Chapter 12: Aggregate Demand in Open Economy

The Mundell-Fleming Model Assumption –Small open economy –Free capital mobility (r = r*) –Flexible or fixed foreign exchange rate regime

Flexible Exchange Rate The IS curve: Y = C(Y – T) + I(r*) + G + NX(e) Where e = nominal exchange rate that varies according to its demand and supply An increases in e make imports less expensive to domestic consumer and exports more expensive to foreign consumer, hence reducing NX

Derivation of IS Curve Initial equilibrium: Y = E 1 with Y 1 and e 1 Let e increase, NX decreases and E 1 falls to E 2 New equilibrium: E 2 = Y with Y 2 e 1 Line AB is the IS

Derivation of IS Curve Y2Y2 Y1Y1 Y2Y2 Y1Y1 e1e1 e2e2 Expenditures Exchange Rate Income E1E1 E2E2 Y = E IS(e) B A

Derivation of LM Curve M/P = L(r*, Y) LM is independent of the exchange rate Shift of LM won’t alter the interest rate because r = r*

Derivation of LM Curve LM(r*) r Y Interest Rate Income r = r* Income Exchange Rate LM(e) Y

IS-LM Model LM IS e Y Exchange Rate Income Aggregate Equilibrium

Fiscal Policy Initial equilibrium: IS 1 = LM 1 with Y 1 and e 1 As G increase, IS increases. New equilibrium: IS 2 = LM 1 causing Y and e to increase The rise in e makes NX and Y to fall, offsetting the initial increase in income

Fiscal Policy LM IS 1 e1e1 Y Exchange Rate Income IS 2 e2e2 Fiscal policy is ineffective in causing economic growth

Monetary Policy Initial equilibrium: IS 1 = LM 1 with Y 1 and e 1 As M increase, LM increases. New equilibrium: IS 1 = LM 2 causing Y to increase and e to fall The fall in e makes NX and Y to increase

Monetary Policy LM 1 IS 1 e1e1 Y1Y1 Exchange Rate Income LM 2 e2e2 Monetary policy is effective in causing economic growth Y2Y2

Trade Protectionism Initial equilibrium: IS 1 = LM 1 with Y 1 and e 1 Let imports decrease, NX and IS decline. New equilibrium: IS 2 = LM 1 causing Y and e to increase The rise in e makes NX and Y to decrease

Trade Protectionism LM IS 1 e1e1 Y Exchange Rate Income IS 2 e2e2 Trade protectionism is ineffective in causing economic growth

Fixed Exchange Rate Assume: market rate > fixed rate Arbitrageur buys from the market and sells to the central bank at the fixed rate and make profits Money supply and LM increase, causing Y to increase. The market rate falls to the fixed rate

Fixed Exchange Rate LM 1 IS 1 efef Y1Y1 Exchange Rate Income LM 2 emem Y2Y2

Fixed Exchange Rate Assume: market rate < fixed rate Arbitrageur buys from the central bank market and sells to the market at the fixed rate to make profits Money supply and LM decrease, causing Y to fall. The market rate rises to the fixed rate

Fixed Exchange Rate LM 2 IS 1 emem Y2Y2 Exchange Rate Income LM 1 efef Y1Y1

Fiscal Policy Initial equilibrium: IS 1 = LM 1 with Y 1 and e 1 As G increase, IS increases, causing e to rise above the fixed rate. Exchange rate arbitrage causes M s and LM to increase, e falls to the fixed rate New equilibrium: IS 2 = LM 2 causing Y to increase

Fixed Exchange Rate LM 1 IS 1 emem Y1Y1 Exchange Rate Income LM 2 efef Y2Y2 IS 2 Fiscal policy is effective in causing economic growth

Monetary Policy Initial equilibrium: IS 1 = LM 1 with Y 1 and e 1 Let M s increase, LM increases, causing e to decrease below the fixed rate. Exchange rate arbitrage causes M s and LM to decrease, e rises to the fixed rate New equilibrium: IS 1 = LM 1 causing no increase in Y

Monetary Policy LM 1 IS 1 emem Y2Y2 Exchange Rate Income LM 2 efef Y1Y1 Monetary policy is ineffective in causing economic growth

Trade Protectionism Initial equilibrium: IS 1 = LM 1 with Y 1 and e 1 As imports increase NX and IS increase, causing e to increase above the fixed rate Exchange rate arbitrage causes M s and LM to increase, lowering e to the fixed rate New equilibrium: IS 2 = LM 2 causing Y to increase

Trade Protectionism LM 1 IS 1 emem Y1Y1 Exchange Rate Income LM 2 efef Y2Y2 IS 2 Trade protectionism is effective in causing economic growth

Policy Effectiveness PolicyFlexible Exchange Rate Fixed Exchange Rate Fiscal Monetary Trade Protectionism Ineffective Effective Ineffective Effective Ineffective Effective

Effect of Political Risk Define r = r*+ Θ where Θ is the risk premium for political instability IS curve: Y = C(Y-T) + I(r*+ Θ) + G + NX(e) LM curve: (M/P) = L(r*+ Θ, Y) Let Θ increase, causing LM to increase and e to decrease

Effect of Political Risk An increases in r reduces investment and the IS, but exchange rate depreciation increases NX Reasons for lack of economic growth –Reaction of the central bank to reduce LM in order to offset depreciation –Depreciation causes import prices to rise, reducing NX and Y –People increase the money demand, reducing LM

Effect of Political Risk LM 1 IS 2 e1e1 Y1Y1 Exchange Rate Income LM 2 e2e2 Y2Y2 IS 1