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

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72 views

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

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divyanshi singh
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© © All Rights Reserved
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CHAPTER

The Open Economy Revisited:


the Mundell-Fleming Model and
the Exchange-Rate Regime
Adapted for EC 204 by
Prof. Bob Murphy
MACROECONOMICS SIXTH EDITION

N. GREGORY MANKIW
PowerPoint® Slides by Ron Cronovich
© 2007 Worth Publishers, all rights reserved
The Mundell-Fleming model

 Key assumption:
Small open economy with perfect capital mobility.
r = r*
 Goods market equilibrium – the IS* curve:

where
e = nominal exchange rate
= foreign currency per unit domestic currency

CHAPTER 12 The Open Economy Revisited slide 1


The IS* curve: Goods market eq’m

The IS* curve is drawn e


for a given value of r*.
Intuition for the slope:

IS*
Y

CHAPTER 12 The Open Economy Revisited slide 2


The LM* curve: Money market eq’m

The LM* curve


e LM*
 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, Y
regardless of e.
CHAPTER 12 The Open Economy Revisited slide 3
Equilibrium in the Mundell-Fleming
model

e LM*

equilibrium
exchange
rate

IS*
equilibrium Y
level of
income
CHAPTER 12 The Open Economy Revisited slide 4
Floating & fixed exchange rates

 In a system of floating exchange rates,


e is allowed to fluctuate in response to changing
economic conditions.
 In contrast, under fixed exchange rates,
the central bank trades domestic for foreign
currency at a predetermined price.
 Next, policy analysis –
 first, in a floating exchange rate system
 then, in a fixed exchange rate system
CHAPTER 12 The Open Economy Revisited slide 5
Fiscal policy under floating exchange
rates

e
At any given value of e,
e2
a fiscal expansion
increases Y, e1
shifting IS* to the right.
Results:
e > 0, Y = 0 Y
Y1

CHAPTER 12 The Open Economy Revisited slide 6


Lessons about fiscal policy

 In a small open economy with perfect capital


mobility, fiscal policy cannot affect real GDP.
 “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.

CHAPTER 12 The Open Economy Revisited slide 7


Monetary policy under floating
exchange rates

e
An increase in M
shifts LM* right
because Y must rise
to restore eq’m in e1
the money market. e2
Results:
Y
e < 0, Y > 0 Y1 Y2

CHAPTER 12 The Open Economy Revisited slide 8


Lessons about monetary policy
 Monetary policy affects output by affecting
the components of aggregate demand:
closed economy: M  r  I  Y
small open economy: M  e  NX  Y

 Expansionary mon. policy does not raise world


agg. demand, it merely shifts demand from
foreign to domestic products.
So, the increases in domestic income and
employment are at the expense of losses abroad.

CHAPTER 12 The Open Economy Revisited slide 9


Fixed exchange rates

 Under fixed exchange rates, the central bank


stands ready to buy or sell the domestic currency
for foreign currency at a predetermined rate.
 In the Mundell-Fleming model, the central bank
shifts the LM* curve as required to keep e at its
preannounced rate.
 This system fixes the nominal exchange rate.
In the long run, when prices are flexible,
the real exchange rate can move even if the
nominal rate is fixed.
CHAPTER 12 The Open Economy Revisited slide 10
Fiscal policy under fixed exchange
rates

Under
Underfloating
floatingrates,
rates,
afiscal
fiscalpolicy
expansion
is ineffective
e
would raise e.output.
at changing
To keepfixed
Under e from rising,
rates,
the central
fiscal bank
policy must
is very
sell domestic currency, e1
effective at changing
which
output.increases M
and shifts LM* right.
Results: Y
Y1 Y2
e = 0, Y > 0
CHAPTER 12 The Open Economy Revisited slide 11
Monetary policy under fixed
exchange rates
An increase
Under in Mrates,
floating would
monetary
shift policy
LM* right andisreduce e.
very effective at e
To prevent the fall in e,
changing
the central output.
bank must
buy
Underdomestic currency,
fixed rates,
which reduces
monetary M and
policy cannot e1
shifts LM*toback
be used left.output.
affect
Results:
Y
e = 0, Y = 0 Y1

CHAPTER 12 The Open Economy Revisited slide 12


CASE STUDY:
The Mexican peso crisis

CHAPTER 12 The Open Economy Revisited slide 13


CASE STUDY:
The Mexican peso crisis

CHAPTER 12 The Open Economy Revisited slide 14


The 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

CHAPTER 12 The Open Economy Revisited slide 15


Understanding 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 ( ):
 peasant uprising in Chiapas
 assassination of leading presidential candidate
 Another factor:
The Federal Reserve raised U.S. interest rates
several times during 1994 to prevent U.S. inflation.
(r* > 0)
CHAPTER 12 The Open Economy Revisited slide 16
Understanding the crisis

 These events put downward pressure on the peso.


 Mexico’s central bank had repeatedly promised
foreign 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
have adequate reserves of dollars.
Did it?

CHAPTER 12 The Open Economy Revisited slide 17


Dollar reserves of Mexico’s central
bank

December 1993 ……………… $28 billion


August 17, 1994 ……………… $17 billion
December 1, 1994 …………… $ 9 billion
December 15, 1994 ………… $ 7 billion

During 1994, Mexico’s central bank hid the


fact that its reserves were being depleted.

CHAPTER 12 The Open Economy Revisited slide 18


the disaster
 Dec. 20: Mexico devalues the peso by 13%
(fixes e at 25 cents instead of 29 cents)
 Investors are SHOCKED! – they had no idea
Mexico was running out of reserves.
 , 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%.
CHAPTER 12 The Open Economy Revisited slide 19
The rescue package

 1995: U.S. & IMF set up $50b line of credit to


provide loan guarantees to Mexico’s govt.
 This helped restore confidence in Mexico,
reduced the risk premium.
 After a hard recession in 1995, Mexico began a
strong recovery from the crisis.

CHAPTER 12 The Open Economy Revisited slide 20


Floating vs. fixed exchange rates

Argument for floating rates:


 allows monetary policy to be used to pursue other
goals (stable growth, low inflation).

Arguments for fixed rates:


 avoids uncertainty and volatility, making
international transactions easier.
 disciplines monetary policy to prevent excessive
money growth & hyperinflation.

CHAPTER 12 The Open Economy Revisited slide 21

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