The Mundell-Fleming Model

1
The Mundell-Fleming Model

• Mainstream Thinking on Open Macroeconomics

2
Exchange Rates
E nominal exchange rate between the euro and the
dollar (eg. 1,17 euro/ 0,85 /euro) e real
exchange rate (epsilon) measured in purchasing
power our pespective from USA to EU E number
of units of domestic currency you can get
for one unit of foreign currgency example
EUSD/EUR 1,19 /Euro
domestic foreign
Thomas Dürmeier
Regulating Global Finance
3
Exchange Rate 2
example EUSD/EUR 1,19 /Euro depreciation E
? e ? (value of currency decreases) appreciation
E ? e ? (value of currency increases) Real
exchange rate exchange between commodities one
Volkswagen P vs. one Cadillac P 1. Volkswagen
with US-price P x E 2. In comparison to
Cadillac (P x E)/P e
Thomas Dürmeier
Regulating Global Finance
4
Investement/Savings - Liquidity/Money IS-LM
IS Y C(Y-T) I (Y,i) G LM M/P Y L(i)
- only commodity and captial market - price
level is constant - Keynesian bias - short-run
IS
i
LM
T?, G?
nominal interest rate
M ?
Y social product
Thomas Dürmeier
Regulating Global Finance
5
Aggregated Supply and Demand AS-AD
AD Yt Y(M/Pt, G, T) AS Pt Pt-1 (1µ)
F(1-(Yt/L), z)
- IS-LM plus labor market - neutrality of money -
monetaristic bias - long-run
P
AS
M ?, T?, G?
In the long-runonly AS determines Y
price level
µ ?, L?, z ?
AD
Y social product
Thomas Dürmeier
Regulating Global Finance
6
AS-AD Neutrality of Money
AD Yt Y(M/Pt, G, T) AS Pt Pt-1 (1µ)
F(1-(Yt/L), z)
M ?, T?, G?
In the long-runonly AS determines Y
P
AS
Monetary policy has NO influence on output, only
inflation. Only under certain circumstances.
price level
AD
Y social product
Thomas Dürmeier
Regulating Global Finance
7
Balance of Payment
Commodity flows

• Current account
• Exports - Imports Trade balance
• Investment
• Capital account
• Increase in foreign holdings of US assets
• Increase in US holding of foreign assets
• Statistical discrepancy

Capital flows
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Exchange Rate Regimes

• Free floating no central bank intervention
• Managed floating no fixed exchange rate goal,
  but central bank interventionb
• Target zones exchange rate around a band with
• Crawling pegs no fixed rate, but alinment rate
  and process
• Adjustable peg exchangre rate fixed, no
  alienment
• Currency board autonom body, which controls
  exchange rate target
• Fixed or peeged exchange rate constant
  exchange rate
• Dollarisierung (dollarization), Euroisierung
  (euroization) or currency union
• World currency
• (Privatization of money)
• Source Frankel, Jeffrey A., Sergio Schmukler und
  Luis Serven (2002), Verifiability and the
  Vanishing Intermediate Exchange Rate Regime,
  in Susan M. Collins und Dani Rodrik (Hrsg.)
  Brookings Trade Forum, The Brookings
  Institution. http//muse.jhu.edu/demolbtf

Thomas Dürmeier
Regulating Global Finance
9
Elements of Open Macroeconomics

• Interest rate parity (Mundell-Fleming)
• Purchasing power parity (monetaristic open
  macro)
• Expectations
• Policy credibility

Thomas Dürmeier
Regulating Global Finance
10
Mundell-Fleming Modell
IS Y C(Y-T) I (Y,i) G LM M/P Y L(i)
EEe/(1i-i) interest rate parity
LM
IS
i
i
nominal interest rate
E
Y social product
E Exchange rate
Thomas Dürmeier
Regulating Global Finance
11
Mundell-Fleming Modell flexible exchange rate
and fiscal policy
IS Y C(Y-T) I (Y,i) G LM M/P Y L(i)
EEe/(1i-i) interest rate parity
LM
IS
i
i
G?
nominal interest rate
appreciation
E
Y social product
E Exchange rate
Thomas Dürmeier
Regulating Global Finance
12
Fixed exchange rate and fiscal policy
IS Y C(Y-T) I (Y,i) G LM M/P Y L(i)
EEe/(1i-i) interest rate parity
LM
IS
IS
i
i
G?
LM
Pressure on exchange rate
nominal interest rate
Y social product
E Exchange rate
E
Thomas Dürmeier
Regulating Global Finance