12' The MundellFleming Model

1
12. The Mundell-Fleming Model

• Agenda
• What is the difference between the IS-LM model
  for the open economy (the Mundell-Fleming model)
  and that for the closed economy?
• What are the effects of fiscal policy and
  monetary policy under floating exchange rates and
  under fixed exchange rate?

2
The Mundell-Fleming model

• (1) Key assumption a small open economy with
  prefect capital mobility
• ? The real interest is given by the world
  financial market r r
• The investment I(r) is fixed.
• (2) In the short run, the prices and the expected
  inflation rate are fixed.
• ? We need not to distinguish the real interest
  rate from the nominal interest rate (irpe),
  also not to do the real exchange rate from the
  nominal exchange rate (eeP/P)
• Money demand L(i, Y)L(rpe, Y) can be treated as
  the function of the real interest rate (r) and
  output (Y)
• Net exports NX(e)NX(eP/P) can be treated as the
  function of the nominal exchange rate (e)
• The basic equations of the Mundell-Fleming model
• The IS curve Y C(Y-T)I(r)GNX(e)
• The LM curve M/P L(r, Y)
• We should consider the e and Y diagram (the
  IS-LM model) instead of r and Y diagram (the
  IS-LM model)

3
The exchange rate, net exports and the IS Curve
If the nominal exchange rate (e) changes, the net
exports (NX) is changed. Then, how does output
(Y) change?
e increases ? NX decreases ? Y decreases
The IS Curve
4
The LM curve
M/P L(r, Y) and M, P, r are given
? The output does not depend on the nominal
exchange rate, but it is decided by the money
supply (M), the price level (P), and the world
interest rate (r).
? The LM curve is vertical
5
The IS-LM model

• The intersection of the IS curve and LM curve
  determines the short-run equilibrium of the
  output and the nominal exchange rate.

IS curve Y C(Y-T)I(r)GNX(e)
LM curve M/P L(r, Y)
The intersection represents simultaneous
equilibrium (Y, e) in the market for goods and
services and in the market for real money
balances for given values of government purchases
(G), taxes (T), money supply (M), price level
(P), and world interest rate (r).
6
Floating exchange rates v.s. Fixed exchange rates

• Floating the exchange rate is allowed to
  fluctuate.
• Most countries adopt this system now.
• Fixed the governments agree to fix the exchange
  rates. Most countries adopted this system by the
  early 1970s.
• Some European countries reinstated a system of
  fixed exchange rate later (monetary union Euro)
• Note that we rarely observe exchanges rates
  that are completely fixed or completely floating.
• The effects of fiscal and monetary policy depend
  on which exchange rate system is adopted in the
  country.

7
Under Floating Exchange Rates
If government purchases increases, (fiscal policy)
If money supply increases, (monetary policy)
? The IS curve shifts to the right
? The LM curve shifts to the right
Results Y ? e? NX?
Results Y (0) e? NX?
B
A
A
B
8
How a fixed-exchange-rate system works
The central bank holds exchange rate constant.
1. If the exchange rate is lower than the fixed
level,
2. Foreign arbitrageurs buy the domestic currency
from the market (at e2) and sell it to the
central bank (at e1).
The central bank buys it ? the money supply is
reduced.
3. The LM curve shifts to the left, and the
exchange rate rises
The impossible Trinity You must give up one of
these. (1) Perfect capital mobility (2) Fixed
exchange rate (3) Independent monetary policy
e1
A
B
e2
9
Under Fixed Exchange Rates
If government purchases increases, (fiscal
policy)
If money supply increases, (monetary policy)
? The LM curve shifts to the right
? The IS curve shifts to the right
? The central bank shifts the LM curve to right
to hold exchange rate constant.
? The central ban shifts the LM curve to right
to hold exchange rate constant.
Results Y ? e(0) NX(0)
No monetary policy
B
A

A
10
Summary

• The Mundell-Fleming (IS-LM) model says
• The intersection of the IS and LM curves shows
  the short-run equilibrium points (Y, e). Since
  the LM curve is vertical, it decides the output
  level.
• Under floating exchange rates, fiscal policy
  cannot affect the output, but monetary policy can
  affect the output.
• Under fixed exchange rates, fiscal policy can
  affect the output because it induces the change
  in money supply. On the contrary, the effective
  monetary policy cannot be taken because of
  arbitrageurs.