Transcript 1403_mte_wk9 - Homework Market

WEEK 9-10
OPEN ECONOMY IS-LM FRAMEWORK
THE ‘MUNDELL-FLEMING’ MODEL
G. Mankiw Macroeconomics CH12 slides edited and modified by C.
Fuller
slide 0
r
LM
E
LM*
IS
Y
IS- LM MODEL
IS CURVE
Goods
market
equilibrium
IS*
Closed economy
version
Y
Small open
economy version
Y=C+I+G
Y = C + I + G + NX
Income = planned spending
LM CURVE
MAIN
DIFFERENCES
from closed
economy case:
Money
market
equilibrium
L(Y, r) = M/P
L(Y, r) = M/P
Money supply = money demand
OVERALL EQUILIBRIUM
CHAPTER 11
Determines Y
and national
interest rate r
Aggregate Demand II
Determines Y and
exchange rate
Given world interest rate
(r*) determines national
level of r
slide 1
WEEKS 9-10 SUMMARY
0. The Closed Economy IS-LM model
1. The Open Economy IS-LM model
(‘Mundell-Fleming’ model)
2. Flexible (floating) exchange rates
3. Using the closed and open IS-LM models
CHAPTER 12
The Open Economy Revisited
slide 2
0.Closed Economy IS-LM model:
POLICY
MONETARY
POLICY
FISCAL
POLICY
LM
r
r
LM
r2
LM’
r1
r1
IS’
r0
IS
IS
Y*
Rise in G
Fall in T
Shift in
Y**
Y*
Y
Predict:
Rise in r
Rise in Y
Y
Rise in money
supply
IS
To
right
CHAPTER 12
Y**
The Open Economy Revisited
Shift in
Predict:
Fall in r
Rise in Y
LM
To
right
slide 3
1.The Mundell-Fleming model:
Open Economy IS-LM
 Key assumption:
Small open economy (SOE) with perfect capital mobility.
r = r* [because SOE forced to accept world r]
 Goods market equilibrium – the IS* curve:
Y  C (Y T )  I (r *)  G  NX (e )
where
e = nominal exchange rate
= foreign currency per unit domestic currency
We could use E instead of e as prices are fixed anyway
.
An exam question might have either – won’t make any difference.
CHAPTER 12
The Open Economy Revisited
slide 4
The IS* curve: Goods market eq’m
Y  C (Y T )  I (r *)  G  NX (e )
The IS* curve is drawn
for a given value of r*.
e
Intuition for the slope:
 e   NX  Y
IS*
Y
CHAPTER 12
The Open Economy Revisited
slide 5
The LM* curve: Money market eq’m
M P  L (r *,Y )
The LM* curve
 is drawn for a given
e
LM*
value of r*.
 is vertical because:
given r*, there is
only one value of Y
that equates money
demand with supply,
regardless of e.
CHAPTER 12
The Open Economy Revisited
Y
slide 6
Equilibrium in the Mundell-Fleming
model
Y  C (Y T )  I (r *)  G  NX (e )
M P  L (r *,Y )
e
LM*
equilibrium
exchange
rate
equilibrium
level of
income
CHAPTER 12
The Open Economy Revisited
IS*
Y
slide 7
2. Floating exchange rates
 In a system of floating exchange rates,
e is allowed to fluctuate in response to changing
economic conditions.
 WE FOCUS ON THIS
CHAPTER 12
The Open Economy Revisited
slide 8
FLOATING EXCHANGE RATES: Fiscal policy
Y  C (Y T )  I (r *)  G  NX (e )
M P  L (r *,Y )
At any given value of e,
a fiscal expansion
increases Y,
shifting IS* to the right.
e
LM 1*
e2
e1
IS 2*
Results:
IS 1*
e goes up, no change in Y
Y1
Y
WHY IS FISCAL POLICY
INEFFECTIVE?
CHAPTER 12
The Open Economy Revisited
slide 9
FLOATING EXCHANGE RATES: Fiscal policy
LM
Y  C (Y T )  I (r *)  G  NX (e )
reminder
M P  L (r *,Y )
e
Results [from last slide]
e goes up, no change inY
WHY does e rise?
[1] In CLOSED economy:
Fiscal expansion  rise in Y , rise in r
r
LM
IS
*
1
Y
e2
e1
IS 2*
IS 1*
In SMALL OPEN economy:
[2] but
A rise of domestic ‘r’ above r*..
...causes HUGE CAPITAL INFLOW
CHAPTER 12
IS’
The Open Economy Revisited
Y1
Y
[3] Big rise in demand for
UK currency
slide 10
FLOATING EXCHANGE RATES: Lessons about
fiscal policy
 In a small open economy with perfect capital
mobility, fiscal policy cannot affect Y.
 “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.
CHAPTER 12
The Open Economy Revisited
slide 11
FLOATING EXCHANGE RATES: Monetary policy
Y  C (Y T )  I (r *)  G  NX (e )
M P  L (r *,Y )
e
An increase in M
shifts LM* right
LM 1*LM 2*
e1
e2
IS 1*
Results:
e falls, Y goes up
Y1 Y2
Y
WHY IS MONETARY POLICY SO
EFFECTIVE?
CHAPTER 12
The Open Economy Revisited
slide 12
FLOATING EXCHANGE RATES: Monetary policy
LM
r
Y  C (Y T )  I (r *)  G  NX (e )
IS
reminder
M P  L (r *,Y )
e
Results (from last slide)
LM LM
*
1
Y
*
2
e falls, Y goes up
WHY does e fall?
e1
[1] In CLOSED economy
Rise in M  rise in Y, fall in r
e2
[2]
BUT
CHAPTER 12
In SMALL OPEN economy..
If domestic ‘r’ falls below r*..
IS 1*
Y1 Y2
Y
[3] Big fall in demand for
...this causes a HUGE
UK currency
OUTFLOW Revisited
TheCAPITAL
Open Economy
slide 13
FLOATING EXCHANGE RATES: Lessons about
monetary policy
 Monetary policy is very effective at changing Y
 Monetary policy affects output by affecting
the components of aggregate demand:
closed economy: M  r  I  Y
small open economy: M  e  NX  Y
CHAPTER 12
The Open Economy Revisited
slide 14