[6] The Open Economy: The Mundell-Fleming Model and the Exchange-Rate Regime

Question 1

The Mundell-Fleming model extends our analysis of AD to include ___ ___ and ___.
The model is closely related to the ___ model
Both assume ___ ___ levels and show the causes of __-__ fluctuations in __ ___
One lesson from Mundell-Fleming model: behaviour of open economy depends on its __ ___ ___.

Answer 1

international trade, finance
IS-LM
fixed price levels, short-run, aggregate income
exchange rate system

Question 2

Key difference between Mundell-Flemming and IS-LM?

Answer 2

IS-LM is closed and Mundell-Fleming assumes an open economy.

Question 3

What is a key Assumption of Mundell-Flemming Model?

Answer 3

Small open economy with perfect capital mobility.

r = r*

Question 4

What is the IS curve an equilibrium of ?

Give an equation for it using the Mundell-Flemming assumption of perfect capital mobility? (r=r*)

Answer 4

Goods Market

Y = C ( Y-T ) + I (r*) + G + NX (e)
where
e = nominal exchange rate
= foreign currency per unit domestic currency

Question 5

What happens to ‘Y’ if ‘e’ (the nominal ER) falls?

Answer 5

v e = ^NX = ^Y

Question 6

What is on the axis of the Mundell-Flemming model?

Answer 6

X-axis = Y

Y-axis = e

Question 7

What is the LM curve like in the MF model and why?

Answer 7

The LM curve is vertical because, given r*, there is only one value of Y that equates money demand with supply, regardless of e.

Question 8

In a system of __ exchange rates, e is allowed to __ in response to changing ___ ___.

In contrast, under ___ exchange rates, the central bank trades domestic for foreign currency at a ___ ___.

Answer 8

floating
fluctuate
economic conditions

fixed
predetermined price

Question 9

At any given value of e, a fiscal expansion results in? x2

Answer 9

increases Y, shifting IS* to the right.
Results:
Δe > 0, ΔY = 0

Question 10

In a small open economy with perfect capital mobility, fiscal policy cannot affect ___ _ _ _.
Crowding out
closed economy: Fiscal policy crowds out investment by …
Small open economy: Fiscal policy crowds out net exports by …

Answer 10

real GDP

causing the interest rate to rise

causing the exchange rate to appreciate

Question 11

An increase in M shifts __ __ because …

Δe  0, ΔY  0

Answer 11

LM* right

Y must rise to restore equilibrium in the money market.

Results:
Δe < 0, ΔY > 0

Question 12

Monetary policy affects output by affecting the __ of ___ __ :
closed economy: M → r → I → Y
small open economy: M → e → NX → Y

Expansionary monetary policy does not raise world ___ __; it merely shifts demand from __ __ to __ __.

So, the increases in ___ income and employment are at the expense of losses __.

Answer 12

components
aggregate demand:

closed economy: ^M → v r → ^I → ^Y
small open economy: ^M → v e → ^ NX → ^ Y

aggregate demand
foreign products to domestic products

domestic, abroad

Question 13

At any given value of e, a tariff or quota… x3

Δe  0, ΔY  0

Answer 13

At any given value of e, a tariff or quota reduces imports, increases NX, and shifts IS* to the right.
Results:
Δe > 0, ΔY = 0

Question 14

Import restrictions cannot reduce a __ ___.
Even though NX is unchanged, there is __ trade:
The trade restriction___ ____.
The exchange rate ___ reduces exports.
Less trade means fewer “gains from trade.”
Import restrictions on specific products __ __ in the ___ industries that produce those products but destroy jobs in __-__ sectors.
Hence, import restrictions fail to increase __ __. Also, import restrictions create __ shifts, which cause __ __.

Answer 14

trade deficit
less
reduces imports
appreciation
protects jobs,
domestic
export-producing
total employment
sectoral
frictional unemployment

Question 15

Under ___ exchange rates, the central bank stands ready to buy or sell the __ currency for __ currency at a ____ rate.
In the Mundell–Fleming model, the central bank __ the _ _ __ as required to keep _ at its ___ rate.
This system fixes the __ __ __. In the long run, when prices are __, the __ exchange rate can __ even if the nominal rate is fixed.

Answer 15

fixed
domestic, foreign
predetermined
shifts
LM* curve
e
preannounced/predetermined
nominal exchange rate
flexible
Real, move

Question 16

Under floating rates, a ___ expansion would ___ e.
To keep e from __, the ___ must sell domestic currency, which…

Results: Δe  0, ΔY  0

Answer 16

fiscal, raise
rising, central bank

increases M and shifts LM* to the right.

= >

Question 17

Under floating rates, fiscal policy is __ at changing __.
Under fixed rates, ___ policy is very __ at changing output
Results:
Δe  0, ΔY  0

Answer 17

ineffective, output
fiscal, effective

Δe = 0, ΔY > 0

Question 18

An increase in M would shift LM* ___ and reduce __.
To prevent the fall in __, the central bank must __ _____, which reduces _ and shifts LM* __.
Results:

Δe  0, ΔY  0

Answer 18

right
e
e
buy domestic currency
M
back

Δe = 0, ΔY = 0

Question 19

Under ___ rates, import restrictions do not affect _- or _ _.

Under fixed rates, import restrictions __ _ and _ _.

But these gains come at the expense of other countries: the policy merely shifts ___ from ___ goods to __ goods.

Answer 19

Floating, Y, NX

increase, Y, NX

demand,
foreign
domestic

Question 20

Argument for floating rates:

x1

Answer 20

allow monetary policy to be used to pursue other goals (stable growth, low inflation)

Question 21

Arguments for fixed rates:

x2

Answer 21

avoid uncertainty and volatility, making international transactions easier
discipline monetary policy to prevent excessive money growth and hyperinflation

Question 22

What is the impossible Trinity?

Example for each option

Answer 22

it is impossible to have all three of the following at the same time: 
a fixed foreign exchange rate
 ↕   [Hong Kong]
free capital movement
 ↕ [USA]
Independent Monetary Policy
 ↕ [China]

Question 23

What are the Mundell-Flemming Equations for IS and LM curves?

Answer 23

IS:

Y = C ( Y-T ) + I (r*) + G + NX (e)

LM:

M/P = L (r* , Y)

Question 24

So far in Mundell–Fleming model, _ has been fixed.

Next, to derive the AD curve, consider the impact of a change in _ in the Mundell–Fleming model.

Answer 24

P

Question 25

Use step by step analysis to expalin Why the AD curve has a negative slope:

^P = v (M/P)

x4

Answer 25

Why the AD curve has a negative slope:

^P = v (M/P)
→ LM shifts left
→ ^ ε
→ v NX
→ v Y

Question 26

If Y < ȳ
then there is \_\_\_ pressure on prices. 
Over time, P  will move \_\_\_, causing
(M/P)  
ε 
NX 
Y 

Answer 26

downward
down

(M/P) ^
ε v
NX ^
Y ^

Question 27

SUMMARY
Mundell–Fleming model:
the IS–LM model for a \_\_\_ \_\_\_ economy.
takes _ as given.
can show how policies and shocks affect \_\_ and \_\_ \_\_ \_\_.

Fiscal policy:
affects income under __ exchange rates but not under __ exchange rates.

Monetary policy:
affects __ under ___ exchange rates.
Under __ exchange rates, ___ policy is not available to affect output.

Fixed versus floating exchange rates
Under floating rates, monetary policy is available for purposes other than maintaining__ ___ ___. Fixed exchange rates reduce some of the ___ in international transactions.

Answer 27

small open
P
income
the exchange rate

Fixed , floating

income, floating

Fixed monetary

exchange rate stability

uncertainty