Economics 154a

1. Economics 154a Open Economy andthe Mundell-Fleming Model

2. Paper Assignment The paper should be 3 to 5 pages (double-spaced, printed, plus tables, figures, and references). It will count as 10 percent of the course grade. The paper must left in the box outside Ms. King’s office at 28 Hillhouse Avenue before noon on Thursday, December 11. Guidelines are that the paper must: (a) be a topic in macroeconomics, (b) consider economic history or policy, (c) present evidence and data, and (d) be an application of macroeconomic analysis. Some examples of topics would be the following:  - Administration X’s theories and policies, and their successes and/or failures - The demise of the gold standard or Bretton Woods - The role of the housing price decline in the current recession - The legacy of Alan Greenspan, Paul Volcker, or William Martin You should consult with your Teaching Fellow about your topic to make sure that it makes sense and to get ideas for sources. Consult rules on intellectual honesty and attribution, and don’t procrastinate. See notes on web site for further information.

3. Agenda for Open Economy Macro Reminder on exchange rates Short-run open-economy output determination (Mundell Fleming model) International financial systems Final thoughts

4. Reminder on Exchange rates Foreign-exchange rates are the relative prices of different national monies or currencies. Nominal exchange rate = e = foreign currency/$ Real exchange rate (R) R = e × p d / p f = domestic prices/foreign prices in a common currency

5. The broad index is a weighted average of the foreign exchange values of the U.S. dollar against the currencies of a large group of major U.S. trading partners. The index weights, which change over time, are derived from U.S. export shares and from U.S. and foreign import shares. (For construction, see Winter 2005 Federal Reserve Bulletin.

6. Exchange rate regimes I. . Fixed exchange rate A. Currency union: currencies irrevocably fixed - US states - Eurozone B. Other fixed exchange rate regimes: - Gold standard (1717 - 1933) - Bretton Woods (1945 - 1971) • hard and soft fixed rates of different varieties II. Flexible exchange rates • Currencies are market determined • Governments use monetary policies to affect exchange rates

7. The Mundell-Fleming Model Mundell-Fleming (MF) model is short run Keynesian model for small open economy. Very similar to IS-MP model. It derives impact of policies and shocks in the short run for an open economy. Usual stuff for domestic sectors: • Price and wage stickiness, unemployment, no inflation • Standard determinants for domestic industries (C, I, G, financial markets, etc.) Open economy aspects: • Small open economy • Perfectly mobile international capital so rd = rw • Net exports a function of real exchange rate, NX = NX(R) Since interest rate is given by world interest rates, relevant financial variable is exchange rate, R.

8. Goods market Start with usual expenditure-output equilibrium condition. New wrinkle is the NX function: (1) Y = C(Y - T) + I(rd) + G + NX(R, Y, Yf) Endogenous variables are (Y, R). Financial markets Next we examine the monetary policy equation. (2) rd = f(Y, π ) Important note: This leads to exactly the same model as with LM curve with fixed M rather than Taylor rule approach. Balance of Payments Finally, we have the balance of payments equilibrium in small open economy with mobile capital. (BP$) rd = rw Substituting (BP$) into (1) and (2), we get equation in Y and R: (IS$) Y = C(Y - T) + I(rw) + G + NX(R, Y, Yf) (MP$) r= f(Y, π )

9. Overall equilibrium • As in IS-MP model, in MF we examine equilibrium of financial and goods market – in this case output and exchange rate. • Equilibrium of IS$ and MP$ just like that in conventional IS-MP market, but emphasizes a different endogenous financial market (ex. rate. rather than int. rate)

10. IS$-MP$ curve Real exchange rate (R) MP$ Notes: 1. Simultaneous equilibrium of both goods and financial markets 2. Note slopes of both 3. What happened to interest rate? R* IS$ Y* Real output (Y)

11. The Case of Fixed Exchange Rates In MF model with fixed rates, monetary policy is devoted to maintaining the exchange rate. - I.e., the interest rates must be adjusted so that supply and demand for foreign exchange balance at the world interest rate. - This will occur when r = rw. - We therefore draw the MP$ curve as vertical at R = Rfix

12. Remember key point: open capital markets and equality of risk-free real rates of return. Example of stock prices in last 3 years.

13. Real exchange rate (R) IS$-MP$ curve Note: We interpret MP$ with fixed rates as horizontal = MP$-F R*=Rfix Fixed rate Curve (MP$-F) IS$ Y* Real output (Y)

14. Fiscal policy with fixed rates Suppose you were the economists in the Hoover administration (1929-33) fighting the Great Depression. Situation: fixed exchange rate under gold standard. Or suppose that France is concerned about its high unemployment rate today. Situation: currency union with rest of Euroland. Would you rely upon monetary or fiscal policy? (This analysis is somewhat oversimplified because we treat these as small open economies. Would need to incorporate large economy to get exactly right.)

15. Real exchange rate (R) Fiscal policy with fixed rates • Fiscal policy super-powerful in MF model with fixed exchange rates • But multiplier is small MP$-Fix R fix IS$’ IS$ Y Y’

16. Real exchange rate (R) Monetary policy with fixed rates Monetary policy cannot be used if want to maintain exchange rate. MP$-Fix R fix IS$ Y Real output (Y) Y = Y’

17. Depreciation of exchange rate Suppose a country has a deep recession with fixed exchange rate. One powerful tool is to depreciate the exchange rate.

18. Real exchange rate (R) Depreciation Depreciation powerful stimulus MP$-Fix(R) R fix R fix’ MP$-Fix(R’) IS$ Y Y’ Real output (Y)

19. Conclusions on Fixed Exchange Rates 1. Monetary policy: out of business! • Like central bank of Connecticut or Belgium. 2. Fiscal policy: no crowding out! Full multiplier! - But multiplier is likely to be small because marginal propensity to import is high. - Macro policy hamstrung in Euro zone because of limits on fiscal deficits of countries under Maastricht Treaty of 1992: limited deficits to 3 percent of GDP 3. Depreciation is the major financial instrument of open economies with fixed exchange rates. - But cannot be used by countries in currency unions (France, Michigan)

20. Cases with Flexible Exchange Rates With flexible exchange rates, monetary policy can now be devoted to domestic objectives. But this implies that exchange rate is market determined. (IS$) Y = C(Y - T) + I(rw) + G + NX(R) (MP$) r= f(Y, π )

21. Fiscal Expansion with Taylor rule Real exchange rate (R) Notes: 1. Fiscal expansion leads to exchange rate appreciation 2. No impact on output 3. NX down, G up 3. Leads to “twin deficits” of NX and T-G MP$ R** R* IS$’ IS$ Y*= Y** Real output (Y)

22. Increase output target Real exchange rate (R) MP$’ MP$ 1. Monetary expansion leads to depreciation 2. Output expansion 3. C, NX up; I, G unchanged R* R** IS$ Y* Y** Real output (Y)

23. Reagan-Volcker Real exchange rate (R) MP$ 1. Monetary contraction 2. Fiscal expansion 3. Wow! R** R* IS$’ IS$ MP$’ Real output (Y) Y** Y*

24. Note major appreciation of dollar in Volcker-Reagan period as predicted by the M/F model.

25. Major Conclusions from MF model

26. The Long Run (or Full Employment) with Flexible Rates • Assume that monetary policy keeps the economy at full employment • Then IS-MP becomes: r d = f(Ypot) (MP$-FE) Y = C(Y - T) + I(rw) + G + NX(R) (IS$) 3. Here, exchange rate adjusts to keep output (and S-I) balance.

27. Full Employment Monetary Policy Real exchange rate (R) MP$-FE R** R changes so that IS shifts until Y returns to potential output R* IS$’ IS$ Ypot