Chapter Twelve

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The Open Economy Revisited: The Mundell-Fleming Model and the Exchange-Rate

Regime

®

A PowerPointTutorial

To Accompany

MACROECONOMICS, 8th EditionN. Gregory Mankiw

Tutorial written by:

Mannig J. SimidianB.A. in Economics with Distinction, Duke University

M.P.A., Harvard University Kennedy School of GovernmentM.B.A., Massachusetts Institute of Technology (MIT) Sloan School of

Management

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The issues of open-economy macroeconomics have been very much in the news in recent years. At various European nations, mostnotably Greece, experienced severe financial difficulties, many observers wondered whether it was wise for much of the continentto adopt a common currency—the most extreme form of a fixed-exchange rate. If each nation had its own currency, monetary policyand the exchange rate could have more easily adjusted to theneeds of each nation.

Many American policy makers were objecting that China did notallow the value of its currency to float freely against the U.S. dollar.they agreed that China kept its currency artificially cheap, making itsgoods more competitive on world markets.

The Mundell-Fleming model a useful starting point for understanding and evaluating these often heated international policy debates.

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Introducing…

e

Income, output, Y

LM*

IS*Equilibrium exchange rate

Equilibrium income

This model is a close relative of the IS-LM model; both stress the interaction between the goods market and the money market. Price levels are fixed, and both show short-run fluctuations in aggregate income. TheMundell-Fleming Model assumes an open economy in which trade andfinance are added; the IS-LM assumes a closed economy.

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This model, often described as “the dominant policy paradigm for studying open-economy monetary and fiscal policy,” makes one important and extreme assumption: the economy being studied is a small open economy and there is perfect capital mobility, meaning that it can borrow or lend as much as it wants in world financial markets, and therefore, the economy’s interest rate is controlled by the world interest rate, mathematically denoted as r = r*.

One key lesson about this model is that the behavior of an economydepends on the exchange rate regime it adopts—floating or fixed.

This model will help answer the question of which exchange rateregime should a nation adopt?

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Under a system of floating exchange rates, the exchange rate is setby market forces and is allowed to fluctuate in response to changingeconomic conditions.

The exchange rate e, adjusts to achieve simultaneous equilibrium inthe goods market and the money market. When something changesthat equilibrium, the exchange rate is allowed to adjust to a newrate.

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Assumption 1: The domestic interest rate is equal to the world interest rate (r = r*).Assumption 2: The price level is exogenously fixed since the model is used to analyze the short run (P). This implies that the nominal exchange rate is proportional to the real exchange rate.Assumption 3: The money supply is also set exogenously by the central bank (M).Assumption 4: Our LM* curve will be vertical because the exchange rate does not enter into our LM* equation.

IS*: Y = C(Y-T) + I(r*) + G + NX(e)

Let’s start with two equations (notice the asterisk next to IS and LM to remind us that the equations hold the interest rate constant):

The Small Open Economy Under Floating Exchange Rates

LM*: M/P = L (r*,Y)

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The IS* curve slopes downward because a higher exchange ratereduces net exports (since a currency appreciation makes domestic goods more expensive to foreigners), which in turn, lowers aggregate income.

Income, output, Y

IS*

Exchange rate, e

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Exp

endi

ture

, E

Income, output, Y

Y=EPlanned expenditure,E = C + I + G + NX

Exc

hang

e ra

te, e

Income, output, Y

Exc

hang

e ra

te, e

,

Net exports, NX

NX(e) IS*

An increase in the exchange rate, lowers net exports, which shifts planned expenditure downward and lowers income. The IS* curve summarizes these changes in the goods market equilibrium.

An increase in the exchange rate, lowers net exports, which shifts planned expenditure downward and lowers income. The IS* curve summarizes these changes in the goods market equilibrium.

(a) (c)

(b)

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The LM curve andthe world interest

rate together determinethe level of income.The LM* curve is

vertical because theexchange rate does

not enter into the LM*equation.

Recall the LM* equation is:M/P = L (r*,Y)

The LM curve andthe world interest

rate together determinethe level of income.The LM* curve is

vertical because theexchange rate does

not enter into the LM*equation.

Recall the LM* equation is:M/P = L (r*,Y)

Inte

rest

rat

e, r

Income, output, Y

LM

Exc

hang

e ra

te, e

Income, output, Y

LM*

r = r*

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e

Income, output, Y

LM*

IS*

e

Income, output, Y

LM*

IS*IS*'

LM*'

When income rises in a small open economy, due tothe fiscal expansion, the interest rate tries to rise but capital inflows from abroad put downward pressure on the interest rate. This inflow causes an increase in

the demand for the currency pushing up its value and thus making domestic goods more expensive to foreigners (causing a –NX). The –NX offsets the expansionary fiscal policy and the effect on Y.

When income rises in a small open economy, due tothe fiscal expansion, the interest rate tries to rise but capital inflows from abroad put downward pressure on the interest rate. This inflow causes an increase in

the demand for the currency pushing up its value and thus making domestic goods more expensive to foreigners (causing a –NX). The –NX offsets the expansionary fiscal policy and the effect on Y.

When the increase in the money supply puts downwardpressure on the domestic interest rate, capital flows outas investors seek a higher return elsewhere. The capital

outflow prevents the interest rate from falling. The outflow also causes the exchange rate to depreciate, making domestic goods less expensive relative to

foreign goods, and stimulates NX. Hence, monetary policy influences the e rather than r.

When the increase in the money supply puts downwardpressure on the domestic interest rate, capital flows outas investors seek a higher return elsewhere. The capital

outflow prevents the interest rate from falling. The outflow also causes the exchange rate to depreciate, making domestic goods less expensive relative to

foreign goods, and stimulates NX. Hence, monetary policy influences the e rather than r.

+G, or –T +e, no Y

+G, or –T +e, no Y

+M -e, +Y

+M -e, +Y

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Fixed Exchange RatesUnder a fixed exchange rate, the central bank announces a valuefor the exchange rate and stands ready to buy and sell the domesticcurrency at a predetermined price to keep the exchange rate at its announced level. Fixed exchange rates require a commitmentof a central bank to allow the money supply to adjust to whatever levelwill ensure that the equilibrium exchange rate in the market for foreign-currency exchange equals the announced exchange rate.

Most recently, China fixed the value of its currency against the U.S.dollar, which has resulted in a lot of tension between the two nations.

It is important to realize that this exchange-rate system fixes the nominal exchange rate. Whether it fixes the real exchange rate dependson the time horizon.

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e

Income, output, Y

LM*

IS*

e

Income, output, Y

LM*

IS*IS*'

A fiscal expansion shifts IS* to the right. To maintainthe fixed exchange rate, the Fed must increase themoney supply, thus increasing LM* to the right.

Unlike the case with flexible exchange rates, there is nocrowding out effect on NX due to a higher exchange

rate.

A fiscal expansion shifts IS* to the right. To maintainthe fixed exchange rate, the Fed must increase themoney supply, thus increasing LM* to the right.

Unlike the case with flexible exchange rates, there is nocrowding out effect on NX due to a higher exchange

rate.

If the Fed tried to increase the money supply bybuying bonds from the public, that would put down-

ward pressure on the interest rate. Arbitragers respondby selling the domestic currency to the central bank,

causing the money supply and the LM curveto contract to their initial positions.

If the Fed tried to increase the money supply bybuying bonds from the public, that would put down-

ward pressure on the interest rate. Arbitragers respondby selling the domestic currency to the central bank,

causing the money supply and the LM curveto contract to their initial positions.

+G, or –T + Y+G, or –T + Y

LM*'

+ no Y+ no Y

The Mundell-Fleming Model Under Fixed Exchange Rates

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Fixed vs.

Exchange Rate ConclusionsFixed Exchange

RatesFloating Exchange

Rates• Fiscal Policy is Powerful.• Monetary Policy is Powerless.

• Fiscal Policy is Powerless.• Monetary Policy is Powerful.

The Mundell-Fleming model shows that fiscal policy does not influenceaggregate income under floating exchange rates. A fiscal expansioncauses the currency to appreciate, reducing net exports and offsettingthe usual expansionary impact on aggregate demand.

The Mundell-Fleming model shows that monetary policy does not influence aggregate income under fixed exchange rates. Any attempt to expand the money supply is futile, because the money supplymust adjust to ensure that the exchange rate stays at its announced level.

Hint: (Think of “floating” money.)Hint: (“Fixed” and “Fiscal” sound alike).

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Policy in the Mundell-Fleming Model:

A SummaryThe Mundell-Fleming model shows that the effect of almost any economic policy on a small open economy depends on whether the exchange rate is floating or fixed.

The Mundell-Fleming model shows that the power of monetary and fiscal policy to influence aggregate demand depends on the exchange rate regime.

The Mundell-Fleming model shows that the effect of almost any economic policy on a small open economy depends on whether the exchange rate is floating or fixed.

The Mundell-Fleming model shows that the power of monetary and fiscal policy to influence aggregate demand depends on the exchange rate regime.

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A country with fixed exchange rates can, however, conducta type of monetary policy by deciding to change the level atwhich the exchange rate is fixed.

A reduction in the official value of the currency is called a devaluation, and an increase in the value is called a revaluation.

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The higher return will attract funds from the rest of the world, driving the domestic interest rate back down. And, if the

domestic interest rate were below the world interest rate, r*, domestic residents would lend abroad to earn a higher return,

driving the domestic interest rate back up. In the end, the domestic interest rate would equal the world interest rate.

What if the domestic interest rate were above the world interest rate?

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Why doesn’t this logic always apply? There are two reasons why interestrates differ across countries:

1) Country Risk: when investors buy U.S. government bonds, or makeloans to U.S. corporations, they are fairly confident that they will berepaid with interest. By contrast, in some less developed countries, itis plausible to fear that political upheaval may lead to a default on loanrepayments. Borrowers in such countries often have to pay higherinterest rates to compensate lenders for this risk.

2) Exchange Rate Expectations: suppose that people expect the Frenchfranc to fall in value relative to the U.S. dollar. Then loans made in francswill be repaid in a less valuable currency than loans made in dollars. Tocompensate for the expected fall in the French currency, the interest rate in France will be higher than the interest rate in the United States.

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Differentials in the Mundell-Fleming Model

To incorporate interest-rate differentials into the Mundell-Flemingmodel, we assume that the interest rate in our small open economyis determined by the world interest rate plus a risk premium r = r* + The risk premium is determined by the perceived political risk ofmaking loans in a country and the expected change in the real interestrate. We’ll take the risk premium as exogenously determined.

For any given fiscal policy, monetary policy, price level, and riskpremium, these two equations determine the level of income andexchange rate that equilibrate the goods market and the money market.

IS*: Y = C(Y-T) + I(r* + ) + G + NX(e)LM*: M/P = L (r* + ,Y)

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Now suppose that political turmoil causes the country’s risk premium to rise. The most direct effect is that the domestic interest rate r rises.The higher interest rate has two effects:1) IS* curve shifts to the left, because the higher interest rate reducesinvestment.2) LM* shifts to the right, because the higher interest rate reduces thedemand for money, and this allows a higher level of income for anygiven money supply. These two shifts cause income to rise and thus push down the equilibriumexchange rate on world markets.The important implication: expectations of the exchange rate are partiallyself-fulfilling. For example, suppose that people come to believe that theFrench franc will not be valuable in the future. Investors will place alarger risk premium on French assets: will rise in France. Thisexpectation will drive up French interest rates and will drive down the value of the French franc. Thus, the expectation that a currency will losevalue in the future causes it to lose value today. The next slide willdemonstrate the mechanics.

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e

Income, output, Y

LM*

IS*

LM*'

IS*'

An Increase in the Risk Premium

An increase in the risk premium associated with a country drives upits interest rate. Because the higher interest rate reduces investment,

the IS* curve shifts to the left. Because it also reduces moneydemand, the LM* curve shifts to the right. Income rises, and the

exchange rate depreciates.

An increase in the risk premium associated with a country drives upits interest rate. Because the higher interest rate reduces investment,

the IS* curve shifts to the left. Because it also reduces moneydemand, the LM* curve shifts to the right. Income rises, and the

exchange rate depreciates.

Is this really is where the economy ends

up? In the next slide, we’ll see that

increases in country risk are undesirable.

Is this really is where the economy ends

up? In the next slide, we’ll see that

increases in country risk are undesirable.

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There are three reasons why, in practice, such a boom in income does not occur. First, the central bank might want to avoid the large

depreciation of the domestic currency and therefore, may respondby decreasing the money supply M. Second, the depreciation of the

domestic currency may suddenly increase the price of domestic goods,causing an increase in the overall price level P. Third, when some event

increase the country risk premium , residents of the country mightrespond to the same event by increasing their demand for money (for

any given income and interest rate), because money is often thesafest asset available. All three of these changes would tend to shift

the LM* curve toward the left, which mitigates the fall in the exchangerate but also tends to depress income.

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1) Allows monetary policy to be usedfor other purposes such as stabilizingemployment or prices.

1) Monetary policy is committedto the single goal of maintainingthe announced level.2) May lead to greater volatility inincome and employment.

1) Exchange-rate volatilitycreates uncertainty andmakes trade more difficult.2) Tempers overuse ofmonetary authority.

1) More speculation andvolatility expected.

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A speculative attack is a case where a change in investors’ perceptionsmakes a fixed rate untenable.

To avoid these kinds of attacks, some economists suggest the use of acurrency board, an arrangement by which the central bank holdsenough foreign currency to back each unit of the domestic currency.

The next for a nation is to consider dollarization, a plan in whichthe domestic currency is abandoned and the U.S. dollar is used instead.

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It is impossible for a nation to have free capital flows, a fixedexchange rate, and independent monetary policy.

Free capital flows

IndependentMonetary

Policy

FixedExchange

Rates

Option 1:United States

Option 3:China

Option 2:Hong Kong

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China’s Currency Situation

By January 2009, the exchange rate had moved to 6.84 yuanper dollar– a 21% appreciation of the yuan. Despite this large change in the exchange rate, China’s critics continued to complain about that nation’s intervention in foreign-exchange markets. In January 2009, the new Treasury Secretary Timothy Geithner said, “President Obama– backed by the conclusions of a broad range of economists—believes that China is manipulating its currency. So, President Obama had pledged to use aggressively all diplomatic avenues open to him to seek change in China’s currency practices.Currently, China no longer uses a completely fixed exchange rate.

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IS*: Y=C(Y-T) + I(r*) + G + NX(e)

LM*: M/P=L (r*,Y)

Recall the two equations of the Mundell-Fleming model:

e

Income, output,Y

LM*

IS*

LM*'

P

Income, output,Y

AD

When the price level falls, the LM*curve shifts to the right. Theequilibrium level of income rises.

The second graph displays the negative relationship between P and Y, which is summarized by the aggregate demand curve.

When the price level falls, the LM*curve shifts to the right. Theequilibrium level of income rises.

The second graph displays the negative relationship between P and Y, which is summarized by the aggregate demand curve.

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Realexchangerate

Income, output,Y

LM*

IS*

LM*'

P

Income, output,Y

AD

SRAS2

SRAS1K

C

P1

P2

e1

e2

Point K in both panelsshows the equilibriumunder the Keynesianassumption that prices arefixed at P1. Point C in bothdiagrams shows the equilibriumunder the classical assumptionthat the price level adjusts tomaintain income at its natural levelY.

KC

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Mundell-Fleming ModelFloating exchange ratesFixed exchange ratesDevaluationRevaluationThe Impossible Trinity

Mundell-Fleming ModelFloating exchange ratesFixed exchange ratesDevaluationRevaluationThe Impossible Trinity