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LECTURE SUPPLEMENT
13-6 The Mundell–Fleming Model in Y–r Space
We analyze the open economy in the short run using the Mundell–Fleming model. The basic equations are
The first equation is the IS curve, with the addition of the net exports term. The equivalent loanable-funds
representation is
S(Y) – I(r) = NX(e).
The second equation is the LM curve, and the third is the small-open-economy restriction that the domestic
interest rate must equal the world interest rate. We first think about the model under a flexible- (or
floating) exchange-rate regime and then examine how the conclusions of the model are altered under a
fixed-exchange-rate regime.
What is the economics behind this? If the IS and LM curves intersect above r*, then U.S. interest rates
300 | CHAPTER 13 The Open Economy Revisited: The Mundell-Fleming Model and the Exchange
Rate Regime
301
greater demand for dollars—caused, for example, by high interest rates—simply leads to a greater supply
of dollars. So now, if r > r*, the LM curve shifts out, and conversely.
An expansionary fiscal policy under fixed exchange rates shifts the IS curve to the right and puts
pressure on interest rates to rise. The demand for U.S. dollars thus increases. Whereas previously this led
to an appreciation of the dollar, now the Fed stands willing to supply the extra dollars that are demanded.
The money supply thus expands to meet the demand, leading to increased output.
ADVANCED TOPIC
13-7 Uncovered Interest Parity
The Mundell–Fleming model assumes that the interest rate in a small open economy must equal the world
interest rate. Yet interest rates often differ in different countries. The reason is that something is missing in
the Mundell–Fleming story: exchange rate expectations.
Think about someone with $1 to invest. She could invest it in the United States and earn the (nominal)
Multiplying out and subtracting 1 from each side gives
∆e/e + i + i(∆e/e) = i*.
We can neglect the term i(∆e/e) since it is the product of two small numbers, so we get1
i – i* = –∆e/e.
This equation is the UIP condition. It tells us that if the domestic interest rate exceeds the world
exchange-rate risk.
All of this analysis is in nominal terms. Exactly the same conclusion holds if we measure variables in
real terms. To see this, remember that the Fisher equation tells us that
i = r + π and i* = r* + π*.
If we substitute these into the UIP condition, we get
303
ADDITIONAL CASE STUDY
13-8 Interest Rate Differentials in the European Monetary System
To the extent that interest-rate differences across countries reflect expectations about changes in exchange
rates, these differences can provide information about the credibility of a fixed-exchange-rate system. If
two countries fix the rate at which their currencies can be exchanged for each other and if individuals
believe that the exchange rate will not change, then interest rates in the two countries should be identical.
In 1979 several members of the European Union fixed their exchange rates. Each country’s currency
was allowed to fluctuate only within narrow bands against the currencies of the other members of the
exchange-rate mechanism of the European Monetary System. Interest-rate differences between the
countries indicate changes in the credibility of the exchange-rate system. Figures 1 and 2 show the
differences between short-term (three-month) interest rates in France and Germany and short-term interest
rates in Italy and Germany. Throughout the 1980s the exchange rate system became more credible, and
individuals became increasingly convinced that the exchange rates would be maintained. By the beginning
of 1991, for example, French and German interest rates differed by less than 1 percentage point. In 1992
and 1993, however, interest rates in France and Italy rose relative to German rates, reflecting the crisis in
the European Monetary System during those years.11
305
ADVANCED TOPIC
13-9 The Dornbusch Overshooting Model
Exchange rates have proved to be very volatile under the floating-rate system. One possible explanation of
this volatility was provided by the international economist Rudiger Dornbusch. He showed, using the
Mundell–Fleming model, that the nominal exchange rate might overshoot its long-run value in response to
monetary shocks.1 To explain Dornbusch’s argument, we first consider how to introduce uncovered
interest parity (UIP) into the Mundell–Fleming model.2
The key insight of UIP is that the domestic interest rate can diverge from the world interest rate if
investors anticipate changes in the exchange rate. Specifically, arbitrage should ensure that
r – r* = –∆e/e;
that is, the domestic interest exceeds the world interest rate if the domestic currency is expected to
depreciate.33 Following Dornbusch, we assume that expectations about movements in the exchange rate
depend upon where the current exchange rate is relative to its long-run value. Thus, if e is the long-run
level of the nominal exchange rate, we write
∆e/e=–
θ
e–e
( )
.
This tells us that if the actual exchange rate is above its long-run equilibrium level, the exchange rate is
expected to depreciate. (The parameter θ indicates how responsive the exchange rate is to deviations from
its long-run value.)
Putting these two equations together, we get
In the long run, after all price adjustment has taken place, the IS* and LM* curves both shift down (recall
that the position of both curves depends upon the price level). Money is neutral in the long run: The price
level increases in proportion to the increase in the money supply, so that the real money supply is
unchanged; and the exchange rate depreciates by an amount proportionate to the rise in prices so that the
real exchange rate is unchanged. For example, if M is increased by 10 percent, then P is 10 percent higher
and e is 10 percent lower in the long run.
What are the short-run effects of an increase in the money supply? People know that this decreases the
308
CASE STUDY EXTENSION
13-10 Mexico’s Foreign Exchange Reserves
Figure 1 shows the decline in Mexico’s foreign exchange reserves during 1994. In February 1994 Mexico
had $29 billion in reserves. In March and April reserves fell as pressure mounted on the peso following the
assassination of the leading presidential candidate, Luis Donaldo Colosio. Although reserves fell by nearly
40 percent between February and April, they remained stable throughout the rest of the spring and into the
summer. In the late fall the Mexican central bank had to return to buying pesos and selling its foreign
309
ADDITIONAL CASE STUDY
13-11 Exchange Rate Volatility
Since the world economies abandoned the Bretton Woods system of fixed exchange rates in 1973,
exchange rates have turned out to be very volatile. A broad illustration of this is the dollar’s major
appreciation during the early 1980s and depreciation in the second half of the decade. For example, in
1980, $1 bought 4.2 French francs, 227 Japanese yen, and 1.8 German marks. In 1985, $1 bought 9.0
francs, 238 yen, and 2.9 marks; at the end of 1992, it bought 5.3 francs, 123 yen, and 1.6 marks.1 Not
surprisingly, such large changes in nominal exchange rates also imply substantial fluctuations in real
exchange rates.
1 Economic Report of the President, 1993, Table B-107:470.
2 Supplements 17-3 to 17-8 discuss asset pricing.
CASE STUDY EXTENSION
13-12 The Federal Reserve and the European Central Bank
The structure of the European System of Central Banks is similar to that of the Federal Reserve System.
The Federal Reserve System is composed of 12 regional banks and the Board of Governors. The president
of each regional bank is chosen by the board of directors of that bank and must be approved by the Board
of Governors. The Board of Governors consists of seven members who are appointed by the President of
voting members; only five presidents have voting rights at any one time. The president of the Federal
Reserve Bank of New York is a permanent voting member. The other four positions rotate annually
among the remaining Federal Reserve Banks.1
The Governing Council is the primary monetary decision-making body of the European System of
Central Banks. It consists of the Executive Board (6 members) and the governors of the central banks of
LECTURE SUPPLEMENT
13-13 Additional Readings
The debate over exchange-rate regimes arises frequently in international macroeconomics. The American
Economic Review, Papers and Proceedings included a session in May 1987 on “Reforming the
International Monetary System” and one in May 1989 on “Exchange Rate Policy.” In each issue John
Williamson makes a case for exchange-rate stabilization. He (and Rudiger Dornbusch) also comment on
