Chapt

erFour
Aggr
egat
eDemandint
heOpenEconomy

Atthebeginningofthe21stcent ur
y,nati
onaleconomiesarebecomi ngmor ecloselyint
er r
elated,
andt henot onofgl
i obal i
zation (
thatwear emov i
ngt owardasi nglegl obaleconomy )is
i
ncreasi
ngly [Link] ci nfl
uences fr
om abr oad have power f
ulef fects on t he
domesticeconomyanddomest i
ceconomi cpolici
eshav eevenmor esubst ant
ialeffectson
for
eigneconomi [Link] eviouschapt er,wesi mpli
fi
edouranal y si
sbyassumi ngacl osed
[Link] ealworldsi t
uat i
on,howev er
,acount rycannotbesel f-suff
icientinev erythi
ng.
Accordi
ngly,theeff
ectivenessoft hedemandmanagementpol i
ciest hatweconsi deredunder
theassumpt i
onofclosedeconomydependsont heinter
acti
onoft heeconomywi thther estof
thewor l
[Link] esar el inkedi nt
ernat
ional
lythroughtradei ngoodsandser v
icesand
thr
oughf i
nancialmar [Link],mosteconomi estodayar eopen:t heyexpor tgoodsand
ser
vicesabroad,t
heyimpor
tgoodsandser
vicesf
rom abr
oad,andt
heybor
row andl
endi
n
worl
df i
nanci
almarket
s.
Inthischapt er,weext endouranal ysisofaggr egatedemandt oincludeinternationalt
radeand
fi
[Link] llpresentt hekeyl i
nkagesamongopeneconomi esandi ntr
oducesomef i
rst
piecesofanal [Link] sl i
nkedt ot her estofthewor ldthrought wobr oadchannels:
tr
ade( ingoodsandser vices)andf [Link] radel i
nkagemeanst hatsomeofacount r
y’s
productionisexpor tedt of oreigncount ries,whi l
esomegoodst hatareconsumedori nvest
ed
athomear epr oducedabr oadandi mpor [Link] earealsost ronginternationalli
nksinthe
areaoff [Link] nternat i
onalinv estorsshi fttheirasset
sar oundt hewor ld,theyli
nkasset
mar ket
sher eand abr oad and t her ebyaf fecti ncome,exchanger ates,and t heabili
tyof
monet arypol i
cyt oaffectinterestrat [Link], thebasi cIS-
LM modelofi ncomedet er
minati
on
mustbemodi fi
edt otakei nternati
onal tradeandf i
nancel i
nkagesi nt
oaccount .

4.
1Internati
onalFl owsofCapi talandGoods
Tounder standhow anopeneconomywor ks,wemustunder standt hekeymacr oeconomi c
variablesthatmeasur ethei nteractionsamongcount ri
[Link] oeconomi cdiff
erence
betweenopenandcl osedeconomi esi sthat
, i
nanopeneconomy ,acountry
’sspendi ngi nany
giveny earneednotequalt hegoodsandser v i
[Link] rycan
spendmor et hanitpr oducesbybor rowingfrom abr oad,ori
tcanspendl esst hani tproduces
andl endthedi ff
erencet of [Link] ossdomest i
cpr oduct( GDP)
diff
er sfrom t hatofa cl osed economybecause t hereis an additi
onalinjection-export
expendi t
urewhi chr epresentsf or ei
gnexpendi t
ureondomest i
call
[Link] eis
alsoanaddi ti
onalleakage,expendi tureoni mpor t
swhi chrepr
esentsdomest icexpendi tureon
foreigngoodsandwhi chraisesf [Link] standthismor ef ul
ly,l
et’
s
takeanot herlookatnat i
onal i
ncomeaccount ing.

TheRoleofNetExports
Consi
dertheexpendi
tur
eonaneconomy ’soutputofgoodsandser
vices.I
naclosedeconomy,
al
lout
putissolddomestical
l
y,andexpendit
ureisdivi
dedint
othr
eecomponents:consumpti
on,
i
nvest
ment ,and governmentpur chases. I
n an open economy ,some out put i
s sol
d
domesti
call
yandsomei sexportedtobesol [Link]
deexpendit
ureonanopen
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economy’soutputint
of ourcomponent s:
■Cd, consumptionofdomest i
cgoodsandservices,
■I d,
invest
menti ndomest icgoodsandser
vices,
■Gd, governmentpur chasesofdomesti
cgoodsandser vi
ces,
■X, exportsofdomest icgoodsandservi
ces.
Thedivi
sionofexpenditurei
nt othesecomponent
sisexpr essedinthei
dent
it
y,
Y=Cd+I
d+Gd+X.
Thesum oft hefi
rstthreet
erms,Cd +Id +Gd,i
sdomesti
cspendi
ngondomest icgoodsand
ser
[Link]
thterm,X,
isfor
eignspendingondomest
icgoodsandser
vices.

Not ethatdomest i
c spending on al lgoods and ser vi
ces equals domesti
c spending on
domest i
cgoodsandser vi
cespl usdomest i
cspendi ngonf orei
gngoodsandser vi
[Link],
totalconsumption (C)equal s consumpt ion ofdomest i
c goods and servi
ces (Cd)plus
consumpt i
onoff oreigngoodsandser vi
ces(Cf);totalinvest
ment(I)equalsinvestmentin
domest i
cgoodsandser vi
ces(Id)plusinvestmentinforeigngoodsandservices(I
f);andtotal
gov er
nmentpurchases( G)equalsgov ernmentpurchasesofdomest i
cgoodsandser vices(Gd)
plusgovernmentpurchasesoff orei
gngoodsandser vi
ces( Gf)
.Thus,
C=Cd+Cf, I=I d+If,andG=Gd+Gf.
Wesubst i
tutet
heset hreeequationsintotheaboveidentit
y:
Y=(
C−Cf)+(
I−I
)+(
f G−Gf)+X.
Wecanr
ear
ranget
oobt
ain,
Y=C+I+G+X−(
Cf+I
f+Gf
).
Thesum ofdomest
icspendingonfor
eigngoodsandservces(
i Cf+I
f+Gf)i
sexpendi
tur
eon
i
mports(
M).
Wecan,t
hus,wr
it
ethenat
ionali
ncomeaccount
sident
it
yas:
Y=C+I+G+X−M.
Becausespendingonimport
sisincl
udedindomest
i ng(
cspendi C+I+G) ,andbecausegoods
andser v
icesi
mportedfr
om abroadarenotpar
tofacountry
’sout
put,t
hisequati
onsubtracts
[Link]
ningnetexpor
tstobeexportsminusimports(NX=X−M) ,t he
i
dentit
ybecomes,
Y=C+I+G+NX.
Thi
s equation st
ates t
hatexpenditure on domesti
c out
putisthe sum ofconsumpti
on,
i
nvestment,governmentpurchases,[Link]
sisthemostcommonf orm oft
he
nat
ionali
ncomeaccount si
dentit
y.

Thenationali
ncomeaccountsi
denti
tyshowshow domest
icout
put
,domest
icspendi
ng,and
netexport
sarerel
ated.I
npar
ti
cul
ar,
NX=Y−(
C+I+G)
NetExpor
ts=Output−Domest i
cSpending.
Thi
sequati
onshowst hatinanopeneconomy,domesti
cspendi
ngneednotequaltheoutput
ofgoodsandservices.I
foutputexceedsdomest
icspendi
ng,weexpor
tthediff
erence:net
expor
tsar
eposit
ive.I
fout
putf
all
sshor
tofdomest
icspendi
ng,wei
mpor
tthedi
ff
erence:net
expor
tsar
enegat
ive.

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Inter
nati
onalCapit
alFl
owsandt heTr adeBal
ance
Inanopeneconomy ,asint heclosedeconomy,fi
nancialmarket
sandgoodsmar ket
sare
closel
yrel
[Link]
ati
onship, wemustr
ewri
tethenati
onalincomeaccount
sident
it
y
i
nt ermsofsavingandi
[Link]
hthei
denti
ty,
Y=C+I+G+NX.
Subt
ractCandGf
rom bot
hsi
dest
oobt
ain,
Y−C−G=I+NX.
Recal
lfr
om chapt
er3t hatY−C−G i
snat
ionalsav
ing(
S),whichequalsthesum ofpr
ivat
e
savi
ng Y−T−C)andpubl
( i
csavi T–G)wher
ng( eTstandsf
[Link]
efor
e,
S=I+NX.
Subt
ract
ingIf
rom bot
hsi
desoft
heequat
ion,wecanwr
it
ethenat
ionali
ncomeaccount
s
i
denti
tyas:
S−I=NX.
Thi
sfor
m ofthenat
ionalincomeaccount
sident
it
yshowsthataneconomy
’snetexpor
tsmust
al
waysequal
thedif
ferencebetweeni
tssavi
ngandit
sinv
estment.

Let’
sl ookmor ecl oselyateachpar toft hisident
ity
.Ther ight-handsi dei sthenetexpor tof
goodsandser vi
ces, [Link] hernamef ornetexportsi
st het r
adebal ance,becausei ttel
l
sus
howourt radeingoodsandser vicesdepar t
sfrom thebenchmar kofequal i
mpor tsandexpor t
s.
Thel eft-
handsi deoft heident ityi sthedi ff
erencebetweendomest icsav i
nganddomest i
c
i
nvest ment ,S−I,whichwecal lnetcapi taloutflow (
somet i
mescal ednetf
l oreigni nvestment).
Netcapi taloutflowequal stheamountt hatdomest icr
esidentsar el endingabr oadmi nusthe
amountt hatf oreignersarel endi ngtous.I fnetcapitalout f
low i sposi ti
ve,t heeconomy ’
s
savi
ngexceedsi t
si nvest
ment ,andi tisl endingtheexcesst of [Link] henetcapi tal
outf
lowi snegat iv
e,theeconomyi sexperiencingacapitalinfl
ow:i nvestmentexceedssav ing,
andt heeconomyi sf i
nancingt hisextr ainvestmentbybor rowingf r
om abr [Link],net
capi
tal outflowr efl
ectstheinternat i
onalflowoff undstofinancecapi talaccumul ati
on.

Thenat ionali
ncomeaccount sidenti
tyshowst hatnetcapi taloutfl
owalwaysequal st hetr
ade
[Link],
NetCapi talOutf
low=Tr adeBalance
S−I=NX.
IfS−IandNXar epositi
ve,wehav eat r
adesur plus.I
nt hiscase,wear enetl endersi nworl
d
fi
nancialmar kets,andwear eexport
ingmor egoodst hanwear eimport
i fS−IandNXar
ng.I e
negative,wehav eat r
adedefici
t.I
nthiscase,wear enetbor r
ower sinworl
dfinancialmarkets,
andwear eimpor ti
ngmor egoodsthanwear eex porti
[Link]−IandNXar eexactlyzero,weare
saidtohav ebalancedtradebecausethev al
ueofi mpor t
sequal stheval
ueofexpor ts.

Thenationalincomeaccountsident i
tyshowst hatt
hei nt
ernat
ionalflow off
undst ofinance
capi
talaccumul ati
onandtheinternati
onalflow ofgoodsandser vi
cesaretwosi desoft he
samecoi [Link]
sakeyinsi
ght:theflowofgoodsandser vi
cesacr ossnat
ionalbordersis
al
waysmat chedbyanequivalentflow offundst ofi
nancecapitalaccumulat
ion.I
fdomest i
c
sav
ingexceedsdomesticinvest
ment,t
hesur
plussavi
ngisusedt
omakeloanst
ofor
eigners.
For
eigner
srequi
retheseloansbecauseweareprovi
dingt
hem wi
thmor
egoodsandservi
ces

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thantheyareprovi
[Link]
s,wear erunni
ngatradesurpl
[Link]
mentexceeds
savi
ng,theext
rainvest
mentmustbefi
nancedbyborr
owingf
rom [Link]
eignl
oans
enabl
eust oimportmoregoodsandserv
icesthanweexpor
[Link]
s,wear erunni
ngatrade
defi
cit
.

Tabl
e4-
1summar
izest
hesel
essons.

Tabl
e4.
1:I
nter
nat
ionalFl
owsofGoodsandCapi
tal
:Summar
y

Thi
stabl
eshowst
het
hreeout
comest
hatanopeneconomycanexper
ience.

Tr
adeSur
plus Bal
ancedTr
ade. Tr
adeDef
ici
t

-Expor
ts>I
mpor
ts Expor
ts=I
mpor
ts Expor
ts<I
mpor
ts

-NetExpor
ts>0 NetExpor
ts=0 NetExpor
ts<0

-Y>C+I+G Y=C+I+G Y<C+I+G

-Sav
ing>I
nvest
ment Sav
ing=I
nvest
ment Sav
ing<
I
nvest
ment

-NetCapi
tal
Out
fl
ow>0 NetCapi
tal
Out
fl
ow=0 NetCapi
tal
Out
fl
ow<0

Not ethattheinternationalfl
owofcapi talcantakemanyf [Link] estt oassume—aswe
hav edonesof ar—t hatwhenwer unat radedefici
t,for
eignersmakel oanst ous.
4.2Sav i
ngandI nvestmentint heSmal lOpenEconomy
Sof arinourdi scussi onoft heinter
nat i
onalfl
owsofgoodsandcapi tal
,wehav erear
ranged
account i
ng identiti
[Link] s,we hav e def i
ned some oft he v ariables thatmeasur e
transacti
onsi nanopeneconomy ,andwehav eshownt heli
nksamongt hesev ar
iabl
esthat
foll
owf rom theirdefinit
[Link] epistodev el
opamodelt hatexpl ainsthebehav i
orof
thesev ari
[Link] nethedet erminantsoft hesei nt
ernationalf [Link] el
opa
modeloft hesmal lopeneconomyt hatcor r
espondst omodeloft hecl osedeconomy .The
modelshowst hef actorsthatdeterminewhet heracount ryisabor r
oweroral enderinwor l
d
mar ketsandhowpol i
ciesathomeandabr oadaffectt
hef l
owsofcapi t
al andgoods.

CapitalMobili
tyandt heWor ldI
nterestRate
I
namoment ,wepr esentamodeloft heinternat
ionalfl
owsofcapit
[Link]
t
r adebalanceequalst henetcapi
taloutfl
ow, whichinturnequal
ssavi
ngminusinvest
ment,our
modelf ocusesonsav [Link] el
opthismodel,wedonotassumet hatthe
realint
erestrateequilibr
atessavi
ngandi nvestment.I
nstead,weall
owtheeconomyt oruna

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tr
adedefi
citandbor
row f
rom ot
hercount
ri
esort
orunat
radesur
plusandl
endt
oot
her
count
ri
es.

Iftherealinter estratedoesnotadj usttoequi li

bratesav i
ngandi nvestmentint hismodel ,what
doesdet ermi net her ealinterestrate?Weanswert hisquest i
onher ebyconsi der i
ngt hesimpl e
caseofasmal lopeneconomywi thper fectcapi talmobi li
[Link]“ small’
’wemeant hatt his
economyi sasmal lpar toft hewor ldmar ketand,t hus,byi tself
,canhav eonl yanegl i
gible
effectont hewor ldinterestr [Link]“
at perfectcapitalmobi l
it
y’’wemeant hatr esidentsoft he
countryhav ef ullaccesst owor ldf i
nanci almar kets.I npar t
icular,thegov ernmentdoesnot
i
mpedei nternat i
onalbor r
owi ngorl [Link] hisassumpt ionofper fectcapital
mobi l
it
y,thei nt erestrat ei
noursmal lopeneconomy ,r,mustequalt hewor ldi nter
estr at
e,r*,
therealinterestr atepr evail
inginwor ldfinancialmar kets:
r=r* .
Residentsoft hesmal lopeneconomyneednev erbor rowatanyi nt
erestrateabov er*,because
theycanal way sgetal oanatr *from abr [Link] milarly,r
esident soft hi
seconomyneednev er
l
endatanyi nt erestr at
ebel owr *becauset heycanal waysear nr *bylendingabr [Link],the
wor l
dinterestr atedet erminest heinterestr ateinoursmal lopeneconomy .

Whatdeterminesthewor l
dr ealinter
estrat
e?Inaclosedeconomy ,theequi
libri
um ofdomest i
c
savi
nganddomest i
cinvestmentdet erminestheint
erestrat
[Link]
nterplanet
aryt r
ade,
t he
worl
deconomyi sacl osedeconomy .Therefor
e,theequil
ibr
ium ofwor l
dsav i
ngandwor l
d
i
nvestmentdeterminesthewor l
dinterestr
[Link] i
gibl
eeffect
onthewor l
dreali
nterestratebecause, bei
ngasmal lpar
tofthewor l
d,i
thasanegl i
gibl
eeffect
onwor ldsavingandwor ldi [Link],oursmal lopeneconomyt akest hewor l
d
i
nterestr
ateasexogenousl ygiven.

WhyAssumeaSmal
lOpenEconomy?Theanal
ysi
sint
hebodyoft
hischapt
erassumest
hat
the nat
ion bei
ng studied is a smallopen economy .The mainreason formaki ng thi
s
assumption i
st o develop underst
anding and intuit
ion f
orthe macroeconomics ofopen
[Link] assumpt i
on need notbe r eali
sticto be useful
.Assuming a smal lopen
economysi mpli
fi
est heanalysi
sgr eat
lyand,t heref
ore,wil
lhelpclar
if
yourt hi
nki
[Link]
rel
axthi
sassumpt i
onandmaket hemodel morer eal
isti
c.

TheModel
Tobui
l
dthemodel ofthesmal lopeneconomy ,wet akethr
eeassumpt ions:
 Theeconomy ’
sout putY isf i
xedbyt hef actor
sofpr oduct
ionandt heproduct
ion
functi
[Link] i
tethisas: Y=Y=F( K,L).
 Consumption is positi
vel
yr elat
ed to di
sposabl ei ncome (Y – T) .We writ
et he
consumptionfuncti
onas: C=C( Y−T) .
 Invest
menti snegat i
vel
yr el
atedt other [Link] itethei
nvestment
functi
onas
I=I
(r
).
Thesear
ethethr
eekeypar
tsofourmodel
.
Wecannowr et
urnt
otheaccount
ingi
dent
it
yandwr
it
eitas:
NX=(
Y−C−G)−I
=S−I
.
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Substit
utingtheaboveassumpt
ionsandt
heassumpt
iont
hatt
hei
nter
estr
ateequal
sthewor
ld
i
nterestrate,
weobt ai
n:
NX=[
Y−C(
Y−T)−G]−I
(r*
)=S−I
(r
*).
Thisequat ionshowsthatt hetr
adebal ance( NX)dependsont hosevar
iabl
esthatdetermine
savingandi nvest
[Link] ingdependsonf i
scalpol
icy(l
owergovernmentpurchases
orhi ghertaxesri
senati
onalsaving)andi nvestmentdependsont heworldreali
nter
estrate(a
higherinterestr
atemakessomei nvestmentpr oj
ectsunprofi
tabl
e),t
hetr
adebalancedepends
ont hesev ari
abl
[Link] ol
lowingfigur
e.
Fi
gur
e4.
1:Savi
ngandI
nvest
menti
naSmal
lOpenEconomy

From theabov ef i
gur
e,wecanseet hatint heclosedeconomy ,t
herealinter
estrateadjuststo
equili
bratesavingandinvest
ment—t hatis,t herealint
erestr
ateisf
oundwher ethesav i
ngand
i
nv estmentcurv escr
[Link] lopeneconomy ,
however,t
herealint
erestrateequalsthe
wor l
dr ealinterestrat
[Link] nter
estr atei sdet er
mined i
n worldfinancialmar ket
[Link]
dif
ferencebetweensav ingandinvestmentdet er
mi nesthetr
[Link],thereisatrade
surplus,becauseatt heworldint
erestr ate,savingexceedsinvest
ment .Thet r
adebal anceis
det
ermi
nedbyt
hedi
ff
erencebet
weensavi
ngandi
nvest
mentatt
hewor
ldi
nter
estr
ate.

Atthispoint,youmightwonderaboutt hemechani sm thatcausesthet r

adebalancet oequal
thenetcapi t
aloutf
[Link] er
minantsoft hecapitalfl
owsar eeasyt ounderst
[Link]
savi
ng falls shor
tofi nvestment,investors borr
ow f r
om abr oad;when sav i
ng exceeds
i
nvestment ,theexcessislentt oothercount r
[Link] hosewhoi mpor tand
exporttobehav esoast oensur ethattheinternati
onalfl
ow ofgoodsexact lybalancesthi
s
i
nternat
ionalflowofcapit
al?Fornowwel eavethisquesti
onunanswer ed,butwereturntoiti
n
secti
on4-3whenwedi scussthedeterminati
onofexchanger at
es.

HowPol i
ciesI
nf l
uencet
heTradeBalance
Supposethattheeconomybeginsi
naposi t
ionofbalancedtr
[Link]
s,att
heworl
dinter
est
rat
e,i
nvestmentequalssavi
ngandnetexpor t
[Link]’
suseourmodeltopredi
ctthe
eff
ectsofgovernmentpol
ici
esathomeandabr oad.

Fi
scalPolicyatHome:Consi derfi
rstwhathappenst ot hesmallopen economyi fthe
gover
nmentexpandsdomest i
cspendingbyincreasi
nggover
nmentpur
[Link]
Greducesnationalsavng,becauseS=Y−C−[Link]
i t
hanunchangedworldreali
nterestrate,
i
[Link]
ore,savi
ngf al
l
sbel
owi nv
est
ment,andsomei nvestment
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mustnowbef inancedbybor r
owingfr
om [Link],NX=S−I ,thefal
linSimpliesaf all
i
[Link] unsat r
adedefi
cit
.Thesamel ogicappli
est oadecreaseint axes.A
taxcutlowersTandr ai
sesdi sposabl
eincome( Y–T) ,st
imulat
esconsumpt i
on,andr educes
nati
onalsaving.(Event houghsomeoft het axcutfi
ndsi t
swayi ntoprivat
esav i
ng,publ i
c
savingfal
lsbyt hef ul
lamountoft hetaxcut ;i
ntot
al,savi
ngf al
l
s) .Because,NX =S−I ,the
reducti
oninnationalsavi
ngi ntur
[Link] i
gure4.3bel
ow.
Fi
gur
e4-
2:AFi
scalExpansi
onatHomei
naSmal
lOpenEconomy

Afiscalpol
icychanget hatincreasespriv
ateconsumpt i
on( C)(suchasar educt
ionintaxes)or
publicconsumption (G)(such asan i ncreasein governmentpur chases)reducesnat i
onal
saving(Y−C−G)and,t
her efore,shi
ftstheverti
call
i
net hatrepresent
ssav i
ngt othelef
tfrom S1
[Link] sthedi stancebetweent hesav
ingschedul eandtheinvestmentscheduleat
thewor l
dinter
estrat
e,t [Link] esultistradedefi
[Link],st
t arti
ngf r
om
bal
ancedt
radeachangei
nfi
scalpol
i
cyt
hatr
educesnat
ionalsavi
ngl
eadst
oat
radedef
ici
t.

FiscalPol icyAbr oad:Consi dernow whathappenst oasmal lopeneconomywhenf oreign

gov ernment sincreaset heirgovernmentpur [Link] heseforeigncount ri
esar easmal lpart
oft hewor l
deconomy ,thent hei
rf i
scalchangehasanegl i
giblei
mpactonot [Link],
i
ft hesef oreigncount riesar eal argepar toft hewor ldeconomy ,theiri
ncr easei ngov ernment
pur chasesr educeswor ldsav i
[Link] easei nwor l
dsav ingcausest hewor ldi
nter estrate
tor ise(becauseEar thisacl osedeconomy )
.Thei ncreasei nthewor l
dint erestrat
erai sest he
costofbor rowingand,t hus,reducesi nvestmenti noursmal lopeneconomy .Becauset here
hasbeennochangei ndomest icsaving,sav ingnow exceedsi nvestment ,andsomeofour
sav ingbeginst oflowabr [Link], NX=S−I ,ther educti
oni nIalsoi [Link],
reducedsav ingabr oadl eadst oat radesur [Link] ollowingfigur eil
lust
rateshowa
smal lopeneconomyst arti
ngf rom balancedt raderespondst oaf oreignf i
scalexpansi on.A
fi
scalexpansi oninaf oreigneconomyl argeenought oi nf
luencewor l
dsav i
ngandi nv estment
raisest hewor l
di nterestr [Link] gherwor ldinterestrater educesi nv estmentcausi nga
tradesur pl
us
Fi
gur
e4.
3:AFi
scalExpansi
onAbr
oadi
naSmal
lOpenEconomy

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Becausethepoli
cychangei soccur
ri
ngabr oad,thedomesticsavi
ngandi nvestmentschedules
[Link] ychangeisani ncreaseinthewor l
dinterestratefrom r1*tor2*.
The
tradebal
anceisthedi
fferencebetweenthesav ingandinvest
mentschedul es;becausesav i
ng
exceedsinvest
mentatr 2*,t
hereisatradesur [Link],star
tingfrom bal ancedtrade,an
i
ncr
easei
nthewor
ldi
nter
estr
ateduet
oaf
iscalexpansi
onabr
oadl
eadst
oat
radesur
plus.

ShiftsinInvestmentDemand:Consi derwhathappenst ooursmal lopeneconomyi fits

i
nv estmentschedul eshiftsoutward—t hatis,i
ft hedemandf orinv estmentgoodsatev ery
i
nterestrat
ei [Link]
twouldoccuri f
, f
orexample,thegov er nmentchangedt het ax
l
awst oencouragei nvest
mentbypr ovidi
ngani nvest
mentt [Link] gure4-4i
ll
ust
ratest he
i
mpactofashi [Link] wardshi
ftinthei nvest mentschedul
ef rom
I
(r)1toI(r)
2increasest heamountofi nvestmentatt hewor l
di nterestr ater*.Asar esult
,
i
nv estmentnow exceedssav ing,whichmeanst heeconomyi sbor rowi ngfrom abroadand
runningatradedef i
cit.
Fi
gur
e4-
4:AShi
fti
ntheI
nvest
mentSchedul
einaSmal
lOpenEconomy

Theabovefigur
eshowst hatatagi venwor l
di nt
erestr
ate,i
nvestmentisnowhigher
.Because
savi
ngisunchanged,somei nvestmentmustnow bef inancedbybor r
owingfrom abr
oad.
Becausecapit
alfl
owsintot heeconomyt ofinancetheincreasedinv
estment,t
henetcapital
outf
lowisnegati
[Link]
ferent
ly,becauseNX=S−I ,theincr nIi
easei mpli
esadecreasein
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[Link],star
ti
ngf
rom bal
ancedt
rade,anout
war
dshi
fti
nthei
nvest
mentschedul
ecausesa
t
radedefi
cit
.

Ev al
uat i
ngEconomi cPol i
cy
Ourmodeloft heopeneconomyshowst hatthef l
owofgoodsandser vicesmeasur edbyt he
tradebal anceiscloselyconnectedtot hei nter
nat i
onalfl
owoff undsforcapitalaccumulati
on.
Thenetcapi t
alout f
lowist hediff
erencebet weendomest i
csav i
nganddomest icinv
estment.
Thus, theimpactofeconomi cpolici
esont hetradebalancecanal waysbef oundbyexami ning
theirimpactondomest i
csav i
nganddomest i
ci nvest
[Link]
esthatincreaseinvest
ment
ordecr easesav ingt endtocauseat r adedef icit
,andpol i
ciesthatdecreasei nv
estmentor
i
ncr easesav i
ngtendt ocauseat radesur plus.

Ouranalysi
soft heopeneconomyhasbeenposi t
ive,notnor mat [Link] s,ouranalysi
sof
howeconomi cpol iciesinf l
uencet heinternationalfl
owsofcapi talandgoodshasnott oldus
whetherthesepol ici
esar edesi r
[Link] aluatingeconomi cpol iciesandt heiri
mpactont he
openeconomyi saf requentt opicofdebat eamongeconomi stsandpol i
cymaker [Link]
countryr
unsat radedef icit
,pol icymaker smustconf r
ontthequest ionofwhet heritr
epresents
anat i
[Link] stsv iew at r
adedef icitnotasapr oblem init
self,but
perhapsasasy mpt om ofapr [Link] radedef ici
tcouldbear ef lecti
onofl owsav i
[Link]
cl
osedeconomy ,lowsav i
ngl eadst olowi nv estmentandasmal lerf ut
urecapi t
alst
[Link]
openeconomy ,
lowsav ingl eadst oat radedef ici
tandagr owi ngf or eigndebtwhi cheventuall
y
mustber [Link] hcases,hi ghcur r
entconsumpt i
onl eadst ol owerf utureconsumpt i
on,
i
mpl yi
ngthatfuturegener ati
onsbeart hebur denofl ownational sav ing.

Yettradedef ici
tsarenotal way sar efl
ectionofaneconomi cpr [Link] ural
economiesdev el
opintomoder ni ndustr
ialeconomi es,theysomet i
mesf inancet hei
rhigh
l
evelsofi nvestmentwithforeignbor [Link] hesecases,t radedef ici
tsar easi gnof
economicdev el
[Link] e,Sout hKor earanl argetradedef icit
st hroughoutthe
1970s,andi tbecameoneoft hesuccessst ori
esofeconomi [Link] essoni sthatone
cannotjudgeeconomi cperf
ormancef r
om thet [Link],onemustl ookat
theunderl
yingcausesoftheinternati
onalfl
ows.

4.
3ExchangeRat es
Hav i
ngexami nedthei nt
er nat
ionalfl
owsofcapi talandofgoodsandser vices,wenowext end
theanal ysi
sbyconsi deri
ngt hepr i
cesthatapplyt othesetransacti
ons(i
.e.,pricesatwhicha
countrymakesexchangesi nwor l
dmar kets)
.Theexchanger at
ebet weent wocount r
iesi
st he
pri
ceatwhi chresidentsoft hosecount r
iestr
adewi theachot [Link] i
on,wef ir
st
exami nepreciselywhatt heexchanger atemeasur es,andwet hendiscusshowexchanger ates
aredet er
mi [Link] ysisalsoshowshowpr otect
ionistt
radepolici
esinfluencetheamount
ofinternati
onal t
radeandt heexchanger at
e.

NominalandRealExchangeRat
es
Economist
s di
sti
nguish bet
ween t
wo exchange r
ates:nomi
nalexchange r
ate and r
eal
exchanger
ate.

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TheNomi nalExchangeRat e:Thenomi nalexchanger ateist herelat i
vepr iceoft hecur renci es
oftwocount ri
[Link] e,i
ft heexchanger atebetweent heU. [Link] l
arandt heEt hiopian
bir
ri s40bi rrperdol l
ar,theny oucanexchangeonedol l
arf or40bi rrinwor l
dmar ket sf or
for
eigncur [Link] hi
opianwhowant stoobt aindol l
arswoul dpay40bi rrforeachdol larhe
bought .AnAmer i
canwhowant stoobt ainbirrwoul dget40bi rrforeachdol l
arhepai [Link]
peopler efert o“ t
heexchanger ate’
’betweent wocount ri
es,t heyusual lymeant henomi nal
exchanger ate.
Noticet hatanexchanger atecanber eportedint woway [Link] l
arbuy s40bi rr,t
henone
bir
rbuy s0.025dol [Link] heexchanger ateis40bi rrperdol lar,orwecansayt he
exchanger atei s0.025dol l
arperbi rr
.Theset woway sofexpr essi ngt heexchanger atear e
equivalent.
Witht hisconv enti
on,ar isei nt heexchanger ateiscal ledanappr eciationoft hef or ei
gn
curr
ency ;af allint heexchanger ateiscal l
eddepr [Link] hedomest i
ccur rency
appreciates,i tbuy smor eoft hef orei
gn cur r
ency ;when i tdepr eciates,i tbuy sl [Link]
appreciation is somet imes cal l
ed a st rengthening oft he cur rency ,and depr eciation i s
somet i
mescal l
edaweakeni ngoft hecurrency.

TheRealExchangeRat e:Therealexchangerat
eist herel
ati
vepri
ceofthegoodsoftwo
countri
[Link]
ell
sust her at
eatwhichwecant r
adethegoodsofonecountr
yfort
hegoodsof
[Link]
eissometimescall
edtheter
msoft r
ade.

Toseet herelat
ionbetweent her ealandnomi nalexchanger ates,considerasi nglegood
producedinmanycount r
ies:car [Link] icancarcost s$10,000andasi milar
Japanesecarcosts2,400,
000y [Link] ethepr i
cesoft het wocar s,wemustconv ert
them int
oacommoncur [Link] l
ariswor t
h120y en,thent heAmer i
cancarcost s
1,200,
[Link] i
ngt hepriceoft heAmer i
cancar( 1,
200,000y en)andt hepr i
ceofthe
Japanesecar(2,
400,000yen),weconcl udethattheAmer i
cancarcost sone-hal
fofwhatt he
Japanesecarcosts.I
notherwor ds, atcurr
entpri
ces, wecanexchanget woAmer i
cancarsf or
[Link] i
zeourcalcul
ationasf oll
ows:

Att
hesepri
cesandthi
sexchangerate,
weobtai
none-
hal
fofaJapanesecarperAmer
icancar
.
Moregener
all
y,wecanwr
itethi
scalcul
ati
onas

Ther at
eatwhi chweexchangef orei
gnanddomest icgoodsdependsont hepri
cesofthe
goodsi nthelocalcur r
enciesandont herateatwhichthecurrenci
esar
[Link]
s
calcul
ati
onofther ealexchangerateforasingl
egoodsuggestshowweshoulddefi
nethereal
exchangerateforabr oaderbasketofgoods.
Letebet henomi nalexchangerate,Pbet hepri
cel
eveli
nt hedomesti
ccount
ryandP*bethe
pri
celeveli
nforeigncount r
y.
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Ther
ealexchangerat
ebetweent
wocountr
iesi
scomput edfrom thenominalexchanger
ate
andt
hepricelevel
sinthet
wocount
res.I
i ftherealexchangerat
ei shi
gh,for
eigngoodsare
r
elat
ivel
ycheap,anddomesti
cgoodsar er
elat
ivel
yexpensi
ve.I
ftherealexchanger
atei
slow,
f
orei
gngoodsar erel
ati
vel
yexpensi
ve,
anddomest i
cgoodsarerel
ati
vel
ycheap.

TheRealExchangeRat eandt heTradeBal ance

Whatmacr oeconomi cinfluencedoest her ealexchanger at
eexer t?Toanswert hisquestion,
remembert hatther ealexchanger ateisnot hi
ngmor et hanar elati
vepr i
[Link]
ativepri
ce
ofdomest icandf oreigngoodsaf f
ectsthedemandf ort hesegoods.
Supposef i
rstthatther ealexchanger ateisl [Link] hiscase,becausedomest icgoodsar e
rel
ativ
elycheap, domest icr esi
dentswillwanttopur chasef eweri [Link]
reason,foreignerswillwantt [Link] esultofbothoftheseactions,
the
quantit
yofournetexpor tsdemandedwi l
lbehi [Link] teoccursiftherealexchange
rateishi [Link] icgoodsar eexpensi ver elati
vet of orei
gngoods,domest i
c
resi
dentswi l
lwantt obuymanyi mpor tedgoodsandf or
eignerswi l
lwantt obuyf ew ofour
[Link] efore,t
hequant it
yofournetexpor tsdemandedwi llbelow.
Wewr i
tethisrelati
onshipbet weent herealexchanger ateandnetexpor tsas:

Thi
sequat
ionst
atesthatnetexpor
tsareaf uncti
onoftherealexchanger [Link]
gure4-
5
i
ll
ust
rat
est
henegati
verel
ati
onshi
pbetweent
hetradebal
anceandtherealexchangerate.
Fi
gur
e4.
5:NetExpor
tsandt
heRealExchangeRat
e

Thef i
gureshowsther el
ati
onshi
pbet weentherealexchanger ateandnetexpor t
s:thel
ower
therealexchangerat
e,thelessexpensiv
earedomest icgoodsr elat
ivetoforei
gngoods,and
thusthegr eat
erareournetexpor [Link] ti
onoft hehor i
zont
alaxismeasures
negati
vevaluesofNX:becauseimpor t
scanexceedexports,netexportscanbelessthanzer
o.

TheDet
ermi
nant
soft
heRealExchangeRat
e
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Wenowhav eal lt hepi ecesneededt oconst r
uctamodelt hatexplainswhatf actorsdet ermine
therealexchanger ate.I npar t
icul
ar,wecombi nether elati
onshipbet weennetexpor tsandt he
realexchanger at ewej ustdi scussedwi t
hthemodeloft hetr
adebal ancewedev elopedear li
er
i
nt hechapt [Link] izetheanal ysi
sasfollows:
 Ther ealexchanger at
ei srel
atedt onetexpor [Link] herealexchanger at eislower,
domest i
cgoodsar el essexpensi ver el
ati
vet of or
eigngoods,andnetex port
sar e
greater.
 Thet radebal ance( netexports)mustequalt henetcapi t
alout f
low,whichi ntur nequals
sav i
ngmi nusi nv estment .Savingisf i
xedbyt heconsumpt i
onf unctionandf iscalpoli
cy;
investmenti sf i
xedbyt heinvestmentf uncti
onandt hewor l
dint er
estrate.
Figure4-6i ll
ustrat est heset wocondi ti
[Link] i
neshowi ngt her elati
onshipbet weennet
exportsandt her ealexchanger at
esl opesdownwar dbecauseal owr ealexchanger atemakes
domest ic goods r elativelyinexpensi [Link] line representi
ng the excess ofsav i
ng over
i
nv est
ment ,S−I ,i sv erticalbecause nei t
hersav i
ng nori nvestmentdepends on t he r
eal
exchanger [Link] ossingoft heset wol i
nesdetermi nestheequili
br i
um realexchanger at
e.
Fi
gur
e4.
6:Howt
heRealExchangeRat
eIsDet
ermi
ned

Therealexchangerateisdeterminedbyt heintersecti
onofthev ert
icall
inerepr
esent i
ngsaving
minusinvestmentandt hedownwar d- sl
opi
ngnet -
export
sschedul [Link] hi
sintersecti
on,the
quanti
ti
esofdomest iccurrencysuppliedforthef l
owofcapitalabroadequal st
hequant it
iesof
domesticcurrencydemandedf orthenetexpor tofgoodsandser v i
[Link]
gurelooksl i
ke
anordinar
ysuppl y-
and-demanddi [Link] heequi l
ibr
ium realexchanger at
e,thesuppl yof
domesticcurrencyavail
ablefrom thenetcapi taloutfl
ow balancest hedemandf ordomest i
c
curr
encybyf orei
gnersbuyi
ngournetexpor t
s.

HowPol i
ciesInfl
uencetheRealExchangeRat e
Wecanuset hi
smodelt oshowhowt hechangesi neconomi cpolicyaf f
ecttherealexchange
rate.
FiscalPoli
cyatHome:Whathappenst other ealexchangerateifthegov er
nmenti ncr
eases
gov er
nmentpur chasesorcutti
ngt axes?Aswedi scussedearli
er,thi
sr educesnationalsavi
ng
andt hereductioninsavinglowerS–Iandt [Link] s,t
her eductioninsavingcausesa
tradedefi
[Link] npol
icyshift
slowerst hesupplyofdomest iccur r
encytobei nvest
ed
[Link] owersupplycausest heequil
ibrium realexchangeratet or i
seandt hedomest ic
currencybecomesmor ev al
[Link] icgoodsnowbecomemor eexpensiverelat
ive
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t
oforei
gngoods,whi
chcauseexport
stofallandi
mpor t
stor
[Link]
nexportsand
t
hechangei
nimportsbot
hacttoreducenetexpor
ts.(
SeeonMankiw,page140forgr
aphical
anal
ysi
s).
Fi
scalPol
icyAbr
oad:Whathappenst
other
ealexchanger
atei
ffor
eigngov
ernment
sincr
ease
gov ernmentpur chasesorcutt axes?Thi schangei nf i
scalpol i
cyr educeswor l
dsav i
ngand
raisest hewor ldi nterestr [Link] ncreasei nthewor ldi nterestrater educesdomest i
c
i
nv estment ,whi chr aisesS−Iandt [Link] s,thei ncr easei nt hewor l
di nter
estrate
causesat r
adesur pl
[Link] schangei npol icyshiftsr ai
sest hesuppl yofdomest iccurrencyto
bei nvestedabr [Link] li
brium r ealexchanger atefal
lsanddomest iccur r
encybecomes
l
essv al
uabl eanddomest icgoodsbecomel essexpensi verelativetof orei
[Link], the
netexpor tsr se.(
i SeeonManki w, page140f orgraphicalanal ysis).
Shi f
tsinInvest mentDemand:Whathappenst other ealexchanger ateifinvestment sdemand
athomei ncreases,per hapsbecauset hepar li
amentpassesani nvestmentt axcr edit
?Att he
givenwor ldi nt
erestr ate,thei ncr easei ni nvestmentdemandl eadst ohi gherinv est
ment.A
higherv ueofImeansl
al owerv aluesofS−[Link] s,thei ncreasei ninvestmentdemand
causesat radedef i
cit
.Thei ncreasei ninv estmentdemandr educest hesuppl yofdomest i
c
cur r
encyt obei nv estedabr [Link] librium realexchanger ater i
[Link] hedomest i
c
cur r
encyappr eciates,domest i
cgoodsbecomemor eexpensi ver elat
ivetof orei
gngoods,and
netexpor tsf al.(
l SeeonManki w, page141f orgraphi calanalysis).

TheEf fectsofTr adePol ici

es
Nowt hatwehav eamodelt hatexpl ainsthet radebal anceandt her ealexchanger ate, wehav e
thet ool st oexami net hemacr oeconomi cef fectsoft radepol i
[Link] adepol i
cies,br oadly
defined, arepol i
ciesdesi gnedt oi nfluencedi r
ect l
yt heamountofgoodsandser vicesexpor ted
ori mpor [Link] t
en,t radepol iciest aket hef or m ofpr otect i
ngdomest ici ndust riesf rom
foreigncompet i
tion—ei therbypl aci ngat axonf oreigni mpor ts( at ari
ff)orr est ri
ct i
ngt he
amountofgoodsandser vi
cest hatcanbei mpor t
ed( aquot a)
.Asanexampl eofapr otect i
onist
tradepol icy,consi derwhatwoul dhappeni fthegov ernmentpr ohi bitedt hei mpor toff oreign
[Link] venr ealexchanger ate,impor tswoul dnowbel ower ,imply ingt hatnetexpor ts
(expor t
smi nusimpor ts)woul dbehi [Link],t henet -exportsschedul eshi ftsout war d,asi n
Figure4. [Link] heef fect soft hepol icy,wecompar etheol dequi librium andt henew
equilibri
um.I nt henew equi l
ibrium,t her ealexchanger atei shi gher ,andnetexpor tsar e
[Link] tet heshi f tint henet -
expor tsschedul e,t heequi librium l ev elofnetexpor ts
remai nst hesame, becauset hepr otectionistpol i
cydoesnotal t erei thersav ingori nv estment .
Thisanal ysisshowst hatpr otect i
oni sttradepol iciesdonotaf fectt het radebal [Link] s
surpr i
singconcl usioni sof tenov erlookedi nthepopul ardebat eov ert radepol [Link]
tradedef ici
tr efl
ect sanexcessofi mpor tsov erexpor ts,onemi ghtguesst hatr educi ng
i
mpor ts—suchasbypr ohibitingt hei mpor toff oreigncar s—woul dr educeat radedef i
[Link],
ourmodelshowst hatpr ot
ect ionistpol i
ciesleadonl yt oanappr eciat i
onoft her ealexchange
[Link] ncreasei nthepr iceofdomest icgoodsr elativet ofor eigngoodst endst ol owernet
expor tsbyst imulat i
ngi mpor tsanddepr essingexpor [Link],t heappr eci ationof fset st he
i
ncr easei nnetexpor tsthati sdi rectlyat tr
ibutablet ot het r
ader est r
ict i
on.

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Althoughpr otect i
oni stt r
adepol i
ciesdonotal tert
het radebal ance,theydoaf fecttheamount
oft [Link] eseen, becauset her eal
exchanger at eappr eci
ates,thegoodsandser v ices
wepr oducebecomemor eexpensi ver elat
ivet of oreigngoodsandser [Link],t herefor e,
expor tlessi nt henewequi [Link] tsar eunchanged,wemusti mpor tl ess
aswel l
.(Theappr eci ationoft heexchanger atedoesst imulat eimpor t
stosomeext ent,butt his
onl ypar tlyof fsetst hedecr easei ni mpor t
sduet ot het rader estri
cti
on).Thus,pr otectioni st
pol i
ciesr educebot ht hequant i
tyofi mpor t
sandt hequant ityofexpor t
[Link] sfalli
nt het ot al
amountoft radei st her easoneconomi stsalmostal way sopposepr otectionistt r
adepol i
cies.
Internationalt r
adebenef it
sal lcountriesbyal l
owi ngeachcount ryt ospeci al
izeinwhati t
producesbestandbypr ovidi ngeachcount rywithagr eaterv ar
ietyofgoodsandser vices.
Pr otecti
oni stpol i
ciesdi minisht hesegai nsfrom [Link] thought hesepol iciesbenef i
tcer tai n
groups wi thin soci ety—for exampl e,a ban on i mpor ted cars hel ps domest i
c car
producer s—soci etyonav eragei swor seof fwhenpol iciesr educet heamountofi nternational
trade.
Fi
gur
e4.
7:TheI
mpactofPr
otect
ioni
stTr
adePol
i
ciesont
heRealExchangeRat
e

TheDeter
mi nantsoft
heNomi nalExchangeRat e
Havingseenwhatdet ermi
nestherealexchanger at
e,wenowturnourattent
iontot
henomi nal
exchangerat
e—ther ateatwhichthecurrenciesoftwocount
ri
[Link]
her
elat
ionshi
p
betweentherealandthenominalexchanger ate:

Wecanwr
it
ethenomi
nal
exchanger
ateas:

Thisequati
onshowst hatthenomi nalexchanger atedependsont her ealexchanger ateand
thepri
celevel
sinthetwocount ri
[Link] enthevalueoft her ealexchanger ate,i
fthedomest i
c
pri
celevelP ri
ses,thenthenomi nalexchanger ate( forei
gncur rencyperuni tofdomest i
c
curr
ency)wil
lfal
l
:becauseadomest i
ccur rencyiswor thl
ess, adomest i
ccur rencywillbuyl
ess
for
eigncurr
[Link] er
,iftheforeignpr i
celevelP*r i
ses,thent henomi nalexchangerate
wil
lincr
ease:becausethef or
eigncur rencyiswor t
hless,adomest iccurrencywi l
lbuymor e
for
eigncurr
ency.
Iti
sinstr
ucti
vetoconsiderchangesi nexchanger atesov ert i
[Link] at
eequat i
on
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it
tenas:

Thepercent
agechangeinPist
hedomesti
cinfl
ati
onrate,andtheper
centagechangeinP*is
thefor
eigncount
ry’
sinf
lat
ionr
ate .Thus,thepercent
agechangeinthenominalexchange
rat
eis:

Thisequat
ionstat
est hatthepercent
agechangeinthenominalexchanger at
ebetweenthe
curr
enci
esoft wocountri
esequalstheper
centagechangeintherealexchangerat
eplusthe
dif
fer
enceinthei
rinf
lati
onrates.I
facount
ryhasahighrateofinf
lat
ionrelat
ivetot
hefor
eign
country,domest
iccurr
encywil
lbuyanincreasi
ngamountoft heforei
gncurr
encyovert
ime.I
f
acount ryhasal
owr at
eofinfl
ati
onr
elat
ivetothefor
eigncountr
y,domesti
ccurr
encywil
lbuya
decreasingamountofthef
orei
gncurr
encyovertime.

Thisanalysi
sshowshow monet ar
ypol i
cyaf f
ect
st henomi nalexchanger
[Link] t
hat
highgrowthint hemoneysuppl yleadst ohighinflat
[Link],wehav ej
ustseenthatone
consequenceofhi ghinfl
ati
onisadepr eciati
ngforeigncur r
ency:hi
gh impli
esfal
lnge.I
i n
otherwords,justasgrowthi nt
heamountofmoneyr aisesthepri
ceofgoodsmeasuredin
termsofmoney ,i
tal
sotendstorai
set hepriceofforei
gncur r
enci
esmeasuredint
ermsofthe
domest i
ccurrency.
4.
4TheMundel l-
FlemingModel
Themodeldev el
opedi nt hi
schapt eriscall
edt heMundel l
–[Link]
beendescr ibedas“ thedomi nantpol i
cyparadigm f orstudyingopen-economymonet aryand
fi
scalpolicy”.Whenconduct ingmonet aryandf iscalpolicy,poli
cymakersoftenlookbey ond
thei
rowncount ry’
sbor [Link] osperityi
st heirsol
eobjecti
ve,i
tisnecessary
forthem toconsiderther estofthewor l
[Link]
owofgoodsandser vi
cesandt he
i
nternat
ionalf l
ow ofcapi talcanaf fectaneconomyi npr ofoundway [Link]
icymaker
si gnore
theseeffectsattheirri
sk.

The1999Nobell aureateRobertMundel l
,nowapr ofessoratCol umbi aUniversit
y,andt hel ate
Mar cusFlemi ng,whowasar esear
cheratt heI nternati
onalMonet aryFund,dev el
opedt his
anal y
sisint [Link] t
houghl at
err esearchhasr efinedt heiranalysi
s,thei nit
ialMundel l
-
Flemi ngf
ormul ati
ondi scussedhereremai nsessent iall
yintactasawayofunder st
andi nghow
policiesworkunderhi ghcapi t
almobi l
ity
.TheMundel l–Flemi ngmodeli sanopen- economy
versionoft heI S–LM model .Bothmodel sst r
esst hei nteracti
onbet weent hegoodsmar ket
andt hemoneymar [Link] sassumet hatt hepr i
cel evelisfi
xedandt henshowwhat
causesshor t-
runfluctuati
onsi naggregatei ncome( or,equi val
entl
y,shift
si nt heaggr egate
demandcur ve).
Thekeydi ff
erenceist hatt he IS–LM modelassumesacl osedeconomy ,
wher easthe Mundel l
–Fleming modelassumesan open economy .The Mundel l
–Fl emi ng
modelext endst heshor t
-runmodelofnat ionalincomebyi ncludi
ngtheef f
ectsofi nternat i
onal
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radeandf
inance.

TheMundel l
–Flemi ngmodelmakesonei mpor tantandext r
emeassumpt on:i
i tassumest hat
theeconomybei ngst udiedi
sasmal lopeneconomywi thperfectcapi
talmobi l
it
[Link],t he
economycanbor r
oworl endasmuchasi twant sinwor ldfi
nancialmar ketsand,asar esult
,
theeconomy ’sinterestrateisdeter
mi nedbyt hewor l
di nter
estr at
[Link]
om t hismodel,weal so
understandthatt hebehav i
orofaneconomydependsont heexchange- r
atesy st
em i thas
[Link],t hemodelwasf i
rstdev el
opedi nlargepar ttounder standhow alternative
exchange-rat
er egi mes wor k and how the choi ce ofexchange r ater egime imposes on
monet aryandfiscalpol i
[Link]
erdev elopi
ngt hemodel ,wewi l
lbeinaposi ti
ontoaddr essan
i
mpor tantpoli
cyquest ion:whatexchange-ratesystem shouldanat ionadopt ?

TheKeyAssumpt ion:Smal lOpenEconomywi t

hPer fectCapitalMobili
ty
Let’
sbeginwi t
ht heassumpt ionofasmal lopeneconomywi thperfectcapi
talmobil
ity
.This
assumptionmeanst hattheinterestrateinthi
seconomy ,r
,isdet er
minedbythewor l
dinter
est
rat
e,r*.Mathematically,
wecanwr it
et hi
sassumpt ionas:r=r *
.
This worl
di nt
erestr at
ei s assumed t o be exogenousl yfixed because the economyi s
suff
ici
entl
ysmal lrel
at i
vetothewor l
deconomyt hatitcanborroworl endasmuchasi twants
i
nwor ldfi
nancialmar ketswithoutaffecti
ngthewor ldint
erestrate.

Imagi net hatsomeev entoccur redt hatwoul dnormal l

yr aisethei nterestr ate( suchasa
declinei ndomesticsav i
ng).Inasmal lopeneconomy ,thedomest i
cinterestr atemi ghtri
seby
al i
tt
lebi tforashortt ime,butassoonasi tdid,f
orei
gner swoul dseet hehi gheri nter
estrate
andst artlendi
ngt ot hiscount r
y( by,forinstance,buyingt hiscountry’sbonds) .Thecapi t
al
i
nf l
owwoul ddri
vethedomest i
ci nter
estratebackt owar dr*.Simil
arly,ifanyev entstart
edt o
drivet hedomest icint er
estr at
edownwar d,capit
alwoul df l
ow outoft hecount ryt oearna
higherr eturnabr
oad, andt hiscapitaloutf
lowwoul ddr i
vet hedomest icinterestratebackupt o
r*.Hence, t
her=r *equat ionrepresentstheassumpt iont hattheint
ernat i
onalf l
owofcapi t
alis
rapidenought okeept hedomest i
ci nt
erestrateequaltot hewor l
dinterestrate.

TheGoodsMarketandtheI
S*Curve
TheMundell
–Fl
emingmodeldescr
ibesthemarketf
orgoodsandser
vicesmuchast
heI
S–LM
modeldoes,butitaddsanew t erm fornetexpor
ts.I
nparti
cul
ar,thegoodsmar
keti
s
repr
esent
edwit
hthefol
lowi
ngequati
on:
Y=C(
Y–T)+I
(r
)+G+NX(
e).
Thisequationst at esthataggr egateincome,Y,i st hesum ofconsumpt ion,C,investment ,I,
governmentpur chases, G,andnetexpor ts,[Link] i
ondependsposi ti
vel
yondi sposabl e
i
ncome ( Y−T) .Inv estmentdepends negat i
velyon t he int
erestr at
[Link] ts depend
negati
velyont heexchanger [Link] ore,wedefinet heexchanger ate,e,astheamountof
for
eigncur rencyperuni tofdomest iccur r
[Link] i
ously,wer el
atednetexportst other eal
exchanger ate( ther elativ
epr iceofgoodsathomeandabr oad)ratherthant henomi nal
exchanger ate( ther elativepriceofdomest i
candf oreigncur r
enci
es).I
fei st henomi nal
exchanger ate,t
hent her ealexchanger ateequalseP/ P*,wherePi sthedomest icpri
cel ev el
andP*i sthef or
ei gnpricel ev
[Link] l
–Flemingmodel ,howev er
,assumest hatthepr ice

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evelsathomeandabr oadaref i
xed,sother ealexchanger ateispropor
tionalt othenominal
exchanger [Link],whent hedomest i
ccur rencyappreciat
es( t
henomi nalexchangerate
ri
ses),forei
gngoodsbecomecheapercompar edt odomest i
cgoods,andt hiscausesexports
tofal
l andimpor tst
or i
se.
The goods- mar ket equil
ibr
ium condi t
ion abov e has two f i
nancialv ariabl
es af f
ect
ing
expenditureongoodsandser v
ices(theinter
estr ateandtheexchanger ate),butthesituat
ion
canbesi mplifi
edusingt heassumpt i
onofper fectcapit
almobi l
i
ty,sor=r*.Weobt ain;
Y=C(
Y−T)+I
(r
*)+G+NX(
e).
Let’
scal
lthistheIS*equation.(Theast eri
skremindsust hatt
heequati
onholdstheint
erest
rat
econstantattheworl
di nterestrat
er *.
)Wecani ll
ustr
atethi
sequat
iononagraphinwhi ch
i
ncomei sont hehori
zontalaxi sandt heexchanger at
eisont hever
ti
calaxi
[Link]
vei s
showninpanel(c)oft
heFigur ebelow.

TheI S*cur veslopesdownwar dbecauseahi gherexchanger atereducesnetexpor t

s,whichin
turnlower saggr [Link] hi
swor ks,theotherpanelsoft heabovef i
gure
combi net henet-exportsschedul
eandt heKey nesiancrosstoderivetheIS*cur v
[Link](a)
,
ani ncreaseint heexchanger atefrom e1 t
oe2 lowersnetexpor t
sf rom NX( e1)toNX( e2)
.In
panel( b),thereductioninnetexportsshift
st heplanned-expendi
turescheduledownwar dand
thusl ower sincomef om Y1 t
r [Link] S*cur vesummar i
zesthisr el
ati
onshipbetweent he
exchanger e,
at e, andincome,Y.

TheMoneyMar ketandtheLM*Curv
e
TheMundell
–Flemingmodelrepr
esent
sthemoneymar
ketwi
thanequat
iont
hatshoul
dbe
fami
l
iarf
r heI
om t S–LM model
:
M/
P=L(
r,Y)
.

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Thisequati
onstatesthatt
hesuppl yofrealmoneybal ances,M/ P,equal
sthedemand,L( r,Y).
Thedemandf orrealbal
ancesdependsnegat i
velyontheinterestrat
eandpositi
vel
yoni ncome.
Themoneysuppl yisanexogenousv ari
ablecontrol
l
edbyt hecent r
albank,andbecauset he
Mundell–Fl
emingmodeli sdesignedtoanal y
zeshor t-
runf l
uctuati
ons,thepri
celevelisalso
assumedt obeexogenousl yfi
[Link] n,weaddt heassumpt i
onthatthedomest i
c
i
nterestrat
eequalstheworl
dinterestr
ate:
M/
P=L(
r*,
Y).
Let’scallthi
st heLM*equat [Link] epresentitgraphical
l
ywi t
hav erti
call
ine,asi
npanel
(b)oft hefoll
owi ngfi
[Link]*curv eisv er
ti
calbecauset heexchanger at
edoesnotent er
i
nt otheLM*equat i
[Link] hewor
ldinterestrate,theLM*equat iondeterminesaggregate
i
ncome,r [Link] gurebelow showshow t heLM*cur vearises
from thewor l
di nter
estr
ateandt heLM curve,whichr el
atestheint
erestr
ateandi ncome.

Putt
ingthePi
ecesToget
her
Accordi
ngtotheMundel
l–Fl
emingmodel
,asmal
lopeneconomywi
thper
fectcapi
talmobi
l
ity
canbedescri
bedbytwoequati
ons:
Y=C(
Y−T)+I
(r
*)+G+NX(e)……………………I
S*,
M/
P=L(r*
,Y)
……………………………………………LM*
.
Thefir
stequati
ondescri
besequi
l
ibri
um i
nthegoodsmarket;t
heseconddescr
ibesequi
li
bri
um
i
nt hemoneymar ket
.Theexogenousvari
ablesar
efi
scalpoli
cy,GandT,monet ar
ypoli
cy,M,
thepri
celevel
,P,andtheworl
dinter
estr
ate,r*
.Theendogenousvar
iabl
esareincome,Y,and
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t
heexchanger
ate,
e.

Theabovef i
gureil
l
ustratesthesetwor el
ati
onshi
[Link]
bri
um fortheeconomyi sf
ound
wheretheIS*curveandt heLM*cur veinter
[Link]
sinter
sectionshowst heexchangerat
e
andthel evelofincomeatwhi chthegoodsmar ketandt hemoneymar ketarebothin
equi
l
ibr
[Link] t
ht his diagram,we can use t he Mundel
l–Fleming modelt o show how
aggr
egateincome( Y)andt heexchangerate(e)r
espondtochangesi npol
icy
.

4.
5Fi
scal
andMonet
aryPol
ici
esi
nSmal
lOpenEconomywi
thPer
fectCapi
talMobi
li
ty
I
.UnderFl
oat
ingExchangeRat
es
Beforeanal yzi
ngt heimpactofpol ici
esinanopeneconomy ,wemustspeci f
ytheinternat i
onal
monet arysy st
em i nwhichthecount ryhaschosent [Link],wemustconsi derhow
peopleengagedi ninter
nati
onaltradeandf i
nancecanconv ertthecurrencyofonecount ryinto
thecur r
encyofanot [Link] artwiththesy st
em r el
evantformostmaj oreconomi est oday:
fl
oati
ngexchanger at
[Link] st
em off l
oatingexchangerates,t
heexchanger ateissetby
marketf orcesandi sall
owedt of l
uctuat
ei nresponset ochangingeconomi ccondit
ions.I nthis
case,theexchanger ateadjust
st oachiev esimul t
aneousequili
bri
um inthegoodsmar ketand
themoneymar [Link] hinghappenst ochanget hatequili
bri
um,t heexchanger ateis
all
owedt omov et oanewequi li
brium v
[Link] ’
snowconsi dertwopol ici
esthatcanchange
theequi l
ibri
um:f iscalpoli
cyandmonet [Link] stouset heMundel l
–Fl emi ng
modelt oshowt hei mpactofpol i
cychangesandt ounderstandtheeconomi cforcesatwor k
astheeconomymov esfrom equili
bri
um toanot her.

Fi
scalPol
icy

Suppose t hatthe gover

nmentst imulat
es domesti
c spendi
ng by increasing government
purchasesorbycut t
[Link]
yfiscalpoli
cyi ncreasesplanned
expendit
ure,itshif
tstheIS*curvetotheright
,asinFigur
[Link] esult,theexchange
rat
eappr eciat
es,whil
ethelevel
of
i
ncomer emainsthesame.

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Not i
cet hatf i
scalpol icyhasv erydi f
ferentef fectsinasmal lopeneconomyt hani tdoesi na
closedeconomy .Int hecl osed- economyI S–LM model ,af iscalexpansi onr aisesi ncome,
wher easi nasmal lopeneconomywi thaf l
oatingexchanger ate,af iscalexpansi onl eav es
i
ncomeatt hesamel ev [Link] call
y, t
hedi fferencear isesbecauset heLM*cur veisv er t
ical,
whi l
et heLM cur veweusedt ost udyacl osedeconomyi supwar dsl [Link] ,
thisexpl anat ion
i
snotv erysat i
[Link] etheeconomi cforcest hatl i
ebehi ndthedi fferentout comes?To
answert hi
squest ion,wemustt hinkthr oughwhati shappeni ngt ot hei nternat i
onalf low of
capitalandt hei mpl i
cat ionsoft hesecapi talfl
owsf orthedomest i
ceconomy .Thei nterestr ate
andt heexchanger at ear et hekeyv ariablesi nt hest [Link] ncomer i
sesi nacl osed
economy ,thei nterestr ater ises,becausehi gheri ncomei ncreasest hedemandf ormoney .
Thati snotpossi blei nasmal lopeneconomybecause,assoonast hei nterestr atest artst o
ri
seabov et hewor l
di nter estr at
er *,capi t
alqui cklyf l
owsi nfrom abr oadt ot akeadv antageof
thehi gherr [Link] hi scapi talinflowpushest hei nterestr atebackt or *,italsohasanot her
effect:becausef orei
gni nv estorsneedt obuyt hedomest iccurr encytoi nv estint hedomest i
c
economy ,thecapi talinf lowi ncreasest hedemandf orthedomest i
ccur rencyi nt hemar ketf or
foreign-cur r
encyexchange, biddingupt hev alueoft hedomest i
ccur r
ency .Theappr eciationof
thedomest iccur rencymakesdomest i
cgoodsexpensi ver elativet of oreigngoods,r educi ng
netexpor [Link] al
linnetexpor tsexact lyof f
setst heef fectsoft heexpansi onar yfiscalpol icy
oni ncome.

Whyisthefal
linnetexport
ssogr eatthati
trendersfiscalpol
icypower
lesstoi
nfl
uence
i
ncome?Toanswert
hisquest
ion,
considert
heequat
ionthatdescri
besthemoneymar
ket:
M/
P=L(
r,Y)
.
I
nbot
hcl
osedandopeneconomi
es,t
hequant
it
yofr
ealmoneybal
ancessuppl
i
ed,
M/P,i
s

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fi
xedbyt hecent r albank( whi chset sM)andt heassumpt ionofst ickypr ices( whichf i
xesP) .
Thequant i
tyofr eal moneydemanded( determinedbyrandY)mustequal thisf i
xedsuppl y
.
Inacl osedeconomy ,af iscalexpansi oncausest heequi l
i
br i
um i nterestr atetor i
[Link]
i
ncr easei nt hei nterestr ate( whichr educest hequantityofmoneydemanded)i mpl i
esan
i
ncr easei nequi li
br i
um i ncome( whichr ai
sest hequant i
tyofmoneydemanded) ;theset wo
eff
ect st ogethermai ntainequi l
ibri
um int hemoneymar ket .Bycont rast ,inasmal lopen
economy ,risf i
xedatr *, sother eisonlyonel evelofincomet hatcansat isf ythisequation,and
thi
sl evelofi ncomedoesnotchangewhenf iscalpoli
[Link],whent hegov ernment
i
ncr easesspendi ngorcut st axes,theappr eciationofthecur rencyandt hef alli
nnetexpor t
s
mustbel argeenought oof f
setf ull
ytheexpansi onaryeffectoft hepol i
cyoni ncome.
Monet aryPol icy
Supposenow t hatt hecent ralbanki ncreasest hemoneysuppl y
.Becauset hepricelevelis
assumedt obef ixed,t hei ncreasei nthemoneysuppl ymeansani ncr easei nr ealmoney
[Link] ncr easei nrealbal ancesshi f
tst heLM*cur vet other ight,asi nFi
gur ebelow.
Hence, ani ncreasei nthemoneysuppl yr ai
sesi ncomeandl ower stheexchanger at
e.

Althoughmonet arypol icyi nfluencesi ncomei nanopeneconomy ,asi tdoesi nacl osed
economy ,themonet aryt r
ansmi ssionmechani sm i sdif
[Link] lthati nacl osedeconomy
ani ncreasei nthemoneysuppl yi ncreasesspendi ngbecausei tlower st hei nterestr ateand
sti
mul atesi nvestment .Inasmal lopeneconomy ,
thischannelofmonet aryt ransmi ssioni snot
availablebecauset hei nterestr ateisf i
xedbyt hewor l
di nt
erestr [Link],howdoesmonet ary
policyinfl
uencespendi ng?Toanswert hisquest i
on,weonceagai nneedt ot hinkaboutt he
i
nt ernati
onalf lowofcapi talandi tsimplicationsf orthedomest iceconomy .Thei nter estrat e
andt heexchanger ateareagai nt hekeyv [Link] ncr easei nt hemoneysuppl y
startsput ti
ngdownwar dpr essur eont hedomest i
ci nter
estr ate,capi talf lowsoutoft he
economy ,asi nv estorsseekahi gherr eturnel sewher [Link] scapi talout flow pr ev entst he
domest i
cint erestr atef r
om f alli
ngbel owt hewor l
dinterestrat er* .Ital sohasanot heref fect:
becausei nv esti
ngabr oadr equi resconv ertingdomest iccur rencyi ntof oreigncur rency ,the
capitalout flow i ncreasest hesuppl yoft hedomest iccur rencyi nt hemar ketf orf oreign
cur r
encyexchange,causi ngt hedomest i
ccur rencyt odepr eci atei nv al [Link] sdepr eci
ation
makesdomest icgoodsi nexpensi verelati
vet of orei
gngoods, stimul atingnetexpor tsandt hus

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t
otali
[Link],inasmal
lopeneconomy ,monet
arypol
i
cyi
nfl
uencesi
ncomebyal
ter
ing
t
heexchanger
aterathert
hant
heint
erestr
ate.

I
[Link] xedExchangeRat es
Wenowt urnt ot hesecondt ypeofexchange- ratesy stem:fixedexchanger [Link] ixed
exchangerat e,thecent r
albankannouncesav aluefortheexchanger ateandst andsr eadyt o
buyandsel lt hedomest iccurrencyt okeept heexchanger ateati t
sannouncedl [Link] he
1950sand1960s, mostoft he
world’s majoreconomi es,oper at
ed withint he Br etton Woods sy stem—an i nternational
monet ar
ysy st em underwhi chmostgov ernment sagr eedt of i
xexchanger [Link] l
d
abandonedt hi ssystem i
nt heear ly1970s, andmostexchanger ateswer eallowedt of [Link] ,
fi
xedexchanger atesarenotonl yofhi st
or i
[Link] ecentl
y,Chi nafixedt hev alueof
i
tscur r
encyagai nstt [Link].
Inthissect
ion, wedi scusshowsuchasy stem wor ks,andweexami net hei mpactofeconomi c
poli
ciesonaneconomywi t
haf ixedexchanger [Link] er,weexami net hepr os
andconsoff ixedexchanger ates.

HowaFi xed- Exchange- RateSy stem Wor ks

Underasy stem off ixedexchanger ates,acent ralbankst andsr eadyt obuyorsel lt
he
domest iccur rencyf orf oreigncur r
enciesatapr edet erminedpr i
[Link] e,supposet he
ForeignNat ional Bankannouncedt hati twasgoi ngt of i
xtheexchanger ateat20bi rrperdoll
ar.
Itwoul dt henst andr eadyt ogive$1i nexchangef or20bi r
rortogi ve20bi rri
nexchangef or$1.
Tocar ryoutt hispolicy, thenationalbankwoul dneedar eserveofbirr(whichitcanpr int)anda
reserv eofdol lars(whi chi tmusthav epur chasedpr eviously)
.Af i
xedexchanger at ededicatesa
count ry’smonet arypol icyt othesi nglegoalofkeepi ngt heexchanger ateattheannounced
l
ev [Link] herwor ds,theessenceofaf ixed-
exchange- ratesy st
em ist hecommi tmentoft he
centralbankt o all
ow t hemoneysuppl yt o adjustt o what everlevelwi l
lensur et hatthe
equilibri
um exchanger atei nthemar ketf orf
oreign-currencyexchangeequal st heannounced
exchanger [Link] eov er,asl ongast hecent ralbankst andsr eadyt obuyorsel lforei
gn
currencyatt hef ixedexchanger ate,themoneysuppl yadjustsautomat icall
ytot henecessary
l
ev el.

Toseehow f ixingtheexchanger at
edet erminest hemoneysuppl y,considerthef oll
owi ng
exampl [Link] hefor ei
gnnat i
onalbankannouncest hatitwillfixtheexchanger ateat15
bir
rperdol lar,but,int hecur r
entequi li
brium wi tht hecur rentmoneysuppl y
,t hemar ket
exchanger at eis20bi r
rperdol l
[Link] ssi tuati
oni si l
lustr
atedinpanel( a)ofFi gur ebel ow.
Noticet hatt herei sapr ofi
toppor tuni t
y:anar bitrageurcoul dbuy40bi r
rint hef oreign-
exchangemar ketfor$2andt hensellt hebi rrtot hef orei
gnnat i
onalbankf or$2.67,maki nga
$0.67pr ofi
[Link] hefor ei
gnnat i
onalbankbuy st hesebi rrfr
om t hearbit
rageur,thedol larsit
paysf orthem aut omat icall
yincreaset hemoneysuppl [Link] i
sei nthemoneysuppl yshi f
ts
theLM*cur vet other ight,loweri
ngt heequi l
ibrium exchanger [Link] ,t hemoney
supplycont i
nuest or i
seunt i
ltheequilibrium exchanger atef al
l
st otheannouncedl ev el.
Conv ersel
y,suppose t hatwhen t he f oreign nat ionalbankannounces t hatitwi llf i
xt he
exchanger ateat40bi rrperdol lar
,theequi libr
ium hasamar ketexchanger ateof20bi rrper

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doll
ar .Panel( b)ofFi gurebel owshowst hissi tuation.I nthiscase, anar bi
trageurcouldmakea
profitbybuy ing40bi rrfrom t hef or
ei gnnat ionalbankf or$1andt hensel li
ngthebi r
rint he
mar ketplace f or$[Link] t he f or
eign nat i
onalbanksel l
st hese birr
,t he $1 itreceiv es
automat i
call
yr educest hemoneysuppl [Link] allint hemoneysuppl yshiftstheLM*cur vet o
thel eft,rai
singt heequi l
ibrium exchanger [Link] ycont i
nuest of al
luntilt he
equilibri
um exchanger at er i
sest otheannouncedl ev el.
Iti
si mpor t
antt ounder standt hatthi
sexchange- ratesy stem fixesthenomi nalexchanger at e.
Whet heri talsof i
xest her ealexchanger atedependsont het imehor izonunderconsi deration.
Ifpricesar ef lexible,ast heyar einthel ongr un,t hent her ealexchanger at ecanchangeev en
whilet henomi nalexchanger [Link] efor e,inthel ongr un,
apol icytof i
xthenomi nal
exchanger atewoul dnoti nfl
uenceanyr ealv ariabl e,i
ncludingt herealexchanger at
[Link] ixed
nomi nalexchanger atewoul di nf
luenceonl yt hemoneysuppl yandt hepr i
[Link],i
nt he
shortr undescr ibedbyt heMundel l–Flemi ngmodel ,pricesar efi
xed,soaf ixednomi nal
exchanger atei mpl iesaf ixedr ealexchanger at easwel l.

Let’
snowexami
nehoweconomi
cpol
i
ciesaf
fectasmal
lopeneconomywi
thaf
ixedexchange
rat
e.

FiscalPol
icy
Suppose thatthe gov er
nmentst imul
ates domestic spendi ng by increasing gov ernment
purchasesorbycut t
[Link]
icyshif
tstheIS* curvetother ight,asi nFigurebelow,
putti
ngupwar dpressureont [Link] ,becauset hecent ralbankst ands
readytotradeforeignanddomest i
ccurrencyatthefixedexchanger ate,ar bi
tr
ageursqui ckl
y
respondtotherisingexchanger atebyselli
ngforei
gncur rencytot hecent ralbank,leadingto
anaut omati
cmonet [Link] yshiftstheLM* curvet othe

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r
ight
.Thus,
underaf
ixedexchanger
ate,
afi
scal
expansi
onr
aisesaggr
egat
eincome.

Monet ar
yPol i
cy
Imagi net hatacent ralbankoper ati
ngwi t
haf ix
edexchanger atetri
est oi
ncreasethemoney
supply —forexampl e,bybuy i
ngbondsf rom thepubli
[Link] dhappen?Thei nit
ialimpact
oft hi
spol i
cyi stoshi fttheLM*cur vet otheright
,loweringt heexchanger at
e,asi nFi gure
[Link] ,becauset hecentralbanki scommi tt
edtot r
adingfor ei
gnanddomest iccurrencyat
afixedexchanger ate,arbit
rageur squickl
yrespondtot hef al
l
ingexchanger atebysel l
ingt he
domest i
ccur rencytot hecent ralbank,causingthemoneysuppl yandt heLM*cur vetor eturn
tot heirinit
ialpositi
[Link],monet arypoli
cyasusual lyconduct edisineff
ectualundera
fi
xedexchanger [Link] eeingt ofixtheexchangerate,thecent r
albankgivesupi t
scont r
ol
overt hemoneysuppl y.

Acount r
ywi thafixedexchanger at
ecan,howev er,conductat ypeofmonet arypoli
cy :i
tcan
decidetochanget helevelatwhichtheexchangerateisf i
[Link] educti
oni nt heoffi
cialvalue
ofthecurrencyiscall
eddev al
uati
on,andanincreaseinitsoffi
cialvalueiscalledar evaluati
on.
IntheMundel l
–Fl
emingmodel ,adev al
uati
onshift
st heLM*cur vetot heright ;i
tactsl i
kean
i
ncreaseint hemoneysuppl yunderafloat
ingexchanger [Link] al
uation,thus,expandsnet
exportsandr ai
[Link]
y,arevaluati
onshi ft
stheLM* curvetot heleft
,
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r
educesnetexpor
ts,
andl
ower
saggr
egat
eincome.

Thus,justast heIS–LM modelexpl ainstheaggr egat edemandcur veinaclosedeconomy ,the

Mundel l
–Flemi ngmodelexpl ai
nst heaggr egat edemandcur vef orasmal lopeneconomy .In
bothcases, t
heaggr egatedemandcur veshowst hesetofequi libri
um i
nthegoodsandmoney
marketst hatar ise as the price [Link] i n bot h cases,anything thatchanges
equil
i
br i
um income, otherthanachangei nthepr icelevel
, shi
ftstheaggregat edemandcur ve.
Poli
ciesandev entsthatr ai
seincomef oragi venpr icelevelshifttheaggregatedemandcur ve
tother i
ght;pol i
ciesandev ent
st hatloweri ncomef oragi venpr icel
evelshi f
theaggregate
demandcur vetot heleft.

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