OPEN-ECONOMY MACROECONOMICS – III

INSTRUCTOR: DR. MUHAMMAD TARIQ MAHMOOD

LECTURE # 23
BASED ON R.T. FROYEN’S

Federal Urdu University of Arts, Science & Technology, Islamabad

 The Mundell–Fleming Model

 The Mundell–Fleming model is an open economy

version of the IS − LM model
 M = L(Y, r)
 S(Y) + T = I(r) + G
 C+S+T=Y=C+I+G+X–Z

 S(Y) + T + Z(Y, π) = I(r) + G + X(Yf, π)

 Imports also depend negatively on the exchange rate (π).
rise in the exchange rate will, therefore, make foreign
goods more expensive and cause imports to fall.

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 Our exports are other countries’ imports and thus depend
positively on foreign income ( Yf ) and the exchange rate.
 The open economy IS schedule can be shown to be
downward sloping.
 High values of the interest rate will result in low levels of
investment. To satisfy equation above , at such high levels of
the interest rate, income must be low so that the levels of
imports and saving will be low. Alternatively, at low levels of
the interest rate, which result in high levels of investment,
goods market equilibrium requires that saving and imports
must be high; therefore, Y must be high.

Mahmood, MT, Lecture 23 Mac

Mahmood, MT, Lecture 23 Mac
 In constructing the open economy IS schedule in Figure above, we
hold four variables constant: taxes, government spending, foreign
income, and the exchange rate. These are variables that shift 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. 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.
Mahmood, MT, Lecture 23 Mac
 Balance of payments equilibrium
 X(Yf, π) – Z(Y, π ) + F(r - rf) = 0
 The first two terms in equation 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 − rf ).
 A rise in the domestic interest rate relative to the foreign
interest rate leads to an increased demand for domestic
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.
Mahmood, MT, Lecture 23 Mac
 The BP schedule is positively sloped; 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.
 Now consider factors that shift the BP schedule. An increase
in 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.

Mahmood, MT, Lecture 23 Mac

 Similarly, an exogenous rise in export demand 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.

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 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 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.
 Perfect capital mobility implies that r = rf.
Mahmood, MT, Lecture 23 Mac