Macroeconomics

N. Gregory Mankiw

The Open Economy

Revisited: The
Mundell-Fleming
Model and the
Exchange-Rate
Regime
Modified for ECON 2204
by Bob Murphy

© 2019 Worth Publishers, all rights reserved

 IN THIS CHAPTER, YOU WILL LEARN:

§ the Mundell-Fleming model

(IS-LM for the small open economy)
§ causes and effects of interest rate differentials
§ arguments for fixed vs. floating exchange rates
§ how to derive the aggregate demand curve for a
small open economy

1
 The Mundell-Fleming model

§ Key assumption:
Small open economy with perfect capital mobility.
r = r*
§ Goods market equilibrium—the IS* curve:
Y = C (Y −T ) + I (r *) + G + NX (e )
where
e = nominal exchange rate
= foreign currency per unit domestic currency

CHAPTER 13 The Open Economy Revisited 2

 The IS* curve: goods market equilibrium

Y = C (Y −T ) + I (r *) + G + NX (e )

The IS* curve is drawn e

for a given value of r*.
Intuition for the slope:

↓ e ⇒ ↑ NX ⇒ ↑Y
IS*
Y

CHAPTER 13 The Open Economy Revisited 3

 The LM* curve: money market equilibrium

M P = L(r *,Y )
The LM* curve:
e LM*
§ is drawn for a given
value of r*.
§ is vertical because
given r*, there is
only one value of Y
that equates money
demand with supply, Y
regardless of e.
CHAPTER 13 The Open Economy Revisited 4
 Equilibrium in the Mundell-Fleming model

Y = C (Y −T ) + I (r *) + G + NX (e )
M P = L(r *,Y )
e LM*

equilibrium
exchange
rate

IS*
Y
equilibrium
income
CHAPTER 13 The Open Economy Revisited 5
 Floating & fixed exchange rates

§ In a system of floating exchange rates,

e is allowed to fluctuate in response to changing
economic conditions.
§ In contrast, under fixed exchange rates,
the central bank trades domestic for foreign
currency at a predetermined price.
§ Next, policy analysis:
§ in a floating exchange rate system
§ in a fixed exchange rate system
CHAPTER 13 The Open Economy Revisited 6
 Fiscal policy under floating exchange rates

Y = C (Y −T ) + I (r *) + G + NX (e )
M P = L(r *,Y )
e LM 1*
At any given value of e,
e2
a fiscal expansion
increases Y, e1
shifting IS* to the right.
IS 2*
Results:
IS 1*
Δe > 0, ΔY = 0 Y
Y1

CHAPTER 13 The Open Economy Revisited 7

 Lessons about fiscal policy
§ In a small open economy with perfect capital
mobility, fiscal policy cannot affect real GDP.
§ Crowding out
§ closed economy:
Fiscal policy crowds out investment by causing
the interest rate to rise.
§ small open economy:
Fiscal policy crowds out net exports by causing
the exchange rate to appreciate.

CHAPTER 13 The Open Economy Revisited 8

 Monetary policy under floating exchange
rates
Y = C (Y −T ) + I (r *) + G + NX (e )
M P = L(r *,Y )
e LM 1*LM 2*
An increase in M
shifts LM* right
because Y must rise
e1
to restore eq’m in
the money market. e2
Results: IS 1*
Y
Δe < 0, ΔY > 0 Y1 Y2

CHAPTER 13 The Open Economy Revisited 9

 Lessons about monetary policy

§ Monetary policy affects output by affecting

the components of aggregate demand:
closed economy: hM g ir g hI g hY
small open economy: hM g ie g hNX g hY

§ Expansionary mon. policy does not raise world

agg. demand, it merely shifts demand from foreign
to domestic products.
So, the increases in domestic income and
employment are at the expense of losses abroad.

CHAPTER 13 The Open Economy Revisited 10

 Trade policy under floating exchange rates

Y = C (Y −T ) + I (r *) + G + NX (e )
M P = L(r *,Y )
e LM 1*
At any given value of e,
a tariff or quota reduces e2
imports, increases NX,
e1
and shifts IS* to the right.
IS 2*
Results:
IS 1*
Δe > 0, ΔY = 0 Y
Y1

CHAPTER 13 The Open Economy Revisited 11

 Lessons about trade policy
§ Import restrictions cannot reduce a trade deficit.
§ Even though NX is unchanged, there is less
trade:
§ The trade restriction reduces imports.
§ The exchange rate appreciation reduces
exports.
§ Less trade means fewer “gains from trade.”

CHAPTER 13 The Open Economy Revisited 12

 Lessons about trade policy, cont.
§ Import restrictions on specific products save jobs
in the domestic industries that produce those
products but destroy jobs in export-producing
sectors.
§ Hence, import restrictions fail to increase total
employment.
§ Also, import restrictions create sectoral shifts,
which cause frictional unemployment.

CHAPTER 13 The Open Economy Revisited 13

 Fixed exchange rates
§ Under fixed exchange rates, the central bank
stands ready to buy or sell the domestic currency
for foreign currency at a predetermined rate.
§ In the Mundell-Fleming model, the central bank
shifts the LM* curve as required to keep e at its
preannounced rate.
§ This system fixes the nominal exchange rate.
In the long run, when prices are flexible,
the real exchange rate can move even if the
nominal rate is fixed.

CHAPTER 13 The Open Economy Revisited 14

 Fiscal policy under fixed exchange rates

Under
Underfloating
floatingrates,
rates,
afiscal
fiscalpolicy
expansion
is ineffective
e LM 1*LM 2*
would raise e.output.
at changing
To keepfixed
Under e from rising,
rates,
the central
fiscal bank
policy must
is very
sell domestic
effective currency,
at changing e1
which
output.increases M IS 2*
and shifts LM* right.
IS 1*
Results: Y
Y1 Y2
Δe = 0, ΔY > 0
CHAPTER 13 The Open Economy Revisited 15
 Monetary policy under fixed exchange rates

An increase
Under in Mrates,
floating would
monetary
shift policy
LM* right andisreduce e.
very effective at e LM 1*LM 2*
To prevent the fall in e,
changing
the central output.
bank must
buy
Underdomestic currency,
fixed rates,
which reduces
monetary M and
policy cannot e1
shifts LM* toback
be used left.output.
affect
Results: IS 1*
Y
Δe = 0, ΔY = 0 Y1

CHAPTER 13 The Open Economy Revisited 16

 Trade policy under fixed exchange rates
Under floating rates,
import restrictions
A restriction on imports
do notupward
puts affect Y or NX. on e.
pressure
e LM 1*LM 2*
Under
To keepfixed rates,
e from rising,
import restrictions
the central bank must
increase Y and NX.
sell domestic currency,
But, these gains come e1
which increases M
at theshifts
and expense
LM* of other
right. IS 2*
countries: the policy
Results: IS 1*
merely shifts demand from Y
Δe to
foreign = 0, ΔY > 0goods.
domestic Y1 Y2

CHAPTER 13 The Open Economy Revisited 17

 Summary of policy effects in the Mendell-Fleming
model
Type of exchange-rate regime:

Floating: Floating: Floating: Fixed: Fixed: Fixed:

Policy Impact Impact Impact Impact Impact Impact
on: Y on: e on: NX on: Y on: e on: NX

Fiscal expansion 0 ↑ ↓ ↑ 0 0

Mon. expansion ↑ ↓ ↑ 0 0 0

Import restriction 0 ↑ 0 ↑ 0 ↑
 Interest-rate differentials
Two reasons why r may differ from r*
§ country risk:
The risk that the country’s borrowers will default
on their loan repayments because of political or
economic turmoil.
Lenders require a higher interest rate to
compensate them for this risk.
§ expected exchange rate changes:
If a country’s exchange rate is expected to fall,
then its borrowers must pay a higher interest rate
to compensate lenders for the expected currency
depreciation.
CHAPTER 13 The Open Economy Revisited 19
 Differentials in the M-F model

r = r *+ θ
where θ (Greek letter “theta”) is a risk premium,
assumed exogenous.
Substitute the expression for r into the
IS* and LM* equations:

Y = C (Y −T ) + I (r * + θ ) + G + NX (e )
M P = L(r * + θ ,Y )

CHAPTER 13 The Open Economy Revisited 20

 The effects of an increase in θ

IS* shifts left, because

hθ g hr g iI e LM 1*LM 2*
LM* shifts right, because
hθ g hr g i(M/P)d, e1
so Y must rise to restore
money market eq’m.
e2 IS 1*
Results: IS 2*
Δe < 0, ΔY > 0 Y
Y1 Y2

CHAPTER 13 The Open Economy Revisited 21

 The effects of an increase in θ

§ The fall in e is intuitive:

An increase in country risk or an expected
depreciation makes holding the country’s currency
less attractive.
Note: An expected depreciation is a
self-fulfilling prophecy.
§ The increase in Y occurs because
the boost in NX (from the depreciation)
is greater than the fall in I (from the rise in r).

CHAPTER 13 The Open Economy Revisited 22

 Why income may not rise
§ The central bank may try to prevent the
depreciation by reducing the money supply.
§ The depreciation might boost the price of
imports enough to increase the price level
(which would reduce the real money supply).
§ Consumers might respond to the increased risk
by holding more money.
Each of the above would shift LM* leftward.

CHAPTER 13 The Open Economy Revisited 23

 CASE STUDY:
The Mexican peso crisis
35
U.S. Cents per Mexican Peso

30

25

20

15

10
7/10/94 8/29/94 10/18/94 12/7/94 1/26/95 3/17/95 5/6/95

CHAPTER 13 The Open Economy Revisited 24

 CASE STUDY:
The Mexican peso crisis
35
U.S. Cents per Mexican Peso

30

25

20

15

10
7/10/94 8/29/94 10/18/94 12/7/94 1/26/95 3/17/95 5/6/95

CHAPTER 13 The Open Economy Revisited 25

 The Peso crisis didn’t just hurt Mexico
§ U.S. goods became expensive to Mexicans, so:
§ U.S. firms lost revenue
§ Hundreds of bankruptcies along
U.S.-Mexican border
§ Mexican assets lost value (measured in dollars)
§ Reduced wealth of millions of U.S. citizens

CHAPTER 13 The Open Economy Revisited 26

 Understanding the crisis
§ In the early 1990s, Mexico was an attractive place
for foreign investment.
§ During 1994, political developments caused an
increase in Mexico’s risk premium (θ):
§ peasant uprising in Chiapas
§ assassination of leading presidential candidate
§ Another factor:
The Federal Reserve raised U.S. interest rates
several times during 1994 to prevent U.S. inflation.
(Δr* > 0)
CHAPTER 13 The Open Economy Revisited 27
 Understanding the crisis
§ These events put downward pressure on the
peso.
§ Mexico’s central bank had repeatedly promised
foreign investors it would not allow the peso’s
value to fall,
so it bought pesos and sold dollars to
prop up the peso exchange rate.
§ Doing this requires that Mexico’s central bank
have adequate reserves of dollars.
Did it?
CHAPTER 13 The Open Economy Revisited 28
 Dollar reserves of Mexico’s central bank

December 1993 ……………… $28 billion

August 17, 1994 ……………… $17 billion
December 1, 1994 …………… $ 9 billion
December 15, 1994 ………… $ 7 billion

During 1994, Mexico’s central bank hid the

fact that its reserves were being depleted.

CHAPTER 13 The Open Economy Revisited 29

 M the disaster M
§ Dec. 20: Mexico devalues the peso by 13%
(fixes e at 25 cents instead of 29 cents)
§ Investors are SHOCKED! – they had no idea
Mexico was running out of reserves.
§ hθ, investors dump their Mexican assets and
pull their capital out of Mexico.
§ Dec. 22: central bank’s reserves nearly gone.
It abandons the fixed rate and lets e float.
§ In a week, e falls another 30%.
CHAPTER 13 The Open Economy Revisited 30
 The rescue package
§ 1995: U.S. & IMF set up $50b line of credit to
provide loan guarantees to Mexico’s govt.
§ This helped restore confidence in Mexico,
reduced the risk premium.
§ After a hard recession in 1995, Mexico began a
strong recovery from the crisis.

CHAPTER 13 The Open Economy Revisited 31

 CASE STUDY:
The Southeast Asian crisis 1997–98
§ Problems in the banking system eroded
international confidence in SE Asian economies.
§ Risk premiums and interest rates rose.
§ Stock prices fell as foreign investors sold assets
and pulled their capital out.
§ Falling stock prices reduced the value of collateral
used for bank loans, increasing default rates,
which exacerbated the crisis.
§ Capital outflows depressed exchange rates.
CHAPTER 13 The Open Economy Revisited 32
Data on the SE Asian crisis
exchange rate stock market nominal GDP
% change from % change from % change
7/97 to 1/98 7/97 to 1/98 1997–98
Indonesia −59.4 −32.6 −16.2
Japan −12.0 −18.2 −4.3
Malaysia −36.4 −43.8 −6.8
Singapore −15.6 −36.0 −0.1
S. Korea −47.5 −21.9 −7.3
Taiwan −14.6 −19.7 n.a.
Thailand −48.3 −25.6 −1.2
U.S. n.a. 2.7 2.3
 Floating vs. fixed exchange rates
Argument for floating rates:
§ allow monetary policy to be used to pursue other
goals (stable growth, low inflation).

Arguments for fixed rates:

§ avoid uncertainty and volatility, making
international transactions easier.
§ discipline monetary policy to prevent excessive
money growth & hyperinflation.

CHAPTER 13 The Open Economy Revisited 34

 The Impossible Trinity
A nation cannot have free
capital flows, independent Free capital
monetary policy, and a flows
fixed exchange rate
simultaneously. Option 1 Option 2
A nation must choose (U.S.) (Hong Kong)
one side of this
triangle and
give up the Independent Fixed
opposite Option 3
monetary exchange
(China) rate
corner. policy

CHAPTER 13 The Open Economy Revisited 35

 CASE STUDY:
The Chinese Currency Controversy
§ 1995–2005: China fixed its exchange rate at
8.28 yuan per dollar and restricted capital flows.
§ Many observers believed the yuan was significantly
undervalued. U.S. producers complained the cheap
yuan gave Chinese producers an unfair advantage.
§ President Bush called on China to let its currency
float; others wanted tariffs on Chinese goods.
§ July 2005: China began to allow gradual changes
in the yuan/dollar rate. By June 2013, the yuan had
appreciated 35 percent.
CHAPTER 13 The Open Economy Revisited 36
 Mundell-Fleming and the AD curve

§ So far in M-F model, P has been fixed.

§ Next: to derive the AD curve, consider the impact of
a change in P in the M-F model.
§ We now write the M-F equations as:
(IS* ) Y = C (Y −T ) + I (r *) + G + NX (ε )
(LM* ) M P = L(r *,Y )
(Earlier in this chapter, P was fixed, so we
could write NX as a function of e instead of ε.)

CHAPTER 13 The Open Economy Revisited 37

 Deriving the AD curve
ε LM*(P2) LM*(P1)
Why AD curve has
ε2
negative slope:
ε1
hP g i(M/P)
IS*
g LM shifts left Y2 Y1 Y
P
g hε
P2
g iNX P1
g iY AD
Y2 Y1 Y

CHAPTER 13 The Open Economy Revisited 38

 From the short run to the long run
ε LM*(P1) LM*(P2)
If Y1 < Y ,
then there is ε1
downward pressure ε2
on prices. IS*
Over time, P will Y1 Y Y
P LRAS
move down, causing
(M/P) h P1 SRAS1
εi P2 SRAS2
NX h AD
Yh Y1 Y Y

CHAPTER 13 The Open Economy Revisited 39

 Large: Between small and closed
§ Many countries—including the U.S.—are neither
closed nor small open economies.
§ A large open economy is between the polar
cases of closed and small open.
§ Consider a monetary expansion:
§ As in a closed economy,
hM g ir g hI (though not as much)
§ As in a small open economy,
hM g iε g hNX (though not as much)

CHAPTER 13 The Open Economy Revisited 40