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WEEK 9-10 OPEN ECONOMY IS-LM FRAMEWORK THE ‘MUNDELL-FLEMING’ MODEL

WEEK 9-10 OPEN ECONOMY IS-LM FRAMEWORK THE ‘MUNDELL-FLEMING’ MODEL. r. LM. E. LM*. IS. IS*. Y. Y. Closed economy version. Small open economy version. IS- LM MODEL. IS CURVE. Goods market equilibrium. Y = C + I + G. Y = C + I + G + NX. Income = planned spending.

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WEEK 9-10 OPEN ECONOMY IS-LM FRAMEWORK THE ‘MUNDELL-FLEMING’ MODEL

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  1. WEEK 9-10 OPEN ECONOMY IS-LM FRAMEWORK THE ‘MUNDELL-FLEMING’ MODEL G. Mankiw Macroeconomics CH12 slides edited and modified by C. Fuller

  2. r LM E LM* IS IS* Y Y Closed economy version Small open economy version IS- LM MODEL IS CURVE Goods market equilibrium Y = C + I + G Y = C + I + G + NX Income = planned spending MAIN DIFFERENCES from closed economy case: LM CURVE Money market equilibrium L(Y, r) = M/P L(Y, r) = M/P Money supply = money demand OVERALL EQUILIBRIUM Determines Y and national interest rate r Determines Y and exchange rate Given world interest rate (r*) determines national level of r CHAPTER 11 Aggregate Demand II

  3. WEEKS 9-10 SUMMARY 0. The Closed Economy IS-LM model 1. The Open Economy IS-LM model (‘Mundell-Fleming’ model) 2. Flexible (floating) exchange rates 3. Using the closed and open IS-LM models CHAPTER 12 The Open Economy Revisited

  4. 0.Closed Economy IS-LM model: POLICY MONETARY POLICY FISCAL POLICY LM r LM r r2 LM’ r1 r1 r0 IS’ IS IS Y** Y** Y* Y* Y Y Shift in Shift in Rise in money supply Predict: Rise in r Rise in Y Rise in G Fall in T Predict: Fall in r Rise in Y IS LM To right To right CHAPTER 12 The Open Economy Revisited

  5. 1.The Mundell-Fleming model:Open Economy IS-LM • Key assumption: Small open economy (SOE) with perfect capital mobility. r = r* [becauseSOE forced to accept world r] • Goods market equilibrium – the IS* curve: where e = nominal exchange rate = foreign currency per unit domestic currency We could use E instead of e as prices are fixed anyway. An exam question might have either – won’t make any difference. CHAPTER 12 The Open Economy Revisited

  6. The IS* curve is drawn for a given value of r*. Intuition for the slope: e IS* Y The IS* curve: Goods market eq’m CHAPTER 12 The Open Economy Revisited

  7. The LM* curve is drawn for a given value of r*. is vertical because:given r*, there is only one value of Ythat equates money demand with supply, regardless of e. e LM* Y The LM* curve: Money market eq’m CHAPTER 12 The Open Economy Revisited

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

  9. 2. Floating exchange rates • In a system of floating exchange rates, e is allowed to fluctuate in response to changing economic conditions.  WE FOCUS ON THIS CHAPTER 12 The Open Economy Revisited

  10. At any given value of e, a fiscal expansion increases Y,shifting IS* to the right. e e2 e1 Y FLOATING EXCHANGE RATES: Fiscal policy Results: e goes up, no change in Y Y1 WHY IS FISCAL POLICY INEFFECTIVE? CHAPTER 12 The Open Economy Revisited

  11. e e2 e1 Y FLOATING EXCHANGE RATES: Fiscal policy LM r IS’ reminder IS Y Results [from last slide] e goes up, no change inY WHY does e rise? [1] In CLOSED economy: Fiscal expansion  rise in Y , rise in r In SMALL OPEN economy: [2] but A rise of domestic ‘r’ above r*.. Y1 ...causes HUGE CAPITAL INFLOW [3] Big rise in demand for UK currency CHAPTER 12 The Open Economy Revisited

  12. FLOATING EXCHANGE RATES: Lessons about fiscal policy • In a small open economy with perfect capital mobility, fiscal policy cannot affect Y. • “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. CHAPTER 12 The Open Economy Revisited

  13. An increase in Mshifts LM* right e e1 e2 Y Y1 FLOATING EXCHANGE RATES: Monetary policy Results: e falls, Y goes up Y2 WHY IS MONETARY POLICY SO EFFECTIVE? CHAPTER 12 The Open Economy Revisited

  14. e e1 e2 Y Y1 FLOATING EXCHANGE RATES: Monetary policy LM r IS reminder Y Results (from last slide) e falls, Y goes up WHY does e fall? [1] In CLOSED economy Rise in M  rise in Y, fall in r In SMALL OPEN economy.. [2] BUT Y2 If domestic ‘r’ falls below r*.. [3] Big fall in demand for UK currency ...this causes a HUGE CAPITAL OUTFLOW CHAPTER 12 The Open Economy Revisited

  15. FLOATING EXCHANGE RATES: Lessons about monetary policy • Monetary policy is very effective at changing Y • Monetary policy affects output by affecting the components of aggregate demand: closed economy: M rIY small open economy: M eNX Y CHAPTER 12 The Open Economy Revisited

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