GRIPS Macroeconomics II

Fall II Semester, 2014

Lecture 8: Open Economy 2 - Short Run Analysis of a Small Open Economy

Junichi Fujimoto
January 5, 2015

1 The Mundell-Fleming Model

The Mundell-Fleming model is an extension of the IS-LM model to an open economy. More precisely, this model
assumes a small open economy with perfect capital mobility. For now, let us assume that the domestic and the
foreign price levels are xed, and conduct short run analyses.

1.1 The Goods Market and the IS Curve

In the Mundell-Fleming model, the goods market equilibrium is expressed by the following IS equation:
Y = C(Y T ) + I(r ) + G + N X(e)

(1)

As we learned the last time, N X is a decreasing function of the real exchange rate , and the real exchange rate
equals e PP . By assumption, P and P are xed, so is proportional to e. Therefore, N X is also a decreasing
function of the nominal exchange rate e.
Let us call the graph of (1), with e on the vertical axis and Y on the horizontal axis, as the IS curve. To
draw this curve, rst, take two dierent values of e, e1 and e2 , as in the lower left panel of Figure 1, and nd the
corresponding values of net exports, N X1 and N X2 . Then, in the Keynesian cross in the upper right panel, draw
the planned expenditures E1 , E2 which correspond, respectively, to N X1 , N X2 , and nd the equilibrium income
Y1 , Y2 . Finally, in the lower right panel, connect (e1 , Y1 ) and (e2 , Y2 ) to obtain the IS curve.
Recall that the IS curve plots the combinations of Y and r which achieve the goods market equilibrium. In
contrast, the IS curve plots the combinations of Y and e that achieve the goods market equilibrium, given the
exogenous real interest rate, r = r .

1.2 The Money Market and the LM Curve

Next, the money market equilibrium is expressed by the following LM equation:
M
= L(r , Y )
P

(2)

As Figure 2 shows, the equilibrium income is determined by the usual LM curve and r = r . Note that the
equilibrium income does not depend on the nominal exchange rate; thus, the LM curve is vertical.

1.3 Equilibrium in the Goods Market and the Money Market

In the Mundell-Fleming model, a small open economy with perfect capital mobility is expressed by the IS curve
(1) and the LM curve (2), as drawn in Figure 3. The equilibrium nominal exchange rate and the equilibrium
income are given at the intersection of the two curves. Using this gure, we can analyze the eects of scal and
monetary policy.
1

E
E2
NX
E1

Y
NX(e)

e1
e2
IS*
NX1

NX2

NX

Y2

Y1

Figure 1: The IS curve

2 A Small Open Economy Under Floating Exchange Rates

In the Mundell-Fleming model, the eects of policies depend critically on the exchange rate regime. Let us begin
with the oating (or exible) exchange rates, adopted in most developed countries. Under this system, the exchange
rate uctuates in response to economic conditions.

2.1 Fiscal Policy

Suppose the government adopts expansionary scal policy, such as increasing government purchases and reducing
taxes. Such scal policy increases the planned expenditure, so it shifts the IS curve to the right, as shown in
Figure 4. As a consequence, the exchange rate e rises (= appreciation of the domestic currency), but income Y
remains unchanged.
The reason why Y does not change can be understood from the following equation, which expresses the money
market equilibrium:
M
= L(r, Y ).
(3)
P

In a closed economy, expansionary scal policy increases income, which in turn increases the demand for real
balances, so the interest rate rises. Thus, in the new equilibrium, both income and the interest rate are higher than
before.
In a small open economy, the interest rate is xed at the world interest rate, so (3) implies that unless the
real money balances (or, some parameters in the real money demand function) change, income cannot change.
More precisely, when an increase in income raises the interest rate, there will be capital inows from abroad.
This increases the demand for the domestic currency in the foreign exchange market, leading to appreciation of
the domestic currency (rise in e). This in turn makes domestic goods relatively more expensive, and reduces net
exports N X , completely osetting the eect of scal policy.

2.2 Monetary Policy

Next, suppose the central bank increases the money supply. Since the price level is xed by assumption, M
P rises
and the LM curve shifts to the right. So, as drawn in Figure 5, the increase in the money supply raises income,
2

LM

r*

Y
e

LM

Y
Figure 2: The LM curve
and lowers the nominal exchange rate (= depreciation of the domestic currency).
Thus, monetary policy is eective in a small open economy under oating exchange rates, as in a closed economy.
However, the monetary transmission channel is dierent. In a closed economy, an increase in the money supply
lowers the interest rate, and increases expenditure by stimulating investment. In a small open economy, when an
increase in the money supply lowers the interest rate, capital ows out of the economy to obtain higher returns
abroad. This increases the supply of the domestic currency in the foreign exchange market, and decreases the
exchange rate (= depreciation of the domestic currency). Consequently, domestic goods become relatively less
expensive; so net exports increase, and so does the aggregate income.
Again, we can observe this result from (3); when the LHS rises due to an increase in the money supply, Y must
rise, given the assumption that r is xed.

2.3 Trade Policy

Suppose the government reduces the demand for imported goods by imposing an import quota or a tari. Such
policy shifts the net exports schedule to the right, hence increases the planned expenditure. Thus, the IS curve
shifts to the right, causing an increase in e without changing Y (Figure 4). The equilibrium value of N X does not
change either; to conrm this, recall the relationship
N X(e) = Y C(Y T ) I(r ) G.

(4)

A trade restriction does not aect any of the variables in the RHS, so it does not aect N X(e) in the LHS either.

3 A Small Open Economy Under a Fixed Exchange Rate

Next, let us consider the xed exchange rate system (or the xed exchange rate regime). Under this system, the
nominal exchange rate is xed, which requires the central bank to stand ready to buy or sell foreign currencies at
a predetermined price. The central bank can print the domestic currency to buy foreign currencies; however, to be
ready to sell foreign currencies, the central bank must hold foreign currencies as reserves.
3

LM*

IS*

Y
Figure 3: The Mundell-Fleming Model
Under xed exchange rates, monetary policy is dedicated to xing the exchange rate at the announced level.
Suppose, as in the left panel of Figure 6, the equilibrium nominal exchange rate e is below the xed exchange rate
e. This means that one can buy the domestic currency in the foreign exchange market at a cheaper rate than the
xed exchange rate. So one can make prots by purchasing the domestic currency in the market, and selling it to
the central bank. Such transactions reduce the money supply, causing the LM curve to shift to the left, until it
intersects with the IS curve at e = e. Conversely, when e initially exceeds e as in the right panel of Figure 6,
one can make prots by buying the domestic currency from the central bank and selling it in the foreign exchange
market, which increases the money supply and shifts the LM curve to the right.

3.1 Fiscal policy

Suppose the government adopts expansionary scal policy, such as increasing government purchases or reducing
taxes, under the xed exchange rate system. This shifts the IS curve to the right as in Figure 7, putting upward
pressures on the nominal exchange rate (=appreciation of the domestic currency). Arbitrageurs respond to this by
buying the domestic currency from the central bank and selling it in the foreign exchange market, which increases
the money supply and shifts the LM curve to the right. Thus, expansionary scal policy raises aggregate income
under a xed exchange rate.

3.2 Monetary Policy

Next, suppose the central bank increases the money supply. Such policy shifts the LM curve to the right, as drawn
in Figure 8, putting downward pressures on the nominal exchange rate (= depreciation of the domestic currency).
Arbitrageurs respond to this by buying the domestic currency in the foreign exchange market and selling it to the
central bank, which decreases the money supply and shifts the LM curve back to where it was. Therefore, under
a xed exchange rate, monetary policy as usually conducted is ineective. This is because, by xing the exchange
rate, the central bank gives up the control of the money supply.
There is, however, a dierent type of monetary policy which the central bank can conduct under the xed
exchange rate regime: devaluation and revaluation. A devaluation (= lowering e) shifts the LM curve to the right,
expanding net exports and increasing the aggregate income. Conversely, a revaluation (= raising e) shifts the LM
curve to the left, reducing net exports and lowering the aggregate income.
4

LM*

IS2

IS1

Y
Figure 4: Fiscal Policy Under Floating Exchange Rates

3.3 Trade Policy

Suppose the government reduces the demand for imported goods by imposing an import quota or a tari. Such
policy shifts the net exports schedule to the right, hence shifts the IS curve to the right, putting an upward
pressure to the nominal exchange rate. To keep the exchange rate at the xed level, the money supply must rise
and shift the LM curve to the right. Thus, as in the case of scal policy, Y rises (Figure 7). Note that net exports
N X rise as well; the RHS of (4) rises due to the rise in Y , so the LHS must rise as well.

3.4 Policy Eects in The Mundell-Fleming Model

The eects of policies in the Mundell-Fleming Model depend on the exchange rate regime, as summarized in Table
1. Note that the eects of scal, monetary and trade policy on income, the exchange rate, and net exports are all
dierent between oating and xed exchange rates. (In the table, '0' implies there is no impact).

Policy
Fiscal expansion
Monetary expansion
Import Restriction

Exchange Rate Regime

Floating
Fixed
Y
0

NX

e
0
0
0

NX
0
0

Table 1: Policy Eects in the Mundell-Fleming Model

4 Interest Rate Dierentials

So far, we have assumed that the interest rate in a small open economy equals the world interest rate. Let us now
consider the case in which this assumption does not hold, such that there are international interest rate dierentials.
5

LM1

LM2

e1

e2

IS*
Y1

Y2

Figure 5: Monetary Policy Under Floating Exchange Rates

4.1 Country Risk and Exchange Rate Expectations

The interest rate of a small open economy with perfect capital mobility may dier from the world interest rate,
due to the following reasons. The rst is country risk. Lendings to developing countries are often riskier than
those to developed countries, since a revolution or political upheaval, for example, may lead to a default on loan
repayments. Borrowers in such countries often have to pay higher interest rates to compensate for the risk. The
second is expected changes in the exchange rate. The interest rate of a country whose currency is expected to
depreciate becomes higher, so as to compensate for the depreciation.

4.2 Dierentials in the Mundell-Fleming Model

Suppose the interest rate of a small open economy equals the world interest rate plus a risk premium :
r = r + .

(5)

Suppose the risk premium is exogenous. Then, the IS curve and the LM curve are expressed as:
Y = C(Y T ) + I(r + ) + G + N X(e),

(6)

M
= L(r + , Y ).
P

(7)

If the risk premium is constant, policy eects are the same as before.
Suppose this country is under oating exchange rates, and the risk premium rises. This raises the domestic
interest rate and reduces investment, shifting the IS curve to the left. On the other hand, the rise in the interest
rate reduces the demand for real balances, which must be oset by a rise in the aggregate income, given the
constant money supply. Therefore, the LM curve shifts to the right. Consequently, the nominal exchange rate
falls and income rises. The rise in income follows since the increase in net exports, caused by the depreciation of
the domestic currency, exceeds the fall in investment that results from the rise in the interest rate. Interestingly,
people's expectations of the depreciation of the domestic currency, which raise the risk premium, are self-fullling.
However, this prediction that a rise in the risk premium increases income is unrealistic, due to the following
reasons. First, the central bank may decrease the money supply to avoid a large depreciation of the domestic
currency. Second, a depreciation of the domestic currency may increase the price level P , through increased prices
of imports. Third, facing the rise in risk premium, people may increase the demand for money, which is the safest
6

LM2

LM1

LM1

LM2

IS*

IS*

Figure 6: The Money Supply Under Fixed Exchange Rates

asset. These all lead to a leftward shift of the LM curve, which mitigates the depreciation of the domestic currency,
but lowers income. Thus, increases in country risk typically lead to a depreciating currency and falling aggregate
income in the short run; in the long run, the increased interest rate reduces investment, and hampers economic
growth.
(Practice Question)

Explain what happens under a xed exchange rate, when the risk premium of the home country rises (You can
ignore the three channels above, through which the LM curve may shift to the left).

5 The Mundell-Fleming Model with a Changing Price Level

So far, we have conducted analyses of the small open economy in the short run, when the price level is xed. Let
us now consider what happens in the model, when the price level changes. To do so, it requires distinguishing the
nominal exchange rate e and the real exchange rate . The IS and the LM equations are given by:
Y = C(Y T ) + I(r ) + G + N X(),

(8)

M
= L(r , Y ).
P

(9)

First, let us conrm that we can derive the AD curve from the Mundell-Fleming model. As we observe from
(9), a greater P implies a smaller Y for given M and r. Thus, as drawn in the upper panel of Figure 10, P1 > P2
implies that LM (P1 ) lies to the left of LM (P2 ). Thus, we obtain a downward sloping AD curve.
Now, suppose the short run equilibrium (point K in Figure 11) initially diers from the long run equilibrium
(point C). At point K, the demand for goods and services is lower than the natural level Y , so the price level falls.
In the Mundell-Fleming model (upper panel), the fall in prices causes a rightward shift of the LM curve (from
LM (P1 ) to LM (P2 )), such that the economy eventually reaches point C. In the AD-AS diagram (lower panel),
this is expressed by a downward shift of the SRAS curve (from SRAS1 to SRAS2 ).

LM1

LM2*

Y1

Y2

*
1

*
2

IS

IS

Figure 7: Fiscal Policy Under Fixed Exchange Rates

IS*

LM*

Y
Figure 8: Monetary Policy Under Fixed Exchange Rates
8

LM1*

IS1*

LM2*

IS2*

Y
Figure 9: An Increase in the Risk Premium Under Floating Exchange Rates

LM * ( P1 )

LM * ( P2 )

IS *

Y
Y1

Y2

P
P1
P2

AD
Y1

Y2

Figure 10: The Mundell-Fleming Model and the AD Curve

9

LM * ( P1 )

LM * ( P2 )

K
C
IS *

Y
Y1

Y
LRAS

P1

SRAS1

P2

SRAS 2

AD
Y

Figure 11: Short Run and Long Run Equilibrium in a Small Open Economy

10