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Economies that are open, as all economies are to some
extent, have trade and capital flows with other economies.
We now consider monetary and fiscal policy in an open
economy model.
MOOCS by Dr. Subir Maitra, Associate Professor of Economics, HCC, Guest Faculty, Department of Commerce, University of Calcutta, subirmaitra.wixsite.com/moocs 7
The Mundell–Fleming Model
Exports:
• U.S. exports are other countries’ imports and thus depend positively on foreign income
( ) and the exchange rate:
X = X( , π), X > 0; >0
• The latter relationship follows because a rise in the exchange rate lowers the cost of dollars
measured in terms of the foreign currency and makes U.S. goods cheaper to foreign
residents.
Product Market Equilibrium Condition:
• Thus, the product market equilibrium condition can be written as:
I(r) + G0 + [X( , π) — Z(Y, π)] = S(Y—T(Y)) + T(Y)
From this equation, the IS schedule is obtained for the open economy.
MOOCS by Dr. Subir Maitra, Associate Professor of Economics, HCC, Guest Faculty, Department of Commerce, University of Calcutta, subirmaitra.wixsite.com/moocs 8
The Mundell–Fleming Model
The open economy IS schedule is also downward sloping, as shown in the Figure.
result in high levels of investment, goods market equilibrium requires that saving and
imports must be high; therefore, Y, must be high.
MOOCS by Dr. Subir Maitra, Associate Professor of Economics, HCC, Guest Faculty, Department of Commerce, University of Calcutta, subirmaitra.wixsite.com/moocs 9
The Mundell–Fleming Model
• In constructing the open economy IS schedule
in the Figure, we hold four variables constant:
taxes, government spending, foreign income,
and the exchange rate. These are variables that
shift the schedule.
• Expansionary shocks, such as an increase in
government spending, a cut in taxes, an
increase in foreign income, or a rise in the
exchange rate, shift the schedule to the right.
MOOCS by Dr. Subir Maitra, Associate Professor of Economics, HCC, Guest Faculty, Department of Commerce, University of Calcutta, subirmaitra.wixsite.com/moocs 10
The Mundell–Fleming Model
•A rise in foreign income is expansionary because it
increases demand for our exports.
•A rise in the exchange rate is expansionary both
because it increases exports and because it reduces
imports for a given level of income; it shifts demand
from foreign to domestic products.
•An autonomous fall in import demand is
expansionary for the same reason.
•Changes in the opposite direction in these variables
shift the IS schedule to the left.
MOOCS by Dr. Subir Maitra, Associate Professor of Economics, HCC, Guest Faculty, Department of Commerce, University of Calcutta, subirmaitra.wixsite.com/moocs 11
The Mundell–Fleming Model
• In addition to the IS and LM schedules, our
open economy model contains a balance of
payments equilibrium schedule, the BP
schedule in the Figure.
• This schedule plots all interest rate–income
combinations that result in balance of
payments equilibrium at a given exchange rate.
• Balance of payments equilibrium means that
the official reserve transaction balance is zero.
• The equation for the BP schedule can be
written as:
X( , π) — Z(Y, π) + F(r -- )=0
MOOCS by Dr. Subir Maitra, Associate Professor of Economics, HCC, Guest Faculty, Department of Commerce, University of Calcutta, subirmaitra.wixsite.com/moocs 12
The Mundell–Fleming Model
• The first two terms in equation
X( , π) — Z(Y, π) + F(r -- ) = 0
constitute the trade balance (net exports).
• The third item ( F ) is the net capital inflow (the surplus
or deficit in the financial account in the balance of
payments. The net capital inflow depends positively on
the domestic interest rate minus the foreign interest
rate ( r − ).
• A rise in the U.S. interest rate relative to the foreign
interest rate leads to an increased demand for U.S.
financial assets (e.g., bonds) at the expense of foreign assets; the net capital inflow
increases.
• A rise in the foreign interest rate has the opposite effect. The foreign interest rate is
assumed to be exogenous.
MOOCS by Dr. Subir Maitra, Associate Professor of Economics, HCC, Guest Faculty, Department of Commerce, University of Calcutta, subirmaitra.wixsite.com/moocs 13
The Mundell–Fleming Model
• The BP schedule is positively sloped, as shown in the
Figure.
• As income rises, import demand increases, whereas
export demand does not. To maintain balance of
payments equilibrium, the capital inflow must increase,
which will happen if the interest rate is higher.
Factors shifting the BP schedule:
• An increase in π will shift the schedule horizontally to the
right. For a given level of the interest rate, which fixes the
capital flow, at a higher exchange rate, a higher level of
income will be required for balance of payments equilibrium.
• The reason is that the higher exchange rate encourages exports and discourages
imports; thus, a higher level of income that will stimulate import demand is needed
for balance of payments equilibrium. 14
MOOCS by Dr. Subir Maitra, Associate Professor of Economics, HCC, Guest Faculty, Department of Commerce, University of Calcutta, subirmaitra.wixsite.com/moocs
The Mundell–Fleming Model
• Similarly, an exogenous rise in export demand (due to a rise
in ) or a fall in import demand will shift the BP schedule to
the right.
• If exports rise—for example, at a given interest rate that
again fixes the capital flow—a higher level of income and
therefore of imports is required to restore the balance of
payments equilibrium. The BP schedule shifts to the right.
• A fall in the foreign interest rate would also shift the BP
schedule to the right; at a given domestic interest rate ( r )
the fall in the foreign interest rate increases the capital inflow. For equilibrium in the
balance of payments, imports and therefore income must be higher.
MOOCS by Dr. Subir Maitra, Associate Professor of Economics, HCC, Guest Faculty, Department of Commerce, University of Calcutta, subirmaitra.wixsite.com/moocs 15
The Mundell–Fleming Model
Imperfect capital mobility:
• The BP schedule will be upward sloping in the case of
imperfect capital mobility . For this case, domestic and
foreign assets (e.g., bonds) are substitutes, but they are
not perfect ones.
• If assets are less than perfect substitutes, their interest
rates need not be equal.
• Factors that might make assets in foreign countries less than perfect substitutes for
a country’s assets include differential risk on the assets of different countries, risks
due to exchange rate changes, transaction costs, and lack of information on
properties of foreign assets.
• Such factors are sufficient to make foreign and domestic assets less than perfect
substitutes.
MOOCS by Dr. Subir Maitra, Associate Professor of Economics, HCC, Guest Faculty, Department of Commerce, University of Calcutta, subirmaitra.wixsite.com/moocs 16
The Mundell–Fleming Model
Perfect capital mobility:
• If domestic and foreign assets were perfect
substitutes, a situation called perfect capital mobility,
investors would move to equalize interest rates among
countries. If one type of asset had a slightly higher
interest rate temporarily, investors would switch to that
asset until its rate was driven down to restore equality.
• In the context of our model, perfect capital mobility
implies that r = . This equality implies a horizontal BP
schedule.
MOOCS by Dr. Subir Maitra, Associate Professor of Economics, HCC, Guest Faculty, Department of Commerce, University of Calcutta, subirmaitra.wixsite.com/moocs 17
Monetary Policy under Fixed Exchange Rates with Imperfect Capital Mobility
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Monetary Policy under Fixed Exchange Rates with Imperfect Capital Mobility
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Monetary Policy under Fixed Exchange Rates with Imperfect Capital Mobility
• Thus, when an economy is in equilibrium, an
expansionary monetary policy leads to a balance of
payments deficit. This raises potential conflicts
between domestic policy goals and external balance.
MOOCS by Dr. Subir Maitra, Associate Professor of Economics, HCC, Guest Faculty, Department of Commerce, University of Calcutta, subirmaitra.wixsite.com/moocs 20
Fiscal Policy under Fixed Exchange Rates with Imperfect Capital Mobility
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Fiscal Policy under Fixed Exchange Rates with Imperfect Capital Mobility
• If the BP schedule were steeper than the LM schedule,
an expansionary fiscal policy action would lead to a
balance of payments deficit, as can be seen in this
Figure.
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Fiscal Policy under Fixed Exchange Rates with Imperfect Capital Mobility
• The expansionary fiscal policy action depicted in above two Figures causes income to increase.
Increased income leads to a deterioration in the trade balance and causes the interest rate to
rise, resulting in an improvement in the financial account.
• The steeper the BP schedule, the larger the unfavorable effect on imports and the trade balance
and the smaller the favorable effect on capital flows. Therefore, the steeper the BP schedule,
the more likely it becomes that an expansionary fiscal policy action will lead to a balance of
payments deficit.
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Fiscal Policy under Fixed Exchange Rates with Imperfect Capital Mobility
• Thus, the slope of the BP schedule relative to the slope of the LM schedule determines whether
an expansionary fiscal policy action will result in a balance of payments surplus or deficit.
• Given the slope of the BP schedule, the steeper the LM schedule, the more likely it is that the
LM schedule will be steeper than the BP schedule, the condition required for a surplus to result
from an expansionary fiscal policy action.
• This result follows because, other things being equal, the steeper the LM schedule, the larger
the increase in the interest rate (which produces the favorable capital inflow) and the smaller
the increase in income (which produces the unfavorable effect on the trade balance).
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Monetary Policy under Flexible Exchange Rates with Imperfect Capital Mobility
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Monetary Policy under Flexible Exchange Rates with Imperfect Capital Mobility
• The exchange rate adjustment re-equilibrates the
balance of payments after the expansionary monetary
policy and eliminates the potential conflict between
internal and external balance.
• The rise in income as a result of the expansionary
monetary policy action is greater in the flexible rate
case than in the fixed rate case.
• With a fixed exchange rate, income would rise only to
Y1. With a flexible exchange rate, the rise in the
exchange rate would further stimulate income by
increasing exports and reducing import demand (for a
given income level).
• Monetary policy is therefore a more potent
stabilization tool in a flexible exchange rate regime
than in a fixed rate regime.
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Fiscal Policy under Flexible Exchange Rates with Imperfect Capital Mobility
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Fiscal Policy under Flexible Exchange Rates with Imperfect Capital Mobility