This document is a chapter from a textbook on the open economy Mundell-Fleming model and exchange rate regimes. It contains 25 slides that cover topics including: the balance of payments and capital flows; the Mundell-Fleming model with IS-LM curves for a small open economy; the effects of fiscal and monetary policy under fixed and floating exchange rates; and the causes and effects of interest rate differentials in the model. The chapter provides analysis of how different policies impact output and the exchange rate under different exchange rate systems.
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This document is a chapter from a textbook on the open economy Mundell-Fleming model and exchange rate regimes. It contains 25 slides that cover topics including: the balance of payments and capital flows; the Mundell-Fleming model with IS-LM curves for a small open economy; the effects of fiscal and monetary policy under fixed and floating exchange rates; and the causes and effects of interest rate differentials in the model. The chapter provides analysis of how different policies impact output and the exchange rate under different exchange rate systems.
This document is a chapter from a textbook on the open economy Mundell-Fleming model and exchange rate regimes. It contains 25 slides that cover topics including: the balance of payments and capital flows; the Mundell-Fleming model with IS-LM curves for a small open economy; the effects of fiscal and monetary policy under fixed and floating exchange rates; and the causes and effects of interest rate differentials in the model. The chapter provides analysis of how different policies impact output and the exchange rate under different exchange rate systems.
Copyright:
Attribution Non-Commercial (BY-NC)
Available Formats
Download as PPT, PDF, TXT or read online from Scribd
This document is a chapter from a textbook on the open economy Mundell-Fleming model and exchange rate regimes. It contains 25 slides that cover topics including: the balance of payments and capital flows; the Mundell-Fleming model with IS-LM curves for a small open economy; the effects of fiscal and monetary policy under fixed and floating exchange rates; and the causes and effects of interest rate differentials in the model. The chapter provides analysis of how different policies impact output and the exchange rate under different exchange rate systems.
Copyright:
Attribution Non-Commercial (BY-NC)
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Download as PPT, PDF, TXT or read online from Scribd
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C H A P T E R
The Open Economy I :
the Mundell-Fleming Model and the Exchange-Rate Regime by Dr. Ganesh Kawadia slide 1 In this chapter, we will learn the Mundell-Fleming model (IS-LM for the small open economy) causes and effects of interest rate differentials arguments for fixed vs. floating exchange rates how to derive the aggregate demand curve for a small open economy slide 2 The Balance of Payments Balance of payments: the record of the transactions of the residents of a country with the rest of the world Two main accounts: Current account: records trade in goods and services, as well as transfer payments Capital account: records purchases and sales of assets, such as stocks, bonds, and land
Any transaction that gives rise to a payment by a countrys residents is a deficit item in that countrys balance of payments. slide 3 The Balance of Payments The central point of international payments is very simple: Individuals and firms have to pay for what they buy abroad If a person spends more than her income, her deficit needs to be financed by selling assets or by borrowing Similarly, if a country runs a deficit in its current account the deficit needs to be financed by selling assets or by borrowing abroad
Balance: There is no change of official reserves! Otherwise, BP=Current account + Capital account = 0 (1) Current account surplus+ Capital account surplus = increase in official exchange reserves (BP Surplus) Net private capital inflow slide 4 The China Balance of payments slide 5 The Balance of Payments and Capital Flows Assume a home country faces a given price of imports, export demand, and world interest rate, i f
Additionally, capital flows into the home country when the interest rate is above the world rate Balance of payments surplus is: where CF is the capital account surplus The trade balance is a function of domestic and foreign income and the real exchange rate
The capital account depends on the interest differential With perfect capital mobility, BP will balance only when ) ( ) , , ( f f i i CF R Y Y NX BP + = * f i i i = = f eP R P = slide 6 The Mundell-Fleming model Key assumption: Small open economy with perfect capital mobility. i = i* Goods market equilibrium the IS* curve: where e = nominal exchange rate = foreign currency per unit domestic currency = + + + ( ) ( ) ( ) * Y C YD I i G NX e slide 7 The IS* curve: Goods market eqm The IS* curve is drawn for a given value of i*. Intuition for the slope: Y e IS* e NX Y + | | = + + + ( ) ( ) ( ) * Y C YD I i G NX e slide 8 The LM* curve: Money market eqm The LM* curve is drawn for a given value of i*. is vertical because: given i*, there is only one value of Y that equates money demand with supply, regardless of e. Y e LM* = ( , ) * M P L i Y slide 9 Equilibrium in the Mundell-Fleming model Y e LM* IS* equilibrium exchange rate equilibrium level of income = ( , ) * M P L i Y = + + + ( ) ( ) ( ) * Y C YD I i G NX e slide 10 Floating & fixed exchange rates In contrast, under fixed exchange rates, the central bank trades domestic for foreign currency at a predetermined price. In a system of floating exchange rates, e is allowed to fluctuate in response to changing economic conditions. Next, policy analysis First, in a fixed exchange rate system Then, in a floating exchange rate system slide 11 Fixed exchange rates Under fixed exchange rates, the central bank stands ready to buy or sell the domestic currency for foreign currency at a predetermined rate. In the Mundell-Fleming model, the central bank shifts the LM* curve as required to keep e at its preannounced rate. This system fixes the nominal exchange rate. In the long run, when prices are flexible, the real exchange rate can move even if the nominal rate is fixed. slide 12 Monetary policy under fixed exchange rates 2 * LM An increase in M would shift LM* right and reduce e. Y e Y 1
1 * LM 1 * IS e 1
To prevent the fall in e, the central bank must buy domestic currency, which reduces M and shifts LM* back left. Results: Ae = 0, AY = 0
Under fixed rates, monetary policy cannot be used to affect output. 2 * LM slide 13 Monetary Expansion under fixed ER slide 14 Fiscal policy under fixed exchange rates Y e Y 1
e 1
1 * LM 1 * IS 2 * IS Under floating rates, a fiscal expansion would raise e. Results: Ae = 0, AY > 0 Y 2
2 * LM To keep e from rising, the central bank must sell domestic currency, which increases M and shifts LM* right. Under fixed rates, fiscal policy is very effective at changing output. slide 15
IS IS LM LM BP E E E Y 0 Y Y i f
i Fiscal policy under fixed ER slide 16 Trade policy under fixed exchange rates Y e Y 1
e 1
1 * LM 1 * IS 2 * IS A restriction on imports puts upward pressure on e. Results: Ae = 0, AY > 0 Y 2
2 * LM To keep e from rising, the central bank must sell domestic currency, which increases M and shifts LM* right. Under fixed rates, import restrictions increase Y and NX.
But, these gains come at the expense of other countries: the policy merely shifts demand from foreign to domestic goods. slide 17 Fiscal policy under floating exchange rates Y e Y 1
e 1
1 * LM 1 * IS 2 * IS e 2
At any given value of e, a fiscal expansion increases Y, shifting IS* to the right. Results: Ae > 0, AY = 0 = + + + ( ) ( ) ( ) * Y C YD I i G NX e = ( *, ) M P L i Y slide 18 Fiscal policy under floating exchange rates slide 19 Lessons about fiscal policy In a small open economy with perfect capital mobility, fiscal policy cannot affect real GDP. Crowding out closed economy: Fiscal policy crowds out investment by causing the interest rate to rise. small open economy: Fiscal policy crowds out net exports by causing the exchange rate to appreciate. slide 20 Monetary policy under floating exchange rates Y e e 1
Y 1
1 * LM 1 * IS Y 2
2 * LM e 2
An increase in M shifts LM* right because Y must rise to restore eqm in the money market. Results: Ae < 0, AY > 0 = ( , ) * M P L i Y = + + + ( ) ) ( ) ( * Y C YD I i G NX e slide 21 Monetary policy under floating exchange rates slide 22 Lessons about monetary policy Monetary policy affects output by affecting the components of aggregate demand: closed economy: |M +i |I |Y small open economy: |M +e |NX |Y Expansionary mon. policy does not raise world agg. demand, it merely shifts demand from foreign to domestic products. So, the increases in domestic income and employment are at the expense of losses abroad. slide 23 Trade policy under floating exchange rates Y e e 1
Y 1
1 * LM 1 * IS 2 * IS e 2
At any given value of e, a tariff or quota reduces imports, increases NX, and shifts IS* to the right. Results: Ae > 0, AY = 0 = + + + ( ) ( ) ( ) * Y C YD I i G NX e = ( , ) * M P L i Y slide 24 Lessons about trade policy Import restrictions cannot reduce a trade deficit. Even though NX is unchanged, there is less trade: the trade restriction reduces imports. the exchange rate appreciation reduces exports. Less trade means fewer gains from trade. slide 25 Lessons about trade policy, cont. Import restrictions on specific products save jobs in the domestic industries that produce those products, but destroy jobs in export-producing sectors. Hence, import restrictions fail to increase total employment. Also, import restrictions create sectoral shifts, which cause frictional unemployment. slide 26 Summary of policy effects in the Mundell-Fleming model type of exchange rate regime: floating fixed impact on: Policy Y e NX Y e NX fiscal expansion 0 | + | 0 0 mon. expansion | + | 0 0 0 import restriction 0 | 0 | 0 | C H A P T E R The Open Economy II : the Mundell-Fleming Model and the Exchange-Rate Regime by Ganesh Kawadia 12 slide 28 Interest-rate differentials Two reasons why i may differ from i* country risk: The risk that the countrys borrowers will default on their loan repayments because of political or economic turmoil. Lenders require a higher interest rate to compensate them for this risk. expected exchange rate changes: If a countrys exchange rate is expected to fall, then its borrowers must pay a higher interest rate to compensate lenders for the expected currency depreciation. slide 29 Differentials in the M-F model where u (Greek letter theta) is a risk premium, assumed exogenous. Substitute the expression for i into the IS* and LM* equations: = + * i i u u = + + + + ( ) ( ) ( ) * Y C YD I i G NX e u = + ( , ) * M P L i Y slide 30 The effects of an increase in u 2 * LM IS* shifts left, because |u |i +I Y e Y 1
e 1
1 * LM 1 * IS LM* shifts right, because |u |i +(M/P) d , so Y must rise to restore money market eqm. Results: Ae < 0, AY > 0 2 * IS e 2
Y 2
slide 31 The fall in e is intuitive: An increase in country risk or an expected depreciation makes holding the countrys currency less attractive. Note: an expected depreciation is a self-fulfilling prophecy. The increase in Y occurs because the boost in NX (from the depreciation) is greater than the fall in I (from the rise in r ). The effects of an increase in u slide 32 Why income might not rise The central bank may try to prevent the depreciation by reducing the money supply. The depreciation might boost the price of imports enough to increase the price level (which would reduce the real money supply). Consumers might respond to the increased risk by holding more money. Each of the above would shift LM* leftward. slide 33 Floating vs. fixed exchange rates Argument for floating rates: allows monetary policy to be used to pursue other goals (stable growth, low inflation). Arguments for fixed rates: avoids uncertainty and volatility, making international transactions easier. disciplines monetary policy to prevent excessive money growth & hyperinflation. slide 34 The Impossible Trinity A nation cannot have free capital flows, independent monetary policy, and a fixed exchange rate simultaneously. A nation must choose one side of this triangle and give up the opposite corner. Free capital flows Independent monetary policy Fixed exchange rate Option 1 (U.S.) Option 3 (China) Option 2 (Hong Kong) slide 35 CASE STUDY: The Chinese Currency Controversy 1995-2005: China fixed its exchange rate at 8.28 yuan per dollar, and restricted capital flows. Many observers believed that the yuan was significantly undervalued, as China was accumulating large dollar reserves. U.S. producers complained that Chinas cheap yuan gave Chinese producers an unfair advantage. President Bush asked China to let its currency float; Others in the U.S. wanted tariffs on Chinese goods. slide 36 CASE STUDY: The Chinese Currency Controversy Now China allows some flexibility of the exchange rate. Yuan has indeed appreciated. If China also allows greater capital mobility, Will Chinese citizens start moving their savings abroad? Is it possible that such capital outflows could cause the Yuan to depreciate rather than appreciate? slide 37 Mundell-Fleming and the AD curve So far in M-F model, P has been fixed. Next: to derive the AD curve, consider the impact of a change in P in the M-F model. We now write the M-F equations as: (Earlier in this chapter, P was fixed, so we could write NX as a function of e instead of c.) ( *) ( ) ( *) ( ) ( *) / ( *, ) IS Y C Y T I i G NX LM M P L i Y c = + + + = slide 38 Y 1 Y 2 Deriving the AD curve Y c Y P IS* LM*(P 1 ) LM*(P 2 ) AD P 1 P 2 Y 2 Y 1 c 2 c 1 Why AD curve has negative slope: |P LM shifts left |c +NX +Y +(M/P) slide 39 Large: Between small and closed Many countries including the U.S. are neither closed nor small open economies. A large open economy is between the polar cases of closed & small open. Consider a monetary expansion: Like in a closed economy, AM > 0 +i |I (though not as much) Like in a small open economy, AM > 0 +c |NX (though not as much)