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The Open Economy (I); The Mundell-Fleming Model

# The Open Economy (I); The Mundell-Fleming Model

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05/04/2013

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M
ACROECONOMICS
: T
HE
O
PEN
E
CONOMY
(I); T
HE
M
UNDELL
-F
LEMING
M
ODEL

C
OMPETITIVENESS
In international trade, one can measure
competitiveness
· by the following index:
Q
= EP*/P
=
[(Nominal Ex. Rate).(Price of good inforeign currency)] ÷ (Price of good in domesticcurrency)
The Nominal exchange rate (E) can be defined as
the
numb
er
of uni
ts
of
h
om
e
cu
rre
ncy n
eeded

t
opu
r
c
hase
1 uni
t
of fo
re
ign cu
rre
ncy
.
E.g., £0.9 needed to purchase ½1; E
=
0.9/1
DEPRECIATION
of the home currency occurswhen
E RISES
. i.e., when it takes MORE units of domestic currency to purchase 1 unit of foreigncurrency.
An
APPRECIATION
is the opposite ² when
EFALLS
. i.e., when it takes LESS units of domesticcurrency to buy 2 unit of foreign currency.

O
PENING UP THE
IS/LM
MODEL
Assumptions:
Mo
dell
ing
a
s
m
all·

e
conomy
, such that it hasno influence over World Prices.
P
er
e
c
t
C
a
pi
tal
M
arkets

and perfect assetsubstitutability.
P
r
ic
es

a
n
d
w
a
g
es

are
fix
ed
. Thus, expectedinflation is zero and hence the nominal and realrates of interest are equal.

=
C + I + G +
(X-M)
X = Expo
rts
= f(y* [FIXED],
Q
)
=
Function of (fixed) foreign output, competitiveness.
M = Impo
rts
= g(y,
Q
)
=
Function of domesticincome, competitiveness.