/69-30_files/69-3000001im.jpg" width="695"
height="1066" useMap="#Map">
Macroeconomics
ECO 403
VU
LESSON
30
AGGREGATE
DEMAND IN THE OPEN
ECONOMY
The
Mundell-Fleming Model
The
Mundell-Fleming model portrays
the relationship between the
nominal exchange rate and
the
economy output.
It
is an extension of IS-LM
model.
·
Key
assumption:
Small
open economy with perfect
capital mobility.
r
= r* (given)
·
Goods
market equilibrium-the IS*
curve:
Y
= C
(Y
- T
) +
I
(r
*) +
G
+ NX
(e
)
Where:
e
=
nominal exchange rate
=
foreign currency per unit of
domestic currency (e.g. 110
yen per dollar)
The
IS*
curve:
Goods Market
Equilibrium
The
IS* curve is drawn for a
given value of r*.
Intuition
for the slope:
↓
e
⇒ ↑ NX
⇒ ↑ Y
e
IS*
Y
141
/69-30_files/69-3000002im.jpg" width="695"
height="1066" useMap="#Map">
Macroeconomics
ECO 403
VU
The
LM*
curve:
Money Market
Equilibrium
M
P = L
(r
*,Y
)
The
LM*
curve
·
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.
e
LM*
Y
Equilibrium
in the Mundell-Fleming
Model
e
LM*
equilibrium
exchange
rate
IS*
equilibrium
Y
level
of
income
Floating
& fixed exchange
rates
·
In
a system of floating exchange
rates,
e
is allowed to fluctuate in response to
changing economic
conditions.
142
/69-30_files/69-3000003im.jpg" width="695"
height="1066" useMap="#Map">
Macroeconomics
ECO 403
VU
·
In
contrast, under fixed
exchange rates,
the
central bank trades domestic
for 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.
Fiscal
policy under floating
exchange rates
Y
= C
(Y
- T
) +
I
(r
*) +
G
+ NX
(e
)
M
P = L
(r
*,Y
)
At
any given value of e, a
fiscal expansion increases
Y,
shifting
IS*
to the right.
e
LM*1
e2
e1
IS*2
IS*1
Y
Y1
Results:
Δe >
0, ΔY =
0
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.
143
/69-30_files/69-3000004im.jpg" width="695"
height="1066" useMap="#Map">
Macroeconomics
ECO 403
VU
Monetary
Policy under floating
exchange rates
An
increase in M shifts LM*
right because Y must rise to
restore equilibrium in the
money
market.
e
LM*2
LM*1
e1
e2
IS*1
Y
Y1
Y2
Results:
Δe
<
0, ΔY
>
0
Lessons
about monetary
policy
·
Monetary
policy affects output by
affecting one (or more) of
the components of
aggregate
demand:
↑M ⇒
↓r
⇒
↑I
⇒
↑Y
Closed
economy:
Small
open economy: ↑M ⇒
↓e
⇒
↑NX
⇒
↑Y
Expansionary
monetary 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.
144