Topic 6 - The Open Economy: The Mundell-Fleming Model and the Exchange-Rate Regime Flashcards
How is the Mundel Fleming model related to the IS-LM model?
- Open economy extension affects both the goods (IS) and the money (LM) markets.
- Both assume fixed price levels and show the causes of short-run fluctuations in aggregate income.
- Key difference: IS-LM is closed and Mundell-Fleming assumes an open economy.
What is the key assumption behind the Mundell-Flemming model?
Small open economy with perfect capital mobility
r = r*
How do you calculate the Mundell-Flemming model?
Y = C(Y-T) + I(R*) + G + NX(e)
Same as the goods market equilibrium - The IS* Curve
Where:
- e = Nominal Exchange Rate = Foreign currency per unit domestic currency
What does the IS* Curve: Goods market equilibrium look like?
SEE GRAPH IN NOTES
Intuition for the slope is that as e decrease = NX up = Y up
How do you calculate the LM* Curve: Money Market Equilibrium? And how do you draw it?
M/P = L(r*,Y)
SEE GRAPH IN NOTES
What does equilibrium in the Mundell-Flemming Model look like?
SEE GRAPH IN NOTES
What happens to e under floating exchange rates and fixed exchange rates?
Floating - e allowed to fluctuate in response to changing economic conditions
Fixed - Central bank trades domestic for foreign currency at a predetermined price
How does the equilibrium to the Mundell-Flemming model change as a result of fiscal policy under floaring exchange rates?
At any given value of e, a fiscal expansion increases Y, shifting IS* to the right
Results:
Δe >0, ΔY = 0
SEE GRAPH IN NOTES
How does an open economy affect fiscal policy effectiveness?
Under a small open economy with perfect capital mobility, fiscal policy
What is Crowding out?
Under a 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.
How does the equilibrium to the Mundell-Flemming model change as a result of monetary policy under floaring exchange rates?
An increase in M shifts LM* right because Y must rise to restore equilibrium in the money market
Results:
Δe <0, ΔY >0
SEE GRAPH IN NOTES
How does monetary policy affect output in a closed economy and a small open one?
Affects output by affecting components of AD
Closed Economy:
Increase M - Decrease in r - Increase in I - Increase in Y
Small Open Economy:
Increase in M - Decrease in e - Increase in NX - Increase in Y
Expansionary monetary policy does not raise world AD, merely shifts demand from foreign to domestic products
So, increases in domestic income and employment at the expense of losses abroad
How does the equilibrium to the Mundell-Flemming model change as a result of trade policy (tariffs and quotas) under floating exchange rates?
At any given value of e, a tariff or quota reduces imports, increase NX and shifts IS* to the right
Results:
Δe> 0, ΔY=0
SEE GRAPH IN NOTES
Why is it that import restrictions can’t 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.
What do central banks do under a fixed exchange rate?
The central bank stands ready to buy or sell the domestic currency for foreign currency at a predetermined rate.
In the Mundell-Fleming model how do banks impose a fixed exchange rate?
, 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.
How does the equilibrium to the Mundell-Flemming model change as a result of fiscal policy under fixed exchange rates?
Under floating rates, fiscal expansion would raise e
To keep e from rising, the central bank must sell domestic currency, which increases M and shifts LM* to the right
Results:
Δe= 0, ΔY> 0
When is fiscal policy most effective at changing output?
Floating rates - Ineffective
Fixed Rates - Very effective at changing output
How does the equilibrium to the Mundell-Flemming model change as a result of monetary policy under fixed exchange rates?
An increase in M would shift LM* right and reduce e
To prevent fall in e, the central bank must buy domestic currency which reduces M and e1 shifts LM* back left
Results:
Δe= 0, ΔY = 0
When is Monetary policy most effective at changing output?
Floating rate - Very effective at changing output
Fixed Rates - Monetary policy cannot be used to affect output
How does the equilibrium to the Mundell-Flemming model change as a result of trade policy (tariffs and quotas) under fixed exchange rates?
A restriction on imports puts upward pressure on e
To keep e from rising, central bank must sell domestic currency, which increases M and shifts LM* to the right
Results:
Δe= 0, ΔY > 0
When is import restrictions most effective at changing Y or NX?
Floating rates - Import restrictions do not affect Y or NX
Fixed Rates - Import restriction 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
What is the argument for Floating Rates?
allow monetary policy to be used to pursue other goals (stable growth, low inflation)
What is the argument for Fixed Rates?
avoid uncertainty and volatility, making international transactions easier
discipline monetary policy to prevent excessive money growth and hyperinflation
What is the impossible trinity?
Free Capital Flows, Independent monetary policy, Fixed exchange rate
