Chapter 3. Aggregate Demand in the Open Economy H. W. p. 388-89 #1, or 3

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Chapter 13. Aggregate Demand in the Open Economy

H.W. p. 388-89 #1, 2 or 3

mundell_fleming #1, 4, 10
Won’t do appendix (large open econ)

Mundell-Fleming model. Assumes small open economy with perfect capital mobility, world interest rate r*. Short run and long possibilities: mostly short run (prices fixed). Extends normal IS-LM. Produces stark results. Obvious links to Econ 347.

Preview: Fig. 13-3, p. 361. The Mundell-Fleming Model
Changed the vertical axis; now uses nominal exchange rate e. Recall that increases in e are appreciations of our exchange rate.

Preview: Table 13-1, p. 372. Mundell - Fleming Model, summary of policy effects.
Fiscal policy no effect in float, monetary policy no effect in fixed.

Mundell and Dornbusch

No picture of Fleming (IMF economist)

Mundell was born in Canada; Dornbusch in Germany

Introduces the IS* curve: points e and y corresponding to equilibrium of goods market.

Fig. 13-1, p. 359. The IS* Curve
Derivation: if exchange rate increases (a), net exports drop (b), and hence income drops (c).

LM* curve represents points e and Y that correspond to equilibrium in money markets

Fig. 13-2, p. 360. The LM* Curve
If r=r*, then only one level of output is possible.

IS*: Y = C(Y – T) + I(r*) + G + NX(e)

LM*: M/P = L(r*, Y).

Fig. 13-3, p. 360. The Mundell-Fleming Model
Changed the vertical axis; now uses nominal exchange rate e. Recall that increases in e are appreciations of our exchange rate.

Fig. 13-3 p. 361.

With exchange rate info



Will first analyze floating exchange rates.

Fig. 13-4, p. 362. Fiscal Expansion Under Floating Exchange Rates

If G increases, e increases. Y constant.

No fiscal impact on income; appreciation of exchange rate lowers exports. Complete crowding out, via exports.

mt’s attempt at explaining result of fiscal expansion under fixed rates, soe

An increase in government expenditures

→ would raise interest rates,

→ leading to an inflow of foreign capital (loans),

→ appreciating the currency (higher Y/$),

→ lowering net exports,

→ leaving the economy at the same level of output.

Another part of the story is that these effects are so strong that the

domestic interest rate never really rises above the world interest rate.

Fig. 13-5, p. 364. Monetary Expansion Under Floating Exchange Rates
If M increases, LM* moves right, and income changes.

mt‘s attempt at explaining this result of monetary expansion under fixed rates, soe:

The increase in the money supply would initially

→ lower domestic interest rates

→ cause capital outflows and depreciate the currency

→ raise net exports, increasing real output

Fig. 13-6, p. 365. Trade Restriction under Floating Exchange Rates

Tariffs move NX curve out, shifting IS curve out, leading to an increase in e. No change in net exports.

Fixed exchange rates. Most recently, under Bretton Woods 1950s and 1960s. Notes that some economists (like Mundell) desire a return to fixed rates/gold. (Dornbusch advocated giving up currencies entirely). Gold standard was earlier example of fixed x-rates. Key idea is that with perfect capital mobility, a shift of return to assets will give rise to a large flow of capital which cannot be sterilized, but will affect domestic money supply.

Fig. 13-7, p. 367 How a Fixed Exchange Rate Governs the Money Supply.

In (a), if e is 180>fixed rate (150), then arbitrageurs sell dollars overseas, buy them in U.S. to get exchange rate differential, increasing US money supply. Vice versa in other graph.

Fig. 13-7, p. 367 again – with explanation.
How a Fixed Exchange Rate Governs the Money Supply

Fig. 13-8, p. 369. Fiscal Expansion under Fixed Exchange Rates

Increase in G shifts IS*, increasing exchange rate, causing money to flow in, moving LM* curve. Reinforcing shift of LM*. Should decrease NX-different result than in Table 12.1

Fig. 13-9, p. 369. Monetary Expansion under Fixed Exchange Rates.
Increase in M would lower exchange rate, causing an outflow, leaving LM* fixed. Thus, no change in NX.

Fig. 13-10, p. 371. Trade Restriction under Fixed Exchange Rates
Increase in tariffs moves IS* to right, which moves LM* to right. Improvement in NX, because MP Im is <1.

Table 13-1, p. 372. Mundell Fleming Model, summary of policy effects.
I disagree with the 0 under NX under fixed.

Interest rate differentials. Analyzed as caused by exchange rate expectations. Will denote risk premium by θ, so that r = r* + θ.

And so

IS*: Y = C(Y – T) + I(r* + θ) + G + NX(e)

LM*: M/P = L(r* + θ, Y).

Similarly, LM* moves right, because demand for money falls due to less confidence in domestic currency. Result is depreciation, increased income.

Reasons for Y not increasing might be 1) central bank doesn’t allow money to expand; 2) prices may increase, lowering M/P, 3) residents may increase their demand for M.

Applications to Mexico 1994/5, and Asia 1997/8.

Mexico: NAFTA and its contrarian response, zapatista revolt, assassination of Colosio. Led to run out of pesos into dollars. Stock market crashed. Further loss of confidence. Resolved by US bailout, although there was significant recession. Expectation of crisis causes crisis.

Asian crisis was one of confidence, vicious circle. Initially, problems in domestic banking systems (crony capitalism; zaibatsu), which spread over to stock markets. Interest rates were rising, and loans were being defaulted.

Fig. 13-11, p. 374. An Increase in the Risk Premium θ
If θ increases, IS* moves left, because businesses don’t want to invest

Depreciates exchange rate

Figure 13-12 p. 381. Impossible trinity: fixed rates, free capital mobility, independent monetary policy.
Result of SOE assumption, not IS-LM logic.

A devaluation in a fixed rate system works like a rightward shift of the LM* (because new rate is below previous intersection of IS* & LM*. This will increase net exports and Y.

Example is 1930s depression, where there were competitive devaluations. Discusses studies that show faster recovery for countries that devalued.

Raises issue of fixed versus floating exchange rates. Fundamental issue is stability, greater confidence.

If fixed: currency board, or outright dollarization. Mankiw does not espouse a position on this.

Float gives greater independence to monetary policy. Others argue that fixed exchange rates require more fiscal discipline. In practice, countries have systems someplace in the middle, and pursue these and other goals. Float with combination of consider optimum currency areas-us dollar, euro, yen, pound.

Mundell Fleming as a theory of AD.

Fig. 13-13, p. 384. Mundell Fleming as a theory of AD. Derivation of AD.
If prices drop, LM* moves right, increasing Y and lowering e.

Fig. 13-14, p. 385. Short Run and Long Run in an SOE.
How changing prices will move LM*, bringing Y back to equilibrium, so adjustment from short run to long run is normal.

US is described as a large economy. A large economy is an “average” of a closed economy and a SOE.

Putting it all together (Chapter 14 p. 424)


Earlier edition. Appendix
Figure 13.15 p. 391. (appendix) A Short-Run Model of a Large Open Economy

Figure 13.16 p. 392. A Fiscal Expansion in a Large Open Economy

An increase in Gov’t spending raises real interest rate, lowering capital outflows, raising the exchange rate, and reducing net exports

Figure 13.17 p. 393. A Monetary Expansion in a Large Open Economy.

An increase in M moves LM right, lowers r. This increase capital outflow, which lowers the exchange rate, ultimately increasing net exports.

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