This equation is, in effect, an open economy equation for the IS curve.
It specifies the locus of r and y values for which there is equilibrium in
the commodity sector. All of the variables are constants except c(y,-r)
and i(-r). therefore, the derivative the equation (10) is
(10’) Är/Äy = -i’(-r) – c(y,-r, E/P, W/P)* Äy/Är
Therefore, the slope is negative. This means the curve will be
sloped downwards and it will have negative relationship be-
tween the output and real interest rate.
Since A+p+m+x are equal to 0 in a closed economy we get
y= c° + c(y,r) - i°(r) + g° + im° + ex°
Which is an IS relationship for the closed economy.
The LM relationship will be derived from the standard MV=PY rela-
tionship. That is
(11) Y= MV/P
if we log equation (11) we get
(12) y= m + v – p
The equation representing the demand for real money balances will
be:
if we log the above equation we get
(13’) m – p = hy – l(r + ï) – v
we can now combine the m – p + v = x representing the real money
balances and solve for r to get
now we have a function that has a positive correlation with the output.
That is as the output increases so will the real interest rate. The infla-
tion and real money balances are constants and the changes in those
variables will cause the LM curve to shift.
The last part of the model is the derivation of the CM curve.
(15) CM= ù + å
Where ù is the real interest rate imposed on the country from the rest
of the world. The å is the expected change in w at some point in the fu-
ture. Most of the times this variable is zero, but the changes in å will
cause the CM curve to shift up or down.
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In the end the graphical representation of the model looks like
PART III - PROBLEMS
In this part, I will solve some problems using this model. I will focus
on the solutions that the model can provide through the comparative
static method about the impact of monetary and fiscal policy in the
economy. In this investigation, I have purposely ignored the labor
market and I will not use it in any part of this paper, but the stated as-
sumptions from part II about the labor market hold, although in the
study of the model the labor market is irrelevant.
The main question of this part is: can growth in a small open economy
be stimulated through the monetary and fiscal policy?
3.1 THE UNEXPECTED SHIFT IN THE CM CURVE
To start with some basic assumptions that will enable us to under-
stand the model. In the world, there are two parts or we will call them
countries. One is Croatia, because that is the country whose data I am
studying and the “World”. The “World” has many people that live in
it and many companies that are interacting among themselves and
with the companies from Croatia. They are interacting and engaging
in all sorts of business transactions with no constraints on the capital
mobility and no barriers on trade. The workers from the companies in
the “World” are free to enter Croatia and leave Croatia when ever
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they want, so many of them come to Croatia for a vacation. Same
thing goes for the people in Croatia. However, there is one small
catch and that is that all companies in the “World” know the real ex-
change rate and real rate of return on investments they are expecting
when they invest in Croatia. All investors in the “World” have some
expectations of the future real rate they can get from Croatia. All
shifts in the expectations are simultaneous for all investors in the
“World” although their immediate reactions to the change in expecta-
tions vary from investor to investor. The same thing holds for Croatia
and investors in Croatia.
Since both the “World” and Croatia are stabile countries without any
internal political, social or economic crisis and insecurities the main
reason for the shift in the CM curve will be present or the expected
change in the real level of the exchange rate or future expectations
about the recession or a boom.
Here the variable å become important. Due to the trends in real appre-
ciation or depreciation the investors from the “World” might demand
different real rate on their investments then they are currently getting.
3.1.1 The shift down
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the shift up
When the world decides that the real interest rate imposed upon
Croatia is too large and the rate should be lowered. Possibilities why
this might occur in the real world might be multiple: Croatian credit
rating (currently BBB- according to Standard and Poors) might im-
prove, Croatia might gain even more stability in the eyes of the inves-
tors due to joining NATO or EU. In that case the CM curve will shift
down and it will not be in the equilibrium with the IS and LM curve.
There is only one optimal policy to regain equilibrium and that is in-
crease in x (the real money balances) and shift of the LM curve to the
right.
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NEVEN VIDAKOVIÆ: Application of the Mundell-Fleming on Small Open Economy
EKONOMIJA / ECONOMICS, 11 (3) str. 392 - 423 (2005)
www.rifin.com
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