®

The Open Economy Revisited: The Mundell-Fleming

Model and the Exchange-Rate Regime

A PowerPointTutorial
To Accompany

MACROECONOMICS, 8th Edition

N. Gregory Mankiw
Tutorial written by:
Mannig J. Simidian
B.A. in Economics with Distinction, Duke University
Chapter 1
M.P.A., Harvard University Kennedy School of Government
Twelve
M.B.A., Massachusetts Institute of Technology (MIT) Sloan School of Management
 The issues of open-economy macroeconomics have been very
much in the news in recent years. At various European nations, most
notably Greece, experienced severe financial difficulties, many
observers wondered whether it was wise for much of the continent
to adopt a common currency—the most extreme form of a fixed-
exchange rate. If each nation had its own currency, monetary policy
and the exchange rate could have more easily adjusted to the
needs of each nation.
Many American policy makers were objecting that China did not
allow the value of its currency to float freely against the U.S. dollar.
they agreed that China kept its currency artificially cheap, making its
goods more competitive on world markets.
The Mundell-Fleming model a useful starting point for
understanding and evaluating these often heated international policy
debates.

Chapter 2
Twelve
 Introducing…
This model is a close relative of the IS-LM model; both stress the
interaction between the goods market and the money market. Price
levels are fixed, and both show short-run fluctuations in aggregate
income. The
Mundell-Fleming Model assumes an open economy in which trade and
finance are added; the IS-LM e assumes a closed economy.
LM*

Equilibrium
IS*
exchange rate
Income, output, Y
Equilibrium income
Chapter 3
Twelve
This model, often described as “the dominant policy paradigm for
studying open-economy monetary and fiscal policy,” makes one
important and extreme assumption: the economy being studied is a
small open economy and there is perfect capital mobility, meaning
that it can borrow or lend as much as it wants in world financial
markets, and therefore, the economy’s interest rate is controlled by
the world interest rate, mathematically denoted as r = r*.

One key lesson about this model is that the behavior of an economy
depends on the exchange rate regime it adopts—floating or fixed.

This model will help answer the question of which exchange rate
regime should a nation adopt?
Chapter 4
Twelve
Under a system of floating exchange rates, the exchange rate is set
by market forces and is allowed to fluctuate in response to changing
economic conditions.

The exchange rate e, adjusts to achieve simultaneous equilibrium in

the goods market and the money market. When something changes
that equilibrium, the exchange rate is allowed to adjust to a new
rate.

Chapter 5
Twelve
 The Small Open Economy Under Floating Exchange Rates
Let’s start with two equations (notice the asterisk next to IS and LM to
remind us that the equations hold the interest rate constant):
IS*: Y = C(Y-T) + I(r*) + G + NX(e) LM*: M/P = L (r*,Y)

Assumption 1:
The domestic interest rate is equal to the world interest rate (r = r*).
Assumption 2:
The price level is exogenously fixed since the model is used to analyze
the short run (P). This implies that the nominal exchange rate is
proportional to the real exchange rate.
Assumption 3:
The money supply is also set exogenously by the central bank (M).
Assumption 4:
Our LM* curve will be vertical because the exchange rate does not enter
Chapter 6
into our
TwelveLM* equation.
The IS* curve slopes downward because a higher exchange rate
reduces net exports (since a currency appreciation makes domestic
goods more expensive to foreigners), which in turn, lowers
aggregate income.
Exchange rate, e

IS*
Chapter Income, output, Y 7
Twelve
 An increase in the exchange (b)

Expenditure, E
rate, lowers net exports, Y=E
which shifts planned Planned expenditure,
expenditure downward and E = C + I + G + NX
lowers income. The IS*
curve summarizes these
changes in the goods market
equilibrium. Income, output, Y
(a) (c)
Exchange rate, e,

Exchange rate, e

NX(e) IS*
Chapter 8
Twelve Net exports, NX Income, output, Y
 Interest rate, r
LM

r = r*
The LM curve and
the world interest
rate together determine
Income, output, Y
the level of income.
The LM* curve is
LM*
Exchange rate, e
vertical because the
exchange rate does
not enter into the LM*
equation.
Recall the LM* equation is:
M/P = L (r*,Y)
Chapter 9
Twelve Income, output, Y
 e LM* LM*'
e LM*
+G, or –T  + M 
+e, no Y -e, +Y

IS*'
IS*
Income, output, Y
When income rises in a small open economy, due to
the fiscal expansion, the interest rate tries to rise but
capital inflows from abroad put downward pressure
on the interest rate. This inflow causes an increase in
the demand for the currency pushing up its value
and thus making domestic goods more expensive
Chapter (causing a –NX). The –NX offsets
to foreigners
the expansionary
Twelve fiscal policy and the effect on Y.
IS*
Income, output, Y
When the increase in the money supply puts downward
pressure on the domestic interest rate, capital flows out
as investors seek a higher return elsewhere. The capital
outflow prevents the interest rate from falling. The
outflow also causes the exchange rate to depreciate,
making domestic goods less expensive relative to
foreign goods, and stimulates NX. Hence, monetary
10
policy influences the e rather than r.
 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 at a predetermined price to keep the exchange
rate at its announced level. Fixed exchange rates require a commitment
of a 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.

Most recently, China fixed the value of its currency against the U.S.
dollar, which has resulted in a lot of tension between the two nations.

It is important to realize that this exchange-rate system fixes the

nominal exchange rate. Whether it fixes the real exchange rate depends
on the time horizon.
Chapter 11
Twelve
 The Mundell-Fleming Model
Under Fixed Exchange Rates

+G, or –T + Y +  no Y

e LM*
e LM* LM*'

IS*' IS*
IS*
Income, output, Y Income, output, Y
A fiscal expansion shifts IS* to the right. To maintain If the Fed tried to increase the money supply by
the fixed exchange rate, the Fed must increase the buying bonds from the public, that would put down-
money supply, thus increasing LM* to the right. ward pressure on the interest rate. Arbitragers respond
Unlike the case with flexible exchange rates, there is no by selling the domestic currency to the central bank,
crowding out effect on NX due to a higher exchange causing the money supply and the LM curve
Chapter rate. to contract to their initial positions. 12
Twelve
 Fixed vs.
Exchange Rate Conclusions
Fixed Exchange Rates Floating Exchange Rates
• Fiscal Policy is Powerful. • Fiscal Policy is Powerless.
• Monetary Policy is Powerless. • Monetary Policy is Powerful.
Hint: (“Fixed” and “Fiscal” sound alike). Hint: (Think of “floating” money.)

The Mundell-Fleming model shows that fiscal policy does not influence
aggregate income under floating exchange rates. A fiscal expansion
causes the currency to appreciate, reducing net exports and offsetting
the usual expansionary impact on aggregate demand.

The Mundell-Fleming model shows that monetary policy does not

influence aggregate income under fixed exchange rates. Any attempt
to expand the money supply is futile, because the money supply
mustChapter
adjust to ensure that the exchange rate stays at its announced13level.
Twelve
 Policy in the Mundell-Fleming Model:
A Summary

The Mundell-Fleming model shows that the effect of almost any

economic policy on a small open economy depends on whether the
exchange rate is floating or fixed.

The Mundell-Fleming model shows that the power of monetary and

fiscal policy to influence aggregate demand depends on the exchange
rate regime.

Chapter 14
Twelve
A country with fixed exchange rates can, however, conduct
a type of monetary policy by deciding to change the level at
which the exchange rate is fixed.

A reduction in the official value of the currency is called a

devaluation, and an increase in the value is called a revaluation.

Chapter 15
Twelve
 What if the domestic
interest rate were above
the world interest rate?

The higher return will attract funds from the rest of the world,
driving the domestic interest rate back down. And, if the
domestic interest rate were below the world interest rate, r*,
domestic residents would lend abroad to earn a higher return,
driving the domestic interest rate back up. In the end, the
domestic interest rate would equal the world interest rate.
Chapter 16
Twelve
Why doesn’t this logic always apply? There are two reasons why interest
rates differ across countries:

1) Country Risk: when investors buy U.S. government bonds, or make

loans to U.S. corporations, they are fairly confident that they will be
repaid with interest. By contrast, in some less developed countries, it
is plausible to fear that political upheaval may lead to a default on loan
repayments. Borrowers in such countries often have to pay higher
interest rates to compensate lenders for this risk.

2) Exchange Rate Expectations: suppose that people expect the French

franc to fall in value relative to the U.S. dollar. Then loans made in francs
will be repaid in a less valuable currency than loans made in dollars. To
compensate for the expected fall in the French currency, the interest rate
in France
Chapter will be higher than the interest rate in the United States. 17
Twelve
 Differentials in the Mundell-Fleming Model
To incorporate interest-rate differentials into the Mundell-Fleming
model, we assume that the interest rate in our small open economy
is determined by the world interest rate plus a risk premium 
r = r* + 
The risk premium is determined by the perceived political risk of
making loans in a country and the expected change in the real interest
rate. We’ll take the risk premium  as exogenously determined.
IS*: Y = C(Y-T) + I(r* + ) + G + NX(e)
LM*: M/P = L (r* + ,Y)
For any given fiscal policy, monetary policy, price level, and risk
premium, these two equations determine the level of income and
exchange rate that equilibrate the goods market and the money market.

Chapter 18
Twelve
Now suppose that political turmoil causes the country’s risk premium 
to rise. The most direct effect is that the domestic interest rate r rises.
The higher interest rate has two effects:
1) IS* curve shifts to the left, because the higher interest rate reduces
investment.
2) LM* shifts to the right, because the higher interest rate reduces the
demand for money, and this allows a higher level of income for any
given money supply.
These two shifts cause income to rise and thus push down the equilibrium
exchange rate on world markets.
The important implication: expectations of the exchange rate are partially
self-fulfilling. For example, suppose that people come to believe that the
French franc will not be valuable in the future. Investors will place a
larger risk premium on French assets:  will rise in France. This
expectation will drive up French interest rates and will drive down the
value of the French franc. Thus, the expectation that a currency will lose
value in the future causes it to lose value today. The next slide will
Chapter 19
demonstrate
Twelve the mechanics.
 An Increase in the Risk Premium
Is this really is where
e LM* LM*'
the economy ends
up? In the next slide,
we’ll see that
increases in country
risk are undesirable.
IS*
IS*'
Income, output, Y

An increase in the risk premium associated with a country drives up

its interest rate. Because the higher interest rate reduces investment,
the IS* curve shifts to the left. Because it also reduces money
demand, the LM* curve shifts to the right. Income rises, and the
exchange rate depreciates.
Chapter 20
Twelve
 There are three reasons why, in practice, such a boom in income
does not occur. First, the central bank might want to avoid the large
depreciation of the domestic currency and therefore, may respond
by decreasing the money supply M. Second, the depreciation of the
domestic currency may suddenly increase the price of domestic goods,
causing an increase in the overall price level P. Third, when some event
increase the country risk premium , residents of the country might
respond to the same event by increasing their demand for money (for
any given income and interest rate), because money is often the
safest asset available. All three of these changes would tend to shift
the LM* curve toward the left, which mitigates the fall in the exchange
rate but also tends to depress income.

Chapter 21
Twelve
 1) Exchange-rate volatility
creates uncertainty and
1) Allows monetary policy to be used
makes trade more difficult.
for other purposes such as stabilizing
2) Tempers overuse of
employment or prices.
monetary authority.

1) Monetary policy is committed

1) More speculation and to the single goal of maintaining
volatility expected. the announced level.
2) May lead to greater volatility in
income and employment.
Chapter 22
Twelve
A speculative attack is a case where a change in investors’ perceptions
makes a fixed rate untenable.

To avoid these kinds of attacks, some economists suggest the use of a

currency board, an arrangement by which the central bank holds
enough foreign currency to back each unit of the domestic currency.

The next for a nation is to consider dollarization, a plan in which

the domestic currency is abandoned and the U.S. dollar is used instead.

Chapter 23
Twelve
 It is impossible for a nation to have free capital flows, a fixed
exchange rate, and independent monetary policy.
Free capital flows

Option 1: Option 2:
United States Hong Kong

Independent Fixed
Monetary Exchange
Policy Option 3: Rates
Chapter
China 24
Twelve
 China’s Currency Situation
By January 2009, the exchange rate had moved to 6.84 yuan
per dollar– a 21% appreciation of the yuan. Despite this large
change in the exchange rate, China’s critics continued to complain
about that nation’s intervention in foreign-exchange markets. In
January 2009, the new Treasury Secretary Timothy Geithner said,
“President Obama– backed by the conclusions of a broad range of
economists—believes that China is manipulating its currency. So,
President Obama had pledged to use aggressively all diplomatic
avenues open to him to seek change in China’s currency practices.
Currently, China no longer uses a completely fixed exchange rate.
Chapter 25
Twelve
Recall the two equations of the Mundell-Fleming model:
IS*: Y=C(Y-T) + I(r*) + G + NX(e) e LM* LM*'
LM*: M/P=L (r*,Y)

When the price level falls, the LM*

curve shifts to the right. The IS*
equilibrium level of income rises. Income, output,Y
P
The second graph displays the
negative relationship between P and
Y, which is summarized by the
aggregate demand curve.
AD
Chapter 26
Twelve Income, output,Y
 Real LM* LM*'
Point K in both panels exchange
shows the equilibrium rate
under the Keynesian e1 K
assumption that prices are e2 C
fixed at P1. Point C in both IS*
diagrams shows the equilibrium Income, output,Y
P
under the classical assumption
that the price level adjusts to
maintain income at its natural level K
P1 SRAS1
Y. SRAS2
P2
C AD
Chapter 27
Twelve Income, output,Y
 Mundell-Fleming Model
Floating exchange rates
Fixed exchange rates
Devaluation
Revaluation
The Impossible Trinity

Chapter 28
Twelve