macro CHAPTER THREE

Mundell-Fleming
model and AD in an
open economy
 CONTENT
 Introduction to Mundell-Fleming model
 Macroeconomic policies under floating
exchange rates
 Macroeconomic policies under fixed
exchange rates
 Interest rate differentials among countries

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3.1 Introduction to Mundell-Fleming model
 It was developed in the early 1960s by
Robert Mundell & J. Marcus Fleming
 In 1999, Robert Mundell was awarded the
Nobel Prize for his work, including this
model (Fleming died in 1976 => he was not
eligible to share in the Nobel award)

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3.1 Introduction to Mundell-Fleming model

 Assumptions:
– small open economy with perfect
capital mobility => r = r*
– Short-run: prices (P,P*) unchange
=> NX(ε) can be expressed by
NX(e)

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3.1 Introduction to Mundell-Fleming model
The Goods Market & the IS*Curve
 IS* curve represents equilibrium levels in the
goods market
Þ IS* equation:
Y = MPC(Y-T) + I (r*) + G + NX(e)
 Equilibrium level in the goods market can be
expressed by the Keynesian Cross

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 The Keynesian Cross
Expenditure
Actual Expenditure:
Y = PE

Planned Expenditure:
PE = C+I+G+NX

450

Output Y

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How to build up the IS* curve

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3.1 Introduction to Mundell-Fleming model
The Money Market & the LM*Curve
 LM* curve represents equilibrium levels in
the money market
 Equilibrium level:
The supply of real money balances = the
demand for real money balances
=> The LM* equation M/P = L (r*,Y)

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The LM curve ……..

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And the LM* curve…

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The Mundell – Fleming Model

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3.2 Macroeconomic policies under floating
exchange rates
 Under the floating exchange rates
system: e is set by market forces
 Let’s use the Mundell–Fleming
model to show the impact of
policy changes: fiscal policy,
monetary policy, and trade policy

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 Fiscal Policy Under
Floating Exchange Rates
 Expansionary FP:
–↑G => S↓ => r↑ => Kin↑ =>
domesctic currency appreciates
(e↑) => NX↓
 LM* is vertical => ∆G↑ = ∆NX↓
=> Y unchanges

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Expansionary FP Under
Floating Exchange Rates

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 Monetary Policy Under
Floating Exchange Rates
M
↑M1 => P ↑ => LM
shifts right => LM*
shifts right (r <r* => Kout)
e↓ => NX↑ => Y↑)

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Expansionary MP Under
Floating Exchange Rates

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 Trade Policy Under
Floating Exchange Rates
 Import quota/tariff => M↓ => NX ↑
=> IS* shifts right => Y↑ => LM ↑ => r >
r* => Kin => e↑ => NX↓ until r = r* =>
Y ↓ to the initial level
 The quota increases NX↑ at first, but
e↑ reduces NX by the same amount
=>The economy imports less than it
did before, but it exports less as well.
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 Trade Policy Under
Floating Exchange Rates

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3.3 Macroeconomic policies under
Fixed Exchange Rates
Fixed exchange rate system:
The CB
–announces the e
–stands ready to buy/sell the
domestic currency => to keep e
at its announced level

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 How a Fixed-Exchange-Rate
System Works
 suppose the Fed announced a fix e1 = 100¥/$
 the current equilibrium level: e2 = 150¥/$
Þ Is there a profit opportunity
=> In the market, how do e2 & e1 change?

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 How a Fixed-Exchange-Rate
System Works
 To carry out this policy, Fed would need a
reserve of dollars (which it can print) and a
reserve of yen (which it must have
purchased previously).
 Note: this exchange-rate system fixes the
nominal exchange rate.
– In long run: fixed e would not influence ε
– In short run: prices are fixed => fixed e
implies a fixed ε

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 Fiscal Policy Under
Fixed Exchange Rates
 ↑G =>=> S↓ => r↑ => Kin↑ => domesctic
currency appreciates (e↑).
 B/c the CB stands ready to trade foreign and
domestic currency at the fixed exchange
rate
Þ arbitrageurs: buying FC in the market &
selling FC (and buying DC) to the CB =>
money supply ↑ & e↓.
Þ e returns to the initial level, Y↑

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Expansionary FP Under
Fixed Exchange Rates

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 Monetary Policy Under
Fixed Exchange Rates
M
 ↑M1 => P ↑ => LM shifts right
=> LM* shifts right => (r <r* => Kout)
=> e↓ => arbitrageurs: buying FC from
the CB & selling FC in the market
ÞMoney supply↓ to the initial level
ÞBy agreeing to fix the e, the CB gives
up its control over the money supply

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Expansionary MP Under
Fixed Exchange Rates

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 Trade Policy Under
Fixed Exchange Rates
 Import quota/tariff => M↓ => NX ↑ => IS*
shifts right => Y↑ => LM ↑ => r > r* => Kin
=> e↑
 What are arbitrageurs expected to do?
Þ e returns to the initial level? Y?

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 Trade Policy Under
Fixed Exchange Rates

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The Mundell–Fleming Model:
Summary of Policy Effects

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 Excercises
 Textbook:
– Page 388: question 1,2,3,4

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3. 4 Interest Rate Differentials
among Countries
 Mundell-Fleming Assumption: r = r*
 In reality:
– Country risks => r > r*
– Exchange rate expectations: the small
country’s currency is usually expected to
depreciate over time => loans made in DC
is preferred => domestic rate r > r*
=> Assuming: r =r*+ θ

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Should exchange rates be floating or fixed?
 Pros and Cons of Different Exchange-Rate
Systems
 Speculative Attacks, Currency Boards, and
Dollarization
 The Impossible Trinity

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The Impossible Trinity

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 From the SR to the LR:
a Changing Price Level
 We now consider what happens to the
Mundell-Fleming model when the price
level changes.
 B/c there are changes in P => e & ε
will no longer be moving together
 (IS*) Y=C(Y−T) +I(r*) +G+NX(ε)
 (LM*) M/P=L(r*,Y)

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 From the SR to the LR:
a Changing Price Level
 At first, point K describes the short-run
equilibrium with a fixed price level.
Þ The AD is too low to keep the economy
producing at its natural level.
 Over time, low AD =>P↓ => (M/P)↑ => LM*
shifts right => ε↓ => NX↑ => Y↑: the economy
reaches point C - the long run equilibrium
 The speed of transition depends on how quickly
the P adjusts to restore the economy to the
natural level of output.

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From the SR to the LR:
a Changing Price Level

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