Instructor Sandeep Basnyat Sandeep_basnyat@yahoz Mobile: 9841 892281

1. Macroeconomics & The Global Economy -Term IIIAce Institute of ManagementSession 10: The Mundell-Fleming Model and Exchange Rate Regime Instructor SandeepBasnyat Sandeep_basnyat@yahoz.com Mobile: 9841 892281

2. IS-LM and Mundell-Fleming Model • IS-LM: relationship between interest rate (r) and output (Y)- IS is the negative relationship where as LM is the positive relationship. • Mundell-Fleming: relationship between nominal exchange rate (e) and output (Y). • Argue that: an economy can not simultaneously maintain fixed exchange rate, free capital movement and independent monetary policy.

3. CHAPTER 12 The Open Economy Revisited The IS* curve is drawn for a given value of r*. Intuition for the slope: e IS* Y Mundell-Fleming Model:The IS* curve: Goods market eq’m Equation for IS Curve: Y = C+I+G+NX (e)

4. CHAPTER 12 The Open Economy Revisited LM represents money supply by central bank, which is fixed for certain level of output. The LM* curve does not depend on e and is vertical to e. e LM* Y The LM* curve: Money market eq’m

5. CHAPTER 12 The Open Economy Revisited e LM* IS* Y Equilibrium in the Mundell-Fleming model equilibrium exchange rate equilibrium level of income

6. CHAPTER 12 The Open Economy Revisited 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

7. CHAPTER 12 The Open Economy Revisited At any given value of e, a fiscal expansion shifts IS* to the right, increasing e. Therefore, in Floating exchange rate system, fiscal policy is ineffective in increasing output e e2 e1 Y Fiscal policy under floating exchange rates Y1

8. CHAPTER 12 The Open Economy Revisited An increase in Mshifts LM* right . Y increases and e decreases. Therefore, in Floating exchange rate system, monetary policy is effective in increasing output e e1 e2 Y Y1 Monetary policy under floating exchange rates Y2

9. CHAPTER 12 The Open Economy Revisited Under floating rates, a fiscal expansion would raise e. e e1 Y Fiscal policy under fixed exchange rates Under floating rates, fiscal policy is ineffectiveat changing output. Under fixed rates,fiscal policy is very effective at changing output. To keep e from rising, the central bank must sell domestic currency, which increases Mand shifts LM* right. Y1 Y2

10. CHAPTER 12 The Open Economy Revisited An increase in M would shift LM* right and reduce e. e e1 Y Y1 Monetary policy under fixed exchange rates Under floating rates, monetary policy is very effective at changing output. Under fixed rates,monetary policy cannot be used to affect output. 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

11. CHAPTER 12 The Open Economy Revisited 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.

12. CHAPTER 12 The Open Economy Revisited Free capital flows Fixed exchange rate Independent monetary policy The Impossible Trinity A nation cannot have free capital flows, independent monetary policy, and a fixed exchange rate simultaneously. A nation must choose one side of this triangle and give up the opposite corner. Option 2(Nepal) Option 1(U.S.) Option 3(China)

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