[6] The Open Economy: The Mundell-Fleming Model and the Exchange-Rate Regime Flashcards
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 __ ___ ___.
international trade, finance
IS-LM
fixed price levels, short-run, aggregate income
exchange rate system
Key difference between Mundell-Flemming and IS-LM?
IS-LM is closed and Mundell-Fleming assumes an open economy.
What is a key Assumption of Mundell-Flemming Model?
Small open economy with perfect capital mobility.
r = r*
What is the IS curve an equilibrium of ?
Give an equation for it using the Mundell-Flemming assumption of perfect capital mobility? (r=r*)
Goods Market
Y = C ( Y-T ) + I (r*) + G + NX (e)
where
e = nominal exchange rate
= foreign currency per unit domestic currency
What happens to ‘Y’ if ‘e’ (the nominal ER) falls?
v e = ^NX = ^Y
What is on the axis of the Mundell-Flemming model?
X-axis = Y
Y-axis = e
What is the LM curve like in the MF model and why?
The LM curve is vertical because, given r*, there is only one value of Y that equates money demand with supply, regardless of e.
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 ___ ___.
floating
fluctuate
economic conditions
fixed
predetermined price
At any given value of e, a fiscal expansion results in? x2
increases Y, shifting IS* to the right.
Results:
Δe > 0, ΔY = 0
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 …
real GDP
causing the interest rate to rise
causing the exchange rate to appreciate
An increase in M shifts __ __ because …
Δe 0, ΔY 0
LM* right
Y must rise to restore equilibrium in the money market.
Results:
Δe < 0, ΔY > 0
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 __.
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
At any given value of e, a tariff or quota… x3
Δe 0, ΔY 0
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
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 __ __.
trade deficit less reduces imports appreciation protects jobs, domestic export-producing total employment sectoral frictional unemployment
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.
fixed domestic, foreign predetermined shifts LM* curve e preannounced/predetermined nominal exchange rate flexible Real, move
Under floating rates, a ___ expansion would ___ e.
To keep e from __, the ___ must sell domestic currency, which…
Results: Δe 0, ΔY 0
fiscal, raise
rising, central bank
increases M and shifts LM* to the right.
= >
Under floating rates, fiscal policy is __ at changing __.
Under fixed rates, ___ policy is very __ at changing output
Results:
Δe 0, ΔY 0
ineffective, output
fiscal, effective
Δe = 0, ΔY > 0
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
right e e buy domestic currency M back
Δe = 0, ΔY = 0
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.
Floating, Y, NX
increase, Y, NX
demand,
foreign
domestic
Argument for floating rates:
x1
allow monetary policy to be used to pursue other goals (stable growth, low inflation)
Arguments for fixed rates:
x2
avoid uncertainty and volatility, making international transactions easier
discipline monetary policy to prevent excessive money growth and hyperinflation
What is the impossible Trinity?
Example for each option
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]
What are the Mundell-Flemming Equations for IS and LM curves?
IS:
Y = C ( Y-T ) + I (r*) + G + NX (e)
LM:
M/P = L (r* , Y)
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.
P
Use step by step analysis to expalin Why the AD curve has a negative slope:
^P = v (M/P)
x4
Why the AD curve has a negative slope:
^P = v (M/P) → LM shifts left → ^ ε → v NX → v Y
If Y < ȳ then there is \_\_\_ pressure on prices. Over time, P will move \_\_\_, causing (M/P) ε NX Y
downward
down
(M/P) ^
ε v
NX ^
Y ^
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.
small open
P
income
the exchange rate
Fixed , floating
income, floating
Fixed monetary
exchange rate stability
uncertainty
