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The Mundell-Fleming model

Chapter 12: The Open Economy  Key assumption:

Small open economy with perfect capital mobility.
Revisited:
r = r*
 Goods market equilibrium – the IS
IS* curve:
Y  C (Y  T )  I (r *)  G  NX (e )
where
e = nominal exchange rate
= foreign currency per unit domestic currency

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The IS* curve: Goods market eq’m The LM* curve: Money market eq’m

Y  C (Y  T )  I (r *)  G  NX (e ) M P  L (r *,Y )
The LM* curve:
The IS* curve is drawn e e LM*
 is drawn for a given
for a given value of r*.
value of r*.
Intuition for the slope:  is vertical because:
 e   NX   Y given r*, there is
only one value of Y
IS* that equates money
Y demand with supply, Y
regardless of e.
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Equilibrium in the Mundell-Fleming model Floating & fixed exchange rates

Y  C (Y  T )  I (r *)  G  NX (e )  In a system of floating exchange rates,

M P  L (r *,Y ) e is allowed to fluctuate in response to changing
e LM* economic conditions.
 In contrast, under fixed exchange
g rates,
equilibrium the central bank trades domestic for foreign
exchange currency at a predetermined price.
rate
 Next, policy analysis –
IS*
equilibrium Y  first, in a floating exchange rate system
level of
income
 then, in a fixed exchange rate system
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Fiscal policy under floating exchange rates Lessons about fiscal policy

Y  C (Y  T )  I (r *)  G  NX (e )  In a small open economy with perfect capital

mobility, fiscal policy cannot affect real GDP.
M P  L (r *,Y )
e LM 1*  “Crowding out”
At any given value of e,
e2  closed economy:
a fiscal expansion Fiscall policy
Fi li crowds d outt iinvestment
t tbby causing
i
increases Y, e1 the interest rate to rise.
shifting IS* to the right.
IS 2*  small open economy:
Results: Fiscal policy crowds out net exports by causing
IS 1*
e > 0, Y = 0 Y the exchange rate to appreciate.
Y1

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Monetary policy under floating exchange

Lessons about monetary policy
rates
Y  C (Y  T )  I (r *)  G  NX (e )  Monetary policy affects output by affecting
M P  L (r *,Y ) the components of aggregate demand:
e LM 1*LM 2* closed economy: M  r  I  Y
An increase in M
small open economy: M  e  NX  Y
shifts LM
LM* right
because Y must rise
e1
 Expansionary mon. policy does not raise world
to restore eq’m in agg. demand, it merely shifts demand from
the money market. e2 foreign to domestic products.
Results: IS 1* So, the increases in domestic income and
Y
e < 0, Y > 0 Y1 Y2 employment are at the expense of losses abroad.

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Trade policy under floating exchange rates Lessons about trade policy

Y  C (Y  T )  I (r *)  G  NX (e )  Import restrictions cannot reduce a trade deficit.

M P  L (r *,Y )  Even though NX is unchanged, there is less
e LM 1* trade:
At any given value of e,
a tariff or q
quota reduces e2  the trade restriction reduces imports.
imports, increases NX,  the exchange rate appreciation reduces
and shifts IS* to the right. e1 exports.
IS 2*  Less trade means fewer “gains from trade.”
Results:
IS 1*
e > 0, Y = 0 Y
Y1

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Lessons about trade policy, cont. Fixed exchange rates

 Import restrictions on specific products save jobs  Under fixed exchange rates, the central bank
in the domestic industries that produce those stands ready to buy or sell the domestic currency
products, but destroy jobs in export-producing for foreign currency at a predetermined rate.
sectors.
 In the Mundell-Fleming model, the central bank
 Hence,
Hence import restrictions fail to increase total shifts
hift the
th LM* curve as required
i d tto kkeep e att its
it
employment. preannounced rate.
 Also, import restrictions create “sectoral shifts,”  This system fixes the nominal exchange rate.
which cause frictional unemployment. In the long run, when prices are flexible,
the real exchange rate can move even if the
nominal rate is fixed.
CHAPTER 12 The Open Economy Revisited 12 CHAPTER 12 The Open Economy Revisited 13

Fiscal policy under fixed exchange rates Monetary policy under fixed exchange rates

Under
Underfloating
floatingrates,
rates, An increase
Under in Mrates,
floating would
afiscal
fiscalpolicy
expansion
is ineffective monetary
shift policy
LM* right andisreduce e.
e LM 1*LM 2* very effective at in e, e LM 1*LM 2*
would raise e.output.
at changing To prevent the fall
To keepfixed
e from rising,
changing
the output.
central bank must
Under rates,
the central bank must buy
Underdomestic currency,
fixed rates,
fiscal policy is very
sell domestic
effective currency,
at changing e1 which reduces
monetary M and
policy cannot e1
which
output.increases M IS 2* shifts LM* toback
be used left.output.
affect
and shifts LM* right.
IS 1* Results: IS 1*
Results: Y Y
Y1 Y2 e = 0, Y = 0 Y1
e = 0, Y > 0
CHAPTER 12 The Open Economy Revisited 14 CHAPTER 12 The Open Economy Revisited 15

Trade policy under fixed exchange rates Summary of policy effects in the
Mundell-Fleming model
Under floating rates,
A restriction on imports type of exchange rate regime:
import restrictions
puts upward pressure on e.
do not affect Y or NX. e LM LM
* *
floating fixed
1 2
To keep
Under e from
fixed rates,rising,
the central bank must impact on:
import restrictions
sell domestic
increase Y andcurrency,
NX. Policy Y e NX Y e NX
which increases M e1
But, these gains come
IS 2* fiscal expansion 0    0 0
atand
theshifts LM*of
expense right.
other
countries:
Results: the policy IS 1* mon. expansion    0 0 0
merely Y
eshifts
= 0, demand
Y > 0 from Y1 Y2
foreign to domestic goods. import restriction 0  0  0 

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Interest-rate differentials Differentials in the M-F model

Two reasons why r may differ from r* r  r * 

 country risk: The risk that the country’s borrowers where  (Greek letter “theta”) is a risk premium,
will default on their loan repayments because of assumed exogenous.
political or economic turmoil.
Lenders require a higher interest rate to Substitute the expression
p for r into the
compensate them for this risk. IS* and LM* equations:
 expected exchange rate changes: If a country’s Y  C (Y  T )  I (r *   )  G  NX (e )
exchange rate is expected to fall, then its borrowers
must pay a higher interest rate to compensate M P  L (r *   ,Y )
lenders for the expected currency depreciation.

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The effects of an increase in  The effects of an increase in 

 The fall in e is intuitive:

IS* shifts left, because
An increase in country risk or an expected
  r  I e depreciation makes holding the country’s currency
LM 1*LM 2*
less attractive.
LM* shifts right, because
  r
  (M/P)
 d, e1 Note: an expected depreciation is a
self-fulfilling prophecy.
so Y must rise to restore
money market eq’m.
e2
 The increase in Y occurs because
IS 1*
Results: IS 2* the boost in NX (from the depreciation)
e < 0, Y > 0 Y is greater than the fall in I (from the rise in r).
Y1 Y2

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CASE STUDY:
Why income might not rise
The Mexican peso crisis
 The central bank may try to prevent the 35

depreciation by reducing the money supply.

Mexican Peso

30
 The depreciation might boost the price of
imports enough to increase the price level 25
U.S. Cents per M

(which would reduce the real money supply)

supply).
20
 Consumers might respond to the increased risk
by holding more money. 15

Each of the above would shift LM* leftward.

10
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CASE STUDY:
The Peso crisis didn’t just hurt Mexico
The Mexican peso crisis
35  U.S. goods became expensive to Mexicans, so:
 U.S. firms lost revenue
Mexican Peso

 Hundreds of bankruptcies along

30

25
U.S.-Mexican border
U.S. Cents per M

M
Mexican
i assets
t lost
l t value
l ((measured d iin d
dollars)
ll )
20
 Reduced wealth of millions of U.S. citizens
15

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Understanding the crisis Understanding the crisis

 In the early 1990s, Mexico was an attractive place  These events put downward pressure on the
for foreign investment. peso.
 During 1994, political developments caused an  Mexico’s central bank had repeatedly promised
increase in Mexico’s risk premium ( ): foreign investors that it would not allow the peso’s
 peasantt uprising
i i iin Chi
Chiapas value to fall
fall,
 assassination of leading presidential candidate so it bought pesos and sold dollars to
“prop up” the peso exchange rate.
 Another factor:
The Federal Reserve raised U.S. interest rates  Doing this requires that Mexico’s central bank
several times during 1994 to prevent U.S. inflation. have adequate reserves of dollars.
(r* > 0) Did it?
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Dollar reserves of Mexico’s central bank  the disaster 

 Dec. 20: Mexico devalues the peso by 13%
December 1993 ……………… $28 billion (fixes e at 25 cents instead of 29 cents)
August 17, 1994 ……………… $17 billion  Investors are SHOCKED! – they had no idea
December 1, 1994 …………… $ 9 billion Mexico was running out of reserves.

December 15, 1994 ………… $ 7 billion  , investors dump their Mexican assets and
pull their capital out of Mexico.
 Dec. 22: central bank’s reserves nearly gone.
During 1994, Mexico’s central bank hid the It abandons the fixed rate and lets e float.
fact that its reserves were being depleted.
 In a week, e falls another 30%.
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The rescue package CASE STUDY:

 1995: U.S. & IMF set up $50b line of credit to
provide loan guarantees to Mexico’s govt.
 This helped restore confidence in Mexico,
reduced the risk premium.
 After a hard recession in 1995, Mexico began a
strong recovery from the crisis.
CHAPTER 12 The Open Economy Revisited
The Southeast Asian crisis 1997-98
 Problems in the banking system eroded
international confidence in SE Asian economies.
 Risk premiums and interest rates rose.
 Stock prices fell as foreign investors sold assets
and pulled their capital out.
 Falling stock prices reduced the value of collateral
used for bank loans, increasing default rates,
which exacerbated the crisis.
 Capital outflows depressed exchange rates.
30 CHAPTER 12 The Open Economy Revisited 31

Data on the SE Asian crisis Floating vs. fixed exchange rates

exchange rate stock market nominal GDP
Argument for floating rates:
% change from % change from % change
7/97 to 1/98 7/97 to 1/98 1997-98  allows monetary policy to be used to pursue other
Indonesia -59.4% -32.6% -16.2% goals (stable growth, low inflation).
Japan -12.0% -18.2% -4.3% Arguments for fixed rates:
Malaysia -36.4% -43.8% -6.8%  avoids uncertainty and volatility, making
Singapore -15.6% -36.0% -0.1% international transactions easier.
S. Korea -47.5% -21.9% -7.3%  disciplines monetary policy to prevent excessive
Taiwan -14.6% -19.7% n.a. money growth & hyperinflation.
Thailand -48.3% -25.6% -1.2%
U.S. n.a. 2.7% 2.3%
CHAPTER 12 The Open Economy Revisited 33

CASE STUDY:
The Impossible Trinity
The Chinese Currency Controversy
A nation cannot have free
capital flows, independent Free capital  1995-2005: China fixed its exchange rate at 8.28
monetary policy, and a flows yuan per dollar, and restricted capital flows.
fixed exchange rate
simultaneously. Option 2
 Many observers believed that the yuan was
Option 1
(U S )
(U.S.) (Hong Kong) significantly undervalued, as China was
A nation must choose
accumulating large dollar reserves.
one side of this
triangle and  U.S. producers complained that China’s cheap
give up the Independent Fixed yuan gave Chinese producers an unfair advantage.
opposite Option 3 exchange
monetary
corner. policy
(China) rate  President Bush asked China to let its currency float;
Others in the U.S. wanted tariffs on Chinese goods.
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CASE STUDY:
Mundell-Fleming and the AD curve
The Chinese Currency Controversy

 If China lets the yuan float, it may indeed  So far in M-F model, P has been fixed.
appreciate.  Next: to derive the AD curve, consider the impact of
 However, if China also allows greater capital a change in P in the M-F model.
mobility, then Chinese citizens may start moving  We now write the M
M-F
F equations as:
their savings abroad.
(IS* ) Y  C (Y  T )  I (r *)  G  NX (ε )
 Such capital outflows could cause the yuan to
depreciate rather than appreciate. (LM* ) M P  L (r *,Y )
(Earlier in this chapter, P was fixed, so we
could write NX as a function of e instead of .)
CHAPTER 12 The Open Economy Revisited 36 CHAPTER 12 The Open Economy Revisited 37

Deriving the AD curve From the short run to the long run
 LM*(P2) LM*(P1)  LM*(P1) LM*(P2)
Why AD curve has If Y1  Y ,
2 then there is 1
negative slope:
1 downward pressure 2
P  (M/P)
IS* on prices. IS*
 LM shifts left Y Y
Y2 Y1 Over time, P will Y1 Y
P P
  move down, causing LRAS
P2 (M/P ) P1 SRAS1
 NX P1  P2 SRAS2
 Y AD NX  AD
Y2 Y1 Y Y Y1 Y Y

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Large: Between small and closed Chapter Summary

 Many countries – including the U.S. – are neither 1. Mundell-Fleming model

closed nor small open economies.  the IS-LM model for a small open economy.
 takes P as given.
 A large open economy is between the polar  can show how policies and shocks affect income
cases of closed & small open. g rate.
and the exchange
 Consider a monetary expansion: 2. Fiscal policy
 Like in a closed economy,  affects income under fixed exchange rates, but
M > 0  r  I (though not as much) not under floating exchange rates.
 Like in a small open economy,
M > 0    NX (though not as much)

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Chapter Summary Chapter Summary

3. Monetary policy 5. Fixed vs. floating exchange rates
 affects income under floating exchange rates.  Under floating rates, monetary policy is available
 under fixed exchange rates, monetary policy is for purposes other than maintaining exchange
not available to affect output. rate stability.
 Fixed exchange rates reduce some of the
4 Interest rate differentials
4.
uncertainty in international transactions.
 exist if investors require a risk premium to hold a
country’s assets.
 An increase in this risk premium raises domestic
interest rates and causes the country’s exchange
rate to depreciate.