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Mundell_Fleming_Model II

The Mundell-Fleming model describes a small open economy with perfect capital mobility, focusing on goods and money market equilibrium. It highlights the effects of fiscal and monetary policies under both floating and fixed exchange rates, indicating that fiscal policy is ineffective under floating rates but effective under fixed rates, while monetary policy is effective under floating rates but ineffective under fixed rates. Additionally, it addresses the relationship between domestic and foreign interest rates, factoring in default risk.

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Manas Vashi
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12 views

Mundell_Fleming_Model II

The Mundell-Fleming model describes a small open economy with perfect capital mobility, focusing on goods and money market equilibrium. It highlights the effects of fiscal and monetary policies under both floating and fixed exchange rates, indicating that fiscal policy is ineffective under floating rates but effective under fixed rates, while monetary policy is effective under floating rates but ineffective under fixed rates. Additionally, it addresses the relationship between domestic and foreign interest rates, factoring in default risk.

Uploaded by

Manas Vashi
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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THE MUNDELL-

FLEMING MODEL II
The Mundell-Fleming model
• Key assumption:
Small open economy with perfect capital mobility.
r = r*
• Goods market equilibrium—the IS* curve:

Y = C + I + G + NX

where
NX = net exports is affected by the nominal
exchange rate, e.
The IS* curve: goods market equilibrium

Y = C + I + G + NX

The IS* curve is drawn e


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

 e   NX   Y

IS*
Y
The LM* curve: money market equilibrium
M = L(r*, Y)
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.
Equilibrium in the Mundell-Fleming model
Y = C + I + G + NX
M = L(r*, Y)
e LM*

equilibrium
exchange
rate

IS*
Y
equilibrium
income
Applications: Floating & fixed exchange rates

• New Zealand has a floating exchange rate system.


e is allowed to fluctuate in response to changing
economic conditions.
Fiscal policy under floating exchange rates: New
Zealand
Y = C + I + G + NX
M = L(r*, Y)
e LM1*
At any given value of e, e2

a fiscal expansion e1
increases Y,
I S 2*
shifting IS* to the right.
Results: I S1*
Y
G↑, Y ↑ , money demand ↑, r ↑, Y1
capital inflow, e ↑ , NX↓, Y ↓
Monetary policy under floating exchange rates:
New Zealand
Y = C + I + G + NX
M = L(r*, Y)
e LM1*LM2*
An increase in M
shifts LM* right
because Y must rise
e1
to restore eq’m in
the money market. e2
I S1*
Results: Y
Y1 Y2
Money supply↑, r ↓ , capital
outflow, e ↓ , NX ↑, Y ↑
Fiscal policy under fixed exchange rates
A fiscal expansion
would raise e. To keep e
from rising, e LM1*
the central bank must
increases money supply

and shifts LM* right. e1

I S1*
Y
Y1
Fiscal policy under fixed exchange rates
A fiscal expansion
would raise e. To keep e
from rising, e LM1*LM2*
the central bank must
increases money supply

and shifts LM* right. e1


Results: I S 2*
G↑, Y ↑ , money demand ↑, r ↑, I S1*
capital inflow, e ↑, Y
Y1 Y2
to prevent e from changing,
money supply ↑, Y ↑
Monetary policy under fixed exchange rates
An increase in money supply
would
shift LM* right and reduce e.
e LM1*
To prevent the fall in e, the
central bank must reduce
money supply and shifts LM*
back left. e1

I S1*
Y
Y1
Monetary policy under fixed exchange rates
An increase in money supply
would
shift LM* right and reduce e.
e LM1*LM2*
To prevent the fall in e, the
central bank must reduce
money supply and shifts LM*
back left. e1
Results:
Money supply↑, r ↓ , capital I S1*
outflow, e ↓ , Y ↑ , Y
Y1
to prevent e from changing,
money supply ↓, Y ↓
Summary of policy effects in the Mundell-
Fleming model
Under floating exchange rates,
fiscal policy is ineffective
at changing output.
Under fixed exchange rates,
fiscal policy is very effective at changing output.

Under floating exchange rates,


monetary policy is
very effective at changing output.
Under fixed exchange rates,
monetary policy cannot be used to affect output.
Is r always equal to r*?
Key assumption:
Small open economy with perfect capital mobility.
r = r*

We are assuming that the risk of default is the same


across economies.

If we take into account of risks,


r = r* + θ
where θ is the risk premium, which captures default
risk.
US and New Zealand Interest
Rates

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