Introduction The role of net exports Capital flow and NX Model for SOE Exchange rate Mundell Fleming

Model

Ch-4:Aggregate Demand in the Open

Economy(Econ-2031)

(Main refernce book : Macroeconomicss, Gregory N.Mankiw,

2010)

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The International Flows of Capital and Goods

► Countries export goods and services abroad, they import

goods and services from abroad, and they borrow and lend in
world financial markets.
► The key macroeconomic difference between open and closed
economies is that, in an open economy, a country’s spending
in any given year need not equal its output of goods and
services.
► Some times it has excess output , some other times it has a
shortage and buys from other countries.(X, IM̸=0)

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The Role of Net Exports

► We can divide expenditure on an open economy’s output Y

into four components:
► Cd , consumption of domestic goods and services,
▶ I d , investment in domestic goods and services,
► Gd , government purchases of domestic goods and services,
► X, exports of domestic goods and services.
► The division of expenditure into these components is
expressed in the identity

Y = Cd + I d + Gd + X

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The Role of Net Exports

► Domestic spending on all goods and services equals domestic

spending on domestic goods and services plus domestic
spending on foreign goods and services.

C = Cd + Cf
I = Id + If
G = Gd + Gf

► By substituting these three equations into the identity above:

► The division of expenditure into these components is
expressed in the identity

Y = (C − Cf ) + (I − I f ) + (G − Gf ) + X
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The Role of Net Exports

► The sum of domestic spending on foreign goods and services

(Cf + I f + Gf ) is expenditure on imports (IM ).

Y = C + I + G + X − IM

► Defining net exports to be exports minus imports

(NX = X − IM), the identity becomes

Y = C + I + G + NX

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The Role of Net Exports

► The national income accounts identity shows how domestic

output, domestic spending, and net exports are related. In
particular,
NX = Y − (C + I + G+)
► Net Exports= Output- Domestic Spending

Y = C + I + G + NX

► If output exceeds domestic spending, we export the difference:

net exports are positive. If output falls short of domestic
spending, we import the difference: net exports are negative.

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International Capital Flows and the Trade Balance

► Financial markets and goods markets are closely related.

Y = C + I + G + NX
► Subtract C and G from both sides to obtain
Y − C − G = I + NX.
► We know Y − C − G is national saving S, which equals the
sum of private saving, Y − T − C, and public saving, T − G,
where T stands for taxes.
S = I + NX
S − I = NX
► Where NX, the net export of goods and services or trade
balance and S − I net capital outflow or net foreign
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International Capital Flows and the Trade Balance

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Saving and Investment in a Small Open Economy

► Capital Mobility and the World Interest Rate

► A small open economy has a negligible effect on the world
interest rate.
► We assume a perfect capital mobility, which equalizes the
interest rate in the small open economy, r, must equal the
world interest rate r∗, the real interest rate prevailing in world
financial markets:
r = r ∗. (1)

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The Model for Small open economy(SOE)

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The Model for Small open economy

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Saving and Investment in a Small Open Economy

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A Fiscal Expansion at Home in a Small Open Economy

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A Fiscal Expansion Abroad in a Small Open Economy A

fiscal expansion in a foreign

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A Shift in the Investment Schedule in a Small Open

Economy

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Exchange Rate

► The exchange rate between two countries is the price at which

residents of those countries trade with each other.
► The Nominal Exchange Rate: nominal exchange rate is the
relative price of the currencies of two countries.
► Example : the exchange rate between U.S. dollar and the
Ethiopian birr is 54 birr per dollar
► The Real Exchange Rate : real exchange rate is the relative
price of the goods of two countries.
► It tells us the rate at which we can trade the goods of one
country for the goods of another.
► Example: Suppose an American car costs $10, 000 and a
similar Japanese car costs 2,400,000 yen.
► To compare the prices of the two cars, we must convert them
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Real Exchange Rate

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Concepts related Exchange rate

► An appreciation: is an increase in the value of a currency due

to market forces. It refers to a strengthening of the currency.
► And a depreciation is a decrease in the value of a currency /
a weakening of the currency due to market forces.
► Revaluation is an increase in the value of a currency due to
policy action.
► And a devaluation is a decrease in the value of a currency /
a weakening of the currency due to policy action.

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Real Exchange Rate and Net exports

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Determinants of Real Exchange Rate

► When the real exchange rate is lower, domestic goods are less
expensive relative to foreign goods, and net exports are
greater.
► The trade balance (net exports) must equal the net capital
outflow, which in turn equals saving minus investment. Saving
is fixed by the consumption function and fiscal policy;
investment is fixed by the investment function and the world
interest rate.

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Determinants or Real Exchange Rate

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The Impact of Expansionary Fiscal Policy at Home on the

Real Exchange Rate Expansionary fiscal poli

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The Effects of Trade Policies

► Trade policies, broadly defined, are policies designed to

influence directly the amount of goods and services exported
or imported.
► Purpose of trade policies:- protecting domestic industries from
foreign competition.
► It includes placing a tax on foreign imports (a tariff) or
restricting the amount of goods and services that can be
imported (a quota).
► What would happen if the government prohibited the import
of foreign cars. For any given real exchange rate, imports
would now be lower, implying that net exports (exports minus
imports) would be higher. Thus, the net-exports schedule
shifts outward
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The Impact of Protectionist Trade Policies on the Real

Exchange Rate

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Mundell Fleming Model

► Like IS-LM model, Mundell Fleming Model stresses the

interaction between the goods market and the money market.
► Both models assume that the price level is fixed and then
show what causes short-run fluctuations in aggregate income.
► IS-LM model is used for closed economy while Mundell
Fleming is used for an open economy/international trade.
► Mundell-Fleming model makes one important and extreme
assumption: it assumes that the economy being studied is a
small open economy with perfect capital mobility.
► The behavior of an economy in the Mundell-Flemming Model
depends on the exchange-rate system it has adopted.
► It helps to understand how alternative exchange-rate regimes
work and how the choice of exchange-rate regime impinges on
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The Goods Market and the IS∗ Curve

► It assumes a small open economy with perfect capital

mobility. r = r ∗
► The Goods Market and the IS ∗ Curve. Now, in addition to
IS-LM model, it adds a new term for net exports.

Y = C(Y − T ) + I (r ∗) + G + NX (e).

► Here, we define the exchange rate e as the amount of foreign

currency per unit of domestic currency—for example
► The Mundell-Fleming model, however, assumes that the price
levels at home and abroad are fixed, so the real exchange rate
is proportional to the nominal exchange rate.

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The Goods Market and the IS∗ Curve

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Mundell Fleming Model

► The IS∗ curve slopes downward because a higher exchange

rate reduces net exports, which in turn lowers aggregate
income.
► As shown in the graph, an increase in the exchange rate from
e1 to e2 lowers net exports from NX(e1) to NX(e2).
► The reduction in net exports shifts the planned-expenditure
schedule downward and thus lowers income from Y1 to Y2.
► The IS∗ curve summarizes this relationship between the
exchange rate e and income Y

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The Money Market and the LM∗ Curve

► Similar to the IS-LM model, here too, the supply of real

money balances M/P equals the demand L(r, Y). But now,
r = r ∗. Hence,
M/P = L(r ∗, Y ).
► The LM ∗ curve is vertical because the exchange rate does not
enter into the LM ∗ equation.
► Given the world interest rate, the LM ∗ equation determines
aggregate income, regardless of the exchange rate.

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The Money Market and the LM∗ Curve

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Mundell Fleming Model: Putting the Pieces Together

► According to the Mundell–Fleming model, a small open

economy with perfect capital mobility can be described by two
equations:

Y = C(Y − T ) + I (r ∗) + G + NX (e) IS ∗
M/P = L(r ∗,Y ) LM∗

► The first equation describes equilibrium in the goods market;

the second describes equilibrium in the money market.
► The exogenous variables are fiscal policy G and T, monetary
policy M, the price level P, and the world interest rate r∗.
► The endogenous variables are income Y and the exchange rate
e.

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Mundell Fleming Model: Putting the Pieces Together

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The Small Open Economy Under Floating Exchange Rates

► Floating exchange rates Under a system of floating exchange

rates, the exchange rate is set by market forces and is allowed
to fluctuate in response to changing economic conditions.
► More specifically, the value of a currency is determined by the
supply of and demand for it.
► The supply of and demand for a currency are in turn is
affected by interest rate differences, capital outflow and so on.

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Mundell Fleming Model: Fiscal policy with floating

exchange rate

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Mundell Fleming Model: A Monetary Expansion Under

Floating Exchange Rates

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Mundell Fleming Model:A Trade Restriction Under

Floating Exchange Rates

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Mundell Fleming Model:The Small Open Economy Under

Fixed Exchange Rates

► Under a fixed exchange rate, the central bank announces a

value for the exchange rate and stands ready to buy and sell
the domestic currency to keep the exchange rate at its
announced level.
► Example, if National Bank of Ethiopia fixes the exchange rate
of Birr , say, at 50 ETb=$1

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How a Fixed Exchange Rate Governs the Money Supplys

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A Fiscal Expansion Under Fixed Exchange Rates

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A Monetary Expansion Under Fixed Exchange Rates If the

Fed tries to increase the

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A Trade Restriction Under Fixed Exchange Rates

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The Mundell–Fleming Model: Summary of Policy Effects

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Pros and Cons of Different Exchange-Rate Systems

► Floating exchange rate allows monetary policy to be used for

other purposes. Under fixed rates, monetary policy is
committed to the single goal of maintaining the exchange rate
at its announced level.
► Advocates of fixed exchange rates argue that exchange-rate
uncertainty makes international trade more difficult.
► However, it is impossible for a nation to have free capital
flows, a fixed exchange rate, and independent monetary
policy. This fact, often called the impossible trinity

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The Impossible Trinity

▶ The first option is to allow free flows of capital and to conduct an independent monetary policy, as the
United States has done in recent years. In this case, it is impossible to have a fixed exchange rate.
▶ The second option is to allow free flows of capital and to fix the exchange rate, as Hong Kong has done in
recent years. In this case, the nation loses the ability to run an independent monetary policy.
▶ The third option is to restrict the international flow of capital in and out of the country, as China has done
in recent years.

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Summary

► 1. The Mundell–Fleming model is the IS–LM model for a small

open economy. It takes the price level as given and then shows what
causes fluctuations in income and the exchange rate.
► 2. The Mundell–Fleming model shows that fiscal policy does not
influence aggregate income under floating exchange rates. A fiscal
expansion causes the currency to appreciate, reducing net exports
and offsetting the usual expansionary impact on aggregate income.
Fiscal policy does influence aggregate income under fixed exchange
rates.
► 3. The Mundell–Fleming model shows that monetary policy does
not influence aggregate income under fixed exchange rates. Any
attempt to expand the money supply is futile, because the money
supply must adjust to ensure that the exchange rate stays at its
announced level. Monetary policy does influence aggregate income
under floating exchange rates.
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Summary

► 4. If investors are wary of holding assets in a country, the

interest rate in that country may exceed the world interest
rate by some risk premium. According to the Mundell-Fleming
model, an increase in the risk premium causes the interest
rate to rise and the currency of that country to depreciate.
► 5. There are advantages to both floating and fixed exchange
rates. Floating exchange rates leave monetary policymakers
free to pursue objectives other than exchange-rate stability.
Fixed exchange rates reduce some of the uncertainty in
international business transactions. When deciding on an
exchange-rate regime, policymakers are constrained by the
fact that it is impossible for a nation to have free capital
flows, a fixed exchange rate, and independent monetary policy.

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