Lecture 8: the mundell-fleming model (continued) trade policy under floating exchange rates



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LECTURE 08: THE MUNDELL-FLEMING MODEL (CONTINUED)

8.1 TRADE POLICY UNDER FLOATING EXCHANGE RATES

At any given value of e, a tariff or quota reduces imports, increases NX, and shifts IS* to the right.




8.2 LESSONS ABOUT TRADE POLICY

Import restrictions cannot reduce a trade deficit. Even though NX is unchanged, there is less trade:




  • The trade restriction reduces imports




  • Exchange rate appreciation reduces exports

Less trade means fewer ‘gains from trade. Import restrictions on specific products save jobs in the domestic industries that produce those products, but destroy jobs in export-producing sectors. Hence, import restrictions fail to increase total employment. Worse yet, import restrictions create “sectoral shifts,” which cause frictional unemployment.

8.3 FIXED EXCHANGE RATES

Under a system of fixed exchange rates, the country’s central bank stands ready to buy or sell the domestic currency for foreign currency at a predetermined rate. In the context of the Mundell-Fleming model, the central bank shifts the LM* curve as required to keep e at its pre-announced rate. This system fixes the nominal exchange rate. In the long run, when prices are flexible, the real exchange rate can move even if the nominal rate is fixed.


a. The Equilibrium exchange rate is Greater than the fixed exchange rate


b. The Equilibrium exchange rate is less than the fixed exchange rate


8.4 FISCAL POLICY UNDER FIXED EXCHANGE RATES

Under fixed exchange rates, a fiscal expansion would raise e. To keep e from rising, the central bank must sell domestic currency, which increases M and shifts LM* right.





Results: ∆e = 0, ∆Y > 0. Under floating rates, fiscal policy ineffective at changing output. Under fixed rates, fiscal policy is very effective at changing output. LM shifts out!

8.5 MONETARY POLICY UNDER FIXED EXCHANGE RATES

An increase in M would shift LM* right and reduce e. To prevent the fall in e, the central bank must buy domestic currency, which reduces M and shifts LM* back left.



Results: ∆e = 0, ∆Y = 0. Under floating rates, monetary policy is very effective at changing output. Under fixed rates, monetary policy cannot be used to affect output.


8.6 TRADE POLICY UNDER FIXED EXCHANGE RATES

A restriction on imports puts upward pressure on e. To keep e from rising, the central bank must sell domestic currency, which increases M and shifts LM* right.



Results: ∆e = 0, ∆Y > 0. Under floating rates, import restrictions do not affect Y or NX. Under fixed rates, import restrictions increase Y and NX. But, these gains come at the expense of other countries, as the policy merely shifts demand from foreign to domestic goods




8.7 DIFFERENTIALS IN THE M-F MODEL


Where θ is a risk premium. Substitute the expression for r into the IS* and LM* equations:





8.8 THE EFFECTS OF AN INCREASE IN θ











IS* shifts left, because ↑ θ⇒ r ⇒↑↓I










LM* shifts right, because ↑θ ⇒ ↑r ⇒ ↓(M/P)

d, So Y must rise to restore money market

equilibrium.











8.9 THE EFFECTS OF AN INCREASE IN θ

The fall in e is intuitive: An increase in country risk or an expected depreciation makes holding the country’s currency less attractive.


Note: an expected depreciation is a self- fulfilling prophecy. The increase in Y occurs because the boost in NX (from the depreciation) is even greater than the fall in I (from the rise in r).

8.10 WHY INCOME MIGHT NOT RISE?





  • The central bank may try to prevent the depreciation by reducing the money supply.




  • The depreciation might boost the price of imports enough to increase the price level (which would reduce the real money supply).

  • Consumers might respond to the increased risk by holding more money.

Each of the above would shift LM* leftward.


8.11 FLOATING VS. FIXED EXCHANGE RATES


Argument for floating rates:
Allows monetary policy to be used to pursue other goals (stable growth, low inflation).
Arguments for fixed rates:

Avoids uncertainty and volatility, making international transactions easier.

Disciplines monetary policy to prevent excessive money growth & hyperinflation.

8.12 MUNDELL-FLEMING AND THE AD CURVE

Previously, we examined the M-F model with a fixed price level. To derive the AD curve, we now consider the impact of a change in P in the M-F model. We now write the M-F equations

as:

Y = C (Y T ) I+( r *) G+ NX+(ε)




M P = L (r *,Y )


(Earlier, we could write NX as a function of e because e and ε move in the same direction when P is fixed.)


8.13 DERIVING THE AD CURVE

AD curve has negative slope because:


As P ⇒ ↓(M/P)LM shifts left ⇒ ε⇒ ↓NX ⇒ ↓Y


8.13.1 From Short Run To The Long Run

If Y1 < Y then there is downward pressure on prices. Over time, P will move down, causing (M/P)ε↓⇒ NXY




8.13.2 Large: Between Small And Closed

Many countries - including the U.S. - are neither closed nor small open economies. A large open economy is in between the polar cases of closed & small open. Consider a monetary expansion:

Like in a closed economy,

∆M > 0 ⇒ ↓r ⇒ ↑I (though not as much) Like in a small open economy,


∆M > 0 ⇒ ↓ε⇒ ↑NX (though not as much)

@St. Paul’s University


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