Lecture 19 Mundell Fleming (Short Run Small Open) Flashcards
Show in Mundel Fleming…
Increase in gov expenditure funded by bond issues under fixed exchange rates.
g increases, shift in IS1 to IS2 right
Exchange rate appreciates since the bonds are bought from abroad, so demand domestic currency.
But since exchange rate is fixed, policymakers intervene (monetary) to stop appreciation by increasing money supply which is shown by LM1 to LM2.
So we get the full multiplier (y₁>y₂) effect as exchnage rate hasnt changed.
Expansionary monetary in a small open economy with a fixed/pegged exchange rate (pg 4)
and how does this uphold to the trilemma
Ineffective.
Expansionary monetary policy will shift lM right, but it would cause a depreciation as we may supply currency to buy foreign assets. Therefore LM must fall back to original to get back to fixed exchange rate.
(this shows trilemma: we have open capital markets and fixed exchange rate, so we can’t have an independent monetary policy as shown)
Fiscal policy under a small open economy with a flexible exchange rate : what happens
Only an appreciation.
G increases = shift in IS.
Bonds are bought by foreign investors, so demand for domestic currency increases.
No change in Y since increase in G is matched by a fall in NX. (Appreciation so SPICED so exports fall)
Expansionary monetary policy in a small open flexible exchange rate economy
Depreciation and increase in Y
Increase in MS increase LM1>LM2.
Supply our currency to buy foreign assets, causing depreciation, and so exports are cheap so NX, and AD (Y) rises.
(so expansionary monetary is effective in a flexible exchange rate economy, not in a fixed one tho!!)
Show effect of trade restriction, under fixed exchange rates.
e.g quota under fixed exchange rates.
Effect: No overall change in ε, increase in Y
Increases NX at any exchange rate, so shift right in IS to IS2.
This causes an appreciation, so policy has to intervene and increase money supply LM>LM2 to depreciate the economy.
Up till now we assumed for a small open economy r=r*.
This is not full right. There is a risk premium :
2 main reasons why a country’s interest rate is not equal to global interest rate
Expected exchange rate changes
Country risk
Expected exchange rate changes
Investors take account of changes in e when calculating ROI in different countries.
e.g for a US investor, if UK interest is 6% and US dollar was to appreciate by 3%, the return on UK assets is 3% in dollar terms, so will only invest if return >3%. if UK interest was 5%, wouldnt invest as return is 2%.
How is a country’s risk represented
Represented by the probability of default by the borrower.
So there is risk premium for the small open economy.
How is this written
r=r* + Ø
r* is global r
Ø is risk premium
How does this risk premium impact our mundell fleming equations (IS and LM)
IS* =
Y=a+bY+I(r+Ø)+G-bT+NX(e)
LM* =
M/P = L(Y,r*+Ø)
What does this risk premium look like in Mundel
Firms have to pay more to borrow (r=r*+Ø) , so reduce investment, shifting IS left.
Risk premium reduces demand for money, since cost of holding money rises. So money supply increases, LM1>LM2 causing a depreciation and higher y.
However.. not always the case
If depreciation can cause p to rise (WPIDEC making exports cheap), MS falls (M/P) and LM shifts left again.
Application of brexit in terms of this in SHORT RUN (2 possible outcomes)
Possible outcome 1:
Uncertainty about UK economy future.
Reduced investment at any r*.
Further, Risk premium on lending to the UK increased so r increased above r*.
IS curve shifts left, causing depreciation. (Less consumption and investment)
Possible outcome 2:
With uncertainty, we hold more money (DESPITE R* INCREASING) , reducing real money supply, LM falls left too.
(So these 2 possible outcomes: fall in IS causing a FALL IN e and fall in LM causes a RISE IN e)
Why does uncertainty make LM fall (building on possible outcome 2)
Demand for money goes up as people want money in cash (low risk) , remember LM = M/P = L(r*+Ø,y). r has increased since risk premium increased, so Y must fall.
Fall in real MS causes shift left in LM and fall in output Y (as mentioned above)
What happens when we put those 2 outcomes and their diagrams together. (Pg 13)
REMEMBER HOW THE FALL IN IS DEPRECIATED e, AND FALL IN LM APPRECIATED e!!!!
Uncertainty reduced investment/consumption, and the increased risk premium also contributed to it, causing the shift left in IS. Causing a DEPRECIATION.
Shift left in LM as demand for money increased as people held money in cash, reducing real money supply.
Then, UK and EU came to agreement improved certainty a little bit, to shift IS back slightly, but still in a worse state than usual.
So, what is effect on money suppy (LM curve) if interest rate is high?
Or if there is uncertainty?
So, money supply increases if interest rate is high, since they won’t demand money since opp cost of holding is high, and instead put in banks, to increase money supply.
If uncertainty, they will take money out of banks and as cash, since cash is safe, reducing money supply
