Class Slides for EC 204 Spring 2006 To Accompany Chapter 12

The Small Open Economy in the Short Run: The Mundell-Fleming Model Y = C(Y-T) + I(r) + G + NX(e) (IS) M/P = L(r, Y) (LM) r = r* (Perfect Capital Mobility and Small Country Assumption)

The Small Open Economy Under Floating Exchange Rates Before analyzing effects of policies we need to specify the international monetary system in which the country operates. Floating exchange rates characterize the system relevant for most of today’s major economies. The exchange rate is allowed to move in response to changes in economic conditions.

The Small Open Economy Under Fixed Exchange Rates Central Bank stands ready to buy or sell foreign currency at the fixed rate of exchange Bretton Woods System was fixed exchange rate system Gold Standard was a fixed exchange rate system

Interest Rate Differentials r = r* +  (Risk Premium) Y = C(Y-T) + I(r* +  ) + G + NX(e)(IS*) M/P = L(r* + , Y)(LM*)  can represent either a risk premium and/or expected change in the exchange rate

In Practice, Income Boom does not occur following rise in risk premium: Depreciation raises price of imported goods and the price level Central Bank may try to avoid depreciation by tightening monetary policy Increase in risk premium may directly cause money demand to rise as people seek “safe” asset

Foreign Exchange Market Intervention In practice, governments intervene in foreign exchange markets even under flexible exchange rates in order to move the exchange rate in a desired direction Intervention is typically “sterilized” by the Central Bank Central Bank “sterilizes” (offsets) the effect on the domestic money supply arising from purchases/sales of foreign currency

Sterilized Intervention A purchase (sale) of foreign currency would give rise to an increase (decrease) in the domestic money supply To “sterilize” this effect, the Central Bank uses an offsetting open-market operation by selling (buying) domestic Treasury securities, leaving the money supply unchanged The small open economy model suggests that this will have no effect on the exchange rate, since the money supply is unchanged

Sterilized Intervention But, this sale (purchase) of domestic Treasury securities by the Central Bank will increase (reduce) the amount of Treasury securities held by the public The public may require a rise (decline) in the risk premium on domestic securities in order to be willing to hold the changed amount A change in the risk premium will shift the LM* and IS* curves, leading to a change in the exchange rate, even though the money supply is unchanged

Evidence on the Effectiveness of Sterilized Intervention Very little evidence that intervention operates through this “risk premium” channel Some evidence that intervention works by signaling a future change in monetary policy itself Accordingly, the exchange rate may adjust today in response to this signal of a future shift in monetary policy

The Mundell-Fleming Model with a Changing Price Level Y = C(Y-T) + I(r*) + G + NX(  )(IS*) M/P = L(r*, Y)(LM*) where we note the distinction between the real and nominal exchange rates:  = e(P/P*)

The Large Open Economy in the Short Run Y = C(Y-T) + I(r) + G + NX(e) Goods Market Eqm. M/P = L(r, Y) Money Market Eqm. NX(e) = CF(r) Balance of Payment Eqm. (Net Capital Outflow = Net Exports)

The Large Open Economy in the Short Run: IS-LM Y = C(Y-T) + I(r) + G + CF(r) (IS) M/P = L(r, Y) (LM)