Lecture 13

The Mundell-Fleming Model Continued

Basic Mundell-Fleming Summary

Mundell-Fleming with a Changing Price Level
The Large Open Economy
Mundell-Fleming in (Y, r) Diagram
Uncovered Interest Parity and Exchange Rate Volatility
Collapse of the European "Exchange Rate Mechanism": increase in r*

Chaper 15 Froyen

Basic Mundell-Fleming Summary

Y = C(Y-T) + I(r) + G + NX(e)

M/P = L(i, Y)

i = r (from no expected inflation; no shifts in interest rates expected to mess up the term
structure)

r = r* (where r* is the real interest rate "out there" in the world, set by forces removed
from the domestic economy)

Note that the international economy impinges on the model in two places--in the goods
market (with the net exports function) and in the asset markets (with the interest rate
equilibrium condition)

IS*: Y = C(Y-T) + I(r*) + G +NX(e) downward sloping in Y-e space, with e on the
vertical axis, and:

LM*: M/P = L(r*, Y) a vertical curve at equilibrium output.

MF Under Flexible Exchange Rates

A fiscal expansion rates shifts the IS* curve outwards on the Y-e diagram, producing
higher exchange rate, no change in output, and a fall in the balance of trade.

A monetary expansion causes a fall in the exchange rate, an increase in output, and an
improvement in the balance of trade

A trade policy to restrict imports fails to affect the trade balance, raises the exchange rate
(improving terms of trade), and has no effect on production or employment.

An increase in the foreign interest rate r* (a) moves the IS* curve to the left and (b)
moves the LM* curve to the right, so lowers the exchange rate, boosts output, and leads
to a rise in the balance of trade.
MF Under Fixed Exchange Rates

Monetary policy is forced to do whatever is necessary to make sure that e = e*; you don't
have an independent monetary policy

A fiscal expansion rates shifts the IS* curve outwards on the Y-e diagram, the money
supply has to shift out too to keep the exchange rate from rising, so higher output (and no
change in exchange rate; and no change in net exports) (unless you want to allow net
exports to depend on total demand as well as on the exchange rate),

A monetary expansion is immediately undone by international currency traders.

A trade policy to restrict imports shifts the IS* curve out as well--and since the money
supply has to follow, protection is expansionary and does lead to an increase in the
balance of trade.

An increase in the foreign interest rate r* (a) moves the IS* curve to the left, so (b) the
money stock must fall if the exchange rate is to be maintained--and so causes recession...
There is no effect on the balance of trade... (Do the collapse of the ERM here).

Mundell-Fleming with a Changing Price Level

Suppose output low relative to potential; then inflation less than expected (and less than
in other countries); hence relative price level falls (and relative real money stock rises);
this price-level adjustment continues until you are back to potential output (under floating
exchange rates).

Under fixed exchange rates the story is different: if output below potential, your relative
price level and costs fall--and you all of a sudden find your producers more competitive:
NX(e) shifts outward, and you find the IS* curve shifting out (and the LM* curve shifting
out along with it) because the exchange rate is fixed in nominal terms--hence shifts in the
price level cause changes in competitiveness and in net exports
 Digression on David Hume
Mundell-Fleming in (Y, r) Diagram

Note that the Mundell-Fleming model is, in sense, just our old IS-LM model with an
extra NX(e) term in the IS equation, and an extra restriction--r=r*--imposed by world
capital markets.

So what happens to force r = r*? Suppose that, at current exchange rates, the IS curve
(augmented by NX(e), but note: no *: IS, not IS*) and the LM curve intersect at r > r*?

Our interest rates exceed world interest rates; money flows in; people bid up the price of
our assets--which is the same thing as the exchange rate rising. And as the exchange rate
rises, the IS curve shifts in and to the left because the trade balance deteriorates.

Equilibrium? When the exchange rate has risen enough to move IS back far enough that
there is no desired short-term speculative capital inflow. (Distinguish between
"speculative" and "fundamental" capital inflows).

Uncovered Interest Parity and Exchange Rate Volatility

Exchange rates, since the early-1970s breakdown of the Bretton Woods fixed exchange
rate system, have been much more volatile than anyone had predicted. Why? A bunch of
reasons--one that governments were let loose to pursue independent monetary policies.
But here I want to focus on expectations and exchange rate dynamics.

Begin by noting that so far we have assumed a fixed exchange rate that sometimes jumps
in response to shocks. This seems inconsistent. Allow for differences in interest rates
supported by expected exchange rate movements:

r - r* = -De

And suppose that we call e* the "long run" value of the exchange rate, and say that De =
(e* - e)

So: r - r* = -(e* - e)

Our LM* curve changes: it becomes: M/P = L(r* + (e - e*), Y)

the higher is the exchange rate e, the higher are domestic interest rates--and so the LM*
curve is upward sloping...

Now let's consider a monetary expansion--something that raises the real money supply,
and lowers domestic interest rates and raises output. In the long run such a monetary
expansion will generate higher inflation and eventually push the economy back to its
long-run equilibrium position--with the same real money stock, a higher nominal money
stock, a higher price level, and a lower exchange rate. So e* falls as well as r falling and
Y rising in response to a monetary expansion...

Stare at r-r* = -(e*-e) and convince yourself that a monetary expansion has to cause a fall
in the nominal exchange rate e today that is greater than the long-run fall in the exchange
rate.

Collapse of the European "Exchange Rate Mechanism": increase in r*