Chapter 12: Aggregate Demand in Open Economy

Chapter 12: Aggregate Demand in Open Economy

The Mundell-Fleming Model

Assumption– Small open economy

– Free capital mobility (r = r*)

– Flexible or fixed foreign exchange rate regime

Flexible Exchange RateThe IS curve:

Y = C(Y – T) + I(r*) + G + NX(e)

Where e = nominal exchange rate that varies according to its demand and supply

An increases in e make imports less expensive to domestic consumer and exports more expensive to foreign consumer, hence reducing NX

Derivation of IS Curve

Initial equilibrium: Y = E1 with Y1 and e1

Let e increase, NX decreases and E1 falls to E2

New equilibrium: E2 = Y with Y2<Y1 and e2>e1

Line AB is the IS

Derivation of IS Curve

Y2 Y1 Y2 Y1

e1

e2

Expenditures Exchange Rate

Income Income

E1

E2

Y = E

IS(e)

BA

Derivation of LM Curve

M/P = L(r*, Y)

LM is independent of the exchange rate

Shift of LM won’t alter the interest rate because r = r*

Derivation of LM Curve

LM(r*)

r

Y

Interest Rate

Income

r = r*

Income

Exchange Rate

LM(e)

Y

IS-LM Model

LM

IS

e

Y

Exchange Rate

Income

Aggregate Equilibrium

Fiscal Policy

Initial equilibrium: IS1 = LM1 with Y1 and e1

As G increase, IS increases. New equilibrium: IS2 = LM1 causing Y and e to increase

The rise in e makes NX and Y to fall, offsetting the initial increase in income

Fiscal Policy

LM

IS1

e1

Y

Exchange Rate

Income

IS2

e2

Fiscal policy is ineffective in causing economic growth

Monetary Policy

Initial equilibrium: IS1 = LM1 with Y1 and e1

As M increase, LM increases. New equilibrium: IS1 = LM2 causing Y to increase and e to fall

The fall in e makes NX and Y to increase

Monetary Policy

LM1

IS1

e1

Y1

Exchange Rate

Income

LM2

e2

Monetary policy is effective in causing economic growth

Y2

Trade Protectionism

Initial equilibrium: IS1 = LM1 with Y1 and e1

Let imports decrease, NX and IS decline. New equilibrium: IS2 = LM1 causing Y and e to increase

The rise in e makes NX and Y to decrease

Trade Protectionism

LM

IS1

e1

Y

Exchange Rate

Income

IS2

e2

Trade protectionism is ineffective in causing economic growth

Fixed Exchange Rate

Assume: market rate > fixed rate

Arbitrageur buys from the market and sells to the central bank at the fixed rate and make profits

Money supply and LM increase, causing Y to increase. The market rate falls to the fixed rate

Fixed Exchange Rate

LM1

IS1

ef

Y1

Exchange Rate

Income

LM2

em

Y2

Fixed Exchange Rate

Assume: market rate < fixed rate

Arbitrageur buys from the central bank market and sells to the market at the fixed rate to make profits

Money supply and LM decrease, causing Y to fall. The market rate rises to the fixed rate

Fixed Exchange Rate

LM2

IS1

em

Y2

Exchange Rate

Income

LM1

ef

Y1

Fiscal PolicyInitial equilibrium: IS1 = LM1 with Y1 and e1

As G increase, IS increases, causing e to rise above the fixed rate.

Exchange rate arbitrage causes Ms and LM to increase, e falls to the fixed rate

New equilibrium: IS2 = LM2 causing Y to increase

Fixed Exchange Rate

LM1

IS1

em

Y1

Exchange Rate

Income

LM2

ef

Y2

IS2

Fiscal policy is effective

in causing economic growth

Monetary PolicyInitial equilibrium: IS1 = LM1 with Y1 and e1

Let Ms increase, LM increases, causing e to decrease below the fixed rate.

Exchange rate arbitrage causes Ms and LM to decrease, e rises to the fixed rate

New equilibrium: IS1 = LM1 causing no increase in Y

Monetary Policy

LM1

IS1

em

Y2

Exchange Rate

Income

LM2

ef

Y1

Monetary policy is ineffective in causing economic growth

Trade Protectionism

Initial equilibrium: IS1 = LM1 with Y1 and e1

As imports increase NX and IS increase, causing e to increase above the fixed rate

Exchange rate arbitrage causes Ms and LM to increase, lowering e to the fixed rate

New equilibrium: IS2 = LM2 causing Y to increase

Trade Protectionism

LM1

IS1

em

Y1

Exchange Rate

Income

LM2

ef

Y2

IS2

Trade protectionism is effective

in causing economic growth

Policy Effectiveness

Policy Flexible Exchange Rate

Fixed Exchange Rate

Fiscal

Monetary

Trade Protectionism

Ineffective

Effective

Ineffective

Effective

Ineffective

Effective

Effect of Political RiskDefine r = r*+ Θ where Θ is the risk premium for political instability

IS curve: Y = C(Y-T) + I(r*+ Θ) + G + NX(e)

LM curve: (M/P) = L(r*+ Θ, Y)

Let Θ increase, causing LM to increase and e to decrease

Effect of Political Risk

An increases in r reduces investment and the IS, but exchange rate depreciation increases NX

Reasons for lack of economic growth – Reaction of the central bank to reduce LM in order to offset

depreciation

– Depreciation causes import prices to rise, reducing NX and Y

– People increase the money demand, reducing LM

Effect of Political Risk

LM1

IS2

e1

Y1

Exchange Rate

Income

LM2

e2

Y2

IS1