate demand, it shifts demand from foreign to domestic products. Thus, the increases in income and employment at home come at the expense of losses abroad. CHAPTER 12 Aggregate Demand in the Open Economy 10

Trade policy under floating exchange rates At any given value of e, a tariff Trade policy under floating exchange rates At any given value of e, a tariff or quota reduces imports, increases NX, and shifts IS* to the right. e e 2 e 1 Results: e > 0, Y = 0 CHAPTER 12 Y 1 Aggregate Demand in the Open Economy Y 11

Lessons about trade policy § Import restrictions cannot reduce a trade deficit. § Even Lessons about trade policy § Import restrictions cannot reduce a trade deficit. § Even though NX is unchanged, there is less trade: – the trade restriction reduces imports – the exchange rate appreciation reduces exports CHAPTER 12 Aggregate Demand in the Open Economy 12

Fixed exchange rates § Under a system of fixed exchange rates, the country’s central Fixed exchange rates § Under a system of fixed exchange rates, the country’s central bank stands ready to buy or sell the domestic currency foreign currency at a predetermined rate. § In the context of the Mundell-Fleming model, the central bank shifts the LM* curve as required to keep e at its preannounced rate. CHAPTER 12 Aggregate Demand in the Open Economy 13

Fiscal policy under fixed exchange rates Under floating rates, a fiscal expansion would policy Fiscal policy under fixed exchange rates Under floating rates, a fiscal expansion would policy ineffective at changing output. raise e. To keep e from rising, Under fixed rates, the central bank must fiscal policy is very sell domestic currency, effective at changing output. which increases M and shifts LM* right. e e 1 Results: e = 0, Y > 0 CHAPTER 12 Y 1 Y 2 Aggregate Demand in the Open Economy Y 14

Mon. policy under fixed exchange rates An increase in M would shift Under floating Mon. policy under fixed exchange rates An increase in M would shift Under floating rates, LM* right policy is very. monetary and reduce e effective at changing output. e To prevent the fall in e, Under fixed bank must the central rates, monetary policy cannot be buy domestic currency, used to affect output. e 1 which reduces M and shifts LM* back left. Results: e = 0, Y = 0 CHAPTER 12 Y 1 Aggregate Demand in the Open Economy Y 15

Trade policy under fixed exchange rates A restriction on imports puts upward pressure on Trade policy under fixed exchange rates A restriction on imports puts upward pressure on e. To keep e from rising, the central bank must sell domestic currency, which increases M and shifts LM* right. e e 1 Results: e = 0, Y > 0 CHAPTER 12 Y 1 Y 2 Aggregate Demand in the Open Economy Y 16

Interest-rate differentials Two reasons why r may differ from r* § country risk: The Interest-rate differentials Two reasons why r may differ from r* § country risk: The risk that the country’s borrowers will default on their loan repayments because of political or economic turmoil. § expected exchange rate changes: If a country’s exchange rate is expected to fall, then its borrowers must pay a higher interest rate to compensate lenders for the expected currency depreciation. CHAPTER 12 Aggregate Demand in the Open Economy 17

Differentials in the M-F model where is a risk premium. Substitute the expression for Differentials in the M-F model where is a risk premium. Substitute the expression for r into the IS* and LM* equations: CHAPTER 12 Aggregate Demand in the Open Economy 18

The effects of an increase in IS* shifts left, because r I LM* shifts The effects of an increase in IS* shifts left, because r I LM* shifts right, because r (M/P )d, so Y must rise to restore e e 1 money market eq’m. Results: e < 0, Y > 0 CHAPTER 12 e 2 Y 1 Y 2 Aggregate Demand in the Open Economy Y 19

The effects of an increase in § The fall in e is intuitive: An The effects of an increase in § The fall in e is intuitive: An increase in country risk or an expected depreciation makes holding the country’s currency less attractive. Note: an expected depreciation is a self-fulfilling prophecy. § The increase in Y occurs because the boost in NX (from the depreciation) is even greater than the fall in I (from the rise in r ). CHAPTER 12 Aggregate Demand in the Open Economy 20

Floating vs. Fixed Exchange Rates Argument for floating rates: § allows monetary policy to Floating vs. Fixed Exchange Rates Argument for floating rates: § allows monetary policy to be used to pursue other goals (stable growth, low inflation) Arguments for fixed rates: § avoids uncertainty and volatility, making international transactions easier § disciplines monetary policy to prevent excessive money growth & hyperinflation CHAPTER 12 Aggregate Demand in the Open Economy 21

The Impossible Trinity § Impossible to have free capital flows, a fixed exchange rate The Impossible Trinity § Impossible to have free capital flows, a fixed exchange rate and independent monetary policy § free capital flows +independent monetary policy : U. S. § free capital flows + fixed exchange rate : HK § fixed exchange rate + independent monetary policy: China CHAPTER 12 Aggregate Demand in the Open Economy 22