L7 - The Open Economy: The Mundell-Fleming Model and the Exchange-Rate Regime

Question 1

What is the key assumption of the Mundell-Flemming Model?

Answer 1

• Small open economy with perfect capital mobility.
• Important to define the economies size (if they were large they could affect prices on the world’s market)
• perfect capital mobility –> the country is free to borrow and lend on a international level
  
  • So r=r*(the world’s interest rate)
  • whenever we use r* we are talking about an open economy - as a small economy we take the world’s interest rate

Question 2

What does the IS* curve look like on a graph?

Answer 2

•e = nominal exchange rate = foreign currency per unit domestic currency

• if e falls –> currency is depreciating relative to foreign currencies –> increase demand in exports so NX rises

Question 3

What does the LM* curve look like on a graph?

Answer 3

Question 4

What does Equilibrium in the Mundell-Fleming model look like?

Answer 4

Question 5

What is a floating and fixed exchange rate?

Answer 5

• 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. (then buy and sell that currency to maintain that exchange rate)

Question 6

How does Fiscal policy affect the IS-LM model under a floating exchange rate?

Answer 6

• as the currency appreciates through an increase in demand for the pound, the increase in Y from fiscal expansion is then offset by the fall in NX (due to appreciation of domestic currency) lead to a no change in Output –> looking at the IS-LM equation if M, P and r* arent effected by a shift in IS, any changes in Y would disequilibriate the markets so they must offset by NX in order to equilibriate it again
• • interest rates do not increase when the IS curve is shifted to the right as it is set at the world rate (r*) –>
    
    • what is is that with the shift in IS there is pressure on domestic interest rates
    • however if foreign investors seen domestic interest rates rise above the world rate, the country would see more capital inflow (as foreign investors can make more for their money)
    • this leads to an excess of lended funds causes the rate of lending to fall back to the world rate

Question 7

What can we learn about Fiscal Policy on a small, open economy?

Answer 7

In a small open economy with perfect capital mobility, fiscal policy cannot affect real GDP.

There is also evidence of 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.

Question 8

How does Monetary policy affect the IS-LM model under a floating exchange rate?

Answer 8

• e.g. the central bank increase the money supply
• This causes the LM* to shift to the right
  
  • This causing an upwards pressure on income
  • This would normal causes a downards pressure on r in a closed economy –> it is fixed at the world rate, r*, in this case
  • This leads to an outflow of capital as the domestic starts to fall below the world rate, as they can get better return of their investment elsewhere.
  • This leads to less demand for the domestic currency and thus an excess supply leads to a depreciation in the domestic currencies exchange rate
  • (as r much adjust back to the world rate, there must be an adjustment in e)
  • as the exchange rate falls, NX rises leading to a rise in Y

Question 9

What can we learn about monetary policy in a small,open economy?

Answer 9

• Monetary policy affects output by affecting the components of aggregate demand:
• closed economy: rise M → fall r → rise I → rise Y
• small open economy: rise M → fall e → rise NX → rise Y
• Expansionary monetary policy does not raise world aggregate demand; it merely shifts demand from foreign to domestic products (exporters)

So, the increases in domestic income and employment are at the expense of losses abroad

Question 10

How does Trade Policy affect the IS-LM model under a floating exchange rate?

Answer 10

• Government imposes restrictive trade policys (tariff) –> increases the price of imports OR (quotas) –> limit the level of goods you are allowed to import
• NX increases shifts the IS* to the right
• This causes an upwards pressure on r, as it rises above the world interest rate, r*, we see an influx of capital inflows leading to a reduction in the cost of lending due to an excess supply of capital –> r is fixed
• But with the extra inflow, demand for the currency rises, leading to an appreciation of the domestic currency –> leading to a fall of NX, causing Y to fall back to the equilibrium levels

Question 11

What can we learn about Trade Policy on a small, open economy?

Answer 11

Import restrictions cannot reduce a trade deficit.

• Even though NX is unchanged, there is less trade:
  
  • The trade restriction reduces imports.
  • The exchange rate appreciation reduces exports.
• Less trade means fewer “gains from trade.”
• Import restrictions on specific products save jobs in the domestic industries that produce those products but destroy jobs in export-producing sectors.
• Hence, import restrictions fail to increase total employment.
• Also, import restrictions create sectoral shifts, which cause frictional unemployment.

Question 12

What is the Mundell-Fleming model like under a fixed exchange rate?

Answer 12

• Under fixed exchange rates, the central bank stands ready to buy or sell the domestic currency for foreign currency at a predetermined rate.
• In the Mundell–Fleming model, the central bank shifts the LM* curve as required to keep e at its preannounced rate.

•This system fixes the nominal exchange rate.
In the long run, when prices are flexible, the real exchange rate can move even if the nominal rate is fixed.

Question 13

How does Fiscal Policy affect the IS-LM model under a fixed exchange rate?

Answer 13

• Under floating exchange rates, a fiscal expansion would raise e (due to the increase in G leading to a shift in the IS curve)
• To keep e from rising the central bank must sell domestic currency, which increases M and shifts LM* to the right
• this results in an overall increase in Y without effect the exchange rate.

Question 14

How does Fiscal Policy compare under both Floating and Fixed exchange rates?

Answer 14

Under floating rates, fiscal policy is ineffective at changing output.

Under fixed rates, fiscal policy is very effective at changing output

Question 15

How does Monetary Policy affect the IS-LM model under a fixed exchange rate?

Answer 15

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 e₁ shifts LM* back left. –>

• you are almost pegging your countries currency against another, essentially mimicing their monetary policy, this is why there would be no need for changes in monetary supply as you will just have to change it back
• Leading to no long term effect in e or Y

Question 16

How does Monetary Policy compare under both Floating and Fixed exchange rates?

Answer 16

Under floating rates, monetary policy is very effective at changing output.

Under fixed rates, monetary policy cannot be used to affect output.

Question 17

How does Trade Policy affect the IS-LM model under a fixed exchange rate?

Answer 17

•A restriction on imports puts upward pressure on e. –> tariffs and quotas lead to a shift in NX as imports are reduced/limited

To keep e from rising, the central bank must sell domestic currency, which increases M and shifts LM* to the right

• this results in Y with no effect on the exchange rate

Question 18

How does Trade Policy compare under both Floating and Fixed exchange rates?

Answer 18

Under floating rates, import restrictions do not affect Y or NX.

Under fixed rates, import restrictions increase Y and NX.

But these gains come at the expense of other countries: the policy merely shifts demand from foreign goods to domestic goods.

Question 19

What is the Summary of Policy effects in the Mundell-Fleming Model?

Answer 19

Question 20

What are arguements for Floating Exchanges Rates?

Answer 20

• allows monetary policy to be used to pursue other goals (stable growth, low inflation) –> as under fixed monetary policy is used purely to maintain the exchange rate

Question 21

What are the arguments for Fixed exchange rates?

Answer 21

• avoid uncertainty and volatility, making international transactions easier –> this is harder when exchange rates are constantly fluctuation and your purchasing power can change at any given time like under floating exchange rates
• discipline monetary policy to prevent excessive money growth and hyperinflation
• although a simple rumour could cause a speculative attack on an exchange rate - like in Mexico - This risk would train the central banks reserves and could force the central bank to abandon the peg - in this case the rumour would prove self-fulfilling

Question 22

What is the Impossible Trinity?

Answer 22

• Also called the Tri-lemma
• you can only have two of the three

Question 23

How can the Mundell-Fleming Model be used to derive the AD curve?

Answer 23

• So far P has been fixed but now we want to consider the impact of a change in P in the Mundell-Flemming model so now, NX is a function of ε not e, so the real exchange rate is influenced by the real exchange rate (ε) = eP/P* where P is the domestic price and P* is foreign prices.
• The real exchange rate give the actually purchasing power of a currency, e.g. (1:1.5) i can get 1 unit of a good in the UK for 1.5 units of a good in the US

The AD curve can then be derived by:

• From a low level of prices, if P rises M/P (real money balances) falls so we can purchase less goods so our income has essentially fallen
• This leads to the LM shifting to the left
• ε rises
• NX falls
• Y falls
• plotting the relative Prices and Output derives the AD curve

Question 24

How can the Mundell-Flemming Model explain the change in AD-AS model from the short to long run?

Answer 24

• Starting at a high level of Price, at the short-run position of Y₁ –> P₁ and Y₁ is on the horizontal SRAS₁ where all prices are fixed, at a Short-Run position as Y₁ < Y(bar) (natural level) and are producing less than the natural level
• There is a downwards pressure on prices
• Over time P wil, move down causing:
  
  • M/P to rise –> essentially have more income
  • ε falls
  • NX rises
  • Y increase
• This cycle continues until output returns to the natural level