slide 1

WEEK 9-10

OPEN ECONOMY IS-LM FRAMEWORK

THE ‘MUNDELL-FLEMING’ MODEL

G. Mankiw Macroeconomics CH12 slides edited and modified by C. Fuller

slide 2CHAPTER 11 Aggregate Demand II

IS- LM MODEL Closed economyversion

IS CURVE

LM CURVE

Goods market

equilibrium

Small open economy version

Money market

equilibriumL(Y, r) = M/P

Income = planned spending

Money supply = money demandL(Y, r) = M/P

Y = C + I + G Y = C + I + G + NX

OVERALL EQUILIBRIUMDetermines Y and national interest rate r

Determines Y and exchange rate Given world interest rate (r*) determines national level of r

MAIN DIFFERENCES

from closed economy case:

r

Y

IS

LM

Y

E

IS*

LM*

slide 3CHAPTER 12 The Open Economy Revisited

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

slide 4

0.Closed Economy IS-LM model: POLICY

CHAPTER 12 The Open Economy Revisited

r

Y

r

Y

LM

IS

LM

IS

r1r1

Y* Y*

FISCAL POLICY

MONETARY POLICY

Rise in GFall in T

Shift in

ISTo

right

IS’

Predict:Rise in rRise in Y

Y**

r2

Rise in money supply

Shift in

LM

To right

Predict:Fall in r

Rise in Y

LM’

Y**

r0

slide 5CHAPTER 12 The Open Economy Revisited

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.

slide 6CHAPTER 12 The Open Economy Revisited

The IS* curve: Goods market eq’m

The IS* curve is drawn for a given value of r*.

Intuition for the slope:

Y

e

IS*

( ) ( ) ( )*Y C Y T I r G NX e

e NX Y

slide 7CHAPTER 12 The Open Economy Revisited

The LM* curve: Money market eq’m

The LM* curve is drawn for a given

value of r*. is vertical because:

given r*, there is only one value of Y that equates money demand with supply, regardless of e.

Y

e LM*

( , )*M P L r Y

slide 8CHAPTER 12 The Open Economy Revisited

Equilibrium in the Mundell-Fleming model

Y

e LM*( , )*M P L r Y

IS*

( ) ( ) ( )*Y C Y T I r G NX e

equilibriumexchange

rate

equilibriumlevel ofincome

slide 9CHAPTER 12 The Open Economy Revisited

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

slide 10CHAPTER 12 The Open Economy Revisited

FLOATING EXCHANGE RATES: Fiscal policy

Y

e( , )*M P L r Y

( ) ( ) ( )*Y C Y T I r G NX e

Y1

e1

1*LM

1*IS2*IS

e2 At any given value of e, a fiscal expansion increases Y, shifting IS* to the right.

Results: e goes up, no change in Y

WHY IS FISCAL POLICY INEFFECTIVE?

slide 11CHAPTER 12 The Open Economy Revisited

FLOATING EXCHANGE RATES: Fiscal policy

Y

e( , )*M P L r Y

( ) ( ) ( )*Y C Y T I r G NX e

Y1

e1

1*LM

1*IS2*IS

e2 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

[2] butIn SMALL OPEN economy:

A rise of domestic ‘r’ above r*..

...causes HUGE CAPITAL INFLOW [3] Big rise in demand for UK currency

IS

r

Y

LM

IS’

reminder

slide 12CHAPTER 12 The Open Economy Revisited

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.

slide 13CHAPTER 12 The Open Economy Revisited

FLOATING EXCHANGE RATES: Monetary policy

Y

e

e1

Y1

1*LM

1*IS

Y2

2*LM

e2

An increase in M shifts LM* right

Results: e falls, Y goes up

( , )*M P L r Y

( ) ( ) ( )*Y C Y T I r G NX e

WHY IS MONETARY POLICY SO EFFECTIVE?

slide 14CHAPTER 12 The Open Economy Revisited

FLOATING EXCHANGE RATES: Monetary policy

Y

e

e1

Y1

1*LM

1*IS

Y2

2*LM

e2

Results (from last slide) e falls, Y goes up

( , )*M P L r Y

( ) ( ) ( )*Y C Y T I r G NX e

WHY does e fall?

[1] In CLOSED economyRise in M rise in Y, fall in r

[2] BUT

In SMALL OPEN economy..

If domestic ‘r’ falls below r*..

...this causes a HUGE CAPITAL OUTFLOW

[3] Big fall in demand for UK currency

r

Y

LM

ISreminder

slide 15CHAPTER 12 The Open Economy Revisited

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 Ysmall open economy: M e NX Y