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Open Economy in the Short Run
Intermediate Macroeconomic TheoryMacroeconomic Analysis
University of North Texas
ECON 3560 / 5040 Open Economy in the Short Run
Outline
1 Aggregate Demand in the Open Economy
2 The Small Open Economy under Floating Exchange Rates
3 The Small Open Economy under Fixed Exchange Rates
4 Should Exchange Rates Be Floating or Fixed?
5 The Mundell-Fleming Model with a Changing Price
ECON 3560 / 5040 Open Economy in the Short Run
Outline
1 Aggregate Demand in the Open Economy
2 The Small Open Economy under Floating Exchange Rates
3 The Small Open Economy under Fixed Exchange Rates
4 Should Exchange Rates Be Floating or Fixed?
5 The Mundell-Fleming Model with a Changing Price
ECON 3560 / 5040 Open Economy in the Short Run
Aggregate Demand in the Open EconomyMondell-Fleming Model
The Mondell-Fleming Model: an international version of theIS− LM model (IS∗ − LM∗ model)
The key assumption: small open economy with perfect capitalmobility (r = r∗)
The goods market and the IS∗ curve
⇒ Y = C(Y − T) + I(r∗) + G + NX(e)
The money market and the LM∗ curve
⇒ M/P = L(r∗, Y)
Equilibrium exchange rate and income
ECON 3560 / 5040 Open Economy in the Short Run
Aggregate Demand in the Open EconomyMondell-Fleming Model
The Mondell-Fleming Model: an international version of theIS− LM model (IS∗ − LM∗ model)
The SR model of national income including the effects ofinternational trade and finance
The behavior of an economy depends on the exchange-ratesystem it has adopted
The key assumption: small open economy with perfect capitalmobility (r = r∗)
The goods market and the IS∗ curve
⇒ Y = C(Y − T) + I(r∗) + G + NX(e)
The money market and the LM∗ curve
⇒ M/P = L(r∗, Y)
Equilibrium exchange rate and income
ECON 3560 / 5040 Open Economy in the Short Run
Aggregate Demand in the Open EconomyMondell-Fleming Model
The Mondell-Fleming Model: an international version of theIS− LM model (IS∗ − LM∗ model)
The key assumption: small open economy with perfect capitalmobility (r = r∗)
The goods market and the IS∗ curve
⇒ Y = C(Y − T) + I(r∗) + G + NX(e)
The money market and the LM∗ curve
⇒ M/P = L(r∗, Y)
Equilibrium exchange rate and income
ECON 3560 / 5040 Open Economy in the Short Run
Aggregate Demand in the Open EconomyMondell-Fleming Model
The Mondell-Fleming Model: an international version of theIS− LM model (IS∗ − LM∗ model)
The key assumption: small open economy with perfect capitalmobility (r = r∗)
The goods market and the IS∗ curve
⇒ Y = C(Y − T) + I(r∗) + G + NX(e)
The money market and the LM∗ curve
⇒ M/P = L(r∗, Y)
Equilibrium exchange rate and income
ECON 3560 / 5040 Open Economy in the Short Run
Aggregate Demand in the Open EconomyMondell-Fleming Model
The Mondell-Fleming Model: an international version of theIS− LM model (IS∗ − LM∗ model)
The key assumption: small open economy with perfect capitalmobility (r = r∗)
The goods market and the IS∗ curve
⇒ Y = C(Y − T) + I(r∗) + G + NX(e)
The money market and the LM∗ curve
⇒ M/P = L(r∗, Y)
Equilibrium exchange rate and income
ECON 3560 / 5040 Open Economy in the Short Run
Aggregate Demand in the Open EconomyMondell-Fleming Model
The Mondell-Fleming Model: an international version of theIS− LM model (IS∗ − LM∗ model)
The key assumption: small open economy with perfect capitalmobility (r = r∗)
The goods market and the IS∗ curve
⇒ Y = C(Y − T) + I(r∗) + G + NX(e)
The money market and the LM∗ curve
⇒ M/P = L(r∗, Y)
Equilibrium exchange rate and income
ECON 3560 / 5040 Open Economy in the Short Run
Aggregate Demand in the Open EconomyMondell-Fleming Model
The Mondell-Fleming Model: an international version of theIS− LM model (IS∗ − LM∗ model)
The key assumption: small open economy with perfect capitalmobility (r = r∗)
The goods market and the IS∗ curve
⇒ Y = C(Y − T) + I(r∗) + G + NX(e)
The money market and the LM∗ curve
⇒ M/P = L(r∗, Y)
Equilibrium exchange rate and income
ECON 3560 / 5040 Open Economy in the Short Run
Aggregate Demand in the Open EconomyMondell-Fleming Model
The Mondell-Fleming Model: an international version of theIS− LM model (IS∗ − LM∗ model)
The key assumption: small open economy with perfect capitalmobility (r = r∗)
The goods market and the IS∗ curve
⇒ Y = C(Y − T) + I(r∗) + G + NX(e)
The money market and the LM∗ curve
⇒ M/P = L(r∗, Y)
Equilibrium exchange rate and income
ECON 3560 / 5040 Open Economy in the Short Run
Outline
1 Aggregate Demand in the Open Economy
2 The Small Open Economy under Floating Exchange Rates
3 The Small Open Economy under Fixed Exchange Rates
4 Should Exchange Rates Be Floating or Fixed?
5 The Mundell-Fleming Model with a Changing Price
ECON 3560 / 5040 Open Economy in the Short Run
The Small Open Economy under Floating ExchangeRates
Floating exchange rates: the exchange rate is allowed tofluctuate freely in response to changing economic conditions
1 Fiscal Policy
↑ G(↓ T) ⇒ ↑ e and Y
2 Monetary Policy
↑ M ⇒ ↓ e and ↑ Y
3 Trade Policy
Trade restrictions ⇒ ↑ e and Y
ECON 3560 / 5040 Open Economy in the Short Run
The Small Open Economy under Floating ExchangeRates
Floating exchange rates: the exchange rate is allowed tofluctuate freely in response to changing economic conditions
1 Fiscal Policy
↑ G(↓ T) ⇒ ↑ e and Y
2 Monetary Policy
↑ M ⇒ ↓ e and ↑ Y
3 Trade Policy
Trade restrictions ⇒ ↑ e and Y
ECON 3560 / 5040 Open Economy in the Short Run
The Small Open Economy under Floating ExchangeRates
Floating exchange rates: the exchange rate is allowed tofluctuate freely in response to changing economic conditions
1 Fiscal Policy
↑ G(↓ T) ⇒ ↑ e and Y
2 Monetary Policy
↑ M ⇒ ↓ e and ↑ Y
3 Trade Policy
Trade restrictions ⇒ ↑ e and Y
ECON 3560 / 5040 Open Economy in the Short Run
The Small Open Economy under Floating ExchangeRates
Floating exchange rates: the exchange rate is allowed tofluctuate freely in response to changing economic conditions
1 Fiscal Policy
↑ G(↓ T) ⇒ ↑ e and Y
2 Monetary Policy
↑ M ⇒ ↓ e and ↑ Y
3 Trade Policy
Trade restrictions ⇒ ↑ e and Y
ECON 3560 / 5040 Open Economy in the Short Run
The Small Open Economy under Floating ExchangeRates
Floating exchange rates: the exchange rate is allowed tofluctuate freely in response to changing economic conditions
1 Fiscal Policy
↑ G(↓ T) ⇒ ↑ e and Y
2 Monetary Policy
↑ M ⇒ ↓ e and ↑ Y
3 Trade Policy
Trade restrictions ⇒ ↑ e and Y
ECON 3560 / 5040 Open Economy in the Short Run
The Small Open Economy under Floating ExchangeRates
Floating exchange rates: the exchange rate is allowed tofluctuate freely in response to changing economic conditions
1 Fiscal Policy
↑ G(↓ T) ⇒ ↑ e and Y
2 Monetary Policy
↑ M ⇒ ↓ e and ↑ Y
3 Trade Policy
Trade restrictions ⇒ ↑ e and Y
ECON 3560 / 5040 Open Economy in the Short Run
Outline
1 Aggregate Demand in the Open Economy
2 The Small Open Economy under Floating Exchange Rates
3 The Small Open Economy under Fixed Exchange Rates
4 Should Exchange Rates Be Floating or Fixed?
5 The Mundell-Fleming Model with a Changing Price
ECON 3560 / 5040 Open Economy in the Short Run
The Small Open Economy under Fixed ExchangeRates
How a fixed-exchange-rate system works
1 Fiscal Policy
↑ G(↓ T) ⇒ e and ↑ Y
2 Monetary Policy
↑ M ⇒ e and Y
3 Trade Policy
Trade restrictions ⇒ e and ↑ Y
ECON 3560 / 5040 Open Economy in the Short Run
The Small Open Economy under Fixed ExchangeRates
How a fixed-exchange-rate system works
The commitment of the central bank to allow the money supplyto adjust to whatever level will ensure that the equilibriumexchange rate equals the announced exchange rate
Bretton Woods system: an international monetary system underwhich most governments agree to fix exchange rates in the1950s and 1960s
The fixed exchange rate governs the money supply1 Fiscal Policy
↑ G(↓ T) ⇒ e and ↑ Y2 Monetary Policy
↑ M ⇒ e and Y3 Trade Policy
Trade restrictions ⇒ e and ↑ Y
ECON 3560 / 5040 Open Economy in the Short Run
The Small Open Economy under Fixed ExchangeRates
How a fixed-exchange-rate system works
1 Fiscal Policy
↑ G(↓ T) ⇒ e and ↑ Y
2 Monetary Policy
↑ M ⇒ e and Y
3 Trade Policy
Trade restrictions ⇒ e and ↑ Y
ECON 3560 / 5040 Open Economy in the Short Run
The Small Open Economy under Fixed ExchangeRates
How a fixed-exchange-rate system works
1 Fiscal Policy
↑ G(↓ T) ⇒ e and ↑ Y
2 Monetary Policy
↑ M ⇒ e and Y
3 Trade Policy
Trade restrictions ⇒ e and ↑ Y
ECON 3560 / 5040 Open Economy in the Short Run
The Small Open Economy under Fixed ExchangeRates
How a fixed-exchange-rate system works
1 Fiscal Policy
↑ G(↓ T) ⇒ e and ↑ Y
2 Monetary Policy
↑ M ⇒ e and Y
3 Trade Policy
Trade restrictions ⇒ e and ↑ Y
ECON 3560 / 5040 Open Economy in the Short Run
The Small Open Economy under Fixed ExchangeRates
How a fixed-exchange-rate system works
1 Fiscal Policy
↑ G(↓ T) ⇒ e and ↑ Y
2 Monetary Policy
↑ M ⇒ e and Y
3 Trade Policy
Trade restrictions ⇒ e and ↑ Y
ECON 3560 / 5040 Open Economy in the Short Run
The Small Open Economy under Fixed ExchangeRates
How a fixed-exchange-rate system works
1 Fiscal Policy
↑ G(↓ T) ⇒ e and ↑ Y
2 Monetary Policy
↑ M ⇒ e and Y
3 Trade Policy
Trade restrictions ⇒ e and ↑ Y
ECON 3560 / 5040 Open Economy in the Short Run
The Small Open Economy under Fixed ExchangeRates
How a fixed-exchange-rate system works
1 Fiscal Policy
↑ G(↓ T) ⇒ e and ↑ Y
2 Monetary Policy
↑ M ⇒ e and Y
3 Trade Policy
Trade restrictions ⇒ e and ↑ Y
ECON 3560 / 5040 Open Economy in the Short Run
Outline
1 Aggregate Demand in the Open Economy
2 The Small Open Economy under Floating Exchange Rates
3 The Small Open Economy under Fixed Exchange Rates
4 Should Exchange Rates Be Floating or Fixed?
5 The Mundell-Fleming Model with a Changing Price
ECON 3560 / 5040 Open Economy in the Short Run
Should Exchange Rates Be Floating or Fixed?
Most economists have favored a system of floating exchangerates
In recent years, some have advocated a return to a fixedexchange rate
The role of monetary policy
Advocates of fixed exchange rates
ECON 3560 / 5040 Open Economy in the Short Run
Should Exchange Rates Be Floating or Fixed?
Most economists have favored a system of floating exchangerates
In recent years, some have advocated a return to a fixedexchange rate
The role of monetary policy
Advocates of fixed exchange rates
ECON 3560 / 5040 Open Economy in the Short Run
Should Exchange Rates Be Floating or Fixed?
Most economists have favored a system of floating exchangerates
In recent years, some have advocated a return to a fixedexchange rate
The role of monetary policy
Advocates of fixed exchange rates
ECON 3560 / 5040 Open Economy in the Short Run
Should Exchange Rates Be Floating or Fixed?
Most economists have favored a system of floating exchangerates
In recent years, some have advocated a return to a fixedexchange rate
The role of monetary policy
1 Fixed rates: the single goal of maintaining the exchange rate atits announced level
2 Floating rates: monetary policymakers free to pursue othergoals; stabilizing employment (output) or price
Advocates of fixed exchange rates
ECON 3560 / 5040 Open Economy in the Short Run
Should Exchange Rates Be Floating or Fixed?
Most economists have favored a system of floating exchangerates
In recent years, some have advocated a return to a fixedexchange rate
The role of monetary policy
Advocates of fixed exchange rates
ECON 3560 / 5040 Open Economy in the Short Run
Should Exchange Rates Be Floating or Fixed?
Most economists have favored a system of floating exchangerates
In recent years, some have advocated a return to a fixedexchange rate
The role of monetary policy
Advocates of fixed exchange rates
1 Exchange rate uncertainty makes international trade moredifficult
2 Irrational and destabilizing speculation by international investors
ECON 3560 / 5040 Open Economy in the Short Run
Outline
1 Aggregate Demand in the Open Economy
2 The Small Open Economy under Floating Exchange Rates
3 The Small Open Economy under Fixed Exchange Rates
4 Should Exchange Rates Be Floating or Fixed?
5 The Mundell-Fleming Model with a Changing Price
ECON 3560 / 5040 Open Economy in the Short Run
The Mundell-Fleming Model with a Changing Price
The Mundell-Fleming Model:
1 IS∗: Y = C(Y − T) + I(r∗) + G + NX(e)
2 LM∗: M/P = L(r∗, Y)
Aggregate Demand: negative relationship between P and Y
↓ P ⇒ ↑ (M/P) ⇒ ↑ Y
ECON 3560 / 5040 Open Economy in the Short Run
The Mundell-Fleming Model with a Changing Price
The Mundell-Fleming Model:
1 IS∗: Y = C(Y − T) + I(r∗) + G + NX(e)
2 LM∗: M/P = L(r∗, Y)
Aggregate Demand: negative relationship between P and Y
↓ P ⇒ ↑ (M/P) ⇒ ↑ Y
ECON 3560 / 5040 Open Economy in the Short Run
The Mundell-Fleming Model with a Changing Price
The Mundell-Fleming Model:
1 IS∗: Y = C(Y − T) + I(r∗) + G + NX(e)
2 LM∗: M/P = L(r∗, Y)
Aggregate Demand: negative relationship between P and Y
↓ P ⇒ ↑ (M/P) ⇒ ↑ Y
ECON 3560 / 5040 Open Economy in the Short Run
The Mundell-Fleming Model with a Changing Price
The Mundell-Fleming Model:
1 IS∗: Y = C(Y − T) + I(r∗) + G + NX(e)
2 LM∗: M/P = L(r∗, Y)
Aggregate Demand: negative relationship between P and Y
↓ P ⇒ ↑ (M/P) ⇒ ↑ Y
ECON 3560 / 5040 Open Economy in the Short Run
The Mundell-Fleming Model with a Changing Price
The Mundell-Fleming Model:
1 IS∗: Y = C(Y − T) + I(r∗) + G + NX(e)
2 LM∗: M/P = L(r∗, Y)
Aggregate Demand: negative relationship between P and Y
↓ P ⇒ ↑ (M/P) ⇒ ↑ Y
ECON 3560 / 5040 Open Economy in the Short Run
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