class slides for ec 204 spring 2006 to accompany chapter 12
TRANSCRIPT
Class Slides for EC 204Spring 2006
To Accompany Chapter 12
The Small Open Economyin the Short Run:
The Mundell-Fleming Model
Y = C(Y-T) + I(r) + G + NX(e) (IS)
M/P = L(r, Y) (LM)
r = r* (Perfect Capital Mobilityand Small Country Assumption)
The Small Open Economy UnderFloating Exchange Rates
• Before analyzing effects of policies we need to specify the international monetary system in which the country operates.
• Floating exchange rates characterize the system relevant for most of today’s major economies.
• The exchange rate is allowed to move in response to changes in economic conditions.
The Small Open Economy Under Fixed Exchange Rates
• Central Bank stands ready to buy or sell foreign currency at the fixed rate of exchange
• Bretton Woods System was fixed exchange rate system
• Gold Standard was a fixed exchange rate system
Interest Rate Differentials
r = r* + (Risk Premium)
Y = C(Y-T) + I(r* + ) + G + NX(e) (IS*)
M/P = L(r* + , Y) (LM*)
can represent either a risk premium and/or expected change in the exchange rate
In Practice, Income Boom does not occur following rise in risk
premium:• Depreciation raises price of imported goods
and the price level
• Central Bank may try to avoid depreciation by tightening monetary policy
• Increase in risk premium may directly cause money demand to rise as people seek “safe” asset
Foreign Exchange Market Intervention
• In practice, governments intervene in foreign exchange markets even under flexible exchange rates in order to move the exchange rate in a desired direction
• Intervention is typically “sterilized” by the Central Bank
• Central Bank “sterilizes” (offsets) the effect on the domestic money supply arising from purchases/sales of foreign currency
Sterilized Intervention
• A purchase (sale) of foreign currency would give rise to an increase (decrease) in the domestic money supply
• To “sterilize” this effect, the Central Bank uses an offsetting open-market operation by selling (buying) domestic Treasury securities, leaving the money supply unchanged
• The small open economy model suggests that this will have no effect on the exchange rate, since the money supply is unchanged
Sterilized Intervention
• But, this sale (purchase) of domestic Treasury securities by the Central Bank will increase (reduce) the amount of Treasury securities held by the public
• The public may require a rise (decline) in the risk premium on domestic securities in order to be willing to hold the changed amount
• A change in the risk premium will shift the LM* and IS* curves, leading to a change in the exchange rate, even though the money supply is unchanged
Evidence on the Effectiveness of Sterilized Intervention
• Very little evidence that intervention operates through this “risk premium” channel
• Some evidence that intervention works by signaling a future change in monetary policy itself
• Accordingly, the exchange rate may adjust today in response to this signal of a future shift in monetary policy
The Mundell-Fleming Model with a Changing Price Level
Y = C(Y-T) + I(r*) + G + NX() (IS*)
M/P = L(r*, Y) (LM*)
where we note the distinction between the real and nominalexchange rates: = e(P/P*)
The Large Open Economyin the Short Run
Y = C(Y-T) + I(r) + G + NX(e) Goods Market Eqm.
M/P = L(r, Y) Money Market Eqm.
NX(e) = CF(r) Balance of Payment Eqm.(Net Capital Outflow = Net Exports)
The Large Open Economyin the Short Run: IS-LM
Y = C(Y-T) + I(r) + G + CF(r) (IS)
M/P = L(r, Y) (LM)