chapter 12: aggregate demand in open economy. the mundell-fleming model assumption –small open...
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Chapter 12: Aggregate Demand in Open Economy
Chapter 12: Aggregate Demand in Open Economy
The Mundell-Fleming Model
Assumption– Small open economy
– Free capital mobility (r = r*)
– Flexible or fixed foreign exchange rate regime
Flexible Exchange RateThe IS curve:
Y = C(Y – T) + I(r*) + G + NX(e)
Where e = nominal exchange rate that varies according to its demand and supply
An increases in e make imports less expensive to domestic consumer and exports more expensive to foreign consumer, hence reducing NX
Derivation of IS Curve
Initial equilibrium: Y = E1 with Y1 and e1
Let e increase, NX decreases and E1 falls to E2
New equilibrium: E2 = Y with Y2<Y1 and e2>e1
Line AB is the IS
Derivation of IS Curve
Y2 Y1 Y2 Y1
e1
e2
Expenditures Exchange Rate
Income Income
E1
E2
Y = E
IS(e)
BA
Derivation of LM Curve
M/P = L(r*, Y)
LM is independent of the exchange rate
Shift of LM won’t alter the interest rate because r = r*
Derivation of LM Curve
LM(r*)
r
Y
Interest Rate
Income
r = r*
Income
Exchange Rate
LM(e)
Y
IS-LM Model
LM
IS
e
Y
Exchange Rate
Income
Aggregate Equilibrium
Fiscal Policy
Initial equilibrium: IS1 = LM1 with Y1 and e1
As G increase, IS increases. New equilibrium: IS2 = LM1 causing Y and e to increase
The rise in e makes NX and Y to fall, offsetting the initial increase in income
Fiscal Policy
LM
IS1
e1
Y
Exchange Rate
Income
IS2
e2
Fiscal policy is ineffective in causing economic growth
Monetary Policy
Initial equilibrium: IS1 = LM1 with Y1 and e1
As M increase, LM increases. New equilibrium: IS1 = LM2 causing Y to increase and e to fall
The fall in e makes NX and Y to increase
Monetary Policy
LM1
IS1
e1
Y1
Exchange Rate
Income
LM2
e2
Monetary policy is effective in causing economic growth
Y2
Trade Protectionism
Initial equilibrium: IS1 = LM1 with Y1 and e1
Let imports decrease, NX and IS decline. New equilibrium: IS2 = LM1 causing Y and e to increase
The rise in e makes NX and Y to decrease
Trade Protectionism
LM
IS1
e1
Y
Exchange Rate
Income
IS2
e2
Trade protectionism is ineffective in causing economic growth
Fixed Exchange Rate
Assume: market rate > fixed rate
Arbitrageur buys from the market and sells to the central bank at the fixed rate and make profits
Money supply and LM increase, causing Y to increase. The market rate falls to the fixed rate
Fixed Exchange Rate
LM1
IS1
ef
Y1
Exchange Rate
Income
LM2
em
Y2
Fixed Exchange Rate
Assume: market rate < fixed rate
Arbitrageur buys from the central bank market and sells to the market at the fixed rate to make profits
Money supply and LM decrease, causing Y to fall. The market rate rises to the fixed rate
Fixed Exchange Rate
LM2
IS1
em
Y2
Exchange Rate
Income
LM1
ef
Y1
Fiscal PolicyInitial equilibrium: IS1 = LM1 with Y1 and e1
As G increase, IS increases, causing e to rise above the fixed rate.
Exchange rate arbitrage causes Ms and LM to increase, e falls to the fixed rate
New equilibrium: IS2 = LM2 causing Y to increase
Fixed Exchange Rate
LM1
IS1
em
Y1
Exchange Rate
Income
LM2
ef
Y2
IS2
Fiscal policy is effective
in causing economic growth
Monetary PolicyInitial equilibrium: IS1 = LM1 with Y1 and e1
Let Ms increase, LM increases, causing e to decrease below the fixed rate.
Exchange rate arbitrage causes Ms and LM to decrease, e rises to the fixed rate
New equilibrium: IS1 = LM1 causing no increase in Y
Monetary Policy
LM1
IS1
em
Y2
Exchange Rate
Income
LM2
ef
Y1
Monetary policy is ineffective in causing economic growth
Trade Protectionism
Initial equilibrium: IS1 = LM1 with Y1 and e1
As imports increase NX and IS increase, causing e to increase above the fixed rate
Exchange rate arbitrage causes Ms and LM to increase, lowering e to the fixed rate
New equilibrium: IS2 = LM2 causing Y to increase
Trade Protectionism
LM1
IS1
em
Y1
Exchange Rate
Income
LM2
ef
Y2
IS2
Trade protectionism is effective
in causing economic growth
Policy Effectiveness
Policy Flexible Exchange Rate
Fixed Exchange Rate
Fiscal
Monetary
Trade Protectionism
Ineffective
Effective
Ineffective
Effective
Ineffective
Effective
Effect of Political RiskDefine r = r*+ Θ where Θ is the risk premium for political instability
IS curve: Y = C(Y-T) + I(r*+ Θ) + G + NX(e)
LM curve: (M/P) = L(r*+ Θ, Y)
Let Θ increase, causing LM to increase and e to decrease
Effect of Political Risk
An increases in r reduces investment and the IS, but exchange rate depreciation increases NX
Reasons for lack of economic growth – Reaction of the central bank to reduce LM in order to offset
depreciation
– Depreciation causes import prices to rise, reducing NX and Y
– People increase the money demand, reducing LM
Effect of Political Risk
LM1
IS2
e1
Y1
Exchange Rate
Income
LM2
e2
Y2
IS1