Mankiw: Macroeconomics. Fourth Edition Chapter 12: Aggregate ...

Mankiw: Macroeconomics. Fourth Edition Chapter 12: Aggregate Demand in the Open Economy Page 1 I.

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The Mundell-Fleming Model. A. This is an open economy version of the IS-LM model. 1. The IS-LM model assumes a closed economy. 2. One of the lessons of the Mundell-Fleming model is that the behavior of an economy depends on the exchange rate system that it has adopted. a. The alternatives are (1) flexible exchange rates or (2) fixed exchange rates. The Mundell-Fleming Model A. It builds from components we have used in previous chapters. B. The Key Assumption: Small Open Economy with Perfect Capital Mobility 1. r = r* 2. How often do you read about the influence of the Federal Reserve on interest rates in the US. 3. However, with arbitrage it should have very little effect on the real, real interest rate. a. The real, real interest rate is my term for a domestic rate of interest after adjustment for inflation, taxes and risk. C. The Goods Market and the IS* Curve 1. IS*: Y=C (Y-T) +I(r) +G+ NX(e) a. e is the nominal exchange rate with the real exchange rate being equal to e *(P/P*) where P is domestic prices and P* is foreign prices. b. Since the M-F model assumes that prices are fixed, change in the real exchange rate are proportional to changes in the nominal exchange rate. c. Figure 12-1: The IS* Curve, p. 315. D. The Money Market and the LM* Curve 1. LM: M/P= L (r,Y) 2. Figure 12-2: The LM* Curve, p. 316. E. Putting the Pieces Together 1. According to the M-F Model, a small open economy with perfect capital mobility can be described by two equations: a. IS*: Y=C (Y-T) +I(r*) +G+ NX(e) b. LM*: M/P= L (r*,Y) 2. Figure 12-3: The Mundell-Fleming Model, p. 317. a. The LM* curve is vertical because the exchange rate does not enter into the LM* equation. b. The IS* curve slopes downward because a higher exchange rate lowers net exports and thus lowers aggregate income.

Mankiw: Macroeconomics. Fourth Edition Chapter 12: Aggregate Demand in the Open Economy Page 2 III.

The Small Open Economy Under Floating Exchange Rates. A. Remember: 1. Saving and Investment in a Small Open Economy (Figure 8-2 on Page 200.) 2. Net Exports and the Real Exchange Rate (Figure 8-7 on Page 208.) B. Floating exchange rates: The exchange rate is allowed to fluctuate freely in response to changing economic conditions. C. Fiscal Policy. 1. An increase in G has no effect on Y because the interest rate cannot rise. 2. Figure 12-4: A fiscal expansion under floating exchange rates, p. 319. D. Monetary policy. 1. An increase in M causes r to attempt to fall causing an outflow of capital and a reduction in the exchange rate that stimulates NX and, therefore, Y. 2. Figure 12-5: A monetary expansion under floating exchange rates, p. 319. 3. Case-study: Can World Financial Markets Usurp the Power of the Federal Reserve?, p. 320. E. Trade policy. 1. A restriction on imports causes the NX curve to shift up causing the exchange rate to increase, but having no effect on Y. 2. NX(e) = Y - C (Y-T) - I(r) - G 3. Figure 12-6: A trade restriction under floating exchange rates, p. 321.

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The Small Open Economy Under Fixed Exchange Rates. A. How a fixed-exchange-rate system works. 1. Figure 12-7: How a fixed exchange rate governs the money supply, p. 323. 2. Case-study: The international gold standard, p. 323. B. Fiscal policy. 1. Figure 12-8: A fiscal expansion under fixed exchange rates, p. 325. C. Monetary policy. 1. Figure 12-9: A monetary expansion under fixed exchange rates, p. 325. 2. Devaluation: A reduction in the value of the currency. 3. Revaluation: An increase in the value of the currency. 4. Case-study: Devaluation and the recovery from the Great Depression, p. 326. D. Trade policy. 1. NX = S - I 2. Figure 12-10: A trade restriction under fixed exchange rates, p. 313. 3. Policy in the Mundell-Fleming Model: A Summary

Mankiw: Macroeconomics. Fourth Edition Chapter 12: Aggregate Demand in the Open Economy Page 3 4. 5.

Table 12-1: The Mundell-Fleming model: Summary of policy effects, p. 328. To be more specific, the M-F model shows that the power of MP and FP to influence aggregate income depends on the exchange rate regime. a. Under floating exchange rates, only MP can affect income. b. Under fixed exchange rates, only FP can affect income.

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Interest Rate Differentials A. To this point, we have assumed: r = r*, but real rates do vary around the world. B. Country Risk and Expectations C. Differentials in the Mundell-Fleming Model 1. r = r* + è 2. Figure 12-11: An Increase in the Risk Premium, p. 330. 3. Case Study: International Financial Crisis: Mexico 1994-1995, p. 331. 4. Case Study: International Financial Crisis: Asia 1997- 1998, p. 332.

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Should Exchange Rates Be Floating or Fixed?. A. Case-study: Monetary Union in the United States and Europe, p. 335. 1. Exchange-rate union: Organization of countries in which the currencies fluctuate together.

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The Mundell-Fleming Model With a Changing Price Level. A. IS*: Y=C (Y-T) +I(r*) +G+ NX(å); with å = eP/P* B. LM*: M/P= L (r*,Y) C. An increase in P within the å/Y environment shifts the LM* curve to the left resulting in a decrease in Y. 1. Figure 12-12: Mundell-Fleming as a theory of aggregate demand, p. 337. D. An increase in M shifts the LM* and AD curve to the right, but AD > LRAS so P rises and the LM curve shifts back to the right. E. Figure 12-13: The short-run and long-run equilibria in a small open economy, p. 339.

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A Concluding Reminder.

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Summary.

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Appendix: A Short Run Model of the Large Open Economy A. You will not be tested on this appendix as all countries are essentially small open economies. B. Figure 12-14: A Short Run Model of a Large Open Economy, p. 344.

Mankiw: Macroeconomics. Fourth Edition Chapter 12: Aggregate Demand in the Open Economy Page 4 C. D.

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Fiscal Policy 1. Figure 12-15: A Fiscal Expansion in a Large Open Economy, p. 345. Monetary Policy 1. Figure 11-16: A Monetary Expansion in a Large Open Economy, p. 346. A Rule of Thumb 1. The large open economy is an average of the closed economy and the small open economy. a. To find how any policy will affect any variable, find the answer in the two extreme cases and take an average.