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Chapter 12: The Mundell-FlemingModel & Exchange-Rate Regime *

MACROECONOMICS

Chapter 12: The Mundell-Fleming Model and the Exchange-Rate Regime 0/50

Seventh EditionN. Gregory Mankiw

* Slides based on Ron Cronovich's slides, adjusted for course in Macroeconomics for InternationalMasters Pro ram at the Wan Yanan Institute for Studies in Economics at Xiamen Universit .


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Learning ObjectivesThis chapter introduces you to understanding:

The Mundell-Fleming model


exchange rates

Interest rate differentials

Arguments for fixed vs. floating exchange rates

Deriving the aggregate demand curve


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12.1) The Mundell-Fleming ModelThe IS* Curve: Goods Market eq’m

The IS* curve is drawnfor a given value of r * .

e

( ) ( ) ( )*Y C Y T I r G NX e = − + + +


Intuition for the slope:

Y

IS *

e NX Y ↓ ⇒ ↑ ⇒ ↑


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12.1) The Mundell-Fleming ModelEquilibrium in the Mundell-Fleming Model

e LM * ( , )*

M P L r Y =

( ) ( ) ( )*Y C Y T I r G NX e = − + + +


Y IS *

equilibriumexchange

rate

equilibriumlevel ofincome


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exchange rates





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12.2) Floating & Fixed Exch. RatesFiscal Policy under Floating Exch. Rs

e ( , )*M P L r Y =

( ) ( ) ( )*Y C Y T I r G NX e = − + + +

1

*

LM

At any given value of e ,


Y Y 1

e 1

1

*

IS

2

*

IS

a fiscal expansionincreases Y ,shifting IS* to the right.

Results:∆∆∆∆e > 0, ∆∆∆∆Y = 0


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12.2) Floating & Fixed Exch. RatesLessons about Fiscal Policy

• In a small open economy with perfect capital

mobility, fiscal policy cannot affect real GDP.• “Crowding out”

– closed econom :


Fiscal policy crowds out investment by causingthe interest rate to rise.

– small open economy:

Fiscal policy crowds out net exports by causingthe exchange rate to appreciate.


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12.2) Floating & Fixed Exch. RatesMonetary Policy under Floating Exch. Rs

e 1

*

LM 2

*

LM An increase in M

*

( , )*M P L r Y =

( ) ( ) ( )*Y C Y T I r G NX e = − + + +


Y

e 1

Y 1

1

*

IS

Y 2

e 2

because Y must riseto restore eq’m in

the money market.Results:∆∆∆∆e < 0, ∆∆∆∆Y > 0


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12.2) Floating & Fixed Exch. RatesTrade Policy under Floating Exch. Rs

e 1

*

LM At any given value of e ,

( , )*M P L r Y =

( ) ( ) ( )*Y C Y T I r G NX e = − + + +


Y

e 1

Y 1

1

*

IS

2

*

IS

2

a tariff or quota reducesimports, increases NX ,and shifts IS* to the right.

Results:∆∆∆∆e > 0, ∆∆∆∆Y = 0


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12.2) Floating & Fixed Exch. RatesLessons about Trade Policy

• Import restrictions cannot reduce a trade deficit.• Even though NX is unchanged, there is less trade:

– the trade restriction reduces imports.


– .• Less trade means fewer “gains from trade.”


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12.2) Floating & Fixed Exch. RatesLessons about Trade Policy (ctd.)

• Import restrictions on specific products save jobs

in the domestic industries that produce thoseproducts, but destroy jobs in export-producingsectors.


•

ence, mpor res r c ons a o ncrease o aemployment.• Also, import restrictions create “sectoral shifts,”

which cause frictional unemployment.


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12.2) Floating & Fixed Exch. RatesFixed Exchange Rates

• Under fixed exchange rates, the central bank

stands ready to buy or sell the domestic currencyfor foreign currency at a predetermined rate.• In the Mundell-Fleming model, the central bank


shifts the LM* curve as required to keep e at itspreannounced rate.• This system fixes the nominal exchange rate.

In the long run, when prices are flexible,the real exchange rate can move even if thenominal rate is fixed.


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12.2) Floating & Fixed Exch. RatesFiscal Policy under Fixed Exch. Rs

e 1

*

LM

Under floating rates,

a fiscal expansionwould raise e . 2

*

LM

To keep e from rising,


fiscal policy is ineffectiveat changing output.


fiscal policy is ineffectiveat changing output.


Y Y 1

e 1

1*IS

2

*

IS

Results:∆∆∆∆e = 0, ∆∆∆∆Y > 0

Y 2

the central bank mustsell domestic currency,which increases M

and shifts LM* right.

,fiscal policy is veryeffective at changingoutput.

,fiscal policy is veryeffective at changingoutput.


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12.2) Floating & Fixed Exch. RatesMonetary Policy under Fixed Exch. Rs

2

*

LM

An increase in M would

shift LM* right and reduce e . e 1

*

LM To prevent the fall in e ,the central bank must


monetary policy isvery effective atchanging output.


monetary policy isvery effective atchanging output.

2

*

LM


Y Y 1

1

*

IS

e 1buy domestic currency,which reduces M andshifts LM* back left.

Results:∆∆∆∆e = 0, ∆∆∆∆Y = 0

Under fixed rates,monetary policy cannotbe used to affect output.

Under fixed rates,monetary policy cannotbe used to affect output.


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12.2) Floating & Fixed Exch. RatesTrade Policy under Fixed Exch. Rs

e 1

*

LM

A restriction on imports puts

upward pressure on e .2

*

LM To keep e from rising,


import restrictionsdo not affect Y or NX .

Under fixed rates,


import restrictionsdo not affect Y or NX .

Under fixed rates,


Y Y 1

e 1

1

*IS

2

*

IS

Results:∆∆∆∆e = 0, ∆∆∆∆Y > 0 Y 2

sell domestic currency,which increases M and shifts LM* right.

mpor res r c onsincrease Y and NX .

But, these gains come

at the expense of othercountries: the policymerely shifts demand fromforeign to domestic goods.

mpor res r c onsincrease Y and NX .

But, these gains come

at the expense of othercountries: the policymerely shifts demand fromforeign to domestic goods.


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12.2) Floating & Fixed Exch. RatesSummary of Policy Effects in M-F Model

type of exchange rate regime:

floating fixed

impact on:


Policy Y e NX Y e NX

fiscal expansion 0 ↑ ↓ ↑ 0 0

mon. expansion ↑ ↓ ↑ 0 0 0

import restriction 0 ↑ 0 ↑ 0 ↑


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exchange rates





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12.3) Interest-rate DifferentialsDifferentials in the M-F Model

where θ θθ θ (Greek letter “theta”) is a risk premium,assumed exogenous.

*r r θ θθ θ = +


Substitute the expression for r into theIS* and LM* equations:

( , )*M P L r Y = + θ

( ) ( ) ( )*Y C Y T I r G NX e = − + + + +θ


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12.3) Interest-rate DifferentialsThe Effects of an Increase in θ

2

*

LM

IS* shifts left, because

↑ θ θθ θ ⇒ ↑r ⇒ ↓ I e

1

*

LM

LM* shifts ri ht because


Y Y 1

1

1

*

IS

↑ θ θθ θ ⇒ ↑r ⇒ ↓ (M / P )d,so Y must rise to restoremoney market eq’m.

Results:∆∆∆∆e < 0, ∆∆∆∆Y > 0

2

*IS

e 2

Y 2


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12.3) Interest-rate DifferentialsThe Effects of an Increase in θ

• The fall in e is intuitive:

An increase in country risk or an expecteddepreciation makes holding the country’scurrency less attractive.


Note: an expected depreciation is aself-fulfilling prophecy.• The increase in Y occurs because the boost in

NX (from the depreciation) is greater than the fallin I (from the rise in r ).


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12.3) Interest-rate DifferentialsCASE STUDY: The Mexican Peso Crisis

25

30

35

x i c a n

P e s o


10

15

20

7/10/94 8/29/94 10/18/94 12/7/94 1/26/95 3/17/95 5/6/95

U . S .

C e n

t s p e r

M


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12.3) Interest-rate DifferentialsCASE STUDY: The Mexican Peso Crisis

25

30

35

x i c a n

P e s o


10

15

20

7/10/94 8/29/94 10/18/94 12/7/94 1/26/95 3/17/95 5/6/95

U . S .

C e n

t s p e r

M


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12.3) Interest-rate DifferentialsThe Peso Crisis didn’t just Hurt Mexico

• U.S. goods more expensive to Mexicans– U.S. firms lost revenue– Hundreds of bankruptcies along

U.S.-Mexican border


• Mexican assets worth less in dollars

– Reduced wealth of millions of U.S. citizens


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12.3) Interest-rate DifferentialsUnderstanding the Crisis

• In the early 1990s, Mexico was an attractive place

for foreign investment.• During 1994, political developments caused an

increase in Mexico’s risk premium ( θ θθ θ ):


– peasant uprising in Chiapas– assassination of leading presidential candidate

• Another factor:The Federal Reserve raised U.S. interest ratesseveral times during 1994 to prevent U.S. inflation.(∆r * > 0)


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12.3) Interest-rate DifferentialsUnderstanding the Crisis

• These events put downward pressure on the peso.• Mexico’s central bank had repeatedly promisedforeign investors that it would not allow the peso’s

value to fall,


so it bought pesos and sold dollars to“prop up” the peso exchange rate.

• Doing this requires that Mexico’s central bank hasadequate reserves of dollars.Did it?


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12.3) Interest-rate DifferentialsDollar Reserves of Mexico’s Central Bank

December 1993 ……………… $28 billion

August 17, 1994 ……………… $17 billion


, ……………

December 15, 1994 ………… $ 7 billion

During 1994, Mexico’s central bank hid the factthat its reserves were being depleted.


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12.3) Interest-rate DifferentialsThe Disaster

• Dec. 20: Mexico devalues the peso by 13%

(fixes e at 25 cents instead of 29 cents)• Investors are taken by surprise– they had no idea

Mexico w s runnin out of reserves.


• ↑↑↑↑ θ θθ θ , investors dump their Mexican assets and pull

their capital out of Mexico.• Dec. 22: central bank’s reserves nearly gone.

It abandons the fixed rate and lets e float.• In a week, e falls another 30%.

) ff l


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12.3) Interest-rate DifferentialsThe Rescue Package

• 1995: U.S. & IMF set up $50b line of credit toprovide loan guarantees to Mexico’s govt.

• This helped restore confidence in Mexico, reducedthe risk premium.


• After a hard recession in 1995, Mexico began astrong recovery from the crisis.

12 3) I Diff i l


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12.3) Interest-rate DifferentialsCASE STUDY: The Southeast Asian Crisis

• Problems in the banking system erodedinternational confidence in SE Asian economies.

• Risk premia and interest rates rose.• Stock rices fell as forei n investors sold assets


and pulled their capital out.• Falling stock prices reduced the value of collateral

used for bank loans, increasing default rates,

which exacerbated the crisis.• Capital outflows depressed exchange rates.

12 3) I Diff i l


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12.3) Interest-rate DifferentialsData on the SE Asian Crisis

exchange rate% change from

7/97 to 1/98

stock market% change from

7/97 to 1/98

nominal GDP% change

1997-98

Indonesia -59.4% -32.6% -16.2%


- . - . - .

Malaysia -36.4% -43.8% -6.8%Singapore -15.6% -36.0% -0.1%

S. Korea -47.5% -21.9% -7.3%

Taiwan -14.6% -19.7% n.a.Thailand -48.3% -25.6% -1.2%

U.S. n.a. 2.7% 2.3%


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exchange rates




12 4) A t f T E h R


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12.4) Arguments for Two Exch. RsFloating vs. Fixed Exchange Rates

Argument for floating rates:– allows monetary policy to be used to pursue othergoals (stable growth, low inflation).


rgumen s or xe ra es:– avoids uncertainty and volatility, making

international transactions easier.–

disciplines monetary policy to prevent excessivemoney growth & hyperinflation.

12 4) A g t f T E h R


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12.4) Arguments for Two Exch. RsThe Impossible Trinity

A nation cannot have freecapital flows, independentmonetary policy, and afixed exchange ratesimultaneously.

Free capitalflows

i n 1 O tion 2


A nation must chooseone side of thistriangle andgive up theoppositecorner.

Independentmonetary

policy

Fixedexchange

rate

(U.S.)

Option 3(China)

(Hong Kong)

12 4) Arg ments for T o E ch Rs


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12.4) Arguments for Two Exch. RsCASE: The Chinese Currency Controversy

• 1995-2005: China fixed its exchange rate at 8.28yuan per dollar, and restricted capital flows.

• Many observers believed that the yuan wassignificantly undervalued, as China was


accumu a ng arge o ar reserves.• U.S. producers complained that China’s cheap

yuan gave Chinese producers an unfair advantage.•

President Bush asked China to let its currency float;Others in the U.S. wanted tariffs on Chinese goods.

12 4) Arguments for Two Exch Rs


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12.4) Arguments for Two Exch. RsCASE: The Chinese Currency Controversy

• If China lets the yuan float, it may indeedappreciate.

• However, if China also allows greater capitalmobility, then Chinese citizens may start moving


e r sav ngs a roa .• Such capital outflows could cause the yuan to

depreciate rather than appreciate.


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Learning Objectives

This chapter introduces you to understanding:



exchange rates





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12 5) Deriving the AD Curve


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12.5) Deriving the AD Curve

Deriving the AD Curveε εε ε

IS*

LM* (P 1 )LM* (P 2 )

ε εε ε 2

ε εε ε 1

Why AD curve has

negative slope:↑ P ⇒ ↓ (M / P )


Y 1Y 2 Y

Y

P

AD P 1

P 2

Y 2 Y 1

⇒ LM shifts left⇒ ↑ ε εε ε

⇒ ↓NX

⇒ ↓ Y

12 5) Deriving the AD Curve


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From the Short Run to the Long RunLM* (P 1 )

ε εε ε 1

ε εε ε 2then there isdownward pressureon prices.

ε εε ε

IS*

LM* (P 2 )If ,Y Y


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Large: Between Small and Closed• Many countries – including the U.S. – are neither

closed nor small open economies.• A large open economy is between the polar cases

of closed & small open.


•

Consider a monetary expansion:– Like in a closed economy,

∆∆∆∆M > 0 ⇒ ↓r ⇒ ↑ I (though not as much)– Like in a small open economy,∆∆∆∆M > 0 ⇒ ↓ ε εε ε ⇒ ↑ NX (though not as much)

Economic Text:


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1.Summarize the text in a few sentences.

2.What are the weaknesses of the French economy?

→ The time bomb at the heart o Europe

Economic Text:


3. What makes it difficult for the French government to implement necessaryreforms though it would have enough political sway?

4. Why is a healthy economy in France so important for the Euro(pean project)?

5. What is meant with the phrase ‚You cannot defy economics for long‘?


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Chapter SummaryChapter Summary1. Mundell-Fleming model

–

the IS-LM model for a small open economy.– takes P as given.


– can s ow ow po c es an s oc s a ec ncomeand the exchange rate.

2. Fiscal policy–

affects income under fixed exchange rates, butnot under floating exchange rates.


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Chapter SummaryChapter Summary3. Monetary policy

–

affects income under floating exchange rates.– under fixed exchange rates, monetary policy is


4. Interest rate differentials– exist if investors require a risk premium to hold a

country’s assets.– An increase in this risk premium raises domestic

interest rates and causes the country’s exchangerate to depreciate.


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Chapter SummaryChapter Summary5. Fixed vs. floating exchange rates

–

Under floating rates, monetary policy is availablefor can purposes other than maintaining exchangerate stability.


–

Fixed exchange rates reduce some of theuncertainty in international transactions.

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