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AGGREGATE DEMAND IN THE OPEN ECONOMY:Lessons about fiscal policy

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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
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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.
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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.
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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.
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Table of Contents:
  1. INTRODUCTION:COURSE DESCRIPTION, TEN PRINCIPLES OF ECONOMICS
  2. PRINCIPLE OF MACROECONOMICS:People Face Tradeoffs
  3. IMPORTANCE OF MACROECONOMICS:Interest rates and rental payments
  4. THE DATA OF MACROECONOMICS:Rules for computing GDP
  5. THE DATA OF MACROECONOMICS (Continued…):Components of Expenditures
  6. THE DATA OF MACROECONOMICS (Continued…):How to construct the CPI
  7. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES
  8. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  9. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  10. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  11. MONEY AND INFLATION:The Quantity Equation, Inflation and interest rates
  12. MONEY AND INFLATION (Continued…):Money demand and the nominal interest rate
  13. MONEY AND INFLATION (Continued…):Costs of expected inflation:
  14. MONEY AND INFLATION (Continued…):The Classical Dichotomy
  15. OPEN ECONOMY:Three experiments, The nominal exchange rate
  16. OPEN ECONOMY (Continued…):The Determinants of the Nominal Exchange Rate
  17. OPEN ECONOMY (Continued…):A first model of the natural rate
  18. ISSUES IN UNEMPLOYMENT:Public Policy and Job Search
  19. ECONOMIC GROWTH:THE SOLOW MODEL, Saving and investment
  20. ECONOMIC GROWTH (Continued…):The Steady State
  21. ECONOMIC GROWTH (Continued…):The Golden Rule Capital Stock
  22. ECONOMIC GROWTH (Continued…):The Golden Rule, Policies to promote growth
  23. ECONOMIC GROWTH (Continued…):Possible problems with industrial policy
  24. AGGREGATE DEMAND AND AGGREGATE SUPPLY:When prices are sticky
  25. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…):
  26. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…):
  27. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  28. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  29. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  30. AGGREGATE DEMAND IN THE OPEN ECONOMY:Lessons about fiscal policy
  31. AGGREGATE DEMAND IN THE OPEN ECONOMY(Continued…):Fixed exchange rates
  32. AGGREGATE DEMAND IN THE OPEN ECONOMY (Continued…):Why income might not rise
  33. AGGREGATE SUPPLY:The sticky-price model
  34. AGGREGATE SUPPLY (Continued…):Deriving the Phillips Curve from SRAS
  35. GOVERNMENT DEBT:Permanent Debt, Floating Debt, Unfunded Debts
  36. GOVERNMENT DEBT (Continued…):Starting with too little capital,
  37. CONSUMPTION:Secular Stagnation and Simon Kuznets
  38. CONSUMPTION (Continued…):Consumer Preferences, Constraints on Borrowings
  39. CONSUMPTION (Continued…):The Life-cycle Consumption Function
  40. INVESTMENT:The Rental Price of Capital, The Cost of Capital
  41. INVESTMENT (Continued…):The Determinants of Investment
  42. INVESTMENT (Continued…):Financing Constraints, Residential Investment
  43. INVESTMENT (Continued…):Inventories and the Real Interest Rate
  44. MONEY:Money Supply, Fractional Reserve Banking,
  45. MONEY (Continued…):Three Instruments of Money Supply, Money Demand