Chap12(Agg Demand Open Economy)0

7/31/2019 Chap12(Agg Demand Open Economy)0

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Aggregate Demand in the Open

Economy: The Mundell-Fleming

model, based on ISLM model


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Learning objectives

The Mundell-Fleming model:IS-LM for the small open economy

Causes and effects of interest rate

differentialsArguments for fixed vs. floating

exchange rates

The aggregate demand curve for thesmall open economy

slide 1


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The Mundell-Fleming Model

Key assumption:Small open economy with perfect capitalmobility.

r = r*

Goods market equilibrium---the IS* curve:

slide 2

( ) ( ) ( )*Y C Y T I r G NX e

wheree = nominal exchange rate

= foreign currency per unit of domestic

currency


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The IS*curve: Goods Market Eqm

The IS*curve is drawn

for a given value ofr*.

Intuition for the slope:

slide 3

Y

e

IS*

( ) ( ) ( )*

Y C Y T I r G NX e

e NX Y


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The LM*curve: Money Market Eqm

The LM*curve

is drawn for a given

value ofr*

is vertical because:

given r*, there is

only one value ofY

that equates money

demand with supply,

regardless ofe.

slide 4

Y

e LM*

( , )*

M P L r Y


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Equilibrium in the Mundell-Fleming model

slide 5

Y

e LM*

( , )*M P L r Y

IS*

( ) ( ) ( )*Y C Y T I r G NX e

equilibrium

exchange

rate

equilibrium

level of

income


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Floating & fixed exchange rates

In a system offloating exchange rates,e is allowed to fluctuate in response tochanging economic conditions.

In contrast, under fixed exchange rates,

the central bank trades domestic for foreigncurrency at a predetermined price.

We now consider fiscal, monetary, and trade

policy: first in a floating exchange ratesystem, then in a fixed exchange rate system.

slide 6


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Fiscal policy under floating exchange rates

At any given value ofe,

a fiscal expansionincreases Y,

shifting IS*to the right.

slide 7

Y

e

( , )*M P L r Y ( ) ( ) ( )

*Y C Y T I r G NX e

Y1

e1

1

*LM

1

*IS

2

*IS

e2

Results:

e> 0, Y= 0


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Lessons about fiscal policy

In a small open economy with perfect capitalmobility, 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 bycausing the exchange rate to appreciate.

slide 8


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Mon. policy under floating exchange rates

An increase in M shifts

LM* right because Y

must rise to restore eqm

in the money market.

slide 9

Y

e

( , )*M P L r Y ( ) ( ) ( )

*Y C Y T I r G NX e

e1

Y1

1

*LM

1

*IS

Y2

2

*LM

e2

Results:

e< 0, Y > 0


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Lessons about monetary policy

Monetary policy affects output by affectingone (or more) of 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

aggregate demand, it shifts demand from foreign

to domestic products.Thus, the increases in income and employment

at home come at the expense of losses abroad.

slide 10


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Trade policy under floating exchange rates

At any given value ofe,

a tariff or quota reducesimports, increases NX,

and shifts IS* to the right.

slide 11

( , )*M P L r Y ( ) ( ) ( )

*Y C Y T I r G NX e

Y

e

e1

Y1

1

*LM

1

*IS

2

*IS

e2

Results:

e> 0, Y= 0


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Lessons about trade policy

Import restrictions cannot reduce a trade deficit.

Even though NX is unchanged, there is less trade:

the trade restriction reduces imports

the exchange rate appreciation reduces exports

Less trade means fewer gains from trade. Import restrictions on specific products save jobs in

the domestic industries that produce those products,but destroy jobs in export-producing sectors.

Hence, import restrictions fail to increase totalemployment.

Worse yet, import restrictions create sectoralshifts, which cause frictional unemployment.

slide 12


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Fixed exchange rates

Under a system of fixed exchange rates, thecountrys central bank stands ready to buy or sell

the domestic currency for foreign currency at a

predetermined rate.

In the context of 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.

slide 13


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Fiscal policy under fixed exchange rates

Under floating rates, afiscal expansion would

raise e.

slide 14

Y

e

Y1

e1

1

*LM

1

*IS

2

*IS

Results:

e= 0, Y > 0 Y2

2

*LM

To keep efrom rising,

the central bank mustsell domestic currency,

which increases M

and shifts LM*right.

Under floating rates,fiscal policy ineffective

at changing output.

Under fixed rates,

fiscal policy is veryeffective at changing

output.


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Mon. policy under fixed exchange rates

An increase in M would shiftLM* right and reduce e.

slide 15

2

*LM

Y

e

Y1

1

*LM

1

*IS

e1

To prevent the fall in e,

the central bank mustbuy domestic currency,

which reduces M and

shifts LM* back left.

Results:

e= 0, Y = 0

Under floating rates,monetary policy is very

effective at changing

output.

Under fixed rates,

monetary policy cannot be

used to affect output.

2

*LM


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Trade policy under fixed exchange rates

A restriction on importsputs upward pressure one.

slide 16

Y

e

Y1

e1

1

*LM

1

*IS

2

*IS

Results:

e= 0, Y > 0 Y2

2

*LM

To keep efrom rising,

the central bank must

sell domestic currency,

which increases M

and shifts LM*right.

Under floating rates,import restrictions do not

affect Y or NX.

Under fixed rates,

import restrictionsincrease Y and NX.

But, these gains come at

the expense of other

countries, as the policymerely shifts demand from

foreign to domestic goods.


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M-F: summary of policy effects

type of exchange rate regime:

floating fixed

impact on:

Policy Y e NX Y e NX

fiscal expansion 0 0 0

mon. expansion 0 0 0

import restriction 0 0 0

slide 17


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CASE STUDY:

The Mexican Peso Crisis

slide 18

10

15

20

25

30

35

7/10/94 8/29/94 10/18/94 12/7/94 1/26/95 3/17/95 5/6/95

U.S.

CentsperMex

icanPeso


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CASE STUDY:

The Mexican Peso Crisis

slide 19

10

15

20

25

30

35

7/10/94 8/29/94 10/18/94 12/7/94 1/26/95 3/17/95 5/6/95

U.S.

CentsperMex

icanPeso


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The Peso Crisis didnt just hurt Mexico

U.S. goods more expensive to Mexicans U.S. firms lost revenue

Hundreds of bankruptcies along

U.S.-Mex border

Mexican assets worth less in dollars

Affected retirement savings of

millions of U.S. citizens

slide 20


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Understanding the crisis

In the early 1990s, Mexico was an attractiveplace for foreign investment.

During 1994, political developments caused anincrease in Mexicos risk premium ( ):

peasant uprising in Chiapas assassination of leading presidential

candidate

Another factor:The Federal Reserve raised U.S. interest ratesseveral times during 1994 to prevent U.S.inflation. (So, r*> 0)

slide 21


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Understanding the crisis

These events put downward pressure onthe peso.

Mexicos central bank had repeatedlypromised foreign investors that it

would not allow the pesos value to fall,so it bought pesos and sold dollars to

prop up the peso exchange rate.

Doing this requires that Mexicos centralbank have adequate reserves of dollars.Did it?

slide 22


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Dollar reserves ofMexicos central bank

December 1993 $28 billion

August 17, 1994 $17 billion

December 1, 1994 $ 9 billion

December 15, 1994 $ 7 billion

slide 23

During 1994, Mexicos central bank hid the

fact that its reserves were being depleted.


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the disaster

Dec. 20: Mexico devalues the peso by 13%(fixes e at 25 cents instead of 29 cents)

Investors are shocked! ! !

and realize the central bank must be running

out of reserves

, Investors dump their Mexican assets and

pull their capital out of Mexico.

Dec. 22: central banks reserves nearly gone.It abandons the fixed rate and lets e float.

In a week, e falls another 30%.

slide 24


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The rescue package

1995: U.S. & IMF set up $50b line ofcredit to provide loan guarantees toMexicos govt.

This helped restore confidence in Mexico,reduced the risk premium.

After a hard recession in 1995, Mexicobegan a strong recovery from the crisis.

slide 25


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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

slide 27


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Mundell-Fleming and the ADcurve

So far in M-F model,

Phas been fixed.

Next: to derive theADcurve, consider theimpact of a change in P in the M-F model.

We now write the M-F equations as:

slide 28

(Earlier in this chapter, Pwas fixed, so we

could writeNXas a function ofeinstead of .)

( ) ( , )*M P L r Y LM*

( ) ( ) ( ) ( )*Y C Y T I r G NX IS*


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Deriving the ADcurve

slide 29

Y1Y2 Y

Y

P

IS*

LM*(P1)LM*(P

2)

AD

P1

P2

Y2 Y1

2

1

WhyADcurve has

negative slope:

P

LM shifts left

NX

Y

(M/P)


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From the short run to the long run

slide 30

LM*(P1)

1

2

then there is

downward pressure on

prices.

Over time, P willmove down, causing

(M/P)

NX

Y

P1 SRAS1

1Y

1Y Y

Y

P

IS*

AD

Y

Y

LRAS

LM*(P2)

P2 SRAS2

1

If ,Y Y


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Large: between small and closed

Many countries - including the U.S. - are neither

closed nor small open economies.

A large open economy is in between the

polar cases of closed & small open.

Consider a monetary expansion:

Like in a closed economy,

M > 0 r I (though not as much)

Like in a small open economy,M > 0 NX (though not as much)

slide 31


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Chapter summary

1. Mundell-Fleming model

the IS-LM model for a small open economy.

takes Pas given

can show how policies and shocks affect

income and the exchange rate2. Fiscal policy

affects income under fixed exchange rates, butnot under floating exchange rates.

slide 32


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Chapter summary

3. Monetary policy

affects income under floating exchange rates.

Under fixed exchange rates, monetary policy isnot available to affect output.

4. Interest rate differentials exist if investors require a risk premium to hold

a countrys assets.

An increase in this risk premium raises

domestic interest rates and causes thecountrys exchange rate to depreciate.

slide 33


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Chapter summary

5. Fixed vs. floating exchange rates

Under floating rates, monetary policy isavailable for can purposes other thanmaintaining exchange rate stability.

Fixed exchange rates reduce some of theuncertainty in international transactions.

lid 34

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Chap12(Agg Demand Open Economy)0

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