Ch 13

The Open Economy Revisited: The Mundell–Fleming

Model and the Exchange-Rate Regime.
13-1 The Mundell–Fleming Model
“the dominant policy paradigm for studying open-economy monetary and fiscal policy.”

The Key Assumption: Small Open Economy with Perfect Capital Mobility

this assumption means that the interest rate in this economy r is

determined by the world interest rate r*.

The Goods Market and the IS Curve

If e nominal exc rate, then ɛ (real exc rate)
= eP/P*
Consumption depends positively on disposable income Y-T. Investment depends (P = domestic price, P* = Foreign price)
negatively on the interest rate. Net exports depend negatively on the exchange
rate e. As before, we define the exchange rate e as the amount of foreign currency
per unit of domestic currency; for example, e might be 100 yen per dollar.
If domestic currency rise, ɛ rises.
The Money Market and the LM Curve

This equation states that the supply of real money balances M/P equals the
demand L(r, Y). The demand for real balances depends negatively on the interest
rate and positively on income. The money supply M is an exogenous variable
controlled by the central bank, and because the Mundell–Fleming model is
designed to analyze short-run fluctuations, the price level P is also assumed to be
exogenously fixed.

Once again, we add the assumption that the domestic interest rate equals
the world interest rate,
Putting the Pieces Together

goods market The endogenous variables are income Y and the exchange
Money market rate e.
• We must consider how people can convert the currency of one
country into the currency of another. Generally: FLOATING EXCHANGE
RATE (the exchange rate is set by market forces and can fluctuate in
response to changing economic conditions).

• Three policies that can change the equilibrium: fiscal policy, monetary
policy, and trade policy.
Fiscal Policy
Monetary Policy
13-3 The Small Open Economy Under
Fixed Exchange Rates
• Under a fixed exchange rate, the central bank announces a value for
the exchange rate and stands ready to buy and sell the domestic
currency to keep the exchange rate at its announced level.
How a Fixed-Exchange-Rate System Works

A fixed exchange rate dedicates a country’s

monetary policy to the single goal of
keeping the exchange rate at the
announced level. In other words, the
essence of a fixed-exchange-rate system is
the commitment of the central bank to
allow the money supply to adjust to
whatever level will ensure that the
equilibrium exchange rate in the market for
foreign-currency exchange equals the
announced exchange rate. Moreover, as
long as the central bank stands ready to
buy or sell foreign currency at the fixed
exchange rate, the money supply adjusts
automatically to the necessary level.

arbitrageurs
Fiscal Policy
Interest rate parity theory doesn’t always hold because of country risk and expectation.

 Country risk offers higher r

 Pessimistic expectations offer higher r

risk premium θ
Pro Floating: Can use monetary policy for other purposes such as stabilizing prices increasing GDP and
employment.
(Fixed: monetary policy is committed to single goal of maintaining exchange rate)

Pro Fixed:
- floating e increase uncertainty  harmful to international business (however under floating, international
trade has risen).
- one way to discipline a nation’s monetary authority and prevent excessive growth in the money supply
(however, other policy can be used to discipline as well such as targets nominal GDP or inflation rate..
The Impossible Trinity
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