Economics Chapter 13 Homework The Mundell–Fleming model assumes that both

285

CHAPTER 13

The Open Economy Revisited: The

Mundell–Fleming Model and the

Exchange–Rate Regime

Notes to the Instructor

Chapter Summary

Chapter 13 presents the Mundell–Fleming model of a small open economy in the short run.

Essentially, it is a synthesis of the IS–LM model and the small open economy model of Chapter

1. To introduce students to the distinction between fixed and floating exchange rates.

3. To consider whether exchange rates should be fixed or floating.

Comments

Although much of this chapter is built around the comparison between fixed and floating rates,

instructors could simply present the flexible–exchange–rate case as being the one most applicable

for the current U.S. economy. The main advantage for so doing is that the different cases make

the Mundell–Fleming model inherently complicated. Unless the instructor has time to present

both regimes with some care, students will likely be better served by seeing only the flexible–rate

case. This chapter probably requires two lectures.

In presenting flexible exchange rates using the IS*–LM* model, the lecture notes

emphasize the similarity between the IS and IS* curves and point out the analogies between

Use of the Web Site

Since there are so many different cases to examine in the Mundell–Fleming model—which

means that it can be very confusing for students—the Web site material has the potential to be

particularly useful here. I recommend assigning a lot of questions from this chapter and, if

possible, discussing them in class.

In a manner similar to the analysis of Chapter 6, the large open economy can studied

intuitively by using an “average” of results from the closed–economy model of Chapter 12 and

results from the small–open–economy model of Chapter 13.

286 | CHAPTER 13 The Open Economy Revisited: The Mundell–Fleming Model and the

Exchange Rate Regime

Use of the Dismal Scientist Web Site

Go to the Dismal Scientist Web site and download quarterly data for the broad index of the real

dollar exchange rate over the past 30 years. Also download quarterly data over the same period

for real net exports of goods and services. Assess the relationship between the exchange rate and

Chapter Supplements

This chapter includes the following supplements:

13-1 The Dependence of Net Exports on GDP

13-3 Can World Financial Markets Usurp the Power of the Federal Reserve?

13-4 Bretton Woods

13-6 The Mundell–Fleming Model in Y–r Space

13-8 Interest Rate Differentials in the European Monetary System

13–10 Mexico’s Foreign Exchange Reserves (Case Study)

13–12 The Federal Reserve and the European Central Bank (Case Study)

13-13 Additional Readings

!Figure 13-3

Lecture Notes | 287

Lecture Notes

Introduction

Earlier we examined how the long–run model of the economy is adapted to take account of our

trade with other nations. We now carry out the analogous task for the short–run IS–LM model.

13–1 The Mundell–Fleming Model

The Key Assumption: Small Open Economy with Perfect Capital

Mobility

The interest rate in a small open economy with perfect capital mobility is determined by the

world interest rate, r*, so that

r = r*.

The Goods Market and the IS* Curve

Net exports, NX, are added to the goods market, which, combined with the assumption of perfect

capital mobility, gives a new equation for goods market equilibrium, the IS* curve:

Y = C(Y – T) + I(r*) + G + NX(e).

The Money Market and the LM* Curve

The new equation for money market equilibrium, the LM* curve, incorporates the assumption of

perfect capital mobility so that r = r*:

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

The LM* curve gives combinations of the exchange rate and the level of GDP such that the

money market is in equilibrium. We noted earlier that, given r*, the money market determines Y,

so the LM* curve is vertical.

Putting the Pieces Together

These two equations for the IS* and LM* curves describe the small open economy with perfect

capital mobility:

Y = C(Y – T) + I(r*) + G + NX(e) IS*

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

!Supplement 13–1,

“The Dependence

of Net Exports on

GDP”

!Figure 13-2

13–2 The Small Open Economy Under Floating Exchange Rates

We now use the model to analyze the effects of fiscal and monetary policy under floating

exchange rates.

Fiscal Policy

An increase in government spending or a cut in taxes shifts the IS* curve out. The exchange rate

appreciates and there is no change in income. The reason is that the fiscal expansion puts upward

pressure on the interest rate, leading to a rise in capital inflows, appreciation of the exchange

rate, and crowding out of net exports.

Monetary Policy

Trade Policy

Trade restrictions are unsuccessful under floating exchange rates, in the short run as in the long

run. Since trade restrictions increase the demand for net exports at any given value of the

exchange rate, they simply shift the IS* curve up. The result is appreciation, no change in net

13–3 The Small Open Economy Under Fixed Exchange Rates

How a Fixed–Exchange–Rate System Works

How does the model work under fixed exchange rates? The key point is that to fix the exchange

rate, the Fed must sacrifice control over the supply of money. Monetary policy now consists of

adjusting the money supply such that the exchange rate is at its fixed level. If people demand

more dollars, the Fed supplies them; if people wish to exchange dollars for foreign currencies,

the Fed stands ready to make that exchange. The money supply becomes an endogenous

variable.

Case Study: The International Gold Standard

If different countries agree to fix the price of their currencies in terms of gold, then exchange

rates are fixed. The reason is that if the monetary authorities of two countries stand ready to buy

Fiscal Policy

Under fixed exchange rates, our conclusions are essentially reversed from the case of flexible

exchange rates. An expansionary fiscal policy shifts the IS* curve outward. This puts upward

pressure on the exchange rate—the demand for U.S. dollars increases. But the Fed must now

accommodate the greater demand for dollars, so the supply of dollars increases. Hence the LM*

curve shifts out. The consequence is increased output.

Monetary Policy

Under a fixed–rate system, the Fed gives up control of the money supply. Technically, M is now

an endogenous variable and e is an exogenous variable. It thus is not possible to carry out

monetary policy in the usual way. If, for example, the Fed were to try to increase the money

supply, U.S. dollars would become less attractive, and arbitragers would demand fewer dollars.

!Figure 13-4

Dollar”

!Supplement 13–3,

“Can World

Financial Markets

Usurp the Power

of the Federal

!Figure 13-7

!Figure 13-8

!Supplement 13–5,

“Finland in the

1990s”

!Figure 13-9

!Figure 13-6

Lecture Notes | 289

The Fed does, however, have the option of devaluing or revaluing the currency. A

devaluation reduces the exchange rate and shifts the LM* curve out, implying higher income; the

opposite is true of a revaluation.

Case Study: Devaluation and the Recovery from the Great

Depression

Some countries—for example, the United Kingdom, Denmark, Finland, Norway, and Sweden—

responded to the terrible economic conditions of the Great Depression by devaluing their

Trade Policy

Trade restrictions do work under fixed rates, since, as noted earlier, they shift the IS* curve to

the right. The LM* curve follows, and net exports end up higher.

Policy in the Mundell–Fleming Model: A Summary

The Mundell–Fleming model reveals that the short–run response of the economy to policy

changes depends crucially on the exchange rate regime. Monetary policy is effective under

floating rates and ineffective under fixed rates, whereas the opposite is true of fiscal and trade

policies.

13–4 Interest–Rate Differentials

In the real world, real interest rates are not necessarily equalized in all countries at all times.

Here, we consider two reasons interest rates may differ across countries.

Country Risk and Exchange–Rate Expectations

Differentials in the Mundell–Fleming Model

A simple way to incorporate interest–rate differentials into our existing model is just to suppose

The increase in income predicted by the model, however, is not realistic for several

reasons. First, the central bank may try to avoid the depreciation of the currency by tightening

credit and reducing the money supply. Second, the depreciation may increase import prices and,

in turn, increase the domestic price level. Finally, the rise in the risk premium may lead domestic

residents to increase their demand for domestic money, which they may view as a “safer” asset

!Figure 13–10

!Supplement 13–6,

“The Mundell–

Fleming Model in

Y–r Space”

!Table 13-1

European

Monetary

System”

!Figure 13–11

Bank”

290 | CHAPTER 13 The Open Economy Revisited: The Mundell–Fleming Model and the

Exchange Rate Regime

Case Study: International Financial Crisis: Mexico 1994–1995

Political upheaval in 1994 increased the risk premium on Mexican assets. Because the exchange

rate was fixed, the downward pressure on the exchange rate led to a contraction of the money

supply. Mexico had insufficient reserves to maintain its exchange rate and so was forced to

Case Study: International Financial Crisis: Asia 1997–1998

In 1997 a financial crisis similar to that experienced by Mexico occurred in several Asian

countries. A weak (some would say corrupt) banking system was the starting point for the crisis,

leading to a decline in confidence in the economies. This erosion of confidence raised risk

premiums and interest rates, all of which depressed asset prices. The fall in asset prices increased

13–5 Should Exchange Rates Be Floating or Fixed?

Pros and Cons of Different Exchange–Rate Systems

Economists frequently debate the relative merits of flexible– and fixed–rate systems. The

principal disadvantage of fixed exchange rates is that they force the monetary authorities to give

up control of the money supply. Against this, it is sometimes argued that the observed volatility

of floating exchange rates hinders international trade by complicating business planning. The

Case Study: The Debate over the Euro

The adoption of the euro has resulted in a monetary union in Europe similar to that which exists

in the United States. A single currency in Europe brings benefits for travelers and businesses,

who no longer need to exchange currencies as they travel or send goods throughout Europe.

Along with the common currency has come a common monetary policy for Europe. Some

economists argue that the cost of a common monetary policy is high because countries lose the

ability to react to a national recession.

This loss of national monetary policy and the related ability to devalue one’s currency has

recently been in the spotlight among eurozone countries as a consequence of the Greek debt

crisis. Due to the austerity program Greece was forced to adopt, its economy suffered a severe

!Supplement 13–10,

“Mexico’s Foreign

!Supplement 13–11,

“Exchange Rate

Volatility”

!Supplement 13–12,

“The Federal

Lecture Notes | 291

Speculative Attacks, Currency Boards, and Dollarization

When a country maintains a fixed exchange rate, the central bank must stand ready to buy and

sell domestic currency for foreign currency at the fixed rate. In other words, the central bank

must have sufficient foreign exchange reserves available to meet potential demand. Suppose,

however, that people suddenly become concerned that the exchange rate will be devalued. They

will quickly want to convert their domestic currency to foreign currency and this may exhaust

The Impossible Trinity

The discussion of exchange–rate regimes shows that a nation cannot simultaneously have free

capital flows, a fixed exchange rate, and an independent monetary policy (sometimes referred to

as the trilemma of international finance). One option is to have free flows of capital and an

independent monetary policy but allow the exchange rate to float—as in the United States. A

second option, which Hong Kong has chosen, is to fix the exchange rate and allow free flows of

Case Study: The Chinese Currency Controversy

China pegged its currency, the yuan, at an exchange rate of 8.28 yuan to the dollar over the

period 1995 to 2005. By the early 2000s, many analysts and U.S. politicians believed that the

yuan was substantially undervalued relative to the dollar—spurring charges of unfair

competition on the part of China. As evidence, they cited the rapid expansion in China’s

holdings of dollar reserves. In effect, China was supplying yuan and buying dollars in the

13–6 From Short Run to the Long Run: The Mundell–Fleming Model With a

Changing Price Level

The Mundell–Fleming model is a variation on the IS–LM model. But the IS–LM model is

unsatisfactory because it assumes fixed prices. As explained in Chapter 11, the IS–LM

framework is best understood as a theory of aggregate demand, which must be combined with

!Figure 13–12

the value of the real exchange rate for a given value of the nominal exchange rate.

The small–open–economy aggregate demand curve is derived in the same manner as the

aggregate demand curve in a closed economy. Aggregate demand is given by {P, Y}

combinations such that the foreign exchange market and money market are in equilibrium. As

13.

Note that once we incorporate price adjustment into the model, we cannot unambiguously

13–7 A Concluding Reminder

Just as when we considered the open economy in the long run, it is important to remember that

the appropriate model for the U.S. economy is a combination of the closed economy and the

small open economy. Thus, to understand the U.S. economy in the short run, we should use both

Appendix: A Short–Run Model of the Large Open Economy

The large open economy in the short run is described by three equations:

Y = C(Y – T) + I(r) + G + NX(e),

M/P = L(r, Y),

NX(e) = CF(r),

where the first two equations are the same as those used in the small open economy Mundell–

Fleming model of this chapter. The third equation is from the appendix to Chapter 5 and shows

that the trade balance NX equals the net capital outflow CF, which in turn depends on the

domestic interest rate.

!Figure 13–15

!Figure 13–14

Lecture Notes | 293

Fiscal Policy

An expansionary fiscal policy shifts the IS curve out, raising income and the interest rate. The

higher interest rate leads to a decreased capital outflow and so decreased net exports. The

exchange rate rises. There is crowding out of both investment and net exports.

Monetary Policy

A Rule of Thumb

The large open economy in both the short run and the long run is probably most easily

!Figure 13–16

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LECTURE SUPPLEMENT

13–1 The Dependence of Net Exports on GDP

When GDP increases, so does consumption. Since consumers spend money on imported as well as

domestic goods, it seems likely that imports also tend to increase when people’s income increases.

Remembering that net exports is the difference between exports and imports, it follows that we should

expect net exports to depend (negatively) on both the exchange rate and the level of GDP:

NX = NX(e, Y).

or, equivalently,

S(Y) – I(r*) = NX(e, Y).

An increase in Y increases saving, implying that the left-hand side of this equation increases. To

maintain equilibrium, the exchange rate must fall, increasing the right–hand side of the equation. This is

why the IS* curve slopes downward. But now there is an extra effect: Higher GDP tends to reduce net

exports and so reduces the right–hand side. This means that the exchange rate must fall farther than was

previously the case to maintain equilibrium in the market for foreign exchange. Increased GDP, in other

words, both decreases the net supply of foreign currency and increases the net demand. Taking account of

the dependence of net exports on GDP implies that the IS* curve is steeper.

We can also see this algebraically. Suppose that

C = a + b(Y – T)

I = c – dr

NX = α – βY – γe.

ADDITIONAL CASE STUDY

13–2 The Rise in the Dollar, 1979–1982

In the early 1980s the United States experienced an unusual combination of tight monetary policy and

1.83 German marks. In 1982 the dollar was worth 248 yen or 2.42 marks. This rise in the value of the

dollar made imported goods less expensive. U.S. firms competing against similar foreign companies, such

296

13–3 Can World Financial Markets Usurp the Power of the Federal

Reserve?

Some commentators in the media have suggested that the Fed has less influence over the U.S. economy

today than it had in the past. Their argument goes roughly as follows:

2. As a result, U.S. interest rates are more determined by developments in world financial markets and

less determined by domestic monetary policy than they were previously.

3. With less control over interest rates, the Fed may soon find itself powerless in the fight against short–

run economic fluctuations.

Does this argument makes sense? Should U.S. policymakers worry that world financial markets will soon

hold the U.S. economy hostage?

The Mundell–Fleming model tells us not to worry. We can interpret statement 1 in the above

argument as claiming that the U.S. economy is becoming less like the closed economy described by the

IS–LM model and more like the small open economy described by the Mundell–Fleming model. Let’s

ADDITIONAL CASE STUDY

13–4 Bretton Woods

Much of the world operated under fixed exchange rates between 1944 and 1971, as established in the

Bretton Woods agreement. An international conference held in Bretton Woods, New Hampshire,

established an international financial system, including the International Monetary Fund (IMF). All

currencies were pegged (within a 1 percent band) to the dollar, implying that the U.S. dollar was the

billion). If foreign central banks had all tried to convert their dollars into gold, the United States could not

have supplied that gold. In August 1971, fearing such a run against the gold reserves, President Nixon

ended the convertibility of dollars into gold, effectively ending the Bretton Woods period (although the

system was not formally abandoned until early 1973).

Allan Meltzer suggests that the Bretton Woods system failed in part because of U.S. policy.3 As

ADDITIONAL CASE STUDY

13–5 Finland in the 1990s

Finland was an economic success story in the 1980s. Real GDP growth was averaging over 3 percent per

year in the mid–1980s and rose to 4.9 percent in 1988 and 5.7 percent in 1989.1 At that time it was

operating under a system of fixed exchange rates.

But disaster struck in the early 1990s. Real GDP growth was zero in 1990 and real GDP fell by 7.1

percent in 1991, 3.6 percent in 1992, and 1.2 percent in 1993. Between 1990 and 1993 output declined by

nearly 12 percent.

What caused this extraordinarily severe recession? One explanation is the collapse of the economies

of the former Soviet Union. Finland is a small open economy, in which exports account for over 20

percent of GDP. Prior to its collapse, the Soviet Union was the destination for about 17 percent of Finnish

exports. But between 1990 and 1991, this component of exports fell by almost 72 percent. In the Mundell–