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MACROECONOMICSMACROECONOMICS

Chapter 12Chapter 12

The Open Economy The Open Economy Revisited: The Mundell-Revisited: The Mundell-Fleming Model and the Fleming Model and the Exchange Rate RegimeExchange Rate Regime

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Robert MundellRobert Mundell

http://www.columbia.edu/~ram15/

http://www.columbia.edu/~ram15/nobelLecture.html

Home Page:

1999 Nobel Lecture:

The Works of R.A. Mundell: http://www.robertmundell.net/

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The IS* CurveThe IS* Curve

€/$

NX depends on real exchange ratebut if prices are sticky in the short run both countries will have fixed prices and NX will depend on nominal exchange rate.

Y=C(Y-T)+I(r*)+G+NX(e)+ - -

€/$

The derivation of IS* curve from Keynesian Cross and behavior of NX.

Observe that IS* has e instead of r on the vertical axis.

Small EconomiesSmall Economies

Smallness means cannot affect price; in Smallness means cannot affect price; in this case, interest rate: r*.this case, interest rate: r*.

Perfect mobility implies any deviation from Perfect mobility implies any deviation from the r* will instigate capital flows to bring the r* will instigate capital flows to bring r=r*.r=r*. r>r* => capital inflow => r down.r>r* => capital inflow => r down. r<r* => capital outflow => r up.r<r* => capital outflow => r up.

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The LM* CurveThe LM* Curve

M/P

r

The LM in the upper diagram is derived the regular way: higher Y shifts money demand up and with fixed money supply, r has to go up.

But higher r attracts capital inflow and lowers r back to r*. Capital inflow forces the appreciation of e and lowering of NX, eliminating the reason of Y increase. But if money supply were to increase, then higher Y can be sustained with constant r.

More on LM and LM*More on LM and LM*

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r

M/P Y

r If r=r*, then the interest rate is determined outside of the country and given as a constant. That means we will be at a point on the LM curve. Y will be the level corresponding to r*. In the new LM* where the vertical axis is e, money supply will determine the level of Y but it can come at any e: vertical LM*.

r

Y

LM

r*

e

Y

LM*

IS

IS*

r* determines Y. If r>r* at the intersection of IS and LM, capital inflow matches –NX. The drop in NX shifts IS but it is a movementalong the IS*. Currency appreciates.

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Equilibrium Y and e Equilibrium Y and e Under Mundell-FlemingUnder Mundell-Fleming

€/$

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Fiscal Expansion with Floating FXFiscal Expansion with Floating FXBecause money supply is fixed, and income has to match r* on LM, the expansionary effect of fiscal policy is matched by the contractionary effect of lower NX as capital inflow appreciates the currency.

Refer to slide #6 to see what is happening to IS and LM.

Fiscal Expansion Under Fiscal Expansion Under Floating FXFloating FX

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IS increase raises the interest rate.Capital inflow into the country.Currency appreciates.NX starts to fall until interest rate falls back to r*.

e

Y

r

Y

LM*

LM

As the IS shifts back because of drop of NX. But as long as r>r* currency still appreciates. When IS had shifted all the way to the original IS, e had risen all the way to the new intersection of IS* and LM*.

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Monetary Expansion Monetary Expansion Under Floating FXUnder Floating FX

r*

LMLM’

eY

Y

LM* LM*’

When r=r* more money supply in the system will not affect the real rate of interest.

So Investments will not change. What will make IS* reach a higher Y? How would you show the effect on IS and LM?

Monetary Expansion with Monetary Expansion with Floating FXFloating FX

1111

r

Y

e

Y

IS

LM

LM*

IS*

Money supply increase will depreciate the currency and by increasing NX raise the equilibrium Y.

LM shift lowers the interest rate and causes capital outflow. This results inan increase of NX. In the IS-LM diagram, more NX makes IS increase until r=r*.

1212

Trade Restriction Under Floating Exchange Rates

Trade restriction is a quota on imports or tariff on imports. If the demand for imports is reduced via trade restriction, NX will shift to the right.

What happens to Y, r, e, I, C, NX as a result of the trade restriction that was put to reduce the trade deficit (or increase the trade surplus)?

Trade Restriction Under Trade Restriction Under Floating FXFloating FX

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e

r

Y

Y

Import tariff or quota will restrict imports. NXgoes up and IS shifts right in both ISLM and IS*LM*.

Higher r attracts capital inflow and appreciates the domestic currency. NX falls.

IS*

LM*

LM

IS

1414

Fixed Exchange Rate Governs the Money Supply

Equilibrium e is higher than what the Central Bank wants it to be: $1=€1.50 but the Fed wants it to be $1= €1. The Fed enters the FX market and keeps on buying euros with dollars. Money supply increases until the fixed exchange rate is reached. Of course, higher demand for euros appreciates € and depreciates $.

How easy is this for CB?

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Fixed Exchange Rate Governs the Money Supply

If the Central Bank wants to raise the value of the currency in the FX market, it will keep on buying the domestic currency with foreign reserves it has. CB is withdrawing money from the economy.

If the long run e is the equilibrium e, what do you think will happen in the long run?

How easy is this for CB?

1616

Fiscal Expansion Under Fixed Exchange Rates

Government spending increases: at each and every level of e IS* is larger. IS* shifts right. But the new IS* forces e upwards. The Central Bank, to keep the FX fixed, has to buy foreign currency with the domestic currency. The money supply increases and LM* shifts right. Y increases but e remains constant.

This result holds for any change that shifts IS* to the right.

Fiscal Expansion Under Fiscal Expansion Under Fixed FXFixed FX

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r

e

Y

Y

LM

IS

LM*

IS*

Fiscal expansion raises the interest rate and appreciates the currency. However, we are under fixed exchange rate regime.

In order to bring the currency back, CB will have to put more currency in the FX market by buying foreign currency.

Fixed exchange rates require fixed interest rates. To keep both e and r constant, the Fed increases the money supply.

1818

Monetary Expansion Under Fixed Exchange Rates

Increasing money supply shifts LM* to the right. Exchange rate (e) tends to fall to 2. To keep e constant, CB buys domestic currency with foreign reserves it has. The value of domestic currency in the FX market goes back to the fixed e. In the process, the CB has removed domestic currency from circulation: money supply down.

1

2

Monetary Expansion with Monetary Expansion with Fixed FXFixed FX

1919

r

Y

Y

e

LM

IS

LM*

IS*

Monetary expansion results in lower r and currency depreciation. To bring the FX market into the fixed exchange rate, the central bank has to sell foreign currency and buy domestic currency. As the central bank withdraws money from the economy, interest rate rises back to the original level, too.

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Trade Restriction Under Fixed Exchange Rates

Can you explain why LM* is shifting to the right?

Red IS* and Blue LM* intersects at a higher e than the fixed e the CB wants. CB buys foreign currency with the domestic currency. The amount of currency outstanding increases: money supply up.

Same as slide # 17.

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During a severe recession (depression) what policy action would be effective to improve the GDP under floating and fixed FX regimes?

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Monetary Policy is Ineffective Monetary Policy is Ineffective Under Fixed FX RulesUnder Fixed FX Rules

How can a government make monetary How can a government make monetary policy effective under policy effective under fixed exchange fixed exchange rate rate regime?regime?By By devaluingdevaluing the currency and benefiting from the currency and benefiting from

the increase of NX during recessions.the increase of NX during recessions.Northern European countries during Great Northern European countries during Great

DepressionDepression

By By revaluingrevaluing the currency and slowing the the currency and slowing the economy during inflationary booms.economy during inflationary booms.China??China??

When r Doesn’t Equal r*When r Doesn’t Equal r*

When risk, uncertainty in one country is When risk, uncertainty in one country is higher than the rest, this country will be in higher than the rest, this country will be in equilibrium at a higher interest rate than equilibrium at a higher interest rate than the rest of the world.the rest of the world.

When a country’s currency is expected to When a country’s currency is expected to appreciate, the only way capital flow will appreciate, the only way capital flow will stop is if the interest rate is lower than the stop is if the interest rate is lower than the rest of the world.rest of the world.

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2424

Increase in the Country Risk Premium

As the country risk premium rises, the local real interest rate becomes higher than the world interest rate.

Higher interest rate will curb some of the investments, and at each and every e, IS* will shift to the left.

Higher interest rate lowers the demand for money and forces LM* to shift right. MAYBE!!

Increase in the Country Risk Premium

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e

Yr

Y

LM*

IS*

LM

IS

The top diagram is the same as previous slide. Higher r reduces IS but increases LM. In the bottom slide, this should show as a disequilibrium, since r is on the vertical axis.

But, wait. Top diagram says e has come down quite a bit: domestic currency has depreciated a lot. This should stimulate NX. It was a movement along the IS* line at the top diagram but it will be a shift to the right of IS line at the bottom.

2626

Increase in the Country Risk Premium

2626

e

Yr

Y

LM*

IS*

LM

IS

If risk premium is higher because of increased uncertainty, instead of lowering money demand, people might hoard cash. This would shift LM* left.

But e has come down, so NX must have increased. This will shift IS to the right in the bottom diagram.

Likewise, if CB doesn’t want large depreciation, it might shift LM* left.

2727

The Impossible TrinityWhen a country chooses one of the sides of the triangle, it gives up the opposing corner. Is it better to live with exchange rate volatility, or to give up independent monetary policy, or to not participate in the world financial markets?

2828

Mundell–Fleming as a Theory of Aggregate Demand

Up until now we dealt with e because in the short run we can take price levels in both countries as sticky. In reality, NX depends on the real exchange rate.

When the price level (P) falls, the real money balances increase, shifting LM* right. The lower P means the real exchange rate has fallen as well, increasing NX along the IS* curve.

M/P

ε=(£/$)(P/P*)If we want to derive the AD from the M-F model, we have to change the vertical axis of IS*LM* to real exchange rate.

r

2929

SR (Blue) and LR (Red) Equilibria in a Small Open Economy

The short run equilibrium takes place at a recessionary level. High unemployment and idle capacity forces prices to fall. Lower input prices increase employment of labor and capital until the economy is fully employed.

Observe that the vertical axis in IS*-LM* is real exchange rate. As the domestic price level falls, so does the real exchange rate [(€/$)(PUS/PEU). As a result, NX increases along with I because lower P means lower interest rate (Fisher effect).