SEVENTH EDITIO

MACROECONOMICS
N. Gregory Mankiw
PowerPoint® Slides by Ron Cronovich

CHAPTE
R
12
The Open Economy
Revisited:
The Mundell-Fleming Model
Modified for EC 204

and the Exchange-Rate

by Bob Murphy
© 2010 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
 The Mundell-Fleming model

 Key assumption:
Small open economy with perfect capital mobility.
r = r*
 Goods market equilibrium – the IS* curve:

where
e = nominal exchange rate
= foreign currency per unit domestic currency

CHAPTER 12 The Open Economy Revisited 3

 The IS* curve: Goods market eq’m

The IS* curve is drawn e

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

IS*
Y

CHAPTER 12 The Open Economy Revisited 4

 The LM* curve: Money market eq’m

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
Y
demand with supply,
regardless of e.
CHAPTER 12 The Open Economy Revisited 5
 Equilibrium in the Mundell-Fleming
model

e LM*

equilibrium
exchange
rate

IS*
equilibrium Y
level of
income
CHAPTER 12 The Open Economy Revisited 6
 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 –
 first, in a floating exchange rate system
 then, in a fixed exchange rate system
CHAPTER 12 The Open Economy Revisited 7
 Fiscal policy under floating exchange
rates

e
At any given value of e, e2

a fiscal expansion e1
increases Y,
shifting IS* to the right.
Results:
Δe > 0, ΔY = 0 Y
Y1

CHAPTER 12 The Open Economy Revisited 8

 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 12 The Open Economy Revisited 9

 Monetary policy under floating
exchange rates

e
An increase in M
shifts LM* right
because Y must rise
e1
to restore eq’m in
the money market. e2
Results:
Y
Δe < 0, ΔY > 0 Y1 Y2

CHAPTER 12 The Open Economy Revisited 10

 Lessons about monetary policy

 Monetary policy affects output by affecting

the components of aggregate demand:
closed economy: ↑M ⇒ ↓r ⇒ ↑I ⇒ ↑Y
small open economy: ↑M ⇒ ↓e ⇒ ↑NX ⇒
↑Y

 Expansionary monetary policy does not raise

world aggregate 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 12 The Open Economy Revisited 11
 Trade policy under floating exchange
rates

e
At any given value of e,
e2
a tariff or quota reduces
imports, increases NX,
e1
and shifts IS* to the right.
Results:
Δe > 0, ΔY = 0 Y
Y1

CHAPTER 12 The Open Economy Revisited 12

 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 12 The Open Economy Revisited 13

 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 12 The Open Economy Revisited 14

 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 12 The Open Economy Revisited 15
 Fiscal policy under fixed exchange
rates

Under
Underfloating
floatingrates,
rates,
afiscal
fiscalpolicy
expansion
is ineffective
would raise e.output. e
at changing
To keepfixed
Under e from rising,
rates,
the central
fiscal bank
policy must
is very
sell domestic currency, e1
effective at changing
which
output.increases M
and shifts LM* right.
Results: Y
Y1 Y2
Δe = 0, ΔY > 0
CHAPTER 12 The Open Economy Revisited 16
 Monetary policy under fixed exchange
rates

An increase
Under in Mrates,
floating would
shift LM* right
monetary andisreduce e.
policy
e
very effective at changing
To prevent the fall in e,
output.
the central bank must buy
domestic
Under fixedcurrency,
rates,which
reduces
monetary M policy
and shifts LM*
cannot e1
back left. to affect output.
be used

Results:
Y
Δe = 0, ΔY = 0 Y1

CHAPTER 12 The Open Economy Revisited 17

 Trade policy under fixed exchange
rates
Under floating rates,
A restriction on imports
import restrictions
puts upward pressure on e.
do not affect Y or NX. e
To keep
Under fixede from
rates,rising,
the central
import bank must
restrictions
sell domestic
increase Y andcurrency,
NX.
e1
which increases
But, these gains come M
atand
theshifts
expenseLM*of right.
other
countries:
Results: the policy merely
shiftsΔedemand from > foreign Y
= 0, ΔY 0 Y1 Y2
to domestic goods.
CHAPTER 12 The Open Economy Revisited 18
 Summary of policy effects in the
Mundell-Fleming model
type of exchange rate regime:

floating fixed

impact on:
Policy Y e NX Y e NX

fiscal expansion 0 ↑ ↓ ↑ 0 0

monetary expansion ↑ ↓ ↑ 0 0 0

import restriction 0 ↑ 0 ↑ 0 ↑

CHAPTER 12 The Open Economy Revisited 19

 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 12 The Open Economy Revisited 20
 Differentials in the M-F model

where θ (Greek letter “theta”) is a risk premium,

assumed exogenous.
Substitute the expression for r into the
IS* and LM* equations:

CHAPTER 12 The Open Economy Revisited 21

 The effects of an increase in
θ
IS* shifts left, because
↑θ ⇒ ↑r ⇒ ↓I e

LM* shifts right, because

e1
↑θ ⇒ ↑r ⇒ ↓(M/P)d,
so Y must rise to restore
money market eq’m. e2
Results:
Y
Δe < 0, ΔY > 0 Y1 Y2

CHAPTER 12 The Open Economy Revisited 22

 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 12 The Open Economy Revisited 23

 Why income might not rise
 The central bank may try to prevent the
depreciation by reducing the money supply.
 The depreciation might boost the price of
intermediate imports enough and feed through
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 12 The Open Economy Revisited 24

 CASE STUDY:
The Mexican peso crisis

CHAPTER 12 The Open Economy Revisited 25

 CASE STUDY:
The Mexican peso crisis

CHAPTER 12 The Open Economy Revisited 26

 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 12 The Open Economy Revisited 27

 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 12 The Open Economy Revisited 28
 Understanding the crisis
 These events put downward pressure on the
peso.
 Mexico’s central bank had repeatedly promised
foreign investors that 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 12 The Open Economy Revisited 29
 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 12 The Open Economy Revisited 30

  the disaster 
 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.
 ↑θ, 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 12 The Open Economy Revisited 31
 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 12 The Open Economy Revisited 32

 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 12 The Open Economy Revisited 33
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:
 allows monetary policy to be used to pursue
other goals (stable growth, low inflation).
Arguments for fixed rates:
 avoids uncertainty and volatility, making
international transactions easier.
 disciplines monetary policy to prevent excessive
money growth & hyperinflation.

CHAPTER 12 The Open Economy Revisited 35

 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
(U.S.) (Hong Kong)
A nation must choose
one side of this
triangle and
give up the Independent Fixed
Option 3 exchange
opposite monetary
(China) rate
corner. policy

CHAPTER 12 The Open Economy Revisited 36

 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 that the yuan was
significantly undervalued, as China was
accumulating large dollar reserves.
 U.S. producers complained that China’s cheap
yuan gave Chinese producers an unfair advantage.
 President Bush asked China to let its currency float;
Others in the U.S. wanted tariffs on Chinese goods.
CHAPTER 12 The Open Economy Revisited 37
 CASE STUDY:
The Chinese Currency Controversy

 If China lets the yuan float, it may indeed

appreciate.
 However, if China also allows greater capital
mobility, then Chinese citizens may start moving
their savings abroad.
 Such capital outflows could cause the yuan to
depreciate rather than appreciate.

CHAPTER 12 The Open Economy Revisited 38

 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:

(Earlier in this chapter, P was fixed, so we

could write NX as a function of e instead of ε.)
CHAPTER 12 The Open Economy Revisited 39
 Deriving the AD curve
ε LM*(P2) LM*(P1)
Why AD curve has
ε
negative slope:
ε
2

↑P ⇒ ↓(M/P) 1
IS*
⇒ LM shifts left Y2 Y1 Y
P
⇒ ↑ε
P2
⇒ ↓NX P1
⇒ ↓Y AD
Y2 Y1 Y

CHAPTER 12 The Open Economy Revisited 40

 From the short run to the long run
ε LM*(P1) LM*(P2)

then there is ε
downward pressure ε
1

on prices. 2
IS*
Over time, P will Y
P
move down, causing LRAS
(M/P )↑ P1 SRAS1
ε↓ P2 SRAS2
NX ↑ AD
Y↑ Y

CHAPTER 12 The Open Economy Revisited 41

 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 & small open.
 Consider a monetary expansion:
 Like in a closed economy,
ΔM > 0 ⇒ ↓r ⇒ ↑I (though not as much)
 Like in a small open economy,
ΔM > 0 ⇒ ↓ε ⇒ ↑NX (though not as
much)
CHAPTER 12 The Open Economy Revisited 42
 Chapter Summary
1. Mundell-Fleming model
 the IS-LM model for a small open economy.
 takes P as given.
 can show how policies and shocks affect income
and the exchange rate.
2. Fiscal policy
 affects income under fixed exchange rates, but not
under floating exchange rates.
 Chapter Summary
3. Monetary policy
 affects income under floating exchange rates.
 under fixed exchange rates, monetary policy is not
available to affect output.
4. Interest rate differentials
 exist if investors require a risk premium to hold a
country’s assets.
 An increase in this risk premium raises domestic
interest rates and causes the country’s exchange
rate to depreciate.
 Chapter Summary
5. Fixed vs. floating exchange rates
 Under floating rates, monetary policy is available
for purposes other than maintaining exchange rate
stability.
 Fixed exchange rates reduce some of the
uncertainty in international transactions.