Intermediate macroeconomics chapt12

Chapter 12:
Aggregate Demand
in Open Economy


The Mundell-Fleming Model
Assumption
– Small open economy
– Free capital mobility (r = r*)
– Flexible or fixed foreign exchange rate regime


Flexible Exchange Rate
The IS curve:
Y = C(Y – T) + I(r*) + G + NX(e)
Where e = nominal exchange rate that varies according to
its demand and supply
An increases in e make imports less expensive to
domestic consumer and exports more expensive to foreign
consumer, hence reducing NX


Derivation of IS Curve
Initial equilibrium: Y = E1 with Y1 and e1
Let e increase, NX decreases and E1 falls to E2
New equilibrium: E2 = Y with Y2<Y1 and e2>e1

Line AB is the IS


Derivation of IS Curve

Expenditures

Exchange Rate
Y=E

E1
E2
e2
e1

B
A
IS(e)

Y2 Y1

Income

Y2 Y1

Income


Derivation of LM Curve
M/P = L(r*, Y)
LM is independent of the exchange rate
Shift of LM won’t alter the interest rate because r = r*


Derivation of LM Curve

Interest Rate

Exchange Rate

LM(r*)
LM(e)

r = r*

r

Y

Income

Y

Income


IS-LM Model
Exchange Rate

LM

Aggregate Equilibrium

e

IS

Y

Income


Fiscal Policy
Initial equilibrium: IS1 = LM1 with Y1 and e1
As G increase, IS increases. New equilibrium: IS 2 = LM1
causing Y and e to increase

The rise in e makes NX and Y to fall, offsetting the initial
increase in income


Fiscal Policy
Exchange Rate

LM
Fiscal policy is ineffective
in causing economic growth

e2
e1

IS1
Y

IS2
Income

Monetary Policy
Initial equilibrium: IS1 = LM1 with Y1 and e1
As M increase, LM increases. New equilibrium: IS1 = LM2
causing Y to increase and e to fall

The fall in e makes NX and Y to increase


Monetary Policy
Exchange Rate

LM1 LM2
Monetary policy is effective
in causing economic growth

e1
e2
IS1
Y1

Y2

Income


Trade Protectionism
Initial equilibrium: IS1 = LM1 with Y1 and e1
Let imports decrease, NX and IS decline. New equilibrium:
IS2 = LM1 causing Y and e to increase

The rise in e makes NX and Y to decrease


Trade Protectionism
Exchange Rate

LM
Trade protectionism is ineffective
in causing economic growth

e2
e1

IS1
Y

IS2
Income


Fixed Exchange Rate
Assume: market rate > fixed rate
Arbitrageur buys from the market and sells to the central
bank at the fixed rate and make profits
Money supply and LM increase, causing Y to increase.
The market rate falls to the fixed rate


Fixed Exchange Rate

Exchange Rate

LM1 LM2

em
ef
IS1
Y1

Y2

Income


Fixed Exchange Rate
Assume: market rate < fixed rate
Arbitrageur buys from the central bank market and sells to
the market at the fixed rate to make profits
Money supply and LM decrease, causing Y to fall. The
market rate rises to the fixed rate


Fixed Exchange Rate
Exchange Rate

LM2 LM1

ef
em
IS1

Y2

Y1

Income


Fiscal Policy
Initial equilibrium: IS1 = LM1 with Y1 and e1
As G increase, IS increases, causing e to rise above the
fixed rate.
Exchange rate arbitrage causes Ms and LM to increase, e
falls to the fixed rate
New equilibrium: IS2 = LM2 causing Y to increase


Fixed Exchange Rate
Exchange Rate

LM1 LM2
Fiscal policy is effective
in causing economic growth

em
ef

IS1
Y1

Y2

IS2
Income


Monetary Policy
Initial equilibrium: IS1 = LM1 with Y1 and e1
Let Ms increase, LM increases, causing e to decrease
below the fixed rate.
Exchange rate arbitrage causes Ms and LM to decrease, e
rises to the fixed rate
New equilibrium: IS1 = LM1 causing no increase in Y


Monetary Policy
Exchange Rate

LM1 LM2
Monetary policy is ineffective
in causing economic growth

ef
em
IS1
Y2

Y1

Income

Trade Protectionism
Initial equilibrium: IS1 = LM1 with Y1 and e1
As imports increase NX and IS increase, causing e to
increase above the fixed rate
Exchange rate arbitrage causes Ms and LM to increase,
lowering e to the fixed rate
New equilibrium: IS2 = LM2 causing Y to increase


Trade Protectionism
Exchange Rate

LM1 LM2
Trade protectionism is effective
in causing economic growth

em
ef

IS1
Y1

Y2

IS2
Income


Policy Effectiveness

Policy

Flexible Exchange
Rate

Fixed Exchange
Rate

Fiscal
Monetary
Trade Protectionism

Ineffective
Effective
Ineffective

Effective
Ineffective
Effective