Lecture 11: Mundell-Fleming and

Exchange Rate Systems

• Mundell-Fleming
• Fixed exchange rates

– Policy

– Crises

• Expectations

 Mundell-Fleming

IS : Y = C(Y-T) + I(Y,i) + G + NX(Y,Y*, E / (1+i-i*))

Interest parity
i LM

IS

Y E
e
E = E
------
1+i-i*

* Fiscal and Monetary policy

Fixed Exchange Rates (Credible)

- A little bit of it even in “flexible” exchange

rates systems; “commitment” to E rather
than M

=> i = i*

=> M = YL(i*)

- Central Bank gives up monetary policy

 Interest parity
i LM

i*

IS

Y E

- Fiscal and Monetary policy

- Capital controls; imperfect capital flows

 Crises in Fixed Exchange Rate

Systems
e
i = i* + (E(t+1) - E) / E
50%
45%
40%
35%

30%
25%
20%
15%

10%
5%
0%
Jan-97
Feb-97

Jun-97

Jan-98

Jun-98

Jan-99
Mar-97
Apr-97
May-97

Jul-97
Aug-97
Sep-97
Oct-97
Nov-97
Dec-97

Feb-98
Mar-98
Apr-98
May-98

Jul-98
Aug-98
Sep-98
Oct-98
Nov-98
Dec-98

Feb-99
Mar-99
Apr-99
May-99
Interbank Interest Rates
Argentina Mexico Brazil

Figure by MIT OCW.

* ERM crisis: Sweden (500%)

 i LM

i*

IS

Y E

Note: There is a shift in the IS as well… but this is small, especially in the short run
 Expected Events

- Back to flexible exchange rates; expected M expansion

i
0 1 2

-5%
years
E-E(-)
10%

5%