Session 15 & 16

Prepared by:
Amarendu Nandy
Organization
 The Mundell-Fleming model
(IS-LM for the small open economy)
 causes and effects of interest rate
differentials
 arguments for fixed vs. floating
exchange rates
IS Curve
IS relation: Y  C(Y  T )  I (Y , i )  G
IS Curve is derived from the Goods Market
Clearing condition:
Supply of goods: Y
equals to
Demands of Goods coming from:
Consumption demand: C;
Investment demand: I;
Government Expenditure: G
IS Curve
IS relation: Y  C(Y  T )  I (Y , i )  G
IS Curve captures the effect of nominal interest
rate i on output Y, for given values of T and G.
(tax and government purchase).

Investment demand depends negative on interest

rate. Hence, when i increase, the investment and
then the total demand will fall. So will the total
output Y.

Therefore, IS curve is downward sloping.

LM Curve
M
LM relation:  YL(i )
P
LM Curve is derived from the financial market clearing
condition.

Supply of nominal money: M

equals to Demands of nominal money coming from the
transaction demand, which in turn depends positively on the
price level P, and the total output Y, and negatively on the
nominal interest rate.

(Why? Because higher i implies a higher OC of holding

money).

So nominal money demand is given by PYL(i)

LM Curve
M
LM relation:  YL(i )
P
LM Curve captures the effect of output Y on nominal
interest rate i, for given values of M (nominal money
supply) and P (in short run price is assumed to be fixed).

Higher total output implies higher transaction demand. So for

given level of nominal money supply, high demand implies
the interest rate that clear the money market has to
increase. So when Y increases, the nominal interest rate i
increases.

Therefore, LM curve is upward sloping.

Open-Economy Short-Run
Macro Model
 The current account balance is the
difference between exports and
imports.
 The private capital account balance is
the difference between private capital
inflows and outflows.
 The balance of payments is in
equilibrium when the current account
and private capital account balances
sum to zero.
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 Private Balance of Payments
Deficit
 If the private balance of payments is in deficit,
current account + private capital account < 0
supply of currency>demand for currency
 With a flexible exchange rate, the currency
depreciates until
current account + private capital account = 0
demand for currency = supply of currency
 With a fixed exchange rate, the country must
buy up the excess supply of its currency.

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 Private Balance of Payments
Surplus
 If the private balance of payments is in surplus,
demand for currency>supply of currency
current account + private capital account > 0
 With a flexible exchange rate, the currency
appreciates until
demand for currency = supply of currency
current account + private capital account = 0
 With a fixed exchange rate, the country must sell
its currency to eliminate the excess demand.

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The Mundell-Fleming model
 Key assumption:
Small open economy with perfect capital mobility.
r = r*
 Goods market equilibrium – the IS* curve:

Y  C (Y T )  I (r *)  G  NX (e )
where
e = nominal exchange rate
= foreign currency per unit domestic currency
The IS* curve: Goods market eq’m
Y  C (Y T )  I (r *)  G  NX (e )
The IS* curve is drawn for a
given value of r*. e
Intuition for the slope:

 e   NX  Y
We could derive this using the
“Keynesian cross”.
Remember, the IS curve IS*
incorporates the multiplier effect. Y
The LM* curve: Money market eq’m
M P  L (r *,Y )
The LM* curve
e LM*
 isdrawn for a given
value of r*.
 isvertical because:
given r*, there is
only one value of Y
that equates money
demand with supply, Y
regardless of e.
Equilibrium in the Mundell-Fleming model

Y  C (Y T )  I (r *)  G  NX (e )
M P  L (r *,Y )
e LM*

equilibrium
exchange
rate

IS*
equilibrium Y
level of
income
Floating & fixed exchange rates
 In a system of floating exchange rates,
e is allowed to fluctuate in response to
changing economic conditions.
 In contrast, under fixed exchange rates,
the central bank trades domestic for foreign
currency at a predetermined price.
 Next, policy analysis –
 first, in a floating exchange rate system
 then, in a fixed exchange rate system
Fiscal policy under floating exchange rates

Y  C (Y T )  I (r *)  G  NX (e )
M P  L (r *,Y )
e LM 1*
At any given value of e,
e2
a fiscal expansion
increases Y, e1
shifting IS* to the right.
IS 2*
Results:
IS 1*
e > 0, Y = 0 Y
Y1
Lessons about fiscal policy
 In a small open economy with perfect
capital mobility, fiscal policy cannot
affect real GDP.
 “Crowding out”
 closed economy:
Fiscal policy crowds out investment by
causing the interest rate to rise.
 small open economy:
Fiscal policy crowds out net exports by
causing the exchange rate to appreciate.
Monetary policy under floating exchange
rates
Y  C (Y T )  I (r *)  G  NX (e )
M P  L (r *,Y )
e LM 1*LM 2*
An increase in M
shifts LM* right
because Y must rise
to restore eq’m in e1
the money market. e2
Results: IS 1*
Y
e < 0, Y > 0 Y1 Y2
Lessons about monetary policy
 Monetary policy affects output by affecting
the components of aggregate demand:
closed economy: M  r  I  Y
small open economy: M  e  NX  Y

 Expansionary mon. policy does not raise world

agg. demand, it merely shifts demand from
foreign to domestic products.
So, the increases in domestic income and
employment are at the expense of losses abroad.
Trade policy under floating exchange rates

Y  C (Y T )  I (r *)  G  NX (e )
M P  L (r *,Y )
e LM 1*
At any given value of e,
a tariff or quota reduces e2
imports, increases NX,
and shifts IS* to the right. e1
Results: IS 2*
e > 0, Y = 0 IS 1*
Y
NX does not change! Why? Y1
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.
 the exchange rate appreciation reduces
exports.
 Less trade means fewer “gains from
trade.”
Lessons about trade policy, cont.
 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.
 Also, import restrictions create “sectoral
shifts,” which cause frictional
unemployment.
Fixed exchange rates
 Under fixed exchange rates, the central bank
stands ready to buy or sell the domestic currency
for foreign currency at a predetermined rate.
 In the Mundell-Fleming model, the central bank
shifts the LM* curve as required to keep e at its
preannounced 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.
Fiscal policy under fixed exchange rates

Under
Underfloating
floatingrates,
rates,
afiscal
fiscalpolicy
expansion
is ineffective
e LM 1*LM 2*
would raise e.output.
at changing
To keepfixed
Under e from rising,
rates,
the central
fiscal bank
policy must
is very
sell domestic currency, e1
effective at changing
which
output.increases M IS 2*
and shifts LM* right.
IS 1*
Results: Y
Y1 Y2
e = 0, Y > 0
Monetary policy under fixed exchange rates

An increase
Under in Mrates,
floating would
monetary
shift policy
LM* right andisreduce e.
very effective at e LM 1*LM 2*
To prevent the fall in e,
changing
the central output.
bank must
buy
Underdomestic currency,
fixed rates,
which reduces
monetary M and
policy cannot e1
shifts LM*toback
be used left.output.
affect
Results: IS 1*
Y
e = 0, Y = 0 Y1
Trade policy under fixed exchange rates

Under floating rates,

A restriction on imports puts
import restrictions
upward pressure on e.
do not affect Y or NX. e LM 1*LM 2*
To keep e from rising,
the central bank must
Under fixed rates,
sell domestic currency,
import restrictions e1
which increases
increase Y and NX. M
and shifts LM* right. IS 2*
Results: IS 1*
Y
e = 0, Y > 0 Y1 Y2
 Summary of policy effects in the Mundell-
Fleming model

type of exchange rate regime:

floating fixed
impact on:

Policy Y e NX Y e NX

fiscal expansion 0    0 0

mon. expansion    0 0 0

import restriction 0  0  0 
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.
CASE STUDY:
The Chinese Currency Controversy
 1995-2005: China fixed its exchange rate at 8.28
yuan per dollar, and restricted capital flows.
 Many observers believed that the yuan was
significantly undervalued, as China was
accumulating large dollar reserves.
 U.S. producers complained that China’s cheap
yuan gave Chinese producers an unfair advantage.
 President Bush asked China to let its currency
float; Others in the U.S. wanted tariffs on Chinese
goods.
CASE STUDY:
The Chinese Currency Controversy
 If China lets the yuan float, it may indeed
appreciate.
 However, if China also allows greater capital
mobility, then Chinese citizens may start moving
their savings abroad.
 Such capital outflows could cause the yuan to
depreciate rather than appreciate.
Summary
1. Mundell-Fleming model
 the IS-LM model for a small open economy.
 takes P as given.
 can show how policies and shocks affect income
and the exchange rate.
2. Fiscal policy
 affects income under fixed exchange rates, but not
under floating exchange rates.
Summary
3. Monetary policy
 affects income under floating exchange rates.
 under fixed exchange rates, monetary policy is not
available to affect output.
4. Interest rate differentials
 exist if investors require a risk premium to hold a
country’s assets.
Summary
5. Fixed vs. floating exchange rates
 Under floating rates, monetary policy is available for
can purposes other than maintaining exchange rate
stability.
 Fixed exchange rates reduce some of the
uncertainty in international transactions.
 Policy Effectiveness in the Mundell-
Fleming Model
Fixed Exchange Rate Flexible Exchange Rate

Monetary Ineffective in changing Effective in changing

Policy income by itself; offset income; causes net
by capital inflows or exports to change to
outflows. Effective validate monetary
when coordinated policy.
with fiscal policy.

Fiscal Effective in changing Ineffective in changing

Policy income because it income by itself; net
forces an accommo- exports will change to
dative monetary offset it. Effective
policy. When coordinated with
accomodative
monetary policy.

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International Organizations
International Finance Organizations
International Helps coordinate international
Monetary Fund (IMF) financial flows
[www.imf.org]

World Bank Helps developing countries

[www.worldbank.org] obtain low interest loans

International Trade Organizations

World Trade Works toward free trade in

goods Organization and services and mediates trade
(WTO) disputes among members
[www.wto.org]

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 Regional and Special Issue Organizations
Group of 7 A group of 7 countries (Britain, Canada, France, Germany, Italy, Japan,
and the U.S.) that promotes trade negotiations and
coordinates economic policies among its members
Organization A group of 13 major oil exporting countries in the Middle East,
of Petroleum Africa, and South America established to create greater cooperation
and
Exporting coordination among member countries to help prevent the price of oil
Countries from falling too low
(OPEC)
Organization A group of countries from Europe and North America plus
for Economic Japan, New Zealand, Mexico, the Czech Republic, Korea,
Cooperation & Hungary, and Poland that promotes economic cooperation
Development among its members
(OECD)
North Established to eliminate trade barriers among Mexico,
American Free the United States, and Canada
Trade Agree-
ment (NAFTA)
European Union Seeks to integrate members by eliminating trade barriers and
establishing a common currency. Members are Belgium, Italy,
Germany, France, Luxembourg, the Netherlands, Denmark,
Ireland, the United Kingdom, Greece, Spain, Protugal, Austria,
Finland, and Sweden.

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Advantages of a Common
Currency
 Reduction in exchange rate risk
 Eliminates the risk of exchange rate variability,
which increases capital market stability
 Reduction in transactions costs
 There is no exchange of currencies among
members, so transaction costs are reduced
 Economies of scale
 Along with the dollar, the euro may serve as a
reserve currency, so the EU gets interest free
loans

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Disadvantages of a Common
Currency
 Lossof independent monetary
policy
 With a common currency monetary
policy is the same in all countries
because there is one money supply and
one central bank
 Loss of nationalism
 Losing a national currency may be a
loss of national identity or heritage

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Optimal Currency Areas
 An optimal currency area is a group of
countries suitable to adopt a common
currency without significantly
jeopardizing domestic policy goals.

 Criteria for optimal currency areas

 Similar industries
 Significant labor mobility
 Broad range of industries
 Diverse demand shocks
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