Chapter 13: The Mundell Fleming Model and the Exchange Rate Regime

Question 1

The Mundell Fleming Model

Answer 1

Key assumption: small open economy with perfect capital mobility
r=r*
Goods market equilibrium - IS* curve
Y= C(Y-T)+I(R*)+NX(e)
WHERE
e=nominal exchange rate
=foreign currency per unit of domestic currency

Question 2

The IS* curve: goods market equilibrium

Answer 2

-The IS* curve is drawn for a given value of r*
e decreases, NX rises, Y rises

Question 3

Floating Exchange rates

Answer 3

e is allowed to fluctuate in response to changing economic conditions

Question 4

Fixed exchange rates

Answer 4

the central bank trades domestic for foreign currency at a predetermined price

Question 5

Crowding Out

Answer 5

-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

Question 6

Monetary Policy under floating exchange rates

Answer 6

-An increase in M shifts LM* right because Y must rise to restore equilibrium in the money market
Results: change in e < 0, change in Y > 0

Question 7

Lessons about monetary policy

Answer 7

-Monetary policy affects output by affecting the components of aggregate demand.
-expansionary monetary policy does not raise world aggregate demand, it merely shifts demand from foreign to domestic products

Question 8

Trade Policy Under Floating Exchange Rates

Answer 8

At any e, tariffs of quotas reduce imports, increase NX and shifts IS* to the right

Question 9

Lessons about trade policy

Answer 9

Import restrictions cannot reduce a trade deficit
-even though NX is unchanged, these is less trade
-trade restrictions restrict imports
-the exchange rate appreciation reduces exports
-less trade means fewer ‘gains rom trade”

Question 10

Fixed Exchange Rates

Answer 10

-under fixed exchange rates, the central bank stands ready to buy or sell the domestic currency for foreign currency at a predetermined rate
-the central bank shifts the LM* curve as required to keep e at its proannounced rate
-This system fixes the nominal exchange rate
In the long run, when prices are flexible, the real exchange rate an move even if the nominal rate is fixed

Question 11

Fiscal Policy under fixed exchange rates

Answer 11

-To keep e from rising, the central bank must sell domestic currency, increase M and shifting LM* to the right
change in e = 0, change in y > 0

Question 12

Monetary policy under fixed exchange rates

Answer 12

An increase in M would shift LM* right and reduce e
To prevent the fall in e, the central bank must buy domestic currency, which reduces M and shifts LM* left
-Under fixed rates, monetary policy cannot be used to affect output

Question 13

Trade Policy under fixed exchange rate

Answer 13

A restriction on imports puts upward pressure on e
-To keep e from rising, the central bank must sell domestic currency, which increases M and shifts LM right
-Under fixed exchange rates, import restrictions increase Y and NX

Question 14

Interest rate Differentials

Answer 14

two reasons why r may differ from r*:
country risk: there is a risk that the country’s borrowers will default on their loan payments because of political or economic turmoil
expected exchange rate changes: if a country exchange rate is expected to fall, then its borrowers must pay a higher interest rate to compensate lenders for the expected currency depreciation

Question 15

risk premium

Answer 15

extra reward investors expect to receive for taking on a risky investment, assumed to be exogenous

Question 16

The effects of an increase in THETA (risk premium) (IS* model)

Answer 16

IS* shifts left because increase in theta, increase in r, decrease in I

Question 17

Effects of an increase in theta (LM* model)

Answer 17

LM* shifts right because increase in theta, increases r, and decreases real money balances (M/P)^d
so Y must rise to restore market equilibriumh

Question 18

Increase in Y occurs because…

Answer 18

the boost in NX (from the depreciation) is greater than the fall in I (from the rise in r)

Question 19

Why income may not rise?

Answer 19

The central bank minty to prevent the depreciation by reducing the money supply
-The depreciation might boost the price of imports enough to increase the price level
-consumers might respond to the increased risk by holding more money
each of the above would shift LM* leftward

Question 20

Argument for floating rates

Answer 20

Allow monetary policy to be used to purse other goals (Stable growth, low inflation)

Question 21

Arguments for fixed rates

Answer 21

-avoids uncertainty and volatility, making international transactions easier
-discipline monetary policy to prevent excessive money growth and hyperinflations

Question 22

Mundell Fleming and the AD Curve

Answer 22

So far, P has been fixed
-To derive the AD curve, consider the impact of a change in P in the mundell Fleming model

Question 23

Deriving the AD curve

Answer 23

Increase in P = Decrease in money supply (M/P), LM shifts left, real exchange rate increases, NX decreases, Y decreases