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International Economics
Unit 3Macroeconomic Policy in an Open
Economy. Mundell-Fleming model
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Previous conclusion
The ultimate effects of a devaluation are in large part dependent upon theeconomic policies that accompany the devaluation.
Economic objectives
- Internal Balance:- Price stability- Full employment
- External Balance:- Equilibrium in the BP
Economic policies
- Aggregate supply policies- Aggregate demand policies:
- Expenditure changing policies. Aim to influence the level of AD- Expenditure switching policies. Aim to influence the composition ofAD 2
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RER
O A
IB
E0
E1
Inflation
Unemployment
RER
O A
EB
E0
E1
Surplus
CA > 0
Deficit
CA < 0
Internal and external equilibrium: the SWAN diagram
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The Swan diagram
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Mundell-Fleming model (IS-LM-BP model)
Aim: Analyze the effectiveness of fiscal and monetary policy
Assumptions:- Domestic and foreign prices are constant- Unemployment- International capital mobility
Economic relationships (Equations).
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Exports and Government expenditure are considered to be autonomous
The goods market
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Derivation of the IS schedule
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The money market
Ms= D + R (φ =1)
D = Domestic asset (bond) holdings of the monetary authorities =Domestic creditR = Foreign asset holdings (Foreign exchange and any otherinternationally acceptable assets) of the monetary authorities,valued in domestic currency = International reserves
Mt = Mt(Y) Msp = Msp (r)
Md = Ms
Mt+Msp = Ms 8
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Derivation of the LM schedule
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The foreign sector
X is exogenous
K = K(r)
BP = CA + K = 0
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Derivation of the BP schedule
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Figure 4.5 Equilibrium of the model
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Monetary policy (Example of expansionary MP)
–The Central Bank purchases bonds from the public and injects newly created money. LM to the right–Prices of bonds go up–Interest rates go down–Investment, consumption and income increase–BOP goes into deficit or the domestic currency depreciates
Fiscal policy (Example of expansionary FP)
–G increases (The government pays for this increase by selling bonds) and this increases income. IS to the right–Price of bonds go down–Interest rates go up–Investment, consumption and income decrease–Final result on Y: increases but by less than the increase in G–The CA deteriorates and the K improves: BOP changes? Exchange rates?
As we will see, the exchange rate regime turns out to be crucial to the behaviour of the economy
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r
YY0O
r0
BP
IS
LM
LM’
Y’
A C
B
+ –r
YY0O
r0
BP
IS
LM
LM’
Y’
A
CB
+ –
IS’
r’
r’
MP FP
No capital mobility and fixed exchange rates
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r
YY0O
r0
BP
IS
LMLM’
Y’
A=C
B+
–
r’
MP
Imperfect capital mobility and fixed exchanges rates
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Imperfect capital mobility and fixed exchanges rates
r
YY0O
r0
BP
IS
LM
LM’
Y’
A
B
+–
r’
IS’
C
r
YY0O
r0
BP
IS
LMLM’
Y’
A
C
+–
r’
IS’
B
FP
16
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r
YY0O
r0 BP
IS
LM
LM’
Y’
+
–
r
YY0O
BP
IS
LM
LM’
Y’
A C +
–
IS’
A=Cr0
MPFP
Perfect capital mobility and fixed exchange rates
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Imperfect capital mobility and flexible exchange rates
MP
rBP
IS
LMLM’
A C
B
+ –
IS’
BP’
r
YY0O
BP
IS
LMLM’’
LM’
Y’
A
B
+ –
IS’’
C
BP’’
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Negligible effect on LM Non-negligible effect on LM
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Imperfect capital mobility and flexible exchange rates
FP
IS’’
r
YY0O
BP
IS
LM
A
C
B
IS’+ –
BP’’ r
YO
BP
IS
LM
A
C
B
IS’’
+– IS’
BP’’
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r
YY0O
BP
IS
LM
Y’
+
–
A=C
IS’
r
YY0O
BP
IS
LM
LM’
Y’
A C +
–
IS’
r = r* r = r*
MP FP
Perfect capital mobility and flexible exchange rates
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Monetary and fiscal policies: Summary effects
ER regime Degree of K mobility
Monetary Policy Fiscal Policy
SR LR SR LR
Fixed ER NKM E I E I (Crowding out)
IKM E I E E (the more effective the flatter the BP curve)
PKM I (totally) E (totally)
Floating ER IKM ES increases
ES increases
E E
(the more effective the stepper the BP curve)S increases if BP slope>LM slope.S decreases if BP slope<LM slope
PKM E S increases I (totally) S decreases
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The principle of effective market classification: the assignment problem
MP
O FP
A
IB
CB
DE
Unemp.
Inflation
FPN
MPN
FPR FPE
MPR
MPE
∆MS
∇G ∆G
∇MS
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The assignment problem
O
A
EB
C
B
Surplus
Deficit
FPN
MPN
FPR FPE
MPR
MPE
∇MS
∆MS
∇G ∆G
MP
FP O
A
EBC
Deficit
MPN
FPR FPE
MPR
MPE∆MS
∇G ∆G
MP
FPPFN
Surplus
B
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MP
O
EP
EB
FPN
MPN
FPR FPE
MPR
MPE
IB
FP
J
MP
O
EP
EB
FPN
MPN
FPR FPE
MPR
MPE
IB
FP
DeficitInflation
SurplusUnemp. Surplus
Inflation
DeficitUnemp.
D
F
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The assignment problem
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MPR
MPE
MP
EP
IB
FPN
MPN
FPR FPE
EB
J
FP
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The assignment problem
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Limitations of the Mundell-Fleming model
1. Marshall-Lerner condition2. Interaction of stocks and flows3. Neglect of long run budget constrains4. Aggregate supply curve is horizontal5. Treatment of capital flows6. Monetary and fiscal policies are not that flexible7. Exchange rate expectations
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LM(P1)
IS(P1, G0)
AD
IS(P1, G1)
IS(P0, G1)
r
YY0O
Y1
A B
P
YY0O Y1
AD’
P0
P1
IS(P0, G0)
LM(P0)
r0r1
AD-AS model in an open economy
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AD and fixed exchange rates
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AD-AS model in an open economy
01
1 0
wwP P
=
LLFEO
LD
wP
LS
YYFEO
ASST’P
0
1
wP
L1
ASST
ASLT
Y1
P1
P0
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AS and fixed exchange rates
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AD-AS model in an open economy
P
Y*O
ASST
P*
AD
E
Y
29
ST equilibrium
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AD-AS model in an open economy
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LT equilibrium
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AD-AS model in an open economy
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Is there an automatic adjustment process?
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AD-AS model in an open economy
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Can we help the adjustment process?
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AD-AS model in an open economy
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Effects of a devaluation: short-term and long-term
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AD-AS model in an open economy
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AD and floating exchange rates
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AD-AS model in an open economy
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Are demand policies effective?
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AD-AS model in an open economy
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LT equilibrium
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AD-AS model in an open economy
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Is there an automatic adjustment process?
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AD-AS model in an open economy
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Can we help the adjustment process?
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AD-AS model in an open economy
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Supply shocks