CHAPTER FOUR: AGGREGATE DEMAND IN THE OPEN ECONOMY

CHAPTER FOUR

AGGREGATE DEMAND IN THE OPEN ECONOMY

4.1. International Flows of Capital and Goods

In the previous chapter, we simplified our analysis by assuming a closed economy.

In actuality, however, most economies are open: they export goods and services
abroad, they import goods and services from abroad, and they borrow and lend in
world financial markets.

Open Versus Closed Economies

 A closed economy is one that does not interact with other economies in the
world.
o There are no exports, no imports, and no capital flows.
 An open economy is one that interacts freely with other economies around the
world.
 An open economy interacts with other countries in two ways:
o It buys and sells goods and services in world product markets.
o It buys and sells capital assets in world financial markets.
4.1.1. International Flows of Goods: Exports, Imports, and Net Exports

Consider the expenditure on an open economy’s output of goods and services,

which can be divided into four components:

 , consumption of domestic goods and services,

 , investment in domestic goods and services,
 , government purchases of domestic goods and services,
 EX, exports of domestic goods and services.
o The division of expenditure into these components is expressed in the identity:

1
 CHAPTER FOUR: AGGREGATE DEMAND IN THE OPEN ECONOMY

o Note that domestic spending on all goods and services is the sum of domestic
spending on domestic goods and services and on foreign goods and services.
Therefore,

o We substitute these three equations into the identity above:

and rearranging

( ) ( )

The national income identity in an open economy is therefore:

Or ,

Net Exports = Output − Domestic Spending.

 The national income identity shows how domestic output, domestic

spending, and net exports are related.
o It shows that in an open economy, domestic spending need not equal the output
of goods and services. If output exceeds domestic spending, we export the
difference: net exports are positive. If output falls short of domestic spending,
we import the difference: net exports are negative.

Note: Exports: are domestically produced goods and services that are sold abroad.

Imports: are foreign produced goods and services that are sold domestically.

2
 CHAPTER FOUR: AGGREGATE DEMAND IN THE OPEN ECONOMY

Net exports (NX): -also called the trade balance: refers to the values of a nation’s
exports minus the value of its imports.

Factors That Affect Net Exports

 The tastes of consumers for domestic and foreign goods.
 The prices of goods at home and abroad.
 The exchange rates at which currencies are exchanged.
 The incomes of consumers at home and abroad.
 The costs of transporting goods from country to country.
 International trade policies, etc...
4.1.2. International Capital Flows

Net foreign investment /Net capital outflow/- refers to the purchase of foreign
assets by domestic residents minus the purchase of domestic assets by foreigners.

o For instance, the Ethiopian resident buys stock in the Chinese corporation and
a Chinese buys stock in the Ethiopian corporation.
o When Ethiopian resident buys stock in Telmex, the Mexican phone company,
the purchase raises the Ethiopian net foreign investment.
o When a Japanese resident buys a bond issued by the Ethiopian government, the
purchase reduces the Ethiopian net foreign investment.
 Financial/Capital markets and goods markets are closely related.

Begin with the identity: .

Subtract C and G from both sides to obtain:

Note: is national saving S, the sum of private saving, ,

and public saving, .Therefore,

3
 CHAPTER FOUR: AGGREGATE DEMAND IN THE OPEN ECONOMY

Subtracting from both sides of the equation, we can write the national
income accounts identity as

o This identity shows that an economy’s net exports must always equal the
difference between its saving and its investment.
 – is termed as net capital outflow/net foreign investment (domestic
saving less domestic investment).
o If net capital outflow is positive, our saving exceeds our investment, and
we are lending the excess to foreigners /I.e., When , the country is a
net lender
o If the net capital outflow is negative, our investment exceeds our saving,
and we are financing this extra investment by borrowing from abroad /I.e.,
When , the country is a net borrower/.
o Thus, net capital out flow equals the amount that domestic residents are
lending abroad minus the amount that foreigners are lending to us.
 If and are positive, we have a trade surplus. In this case, we are
net lenders in world financial markets, and we are exporting more goods
than we are importing.
 If and are negative, we have a trade deficit. In this case, we are
net borrowers in world financial markets, and we are importing more goods
than we are exporting.
 If and are exactly zero, we are said to have balanced trade
because the value of imports equals the value of exports.

The national income accounts identity shows that the international flow of funds to
finance capital accumulation and the international flow of goods and services are
two sides of the same coin.
4
 CHAPTER FOUR: AGGREGATE DEMAND IN THE OPEN ECONOMY

o On the one hand, if our saving exceeds our investment, the saving that is not
invested domestically is used to make loans to foreigners. Foreigners require
these loans because we are providing them with more goods and services than
they are providing us. That is, we are running a trade surplus.
o On the other hand, if our investment exceeds our saving, the extra investment
must be financed by borrowing from abroad. These foreign loans enable us to
import more goods and services than we export. That is, we are running a trade
deficit.
Factors that Influence Net Foreign Investment
 The real interest rates being paid on foreign assets.
 The real interest rates being paid on domestic assets.
 The perceived economic and political risks of holding assets abroad.
 The government policies that affect foreign ownership of domestic assets.
4.2. Exchange Rates

Having examined the international flows of capital and of goods and services, we
now extend the analysis by considering the prices that apply to these transactions.

o The exchange rate (E) is the rate at which one currency exchanges for another.
o One may view the exchange rate as indicative of the relative price of goods and
services denominated in the currencies of the two countries concerned.
Alternatively, the exchange rate can be regarded as the relative price of assets
denominated in the currencies of a pair of countries. In any case, conversion
from one currency unit to another is the job of the exchange rate.
o There are two conventions for measuring the exchange rate, the distinction
between which can be the source of serious confusion:

5
 CHAPTER FOUR: AGGREGATE DEMAND IN THE OPEN ECONOMY

A. Domestic currency units per unit of foreign currency

o For example, if the birr is the home currency and the dollar ($) is the foreign
Currency, and 20-birr exchanges for $1, then the exchange rate is 20. The
domestic currency is on the numerator of the ratio.
o Here, whenever E rises the home currency gets weaker; it depreciates. For
example, arise from 20 to 21 means that 21birr exchanged for $1, less than
before.
o Conversely, when E falls, the domestic currency gets stronger, it appreciates.
B. Foreign currency units per unit of domestic currency

This is exactly the converse of the first convention.

o The domestic currency is on the denominator. When 20birr is exchanged for

$1, the exchange rate is 0.05.
o If E rises, the home currency gets stronger, and vice versa.

Real and Nominal Exchange Rates

 The Nominal Exchange Rate (e) is the relative price of the currency of two
countries. For example, if the exchange rate between the Ethiopian birr and the
U.S dollar is 20 birr per dollar, then you can exchange one dollar for 20 birrs in
the world markets for foreign currency.
o An Ethiopian who wants to obtain dollars would pay 20 birrs for each dollar he
bought.
o An American who wants to obtain birr would get 20 birrs for each dollar he
paid.
 The Real Exchange Rate is the relative price of the goods of two countries.
 That is, the real exchange rate tells us the rate at which we can trade the goods
of one country for the goods of another. It measures a country’s
competitiveness in the international trade.
6
 CHAPTER FOUR: AGGREGATE DEMAND IN THE OPEN ECONOMY

The real exchange rate R, is usually defined as

This equation shows that the nominal exchange rate depends on the real exchange
rate and the price levels in the two countries. Given the value of the real exchange
rate, if the domestic price level P rises, then the nominal exchange rate e will fall:
because a dollar is worth less, a dollar will buy fewer yen. However, if the
Japanese price level P* rises, then the nominal exchange rate will increase: because
the yen is worth less, a dollar will buy more yen. It is instructive to consider
changes in exchange rates over time.

The exchange rate equation can be written

7
 CHAPTER FOUR: AGGREGATE DEMAND IN THE OPEN ECONOMY

This equation states that the percentage change in the nominal exchange rate
between the currencies of two countries equals the percentage change in the real
exchange rate plus the difference in their inflation rates. If a country has a high rate
of inflation relative to the United States, a dollar will buy an increasing amount of
the foreign currency over time. If a country has a low rate of inflation relative to
the United States, a dollar will buy a decreasing amount of the foreign currency
over time.

This analysis shows how monetary policy affects the nominal exchange rate.

We know that high growth in the money supply leads to high inflation. Here, we
have just seen that one consequence of high inflation is a depreciating currency:
high p implies falling e.

In other words, just as growth in the amount of money raises the price of goods
measured in terms of money, it also tends to raise the price of foreign currencies
measured in terms of the domestic currency.

o The rate at which we exchange foreign and domestic goods depends on the
prices of the goods in the local currencies and on the rate at which the
currencies are exchanged.
o If the exchange rate equals 1, currencies are at purchasing power parity (PPP).
o A high real exchange rate shows that domestic goods are dearer. Thus, exports
are discouraged while imports are encouraged so, the trade balance deteriorates.
o A low real exchange rate shows that domestic goods are cheaper. Thus, exports
are encouraged while imports are discouraged so, the trade balance improves.

8
 CHAPTER FOUR: AGGREGATE DEMAND IN THE OPEN ECONOMY

Exchange rate Determination/Fixed versus Flexible Exchange rate Regimes/

A. Flexible Exchange Rates:

o Under this system the exchange rate is completely market- determined, without
any interference from government authorities (the central bank).
o The balance of payments balances: surpluses are eliminated via exchange rates
appreciation; deficits are cured by exchange rate depreciation.
o In other words, balance of payments disequilibria is self-correcting.
B. Fixed Exchange Rates:
o Here the rate of exchange is a policy parameter fixed by the authorities. They
have to meet excess demand for a foreign currency (not financed by sales in
that foreign country) from their reserves of foreign currency.
o Net inflows of foreign currency swell the domestic money supply, as private
economic agents who don’t use it to purchase goods abroad convert foreign
currency to domestic money at the fixed rate of exchange.
o Fixed exchange rates make the domestic money Supply dependent on changes
in foreign exchange reserves. Also, balance of payments deficits cause reserve
losses and surpluses cause reserve to be built up: there is no self-correcting
mechanism to balance of payments disequilibria.
 These two exchange rate regimes are the two polar extremes in the economics
of exchange rate. In reality we have a pastiche of arrangement, somewhere in
between the two. Even with flexible rates, central banks do interfere with the
market-determined exchange rate, often in an internationally concerted fashion.
This is known as a managed float (consider the Ethiopian case). Fixed
Exchange rates also allow for realignments and changes in the exchange rate,
usually devaluation.

9
 CHAPTER FOUR: AGGREGATE DEMAND IN THE OPEN ECONOMY

Devaluation Versus Revaluation.

 Devaluation takes place when the price of foreign currencies under fixed
exchange rate regime is increased by official action (you can consider the action
of the Ethiopian government to devalue the currency in 1992. The Birr was
devalued in 1992 and this is expected to promote exporters and discourage
importers. This was expected to narrow the gap between exports and imports
and consequently improve the current account.
 Devaluation thus means that foreigners pay less for devalued currency and that
residents of the devaluing country pay more for foreign currencies. The
opposite of devaluation is revaluation.

Depreciation versus Appreciations

A currency is said to be depreciate when under floating rates it becomes less

expensive in terms of foreign currency. By contrast, currency appreciates
when it becomes more expensive in terms of foreign money.
4.3. Monetary and Fiscal Policy Analysis in an Open Economy with Perfect
Capital Mobility
4.3.1 Saving and investment in a small open economy

So far in our discussion, we have considered the international flows of goods and
capital, and their relationships. Our next step is to develop a model that explains
the behaviour of these variables. We can then use the model to answer questions
such as how the trade balance responds to changes in policy.

Basic Assumptions:

 Small open economy- it is to mean that the economy is a small part of the
world market and thus, by itself, can have only a negligible effect on the
world interest rate.

10
 CHAPTER FOUR: AGGREGATE DEMAND IN THE OPEN ECONOMY

 Perfect capital mobility- residents of the country have full access to world
financial markets. Meaning the government does not impede international
borrowing/lending.
o Owing to the above assumptions, the interest rate r, must equal the world
interest rate (the real interest rate prevailing in world financial markets):

Residents of the small open economy need never borrow at any interest rate
above r*, because they can always get a loan at r* from abroad. Similarly,
residents of this economy need never lend at any interest rate below r * because
they can always earn r * by lending abroad. Thus, the world interest rate
determines the interest rate in our small open economy.

What determines the world real interest rate?

o The equilibrium of world saving and world investment determines the world
interest rate.
o Our small open economy has a negligible effect on the world real interest rate
because, being a small part of the world, it has a negligible effect on world
saving and world investment. Hence, our small open economy takes the world
interest rate as exogenously given.

The Model: To build the model of the small open economy, we make three
assumptions

i) Production function: ̅ ̅ ̅ :The economy’s output Y is fixed by the

factors of production
ii) Consumption function:
iii) Investment function:

We can now return to the accounting identity and write it as

11
 CHAPTER FOUR: AGGREGATE DEMAND IN THE OPEN ECONOMY

Substituting our three assumptions and the condition that the interest rate equals
the world interest rate, we obtain

̅ ̅

This equation shows what determines saving S and investment I, and thus the trade
balance .

o Saving depends on fiscal policy: lower government purchases G or higher

taxes T raise national saving.
o Investment depends on the world real interest rate r*: high interest rates
make some investment projects unprofitable. Therefore, the trade balance
depends on these variables as well.
o The trade balance is determined by the difference between saving and
investment at the world interest rate.

Figure: 4.1: Saving and Investment in a Small Open Economy

12
 CHAPTER FOUR: AGGREGATE DEMAND IN THE OPEN ECONOMY

o In a closed economy, the real interest rate adjusts to equilibrate saving and
investment.
o But, in a small open economy, the interest rate is determined in world financial
markets. The difference between saving and investment determines the trade
balance. Here there is a trade surplus, because at the world interest rate, saving
exceeds investment.
4.3.2. How Policies Influence the Trade Balance

Suppose that the economy begins in a position of balanced trade. That is, at the
world interest rate, investment equal saving , and net exports equal zero.
Let’s use our model to predict the effects of government policies at home and
abroad.

A. Fiscal Policy at Home

What happens to the small open economy if the government expands domestic
spending by increasing government purchases?

o The increase in G reduces national saving, because . With an

unchanged world real interest rate, investment remains the same.
Therefore, saving falls below investment, and some investment must now be
financed by borrowing from abroad. Because , the fall in
implies a fall in . The economy now runs a trade deficit.

13
 CHAPTER FOUR: AGGREGATE DEMAND IN THE OPEN ECONOMY

Figure 4.2: A Fiscal Expansion at Home in a Small Open Economy

 An increase in government
purchases or a reduction in
taxes reduces national
saving and thus shifts the
saving schedule to the left,
from to . The result is a
trade deficit.

Because is the distance between the saving schedule and the investment
schedule at the world interest rate, this shift reduces . Hence, starting from
balanced trade a change in fiscal policy that reduces national saving leads to a
trade deficit.

B. Fiscal Policy Abroad

 What happens to a small open economy when foreign governments increase
their government purchases?
o Assuming these foreign countries are a large part of the world economy, and
thus their increase in government purchases reduces world saving and causes
the world interest rate to rise. The increase in the world interest rate raises the
cost of borrowing and, thus, reduces investment in our small open economy.

14
 CHAPTER FOUR: AGGREGATE DEMAND IN THE OPEN ECONOMY

Figure 4.3: A Fiscal Expansion at Abroad in a Small Open Economy

A fiscal expansion in a
foreign economy large
enough to influence
world saving and
investment raises the
world interest rate from
to .

The higher world interest

rate reduces investment
in this small open
economy, causing a
trade surplus.

C) Shifts in Investment Demand

What happens to our small open economy if its investment schedule shifts
outward —that is, if the demand for investment goods at every interest rate
increases?
o This shift would occur if, for example, the government changed the tax laws to
encourage investment.
Figure: 4.4: A Shift in the Investment Schedule in a Small Open Economy

An outward shift in the

investment schedule
from to
increases the amount of
in-vestment at the
world interest rate . As
a result, investment
now exceeds saving,
which means the
economy is borrowing
from abroad and
running a trade deficit.

15
 CHAPTER FOUR: AGGREGATE DEMAND IN THE OPEN ECONOMY

Because , the increase in I implies a decrease in . Hence, an

outward shift in the investment schedule causes a trade deficit.

4.3.3. The Small Open Economy under Floating Exchange Rates

A) Fiscal Policy under Floating Exchange Rates
o Suppose that the government stimulates domestic spending by increasing
government purchases or by cutting taxes. Because such expansionary fiscal
policy increases planned expenditure, it shifts the IS* curve to the right, as in
Figure 4.10. As a result, the exchange rate appreciates, whereas the level of
income remains the same.

Note the mechanism:

o When income rises in a small open economy, due to the 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 domestic currency pushing up its value (the currency appreciates).

o The appreciation of the exchange rate makes domestic goods expensive for
foreigners, and this reduces net exports. The fall in net exports offsets the
effects of the expansionary fiscal policy on income.

16
 CHAPTER FOUR: AGGREGATE DEMAND IN THE OPEN ECONOMY

Figure: 4.10: A Fiscal Expansion Under Floating Exchange Rates

 An increase in government purchases or a decrease in taxes shifts the IS*

curve to the right. This raises the exchange rate but has no effect on
income.
B) Monetary Policy under Floating Exchange Rates
o Suppose now that the central bank increases the money supply. Because the
price level is assumed to be fixed, the increase in the money supply means an
increase in real balances.
o The increase in real balances shifts the LM* curve to the right, as in Figure
4.11. Hence, an increase in the money supply raises income and lowers the
exchange rate.

Note the mechanism:

 When increase in the money supply puts downward pressure on the domestic
interest rate, capital flows out of the economy as investors seek a higher return
elsewhere. This capital outflow prevents the domestic interest rate from falling.

17
 CHAPTER FOUR: AGGREGATE DEMAND IN THE OPEN ECONOMY

 In addition, because the capital outflow increases the supply of the domestic
currency in the market for foreign-currency exchange, the exchange rate
depreciates. The fall in the exchange rate makes domestic goods cheap
relative to foreign goods and, thereby, stimulates net exports. Hence, in a
small open economy, monetary policy influences income by altering the
exchange rate.

Figure: 4.11: A Monetary Expansion Under Floating Exchange Rates

 An increase in the money supply shifts the LM* curve to the right,
lowering the exchange rate and raising income.

The Small Open Economy under Fixed Exchange Rates

o Under a fixed exchange rate, the central bank announces a value for the
exchange rate and stands ready to buy and sell the domestic currency at a
predetermined price to keep the exchange rate at its announced level.
o Fixed exchange rates require a commitment of a central bank to allow the
money supply to adjust to whatever level will ensure that the equilibrium
exchange rate in the market for foreign-currency exchange equals the
announced exchange rate.
18
 CHAPTER FOUR: AGGREGATE DEMAND IN THE OPEN ECONOMY

o i.e., the sole objective of monetary policy is to keep the exchange rate at the
announced level.

How a Fixed-Exchange-Rate System Works

 Suppose that the Ethiopian national bank announces that it is going to fix the
exchange rate at 32 birr per dollar (I.e., $0.03125 per birr). It would then stand
ready to give 32 birr in exchange for $1 or to give $1 in exchange for 32 birr.
 Hence, the NB would need a reserve of birr (which it can print) and a reserve of
dollars (which must have been purchased previously)
 Suppose in the current equilibrium with the current money supply, the exchange
rate is 20 birr per dollar ($0.05 per birr) that is higher than 32 birr per dollar
determined by the central bank. Arbitrageurs use their birr to buy foreign
currency in foreign-exchange markets and sell it to the domestic national bank
for a profit. This process automatically increases the money supply (the
base money)-shifting the curve to the right and lowers the exchange
rate as the table below presents.
Figure: 4.12: When the equilibrium exchange rate is greater than the fixed
exchange rate

19
 CHAPTER FOUR: AGGREGATE DEMAND IN THE OPEN ECONOMY

Suppose the equilibrium exchange rate is lower than the fixed exchange rate.
Arbitrageurs will buy birr in foreign-exchange markets and use them to buy
foreign currency from national bank of Ethiopia. This process automatically
reduces the money supply, shifting the curve to the left and raises the
exchange rate as figure 4.13, presents.

Figure: 4.13: When the equilibrium exchange rate is less than the fixed exchange
rate

Figures 4.12 and 4.13 shows how a fixed exchange rate governs the money supply.

 Let’s now examine how economic policies affect a small open economy with a
fixed exchange rate.
A) Fiscal Policy under Fixed Exchange Rates
o Suppose that the government stimulates domestic spending by increasing
government purchases or by cutting taxes. This policy shifts the IS* curve to
the right, as in Figure 4.12, putting upward pressure on the exchange rate.
o But because the central bank stands ready to trade foreign and domestic
currency at the fixed exchange rate, arbitrageurs quickly respond to the rising

20
 CHAPTER FOUR: AGGREGATE DEMAND IN THE OPEN ECONOMY

exchange rate by selling foreign currency to the central bank, leading to an

automatic monetary expansion.
o The rise in the money supply (in the base money) shifts the curve to the
right.
 Thus, under a fixed exchange rate, a fiscal expansion raises aggregate income.

Figure: 4.14: A Fiscal Expansion Under Fixed Exchange Rates

 A fiscal expansion shifts the IS* curve to the right. To maintain the fixed
exchange rate, the central bank must increase the money supply, thereby
shifting the LM* curve to the right. Hence, in contrast to the case of floating
exchange rates, under fixed exchange rates a fiscal expansion raises income.
B) Monetary Policy under Fixed Exchange Rates
o Imagine that a central bank operating with a fixed exchange rate were to try to
increase the money supply —for example, by buying bonds from the public.
o What would happen? The initial impact of this policy is to shift the LM* curve
to the right, lowering the exchange rate, as in Figure 4.13.

21
 CHAPTER FOUR: AGGREGATE DEMAND IN THE OPEN ECONOMY

o But, because the central bank is committed to trading foreign and domestic
currency at a fixed exchange rate, arbitrageurs quickly respond to the falling
exchange rate by selling the domestic currency to the central bank, causing the
money supply and the LM* curve to return to their initial positions.
o Hence, monetary policy is ineffectual under a fixed exchange rate. By agreeing
to fix the exchange rate, the central bank gives up its control over the money
supply.

Figure: 4.15: A Monetary Expansion Under Fixed Exchange Rates

 If the National bank tries to increase the money supply -for example, by buying
bonds from the public—it will put downward pressure on the exchange rate. To
maintain the fixed exchange rate, the money supply and the LM* curve must
return to their initial positions. Hence, under fixed exchange rates, monetary
policy is ineffectual.

22
 CHAPTER FOUR: AGGREGATE DEMAND IN THE OPEN ECONOMY

Fixed vs. Floating Exchange Rate Conclusions

Fixed Exchange Rate Floating Exchange Rate

 Fiscal Policy is Powerful.  Fiscal Policy is Powerless.

 Monetary Policy is  Monetary Policy is

Powerless. Powerful

4.4. The Mundell-Fleming Model

o The model developed in this chapter, called the Mundell–Fleming model, is an
open-economy version of the – model.
o This model owes its origins to papers published by James Flemming (1962) and
Robert Mundell (1962, 1963).
o Their major contribution was to incorporate international capital movements
into formal macroeconomic models based on the Keynesian IS-LM framework.
o Their papers led to some dramatic implications concerning the effectiveness of
fiscal and monetary policy on national income.

Notice the Relationship b/n IS-LM and Mundell–Fleming model:

o Both models stress the interaction between the goods market and the money
market.
o Both models assume that the price level is fixed and then show what causes
short-run fluctuations in aggregate income (or, equivalently, shifts in the
aggregate demand curve).
o The key difference is that the IS –LM model assumes a closed economy,
whereas the Mundell–Fleming model assumes an open economy. The Mundell–
Fleming model extends the short-run model of national income by including the
effects of international trade and finance.

23
 CHAPTER FOUR: AGGREGATE DEMAND IN THE OPEN ECONOMY

The Mundell–Fleming model makes one important and extreme assumption:

It assumes that the economy being studied is a small open economy with perfect
capital mobility. That is, the economy can borrow or lend as much as it wants in
world financial markets and, as a result, the economy’s interest rate is determined
by the world interest rate.

One virtue of this assumption is that it simplifies the analysis: once the interest rate
is determined, we can concentrate our attention on the role of the exchange rate.

In this section, we will build the Mundell –Fleming model, and use the model to
examine the impact of various policies to discern how the economy operates under
floating and fixed exchange rate regimes and notice whether a floating or fixed
exchange rate is better - /an important question in recent years, as many nations
around the world have debated what exchange-rate system to adopt/.

Small Open Economy with Perfect Capital Mobility

 r is determined by the world interest rate - the small open economy being
under consideration do not affect world interest rate. Mathematically:
 The equation represents the assumption that the international flow of
capital is rapid enough to keep the domestic interest rate equal to the world
interest rate.
 Since r is fixed, fiscal and monetary policies will affect the IS and LM curves
through the exchange rates.
4.4.1. The Goods Market and the IS* Curve

The Mundell–Fleming model describes the market for goods and services much as
the IS–LM model does, but it adds a new term for net exports. In particular, the
goods market is represented with the following equation:

24
 CHAPTER FOUR: AGGREGATE DEMAND IN THE OPEN ECONOMY

o The net exports depend on the real exchange rate. The Mundell-Fleming model,
however, assumes that the price levels at home and abroad are fixed, so the real
and nominal exchange rates are proportional.
o When the nominal exchange rate appreciates foreign goods become cheaper
compared to domestic goods, and this causes exports to fall and imports to rise,
and lowers the aggregate income.

The relation of the exchange rate and aggregate income is called the curve.

Figure:4.5: The Net-Exports Function

 An increase in the exchange rate from to lowers net exports from

to
25
 CHAPTER FOUR: AGGREGATE DEMAND IN THE OPEN ECONOMY

How changes in the exchange rate do affect income?

Figure: 4.6: The Keynesian Cross

 A decrease in net exports from to shifts the planned-

expenditure schedule downward and reduces income from to as
indicated above.

The IS* curve summarizing this relationship between the exchange rate and
income: the higher the exchange rate, the lower the level of income.

Figure: 4.7: The Curve

26
 CHAPTER FOUR: AGGREGATE DEMAND IN THE OPEN ECONOMY

4.4.2. The Money Market and the LM* Curve

o LM curve is derived from
o The model assumes M as fixed policy variable chosen by central banks and P
is also fixed in the short-run, and thus LM curve draws combinations of r and
Y satisfying the equation written above.
o Since r is fixed by the world interest rate in an open economy, the equation
finds a fixed amount of income Y.
o This is to say Y is not affected by the exchange rate. Hence, the LM curve,
which draws the relation of the exchange rate and aggregate income, is
vertical.

Figure: 4.8: The LM* Curve:

 Panel (a) shows the

standard LM curve [which
graphs the equation
] together with a
horizontal line representing the
world interest rate r*.
 The intersection of these
two curves determines the level
of income, regardless of the
exchange rate. Therefore, as
panel (b) shows, the
curve is vertical.

27
 CHAPTER FOUR: AGGREGATE DEMAND IN THE OPEN ECONOMY

4.4.3. The Equilibrium/Combining the IS* and LM* Curves

According to the Mundell–Fleming model, a small open economy with perfect

capital mobility can be described by two equations:

o The first equation describes equilibrium in the goods market, and the second
equation describes equilibrium in the money market. The exogenous variables
are fiscal policy G and T, monetary policy M, the price level, P and the world
interest rate, r*.
o The endogenous variables are income Y and the exchange rate e.

Figure 4.9 illustrates these two relationships. The equilibrium for the economy is
found where the curve and the curve intersect. This intersection shows the
exchange rate and the level of income at which both the goods market and the
money market are in equilibrium.

With this diagram, we can use the Mundell–Fleming model to show how aggregate
income Y and the exchange rate e respond to changes in policy.

Figure 4.9: Mundell–Fleming model

This graph of the Mundell–

Fleming model plots the
goods market equilibrium
condition IS* and the
money market equilibrium
condition LM*. Both curves
are drawn holding the
interest rate constant at the
world interest rate. The
intersection of these two
curves shows the level of
income and the exchange
28 rate that satisfy equilibrium
both in the goods market
and in the money market.
 CHAPTER FOUR: AGGREGATE DEMAND IN THE OPEN ECONOMY

4.4.4 The Mundell-Fleming Model with a Changing Price Level

Recall the two equations of the Mundell-Fleming model:

 The model is constructed for fixed price level. However, a change in

the price level shifts the curve and changes the equilibrium income.
 Consider reduction in the price level. When the price level falls, the LM* curve
shifts to the right. The equilibrium level of income rises.
 The second graph displays the negative relationship between P and Y, which is
summarized by the aggregate demand curve.

i) The Mundell–Fleming Model b) The Aggregate Demand Curve

29
 CHAPTER FOUR: AGGREGATE DEMAND IN THE OPEN ECONOMY

The Short-Run and Long-Run Equilibria in a Small Open Economy

Now let’s compare the short-run and the long-run equilibrium of the economy
using the and aggregate demand-aggregate supply models.

 Point K in both panels shows the equilibrium under the Keynesian assumption
that the price level is fixed at .
 Point C in both panels shows the equilibrium under the classical assumption
that the price level adjusts to maintain income at its natural rate ̅
a) The Mundell –Fleming Model b) The AD-AS model

 Policy in the Mundell-Fleming Model: A Summary

 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.

30
 CHAPTER FOUR: AGGREGATE DEMAND IN THE OPEN ECONOMY

 To be more specific, the Mundell –Fleming model shows that the power of
monetary and fiscal policy to influence aggregate income depends on the
exchange-rate regime.
 Under floating exchange rates, only monetary policy can affect income. The
usual expansionary impact of fiscal policy is offset by a rise in the value of
the currency.
 Under fixed exchange rates, only fiscal policy can affect income. The
normal potency of monetary policy is lost because the money supply is
dedicated to maintaining the exchange rate at the announced level.
4.4.4. Limitations of the Mundell-Fleming Model
1. Neglect of the long run budget constraints: the model fails to take account of
long run constraints that govern both the private and public sector. In the long
run private sector spending has to equal its disposable income, while in the
absence of money creation government expenditure has to equal its revenue
from taxation. This means that in the long run the current account has to be in
balance. One implication of these budget constraints is that a forward-looking
private sector would realize that increased government expenditure will imply
higher taxation for them in the future, and this will induce increased private
sector savings today that will undermine the effectiveness of fiscal policy.
2. Wealth Effect: the model does not allow for wealth effects that may help in
the process of restoring long run equilibrium. A decrease in wealth resulting
from a fall in foreign assets associated with a current account deficit will
ordinarily lead to a reduction in import expenditure which should help to
reduce the current account deficit. While such an omission of wealth effects on
the import expenditure function may be justified as being small significance in
the short run, the omission nevertheless again emphasizes the essentially short-
term nature of the model.
31
 CHAPTER FOUR: AGGREGATE DEMAND IN THE OPEN ECONOMY

3. Neglect of supply side factors: one of the obvious limitations of the model is
that it concentrates on the demand side of the economy and neglects the supply
side. There is an implicit assumption that supply adjust in accordance with
changes in demand. In addition, because the aggregate supply curve is
horizontal up to full employment, increases in aggregate demand do not lead to
changes in the domestic price level, rather they are reflected solely by
increases in real output.
4. Treatment of capital flows: one of the biggest problems of the model
concerns the modelling of capital flows. It is assumed that a rise in the
domestic interest rate leads to a continuous capital inflow from abroad.
However, to expect such flows to continue indefinitely is unrealistic because
after a point international investor will have rearranged the stocks of their
international portfolios to their desired content and once this happens the net
capital inflows into the country will cease. The only way that the country could
then continue to attract capital inflows would be a further rise in its interest
rate until once again international portfolios are restored to their desired
content. Hence a country that needs a continuous capital inflow to finance its
current account deficit has to continuously raise its interest rate. In other
words, capital inflows are a function of the change in the interest differential
rather than the differential itself.
5. Exchange rate expectations: A major problem with the model is the treatment
of exchange rate expectations. The model does not explicitly model these and
implicitly presumes that the expected change is zero, which is known as static
exchange rate expectation. While this might not seem to be an unreasonable
assumption under fixed exchange rates, it is less tenable under floating
exchange rates. According to the model a monetary expansion leads to a
depreciation of the currency under floating exchange rates- in such
32
 CHAPTER FOUR: AGGREGATE DEMAND IN THE OPEN ECONOMY

circumstances it seems unreasonable to assume that economic agents do not

expect depreciation as well. If agents expect depreciation this may require a
rise in the domestic interest rate to encourage them to continue to hold the
currency which will have an adverse effect on domestic investment- implying a
weaker expansionary effect of monetary policy than is suggested by the model.
Indeed, the need to maintain market confidence in exchange rates can severely
restrict the ability of government to pursue expansionary fiscal and monetary
policies.

33