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Macroeconomics & The Global Economy -Term III Ace Institute of Management Session 10: The Macroeconomics & The Global Economy -Term III Ace Institute of Management Session 10: The Mundell-Fleming Model and Exchange Rate Regime Instructor Sandeep Basnyat [email protected] com Mobile: 9841 892281

IS-LM and Mundell-Fleming Model § IS-LM: relationship between interest rate (r) and output (Y)- IS-LM and Mundell-Fleming Model § IS-LM: relationship between interest rate (r) and output (Y)- IS is the negative relationship where as LM is the positive relationship. § Mundell-Fleming: relationship between nominal exchange rate (e) and output (Y). § Argue that: an economy can not simultaneously maintain fixed exchange rate, free capital movement and independent monetary policy.

Mundell-Fleming Model: The IS* curve: Goods market eq’m Equation for IS Curve: Y = Mundell-Fleming Model: The IS* curve: Goods market eq’m Equation for IS Curve: Y = C+I+G+NX (e) The IS* curve is drawn for a given value of r*. e Intuition for the slope: IS* Y CHAPTER 12 The Open Economy Revisited

The LM* curve: Money market eq’m LM represents money supply by central bank, which The LM* curve: Money market eq’m LM represents money supply by central bank, which is fixed for certain level of output. e LM* The LM* curve does not depend on e and is vertical to e. Y CHAPTER 12 The Open Economy Revisited

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* The Open Economy Revisited Y

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. § Next, policy analysis – § first, in a floating exchange rate system § then, in a fixed exchange rate system CHAPTER 12 The Open Economy Revisited

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 shifts IS* to the right, increasing e. Therefore, in Floating exchange rate system, fiscal policy is ineffective in increasing output CHAPTER 12 e e 2 e 1 The Open Economy Revisited Y 1 Y

Monetary policy under floating exchange rates An increase in M shifts LM* right. e Monetary policy under floating exchange rates An increase in M shifts LM* right. e Y increases and e decreases. Therefore, in Floating exchange rate system, monetary policy is effective in increasing output CHAPTER 12 e 1 e 2 The Open Economy Revisited Y 1 Y 2 Y

Fiscal policy under fixed exchange rates Under floating rates, afiscal policy is ineffective fiscal Fiscal policy under fixed exchange rates Under floating rates, afiscal policy is ineffective fiscal expansion would raise e. output. at changing To keepfixed rates, Under e from rising, the central bankvery fiscal policy is must sell domesticchanging effective at currency, which increases M output. and shifts LM* right. e e 1 Y 2 CHAPTER 12 The Open Economy Revisited Y

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

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 The Open Economy Revisited

The Impossible Trinity A nation cannot have free Free capital flows, independent flows monetary The Impossible Trinity A nation cannot have free Free capital flows, independent flows monetary policy, and a fixed exchange rate Option 2 Option 1 simultaneously. (Nepal) (U. S. ) A nation must choose one side of this triangle and Independent give up the monetary opposite policy corner. CHAPTER 12 Option 3 (China) The Open Economy Revisited Fixed exchange rate

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