1. Chapter 13 The Open Economy Revisited: The Mundell-Fleming Model and the Exchange-Rate Regime

2. IN THIS CHAPTER, YOU WILL LEARN:
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
how to derive the aggregate demand curve for a small open economy 1

3. The Mundell-Fleming model
Key assumption: Small open economy with perfect capital mobility.
r = r*
Goods market equilibrium—the IS* curve:
In this and the following sections (in which we analyze policies with the M-F model), we assume the price level is fixed—just as we did when we first used the closed economy IS-LM model to do policy analysis in Chapter 12.
As we learned in Chapter 6, NX depends on the real exchange rate. However, with price levels fixed, the real & nominal exchange rates move together. So, for simplicity, we write NX as a function of the nominal exchange rate here.
(At the end of this chapter, when we use M-F to derive the aggregate demand curve, we go back to writing NX as a function of the real exchange rate, because the nominal & real exchange rates may behave differently when the price level is changing.)
Chapter 6 introduced the notation r* for the world interest rate, and explained why r = r* in a small open economy with perfect capital mobility. Perfect capital mobility means that there are no restrictions on the international flow of financial capital: the country’s residents can borrow or lend as much as they wish in the world financial markets; and because the country is small, the amount its residents borrow or lend in the world financial market has no impact on the world interest rate.
Chapter 6 also explained why net exports depend negatively on the exchange rate.
where
e = nominal exchange rate
= foreign currency per unit domestic currency

4. The IS* curve: goods market equilibrium
The IS* curve is drawn for a given value of r*.
Intuition for the slope: Y e
IS*
The text (p.359) shows how the Keynesian Cross can be used to derive the IS* curve.
Suggestion: Before continuing, ask your students to figure out what happens to this IS* curve if taxes are reduced.
Answer: The IS* curve shifts rightward (i.e., upward).
Explanation:
Start at any point on the initial IS* curve. At this point, initially, Y = C + I + G + NX. Now cut taxes. At the initial value of Y, disposable income is higher, causing consumption to be higher. Other things equal, the goods market is out of equilibrium: C + I + G + NX > Y. An increase in Y (of just the right amount) would restore equilibrium. Hence, each value of e is associated with a larger value of Y. OR, a decrease in NX of just the right amount would restore equilibrium at the initial value of Y. But the decrease in NX requires an increase in e. Hence, each value of Y is associated with a higher value of e.
Rationale: Doing this exercise now will break up your lecture, and will prepare students for the fiscal policy experiment that is coming up in just a few slides.

5. The LM* curve: money market equilibrium
is drawn for a given value of r*.
is vertical because given r*, there is only one value of Y that equates money demand with supply, regardless of e. Y e
LM*
The text (Figure 13-2 on p.360) shows how the LM curve in (Y,r) space, together with the fixed r*, determines the value of Y at which the LM* curve here is vertical.
Suggestion: Before continuing, ask your students to figure out what happens to this LM* curve if the money supply is increased.
Answer: LM* shifts to the right.
Explanation: The equation for the LM* curve is:
M/P = L(r*, Y)
P is fixed, r* is exogenous, the central bank sets M, then Y must adjust to equate money demand (L) with money supply (M/P). Now, if M is raised, then money demand must rise to restore equilibrium (remember: P is fixed). A fall in r would cause money demand to rise, but in a small open economy, r = r* is exogenous. Hence, the only way to restore equilibrium is for Y to rise.
Rationale: Doing this exercise now will break up your lecture, and will prepare students for the monetary policy experiment that is coming up in just a few slides.

6. Equilibrium in the Mundell-Fleming modelY e
LM*
IS*
equilibrium
exchange
rate
equilibrium
income

7. 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 for foreign currency at a predetermined price.
Next, policy analysis:
in a floating exchange rate system
in a fixed exchange rate system

8. Fiscal policy under floating exchange rates
At any given value of e, a fiscal expansion increases Y, shifting IS* to the right. e2 e1
Intuition for the shift in IS*:
At a given value of e (and hence NX), an increase in G causes an increase in the value of Y that equates planned expenditure with actual expenditure.
Intuition for the results:
As we learned in earlier chapters, a fiscal expansion puts upward pressure on the country’s interest rate. In a small open economy with perfect capital mobility, as soon as the domestic interest rate rises even the tiniest bit about the world rate, tons of foreign (financial) capital will flow in to take advantage of the rate difference. But in order for foreigners to buy these U.S. bonds, they must first acquire U.S. dollars. Hence, the capital inflows cause an increase in foreign demand for dollars in the foreign exchange market, causing the dollar to appreciate. This appreciation makes exports more expensive to foreigners, and imports cheaper to people at home, and thus causes NX to fall. The fall in NX offsets the effect of the fiscal expansion.
How do we know that Y = 0? Because maintaining equilibrium in the money market requires that Y be unchanged: the fiscal expansion does not affect either the real money supply (M/P) or the world interest rate (because this economy is “small”). Hence, any change in income would throw the money market out of whack. So, the exchange rate has to rise until NX has fallen enough to perfectly offset the expansionary impact of the fiscal policy on output.
Results:
e > 0, Y = 0 Y1

9. Lessons about fiscal policy
In a small open economy with perfect capital mobility, fiscal policy cannot affect 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.

10. Monetary policy under floating exchange rates
An increase in M shifts LM* right because Y must rise to restore eq’m in the money market. e1
Suggestion: Treat this experiment as an in-class exercise. Display the graph with the initial equilibrium. Then give students 2-3 minutes to use the model to determine the effects of an increase in M on e and Y.
Intuition for the rightward LM* shift:
At the initial (r*,Y), an increase in M throws the money market out of equilibrium. To restore equilibrium, either Y must rise or the interest rate must fall, or some combination of the two. In a small open economy, though, the interest rate cannot fall. So Y must rise to restore equilibrium in the money market.
Intuition for the results:
Initially, the increase in the money supply puts downward pressure on the interest rate. (In a closed economy, the interest rate would fall.) Because the economy is small and open, when the interest rate tries to fall below r*, savers send their loanable funds to the world financial market. This capital outflow causes the exchange rate to fall, which causes NX—and hence Y—to increase. e2
Results:
e < 0, Y > 0 Y2

11. Lessons about monetary policy
Monetary policy affects output by affecting 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 agg. demand, it merely shifts demand from foreign to domestic products.
So, the increases in domestic income and employment are at the expense of losses abroad.
Suggestion:
Before revealing the text on this slide, ask students to take out a piece of paper and answer this question:
“Contrast the way in which monetary policy affects output in the closed economy with the small open economy.”

12. 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. e2
Intuition for results:
At the initial exchange rate, the tariff or quota shifts domestic residents’ demand from foreign to domestic goods. The reduction in their demand for foreign goods causes a corresponding reduction in the supply of the country’s currency in the foreign exchange market. This causes the exchange rate to rise. The appreciation reduces NX, offsetting the import restriction’s initial expansion of NX.
How do we know that the effect of the appreciation on NX exactly cancels out the effect of the import restriction on NX? There is only one value of Y that allows the money market to clear; since Y, C, I, and G are all unchanged, NX = Y-(C+I+G) must also be unchanged.
Or looking at it differently: As we learned in Chapter 6, the accounting identities say that NX = S − I. The import restriction does not affect S or I, so it cannot affect the equilibrium value of NX.
Results:
e > 0, Y = 0

13. 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.
Less trade means fewer “gains from trade.”

14. Lessons about trade policy, cont.
Import restrictions on specific products save jobs in the domestic industries that produce those products but destroy jobs in export-producing sectors.
Hence, import restrictions fail to increase total employment.
Also, import restrictions create sectoral shifts, which cause frictional unemployment.
Import restrictions cause a sectoral shift, a shift in demand from export-producing sectors to import-competing sectors. As we learned in Chapter 7, sectoral shifts contribute to the natural rate of unemployment, because displaced workers in declining sectors take time to be matched with appropriate jobs in other sectors.

15. Fixed exchange rates
Under fixed exchange rates, the central bank stands ready to buy or sell the domestic currency for foreign currency at a predetermined rate.
In the Mundell-Fleming model, the central bank shifts the LM* curve as required to keep e at its preannounced rate.
This system fixes the nominal exchange rate. In the long run, when prices are flexible, the real exchange rate can move even if the nominal rate is fixed.

16. Fiscal policy under fixed exchange rates
Under floating rates, a fiscal expansion would raise e.
Under floating rates, fiscal policy is ineffective at changing output.
Under fixed rates, fiscal policy is very effective at changing output. Y e
To keep e from rising, the central bank must sell domestic currency, which increases M and shifts LM* right. e1
Results:
e = 0, Y > 0 Y1 Y2

17. Monetary policy under fixed exchange rates
An increase in M would shift LM* right and reduce e.
Under floating rates, monetary policy is very effective at changing output.
Under fixed rates, monetary policy cannot be used to affect output. Y e Y1 e1
To prevent the fall in e, the central bank must buy domestic currency, which reduces M and shifts LM* back left.
The monetary expansion puts downward pressure on the exchange rate. To prevent it from falling, the central bank starts buying domestic currency in greater quantities to “prop up” the value of the currency in foreign exchange markets. This buying removes domestic currency from circulation, causing the money supply to fall, which shifts the LM* curve back.
Another way of looking at it: To keep the exchange rate fixed, the central bank must use monetary policy to shift LM* as required so that the intersection of LM* and IS* always occurs at the desired exchange rate. Unless the IS* curve shifts right (an experiment we are not considering now), the central bank simply cannot increase the money supply.
Results:
e = 0, Y = 0

18. Trade policy under fixed exchange rates
Under floating rates, import restrictions do not affect Y or NX.
Under fixed rates, import restrictions increase Y and NX.
But, these gains come at the expense of other countries: the policy merely shifts demand from foreign to domestic goods.
A restriction on imports puts upward pressure on e. Y e Y1 e1
To keep e from rising, the central bank must sell domestic currency, which increases M and shifts LM* right.
Suggestion: Assign this experiment as an in-class exercise. Give students three minutes to work on it before displaying the answer on the screen.
Results:
e = 0, Y > 0 Y2

19. Summary of policy effects in the Mundell-Fleming model
type of exchange rate regime:
floating
fixed
impact on:
Policy Y e NX
fiscal expansion  
mon. expansion
import restriction
Table 13-1 on p.372.
This table makes it easy to see that the effects of policies depend very much on whether exchange rates are fixed or flexible.

20. Floating vs. fixed exchange rates
Argument for floating rates:
allow monetary policy to be used to pursue other goals (stable growth, low inflation).
Arguments for fixed rates:
avoid uncertainty and volatility, making international transactions easier.
discipline monetary policy to prevent excessive money growth & hyperinflation.
Please refer your students to the excellent case study entitled “The Debate Over the Euro” on pp.378–380.

21. The Impossible Trinity
A nation cannot have free capital flows, independent monetary policy, and a fixed exchange rate simultaneously.
A nation must choose one side of this triangle and give up the opposite corner.
Free capital flows
Independent monetary policy
Fixed exchange rate
Option 1 (U.S.)
Option 2 (Hong Kong)
See pp
The impossible trinity is also known as the trilemma.
Option 1 involves allowing free capital flows and maintaining independent monetary policy, but giving up a fixed exchange rate. An example of a country that chooses this option is the United States.
Option 2 entails allowing free capital flows keeping a fixed exchange rate, but giving up independent monetary policy. A country that chooses this option is Hong Kong.
Option 3 is keeping monetary policy independent, yet fixing the exchange rate. Doing this requires limiting capital flows. An example of a country that practices this option is China.
Option 3 (China)

22. CASE STUDY: The Chinese Currency Controversy
1995–2005: China fixed its exchange rate at yuan per dollar and restricted capital flows.
Many observers believed the yuan was significantly undervalued. U.S. producers complained the cheap yuan gave Chinese producers an unfair advantage.
President Bush called on China to let its currency float; others wanted tariffs on Chinese goods.
July 2005: China began to allow gradual changes in the yuan/dollar rate. By October 2011, the yuan had appreciated about 30 percent.
From pp

23. Mundell-Fleming and the AD curve
So far in M-F model, P has been fixed.
Next: to derive the AD curve, consider the impact of a change in P in the M-F model.
We now write the M-F equations as:
Net exports really depend on the real exchange rate, not the nominal exchange rate. Earlier in the chapter, we wrote NX as a function of the nominal rate, because the price level was assumed fixed, so the nominal & real rates always moved together. But now, with the price level changing also, we need to write NX as a function of the real exchange rate.
(Earlier in this chapter, P was fixed, so we could write NX as a function of e instead of .)

24. Deriving the AD curve Why AD curve has negative slope: P  (M/P)
LM*(P2)
LM*(P1)
Why AD curve has negative slope:
IS* 2 1 P
 (M/P)
 LM shifts left Y2 Y1 Y P
  P2
 NX
Like Figure on p.384, except here we are showing what happens to Y when P increases (not falls).
The derivation of the open economy AD curve is very similar to that of the closed economy AD curve (covered in Chapter 12). P1
 Y AD Y2 Y1

25. From the short run to the long runY  P
IS* AD
LRAS
LM*(P2) P2
SRAS2
LM*(P1)
then there is downward pressure on prices. 1 2
Over time, P will move down, causing
(M/P )
 
NX 
Y 
Figure on p.385.
Suggestion:
Have your students draw the two panels of the diagram on this screen, with the economy in an initial equilibrium with output equal to its natural rate. Then, have them use their diagrams to analyze the short-run and long-run effects of a negative IS* shock. P1
SRAS1

26. Large: Between small and closed
Many countries—including the U.S.—are neither closed nor small open economies.
A large open economy is between the polar cases of closed and small open.
Consider a monetary expansion:
As in a closed economy, M > 0  r  I (though not as much)
As in a small open economy, M > 0    NX (though not as much)
For more details, see the Appendix to Chapter 13 (not included in this PowerPoint presentation).

27. CHAPTER SUMMARY the IS-LM model for a small open economy.
1. Mundell-Fleming model:
the IS-LM model for a small open economy.
takes P as given.
can show how policies and shocks affect income and the exchange rate.
2. Fiscal policy:
affects income under fixed exchange rates, but not under floating exchange rates. 41

28. CHAPTER SUMMARY affects income under floating exchange rates.
3. Monetary policy:
affects income under floating exchange rates.
under fixed exchange rates is not available to affect output.
4. Interest rate differentials:
exist if investors require a risk premium to hold a country’s assets.
An increase in this risk premium raises domestic interest rates and causes the country’s exchange rate to depreciate. 42

29. CHAPTER SUMMARY
5. Fixed vs. floating exchange rates
Under floating rates, monetary policy is available for purposes other than maintaining exchange rate stability.
Fixed exchange rates reduce some of the uncertainty in international transactions. 43