曼昆第10版讲义mankiw10e-irm-ch13

|CHAPTER13 TheOpenEconomyRevisited:TheMundell–FlemingModelandtheExchange-RateRegime

LectureNotes|

|CHAPTER13 TheOpenEconomyRevisited:TheMundell-FlemingModelandtheExchangeRateRegime

LectureNotes

Introduction

Earlierweexaminedhowthelong-runmodeloftheeconomyisadaptedtotakeaccountofourtradewithothernations.Wenowcarryouttheanalogoustaskfortheshort-runIS–LMmodel.Aswiththelong-runanalysis,wepaymostattentiontothecaseofthesmallopeneconomy.Wefirstthinkaboutthemodelunderaflexible-(orfloating-)exchange-rateregimeandthenexaminehowtheconclusionsofthemodelarealteredunderafixed-exchange-rateregime.

13-1 TheMundell–FlemingModel

TheKeyAssumption:SmallOpenEconomywithPerfectCapitalMobility

Theinterestrateinasmallopeneconomywithperfectcapitalmobilityisdeterminedbytheworldinterestrate,r*,sothat

r=r*.

TheGoodsMarketandtheIS*Curve

Supplement13-1,“TheDependenceofNetExportsonGDP”

Netexports,NX,areaddedtothegoodsmarket,which,combinedwiththeassumptionofperfectcapitalmobility,givesanewequationforgoodsmarketequilibrium,theIS*curve:

Y=C(Y–T)+I(r*)+G+NX(e).

Figure13-1

TheMundell–Flemingmodelassumesthatbothdomesticandoverseasinflationarezero,andthusthereisnodifferencebetweenthenominalandrealexchangerates.TheIS*curveisnowthecombinationoftheexchangerateandGDPconsistentwithgoods-marketequilibrium,givenr=r*.Otherthingsbeingequal,ahigherlevelofincomeleadstohighersavingandthusagreatersupplyofdollarstotheforeign-exchangemarket.Thisleadstoafallintheexchangerate.TheIS*curvethusslopesdown.

TheMoneyMarketandtheLM*Curve

Thenewequationformoneymarketequilibrium,theLM*curve,incorporatestheassumptionofperfectcapitalmobilitysothatr=r*:

M/P=L(r*,Y).

Figure13-2

TheLM*curvegivescombinationsoftheexchangerateandthelevelofGDPsuchthatthemoneymarketisinequilibrium.Wenotedearlierthat,givenr*,themoneymarketdeterminesY,sotheLM*curveisvertical.

PuttingthePiecesTogether

ThesetwoequationsfortheIS*andLM*curvesdescribethesmallopeneconomywithperfectcapitalmobility:

Y=C(Y–T)+I(r*)+G+NX(e) IS*

M/P=L(r*,Y) LM*.

Figure13-3

TheY–ediagramisanaturalcounterparttotheIS–LMdiagram.Inthesmall-open-economymodel,theinterestrateisfixedandtheexchangeratecanvary.Intheclosedeconomy,theinterestratecanvary(andtheexchangerateisirrelevant).

13-2 TheSmallOpenEconomyUnderFloatingExchangeRates

Wenowusethemodeltoanalyzetheeffectsoffiscalandmonetarypolicyunderfloatingexchangerates.

FiscalPolicy

Figure13-4

AnincreaseingovernmentspendingoracutintaxesshiftstheIS*curveout.Theexchangerateappreciates,andthereisnochangeinincome.Thereasonisthatthefiscalexpansionputsupwardpressureontheinterestrate,leadingtoariseincapitalinflows,appreciationoftheexchangerate,andcrowdingoutofnetexports.

MonetaryPolicy

Figure13-5

Supplement13-2,“TheRiseintheDollar,1979–1982”

Supplement13-3,“CanWorldFinancialMarketsUsurpthePoweroftheFederalReserve?”

Figure13-6

Monetarypolicy,bycontrast,isveryeffectiveunderfloatingrates.AnincreaseinthemoneysupplyshiftstheLM*curvetotheright.TheIS*–LM*diagramrevealsthatincomerisesandtheexchangeratefalls.Inthenewequilibrium,thecurvesintersectatr*andahigherlevelofY.

TradePolicy

Traderestrictionsareunsuccessfulunderfloatingexchangerates,intheshortrunasinthelongrun.Sincetraderestrictionsincreasethedemandfornetexportsatanygivenvalueoftheexchangerate,theysimplyshifttheIS*curveup.Theresultisappreciation,nochangeinnetexports,andnochangeinoutput.Althoughnetexportsareunchanged,bothimportsandexportsarelower,sothetraderestrictionreducestheamountoftrade,reducingthecountry’swelfare.

13-3 TheSmallOpenEconomyUnderFixedExchangeRates

HowaFixed-Exchange-RateSystemWorks

Figure13-7

Howdoesthemodelworkunderfixedexchangerates?Thekeypointisthattofixtheexchangerate,theFedmustsacrificecontroloverthesupplyofmoney.Monetarypolicynowconsistsofadjustingthemoneysupplysuchthattheexchangerateisatitsfixedlevel.Ifpeopledemandmoredollars,theFedsuppliesthem;ifpeoplewishtoexchangedollarsforforeigncurrencies,theFedstandsreadytomakethatexchange.Themoneysupplybecomesanendogenousvariable.

CaseStudy:TheInternationalGoldStandard

Supplement13-4,“BrettonWoods”

Ifdifferentcountriesagreetofixthepriceoftheircurrenciesintermsofgold,thenexchangeratesarefixed.Thereasonisthatifthemonetaryauthoritiesoftwocountriesstandreadytobuyandsellgoldatafixedpriceintermsoftheirrespectivedomesticcurrencies,thenthereisonlyonevalueoftheexchangeratethateliminatesthepossibilityofarbitrage.Themajorworldeconomiesoperatedonagoldstandard,andhenceunderfixedexchangerates,formuchofthenineteenthcentury.

FiscalPolicy

Figure13-8

Supplement13-5,“Finlandinthe1990s”

Underfixedexchangerates,ourconclusionsareessentiallyreversedfromthecaseofflexibleexchangerates.AnexpansionaryfiscalpolicyshiftstheIS*curveoutward.Thisputsupwardpressureontheexchangerate:thedemandforU.S.dollarsincreases.ButtheFedmustnowaccommodatethegreaterdemandfordollars,sothesupplyofdollarsincreases.HencetheLM*curveshiftsout.Theconsequenceisincreasedoutput.

MonetaryPolicy

Figure13-9

Underafixed-ratesystem,theFedgivesupcontrolofthemoneysupply.Technically,Misnowanendogenousvariable,andeisanexogenousvariable.Itthusisnotpossibletocarryoutmonetarypolicyintheusualway.If,forexample,theFedweretotrytoincreasethemoneysupply,U.S.dollarswouldbecomelessattractive,andarbitrageurswoulddemandfewerdollars.

TheFeddoes,however,havetheoptionofdevaluingorrevaluingthecurrency.AdevaluationreducestheexchangerateandshiftstheLM*curveout,implyinghigherincome;theoppositeistrueofarevaluation.

CaseStudy:DevaluationandtheRecoveryfromtheGreatDepression

Somecountries—forexample,theUnitedKingdom,Denmark,Finland,Norway,andSweden—respondedtotheterribleeconomicconditionsoftheGreatDepressionbydevaluingtheircurrencies.Theydidthisbyreducingthefixedpriceoftheircurrenciesintermsofgold.TheiractionshelpedspeedtheirrecoveryfromtheDepression.Countriesthatmaintainedthevalueoftheircurrenciesintermsofgold—suchasFrance,Germany,Italy,andtheNetherlands—recoveredmoreslowly.TheUnitedStatesremainedonthegoldstandarduntilJune1933,thedatethatroughlymatcheswhendeflationendedandrecoverybegan.

TradePolicy

Figure13-10

Traderestrictionsdoworkunderfixedrates,since,asnotedearlier,theyshifttheIS*curvetotheright.TheLM*curvefollows,andnetexportsenduphigher.

PolicyintheMundell–FlemingModel:ASummary

Supplement13-6,“TheMundell-FlemingModelinY-rSpace”

Table13-1

TheMundell-Flemingmodelrevealsthattheshort-runresponseoftheeconomytopolicychangesdependscruciallyontheexchange-rateregime.Monetarypolicyiseffectiveunderfloatingratesandineffectiveunderfixedrates,whereastheoppositeistrueoffiscalandtradepolicies.

13-4 InterestRateDifferentials

Intherealworld,realinterestratesarenotnecessarilyequalizedinallcountriesatalltimes.Here,weconsidertworeasonsinterestratesmaydifferacrosscountries.

CountryRiskandExchange-RateExpectations

Supplement13-7,“UncoveredInterestParity”

Supplement13-8,InterestRateDifferentialsintheEuropeanMonetarySystem”

Interestratesmaybehigherinpoliticallyunstablecountriesbecauseinvestorsmayperceiveariskthattheirloansmightnotberepaid.Investorsmustbecompensatedforthisriskwithhigherinterestrates.Expectationsaboutfuturechangesinexchangeratescanalsoleadtointerestratedifferentials;ifinvestorsexpectthedollartoriserelativetothepeso,forinstance,theninvestorswillrequireahigherinterestratetoinvestinMexicorelativetotheUnitedStates.

DifferentialsintheMundell–FlemingModel

Supplement13-9,“TheDornbuschOvershootingModel”

Asimplewaytoincorporateinterestratedifferentialsintoourexistingmodelisjusttosupposethatthedomesticinterestrateequalstheworldrateplusapremium:r=r*+θ.AnincreaseinthispremiumwillshifttheIS*curvetotheleftandtheLM*curvetotheright.Itfollowsthattheexchangeratewilldepreciate,andnetexportsandoutputwillrise.

Oneimplicationisthatexchange-ratemovementscanbepartlyself-fulfilling.Supposenewinformationcausesinvestorstoanticipatethatthepesowillfallinvalue.Thepremiumonthepesowillrise,causingthevalueofthepesotofallimmediately.

Figure13-11

Theincreaseinincomepredictedbythemodel,however,isnotrealisticforseveralreasons.First,thecentralbankmaytrytoavoidthedepreciationofthecurrencybytighteningcreditandreducingthemoneysupply.Second,thedepreciationmayincreaseimportpricesand,inturn,increasethedomesticpricelevel.Finally,theriseintheriskpremiummayleaddomesticresidentstoincreasetheirdemandfordomesticmoney,whichtheymayviewasa“safer”assetthaninterest-earningbonds.AlloftheseeffectswillshifttheLMcurvetotheleft,offsettingtheexpansioninincome.

CaseStudy:InternationalFinancialCrisis:Mexico1994–1995

Supplement13-10,“Mexico’sForeignExchangeReserves”

Politicalupheavalin1994increasedtheriskpremiumonMexicanassets.Becausetheexchangeratewasfixed,thedownwardpressureontheexchangerateledtoacontractionofthemoneysupply.Mexicohadinsufficientreservestomaintainitsexchangerateandsowasforcedtodevalue.This,inturn,increasedtheriskpremiumonMexicanassetsstillfurtherandledtoacrisisinMexicanfinancialmarkets.

TheUnitedStatesintervenedbyputtingtogetherabailoutpackage,includingloanguaranteesthathelpedtoreducethecountry’sriskpremium.

CaseStudy:InternationalFinancialCrisis:Asia1997–1998

In1997afinancialcrisissimilartothatexperiencedbyMexicooccurredinseveralAsiancountries.Aweak(somewouldsaycorrupt)bankingsystemwasthestartingpointforthecrisis,leadingtoadeclineinconfidenceintheeconomies.Thiserosionofconfidenceraisedriskpremiumsandinterestrates,allofwhichdepressedassetprices.Thefallinassetpricesincreasedthedefaultratesonbankloans,resultinginmoretroubleforthebankingsystem.Asaresult,confidenceerodedfurther,startingtheprocessoverinaviciouscircle.Anotherfactorinthecrisiswasacurrencymismatchbetweentheassetsandliabilitiesoffinancialinstitutions.Banksinthesecountriesgenerallyborrowedabroadinforeigncurrencies,suchastheU.S.dollar,andmadeloansathomeintheirowncurrencies.Whentheircurrenciesdepreciatedagainstforeigncurrenciesduringthecrisis,thevalueofthesebanks’assetsfellrelativetotheirliabilities,worseningtheproblemsfacingtheirbankingsystems.

13-5 ShouldExchangeRatesBeFloatingorFixed?

ProsandConsofDifferentExchange-RateSystems

Supplement13-11,“Exchange-RateVolatility”

Economistsfrequentlydebatetherelativemeritsofflexible-andfixed-ratesystems.Theprincipaldisadvantageoffixedexchangeratesisthattheyforcethemonetaryauthoritiestogiveupcontrolofthemoneysupply.Againstthis,itissometimesarguedthattheobservedvolatilityoffloatingexchangerateshindersinternationaltradebycomplicatingbusinessplanning.Theforceofthislatterargumentisweakenedbytheexistenceoffinancialinstrumentsthatallowfirmstoinsulatethemselvesfromexchange-ratevolatility.Inanycase,neitherregimeispureinpractice.Revaluationsanddevaluationsoccurunderfixedrates,whereascentralbanksinterveneonforeign-exchangemarketstoaffectexchangeratesevenunderfloatingrates.

CaseStudy:TheDebateovertheEuro

TheadoptionoftheeurohasresultedinamonetaryunioninEuropesimilartothatwhichexistsintheUnitedStates.AsinglecurrencyinEuropebringsbenefitsfortravelersandbusinesses,whonolongerneedtoexchangecurrenciesastheytravelorsendgoodsthroughoutEurope.AlongwiththecommoncurrencyhascomeacommonmonetarypolicyforEurope.Someeconomistsarguethatthecostofacommonmonetarypolicyishighbecausecountrieslosetheabilitytoreacttoanationalrecession.

Supplement13-12,“TheFederalReserveandtheEuropeanCentralBank”

Thislossofnationalmonetarypolicyandtherelatedabilitytodevalueone’scurrencyhasrecentlybeeninthespotlightamongeuroareacountriesasaresultoftheGreekdebtcrisis.DuetotheausterityprogramGreecewasforcedtoadopt,itseconomysufferedasevererecession.IfGreecehadhaditsowncurrency,itcouldhaveoffsetthecontractionaryeffectofitsfiscalpolicywithamonetaryexpansionanddevaluation,raisingexportsandaggregatedemand.Similarly,economicdownturnsinSpainandPortugalthatresultedfromthefinancialcrisismighthavebeencushionedbymonetaryexpansionanddevaluationifthesecountrieshadhadtheirowncurrencies.

MonetarypolicyintheUnitedStatesisdeterminedonthebasisofnationalratherthanregionalconditions,yetnoonewouldarguethateachstateorregionshouldhaveitsowncurrencyanditsowncentralbank.WhatmakestheUnitedStatesdifferentfromEuropeisgreaterlabormobilityintheUnitedStatesandacentralizedfiscalpolicy.Bothofthesefactorsalleviatetheeffectsofregionalrecessions.

SpeculativeAttacks,CurrencyBoards,andDollarization

Whenacountrymaintainsafixedexchangerate,thecentralbankmuststandreadytobuyandselldomesticcurrencyforforeigncurrencyatthefixedrate.Inotherwords,thecentralbankmusthavesufficientforeign-exchangereservesavailabletomeetpotentialdemand.Suppose,however,thatpeoplesuddenlybecomeconcernedthattheexchangeratewillbedevalued.Theywillquicklywanttoconverttheirdomesticcurrencytoforeigncurrencyandthismayexhaustthecentralbank’sreserves,leavingthebankwithnochoicebuttodevaluethecurrency.Therumoraboutdevaluationbecomesself-fulfilling.

Toavoidsuchanoutcome,someeconomistsadvocateadoptingacurrencyboardunderwhichthedomesticcurrencyisbacked100percentbyforeign-exchangereserves.Thecurrencyboardisintendedtoeliminateconcernthatthecentralbankwillrunoutofreservesifpeoplesuddenlydecidetoconverttheirdomesticcurrencyintoforeigncurrency.

Acentralbankusingacurrencyboardmightdecidetogoevenfurtherbyremovingthedomesticcurrencyfromcirculationandrequiringthatforeigncurrencybeusedfordomestictransactions.Whentheforeigncurrencyinvolvedisthedollar,thisisknownasdollarization.

TheImpossibleTrinity

Figure13-12

Thediscussionofexchange-rateregimesshowsthatanationcannotsimultaneouslyhavefreecapitalflows,afixedexchangerate,andanindependentmonetarypolicy(sometimesreferredtoasthetrilemmaofinternationalfinance).Oneoptionistohavefreeflowsofcapitalandanindependentmonetarypolicybutallowtheexchangeratetofloat—asintheUnitedStates.Asecondoption,whichHongKonghaschosen,istofixtheexchangerateandallowfreeflowsofcapitalbutgiveuptheabilitytoconductanindependentmonetarypolicy.Finally,asChinahasdone,acountrycanfixitsexchangerateandstilloperateanindependentmonetarypolicyifitiswillingtorestrictcapitalflows.Alloptionshavecosts.TheUnitedStatesmustacceptvolatilityinthedollar,HongKongmustforgousingmonetarypolicyasastabilizationtool,andChina’scitizenscannotfreelyinvestabroad.

CaseStudy:TheChineseCurrencyControversy

Chinapeggeditscurrency,theyuan,atanexchangerateof8.28yuantothedollarovertheperiod1995to2005.Bytheearly2000s,manyanalystsandU.S.politiciansbelievedthattheyuanwassubstantiallyundervaluedrelativetothedollar—spurringchargesofunfaircompetitiononthepartofChina.Asevidence,theycitedtherapidexpansioninChina’sholdingsofdollarreserves.Ineffect,Chinawassupplyingyuanandbuyingdollarsintheforeign-exchangemarkettokeeptheyuanfromappreciating.InJuly2005,Chinaannouncedthatitwouldmovetowardallowinggradualchangesintheyuan’svaluethroughmanagedinterventioninforeign-exchangemarkets.BylateOctober2014,theyuanhadmovedtoavalueof6.12yuanperdollar—a35percentappreciationoftheyuan.Evenwiththislargechangeintheexchangerate,China’scriticscontinuetocomplainaboutitsinterventioninforeign-exchangemarkets.

13-6 FromShortRuntotheLongRun:

TheMundell–FlemingModelwithaChangingPriceLevel

TheMundell–FlemingmodelisavariationontheIS–LMmodel.ButtheIS–LMmodelisunsatisfactorybecauseitassumesfixedprices.AsexplainedinChapter11,theIS–LMframeworkisbestunderstoodasatheoryofaggregatedemand,whichmustbecombinedwithaggregatesupplytoanalyzetheeconomyintheshortrun.HereweconsiderhowtointerprettheMundell–Flemingmodelasatheoryofaggregatedemand.

TheequationsoftheMundell–Flemingmodelare

Y=C(Y–T)+I(r*)+G+NX(ε)

M/P=L(r*,Y)

ε=eP/P*.

Whereaswepreviouslyignoredthedistinctionbetweenthenominalandrealexchangerates,wecannolongerdosoonceweallowthepriceleveltochange.Changesinthepricelevelchangethevalueoftherealexchangerateforagivenvalueofthenominalexchangerate.

Figure13-13

Thesmall-open-economyaggregatedemandcurveisderivedinthesamemannerastheaggregatedemandcurveinaclosedeconomy.Aggregatedemandisgivenby{P,Y}combinationssuchthattheforeign-exchangemarketandmoneymarketareinequilibrium.Asthepriceleveldecreases,therealmoneysupplyrises,andtheLM*curveshiftsout.EquilibriumintheIS*–LM*diagramisthusattainedatahigherlevelofincome.Sotheaggregatedemandcurveslopesdownward,asbefore.Theonlydifferenceisthattheunderlyingreasonisslightlydifferent.IntheIS–LMmodel,ahigherrealmoneysupplyisassociatedwithlowerinterestrates,leadingtohigherinvestment.IntheIS*–LM*model,downwardpressureoninterestratesleadstoadepreciationoftherealexchangeratethatinturnencouragesnetexports.

Figure13-14

Havingderivedtheopen-economyaggregatedemandcurve,wecancombineitwiththeaggregatesupplycurveintheusualwaytoanalyzetheeffectsofdifferentpoliciesonoutputandprices.WhileFigure13-14illustratesthecaseofahorizontalshort-runaggregatesupplycurve,wecouldequallyuseanupward-slopingaggregatesupplycurveofthesortderivedinChapter14.

Notethatonceweincorporatepriceadjustmentintothemodel,wecannotunambiguouslysaywhatwillhappentothenominalexchangerate.TheIS*–LM*diagramtellsusthattherealexchangeratefallswhenthepricelevelislower.Dependingonthesensitivityofnetexportstotherealexchangerate,thisadjustmentmayentailadecreaseoranincreaseinthenominalexchangerate.

13-7 AConcludingReminder

Justaswhenweconsideredtheopeneconomyinthelongrun,itisimportanttorememberthattheappropriatemodelfortheU.S.economyisacombinationoftheclosedeconomyandthesmallopeneconomy.Thus,tounderstandtheU.S.economyintheshortrun,weshoulduseboththeIS–LMandtheMundell–Fleming(IS*–LM*)models.Forexample,afiscalexpansionintheUnitedStatesraisesbothincomeandinterestrates,assuggestedbytheIS–LMmodel,butalsocausesappreciationoftheexchangerate,assuggestedbytheMundell–Flemingmodel.Wethusobserveshort-runcrowdingoutofbothinvestment(becauseofhigherinterestrates)andnetexports(becauseofthehigherexchangerate).

Appendix:AShort-RunModeloftheLargeOpenEconomy

Thelargeopeneconomyintheshortrunisdescribedbythreeequations:

Y=C(Y–T)+I(r)+G+NX(e),

M/P=L(r,Y),

NX(e)=CF(r),

wherethefirsttwoequationsarethesameasthoseusedinthesmallopeneconomyMundell–Flemingmodelofthischapter.ThethirdequationisfromtheappendixtoChapter5andshowsthatthetradebalanceNXequalsthenetcapitaloutflowCF,whichinturndependsonthedomesticinterestrate.

Figure13-15

Tosolvethemodel,substitutethethirdequationintothefirst,sothemodelbecomes:

Y=C(Y–T)+I(r)+G+CF(r) IS,

M/P=L(r,Y) LM.

Thesetwoequationsaresimilartothetwoequationsoftheclosed-economyIS–LMmodel.Thedifferenceisthatspendingnowdependsontheinterestratefortworeasons:asintheclosedeconomy,ahigherinterestratereducesinvestment,butitnowalsoreducesthenetcapitaloutflow,whichlowersnetexports.

AsshowninFigure13-15ofthetext,thismodelcanbeillustratedusinganIS–LMdiagramwiththeinterestraterontheverticalaxisandincomeYonthehorizontalaxis.ThisIScurveisflatterthaninaclosedeconomybecausethenet-capital-outflowtermintheISequation,CF(r),impliesthatexpenditureisnowmoresensitivetochangesintheinterestrate.ThecaseofasmallopeneconomyfacingperfectcapitalmobilityisshownbyanIScurvethatishorizontalattheworldinterestrate.

Wecanusethismodeltoconsidershiftsinfiscalandmonetarypolicy.Theresults,forthelargeopeneconomy,areamixtureoftheresultsfromtheclosed-economymodelandthesmall-open-economymodel.

FiscalPolicy

Figure13-16

AnexpansionaryfiscalpolicyshiftstheIScurveout,raisingincomeandtheinterestrate.Thehigherinterestrateleadstoadecreasedcapitaloutflowandsodecreasednetexports.Theexchangeraterises.Thereiscrowdingoutofbothinvestmentandnetexports.

MonetaryPolicy

Figure13-17

AmonetaryexpansionshiftstheLMcurveout,increasingincomeanddecreasingtheinterestrate.Thedecreaseintheinterestrateleadstoalargercapitaloutflowandhenceadepreciationofthecurrencyandanincreaseinnetexports.

ARuleofThumb

Thelargeopeneconomyinboththeshortrunandthelongrunisprobablymosteasilyunderstoodasanaverageofthecorrespondingclosed-economyandsmall-open-economymodels.Thus,thebehaviorofalargeopeneconomyinthelongruncanbeunderstoodusingthemodelsofChapters3and6,whilethelargeopeneconomyintheshortruncanbedescribedbyusingthemodelsofChapters11,12,and13.

|CHAPTER13 TheOpenEconomyRevisited:TheMundell-FlemingModelandtheExchangeRateRegime

LECTURESUPPLEMENT

13-6 TheMundell–FlemingModelinY–rSpace

WeanalyzetheopeneconomyintheshortrunusingtheMundell–Flemingmodel.Thebasicequationsare

Y=C(Y–T)+I(r)+G+NX(e)

M/P=L(r,Y)

r=r*.

ThefirstequationistheIScurve,withtheadditionofthenetexportsterm.Theequivalentloanable-fundsrepresentationis

S(Y)–I(r)=NX(e).

ThesecondequationistheLMcurve,andthethirdisthesmall-open-economyrestrictionthatthedomesticinterestratemustequaltheworldinterestrate.Wefirstthinkaboutthemodelunderaflexible-(orfloating)exchange-rateregimeandthenexaminehowtheconclusionsofthemodelarealteredunderafixed-exchange-rateregime.

WecananalyzetheMundell–FlemingmodelintermsofthefamiliarIS–LMdiagram(Figure1).NotenowthatthepositionoftheIScurvedependsupontheexchangerate—ahigherexchangeratediscouragesnetexportsandcausestheIScurvetoshifttotheleft.TheadjustmentoftheexchangerateensuresthattheIScurvepassesthroughthe{r,Y}combinationdeterminedbytheinterestrateandthemoneymarket.Onewaytothinkofthismodelisthatsincetheinterestrateisgivenbyworldmarketsandthesupplyofmoneyisfixed,thereisthenonlyonelevelofGDPthatisconsistentwithequilibriuminthemoneymarket.GiventhelevelofGDPandoftheinterestrate,theexchangeratethenadjuststoensureequilibriuminthegoodsmarket.

Whatistheeconomicsbehindthis?IftheISandLMcurvesintersectabover*,thenU.S.interestratesexceedworldinterestrates.ThismeansthatforeignerswanttoholdU.S.assets.This,inturn,increasesthedemandforU.S.dollars,biddinguptheexchangerate,reducingnetexports,andcausingtheIScurvetoshiftin.Theoppositeoccursifthedomesticinterestrateistoolow.Thenthereisacapitaloutflow,causingthedollartodepreciateandincreasingnetexports.TheIScurveshiftsout(Figure2).

TheY–randtheY–ediagramsaresimplydifferentwaystoillustratetheworkingsofthemodel.TheY–rdiagramhastheadvantagethatitisfamiliar,sinceitisbasedontheIS–LMdiagram.TheY–ediagramisanaturalcounterparttotheIS–LMdiagramsince,inthesmall-open-economymodel,theinterestrateisfixedandtheexchangeratecanvary,whereastheinterestratecanvary(andtheexchangerateisirrelevant)intheclosedeconomy.

Wefirstconsiderfiscalpolicyunderfloatingexchangerates.AnincreaseingovernmentspendingoracutintaxesshiftstheIScurveout.IntheIS–LMdiagram,theinitialoutwardshiftoftheIScurveisoffsetbyaninwardshiftcausedbytheriseinthevalueofthecurrency.

Nowconsidermonetarypolicyunderfloatingexchangerates.Monetarypolicy,bycontrast,isveryeffectiveunderfloatingrates.AnincreaseinthemoneysupplyshiftstheLMcurvetotheright.IntheIS–LMdiagram,theoutwardshiftoftheLMcurveleadstoacapitaloutflow,andtheresultingdepreciationleadstoincreasednetexportsandhenceanoutwardshiftoftheIScurve.Inthenewequilibrium,thecurvesintersectatr*andahigherlevelofY.

Nowconsideradjustmentunderfixedexchangerates.Underfixedexchangerates,ourpreviousconclusionsarereversed.IntheIS–LMdiagram,theIScurveisnowfixedinplace,sinceeisfixed.Butagreaterdemandfordollars—caused,forexample,byhighinterestrates—simplyleadstoagreatersupplyofdollars.Sonow,ifr>r*,theLMcurveshiftsout,andconversely.

AnexpansionaryfiscalpolicyunderfixedexchangeratesshiftstheIScurvetotherightandputsp