# Chapter 12: The Mundell-Fleming Model & Exchange-Rate Regime *

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1 Chapter 12: The Mundell-Fleming Model & Exchange-Rate Regime * MACROECONOMICS Seventh Edition N. Gregory Mankiw * Slides based on Ron Cronovich's slides, adjusted for course in Macroeconomics for International Chapter 12: The Mundell-Fleming Model and the Exchange-Rate Regime 0/50 Masters Program at the Wang Yanan Institute for Studies in Economics at Xiamen University.

2 Learning Objectives This chapter introduces you to understanding: The Mundell-Fleming model The small open economy under floating and fixed exchange rates Interest rate differentials Arguments for fixed vs. floating exchange rates Deriving the aggregate demand curve Chapter 12: The Mundell-Fleming Model and the Exchange-Rate Regime 1/50

3 12.1) The Mundell-Fleming Model The 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 12: The Mundell-Fleming Model and the Exchange-Rate Regime 2/50

4 12.1) The Mundell-Fleming Model The IS* Curve: Goods Market eq m Y = C( Y T) + I( r* ) + G + NX( e) The IS* curve is drawn for a given value of r*. e Intuition for the slope: e NX Y IS* Y Chapter 12: The Mundell-Fleming Model and the Exchange-Rate Regime 3/50

5 12.1) The Mundell-Fleming Model The LM* Curve: Money Market eq m The LM* curve is drawn for a given value of r*. M P = L( r*, Y ) e LM* is vertical because: given r*, there is only one value of Y that equates money demand with supply, regardless of e. Y Chapter 12: The Mundell-Fleming Model and the Exchange-Rate Regime 4/50

6 12.1) The Mundell-Fleming Model 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 equilibrium level of income IS* Y Chapter 12: The Mundell-Fleming Model and the Exchange-Rate Regime 5/50

7 Learning Objectives This chapter introduces you to understanding: The Mundell-Fleming model The small open economy under floating and fixed exchange rates Interest rate differentials Arguments for fixed vs. floating exchange rates Deriving the aggregate demand curve Chapter 12: The Mundell-Fleming Model and the Exchange-Rate Regime 6/50

8 12.2) Floating & Fixed Exch. Rates Introduction 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 Mundell-Fleming Model and the Exchange-Rate Regime 7/50

9 12.2) Floating & Fixed Exch. Rates Fiscal Policy under Floating Exch. Rs Y = C( Y T) + I( r* ) + G + NX( e) M P = L( r*, Y ) At any given value of e, a fiscal expansion increases Y, shifting IS* to the right. Results: e > 0, Y = 0 e 2 e 1 e * LM1 Y 1 IS * IS 1 * 2 Y Chapter 12: The Mundell-Fleming Model and the Exchange-Rate Regime 8/50

10 12.2) Floating & Fixed Exch. Rates 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 Mundell-Fleming Model and the Exchange-Rate Regime 9/50

11 12.2) Floating & Fixed Exch. Rates Monetary Policy under Floating Exch. Rs Y = C( Y T) + I( r* ) + G + NX( e) M P = L( r*, Y ) An increase in M shifts LM* right because Y must rise to restore eq m in the money market. Results: e < 0, Y > 0 e 1 e 2 e * * LM1 LM 2 Y 1 Y 2 * IS 1 Y Chapter 12: The Mundell-Fleming Model and the Exchange-Rate Regime 10/50

12 12.2) Floating & Fixed Exch. Rates Lessons about Monetary 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 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 12: The Mundell-Fleming Model and the Exchange-Rate Regime 11/50

13 12.2) Floating & Fixed Exch. Rates Trade Policy under Floating Exch. Rs Y = C( Y T) + I( r* ) + G + NX( e) M P = L( r*, Y ) At any given value of e, a tariff or quota reduces imports, increases NX, and shifts IS* to the right. Results: e > 0, Y = 0 e 2 e 1 e * LM1 Y 1 IS * IS 1 * 2 Y Chapter 12: The Mundell-Fleming Model and the Exchange-Rate Regime 12/50

14 12.2) Floating & Fixed Exch. Rates 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 Mundell-Fleming Model and the Exchange-Rate Regime 13/50

15 12.2) Floating & Fixed Exch. Rates Lessons about Trade Policy (ctd.) 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 Mundell-Fleming Model and the Exchange-Rate Regime 14/50

16 12.2) Floating & Fixed Exch. Rates 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 Mundell-Fleming Model and the Exchange-Rate Regime 15/50

17 12.2) Floating & Fixed Exch. Rates Fiscal Policy under Fixed Exch. Rs Under floating rates, rates, a fiscal policy expansion is ineffective e * would raise e. LM1 LM 2 at changing output. To Under keep fixed e from rates, rising, the fiscal central policy bank is very must sell effective domestic at changing currency, which output. increases M and shifts LM* right. Results: e = 0, Y > 0 e 1 Y 1 Y 2 * IS * 2 * IS 1 Y Chapter 12: The Mundell-Fleming Model and the Exchange-Rate Regime 16/50

18 12.2) Floating & Fixed Exch. Rates Monetary Policy under Fixed Exch. Rs An Under increase floating M rates, would shift monetary LM* right policy and is reduce e. To very prevent effective the at fall in e, the changing central output. bank must buy Under domestic fixed rates, currency, which monetary reduces policy M cannot and shifts be used LM* to back affect left. output. e 1 e LM * 1 LM * 2 Results: e = 0, Y = 0 Y 1 * IS 1 Y Chapter 12: The Mundell-Fleming Model and the Exchange-Rate Regime 17/50

19 12.2) Floating & Fixed Exch. Rates Trade Policy under Fixed Exch. Rs Under A restriction floating on rates, imports puts import upward restrictions pressure on e. do not affect Y or NX. e * LM1 LM To keep e from rising, Under fixed rates, the central bank must import restrictions increase sell domestic Y and currency, NX. which increases M e 1 But, these gains come and shifts LM* right. at the expense of other countries: Results: the policy merely e shifts = 0, demand Y > 0 from Y 1 Y 2 foreign to domestic goods. Chapter 12: The Mundell-Fleming Model and the Exchange-Rate Regime 18/50 * 2 IS * 2 * IS 1 Y

20 12.2) Floating & Fixed Exch. Rates Summary of Policy Effects in M-F Model type of exchange rate regime: floating fixed impact on: Policy Y e NX Y e NX fiscal expansion mon. expansion import restriction Chapter 12: The Mundell-Fleming Model and the Exchange-Rate Regime 19/50

21 Learning Objectives This chapter introduces you to understanding: The Mundell-Fleming model The small open economy under floating and fixed exchange rates Interest rate differentials Arguments for fixed vs. floating exchange rates Deriving the aggregate demand curve Chapter 12: The Mundell-Fleming Model and the Exchange-Rate Regime 20/50

22 12.3) Interest-rate Differentials Reasons for 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 Mundell-Fleming Model and the Exchange-Rate Regime 21/50

23 12.3) Interest-rate Differentials 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 12: The Mundell-Fleming Model and the Exchange-Rate Regime 22/50

24 12.3) Interest-rate Differentials The Effects of an Increase in θ IS* shifts left, because θ r I e LM * 1 LM * 2 LM* shifts right, because θ r (M/P) d, so Y must rise to restore money market eq m. Results: e < 0, Y > 0 e 1 e 2 Y 1 Y 2 IS * IS 2 * 1 Y Chapter 12: The Mundell-Fleming Model and the Exchange-Rate Regime 23/50

25 12.3) Interest-rate Differentials 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 Mundell-Fleming Model and the Exchange-Rate Regime 24/50

26 12.3) Interest-rate Differentials 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 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 12: The Mundell-Fleming Model and the Exchange-Rate Regime 25/50

27 12.3) Interest-rate Differentials CASE STUDY: The Mexican Peso Crisis 35 U.S. Cents per Me exican Peso /10/94 8/29/94 10/18/94 12/7/94 1/26/95 3/17/95 5/6/95 Chapter 12: The Mundell-Fleming Model and the Exchange-Rate Regime 26/50

28 12.3) Interest-rate Differentials CASE STUDY: The Mexican Peso Crisis 35 U.S. Cents per Me exican Peso /10/94 8/29/94 10/18/94 12/7/94 1/26/95 3/17/95 5/6/95 Chapter 12: The Mundell-Fleming Model and the Exchange-Rate Regime 27/50

29 12.3) Interest-rate Differentials The Peso Crisis didn t just Hurt Mexico U.S. goods more expensive to Mexicans U.S. firms lost revenue Hundreds of bankruptcies along U.S.-Mexican border Mexican assets worth less in dollars Reduced wealth of millions of U.S. citizens Chapter 12: The Mundell-Fleming Model and the Exchange-Rate Regime 28/50

30 12.3) Interest-rate Differentials 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. ( r* > 0) Chapter 12: The Mundell-Fleming Model and the Exchange-Rate Regime 29/50

31 12.3) Interest-rate Differentials 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 has adequate reserves of dollars. Did it? Chapter 12: The Mundell-Fleming Model and the Exchange-Rate Regime 30/50

32 12.3) Interest-rate Differentials 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 Mundell-Fleming Model and the Exchange-Rate Regime 31/50

33 12.3) Interest-rate Differentials The Disaster Dec. 20: Mexico devalues the peso by 13% (fixes e at 25 cents instead of 29 cents) Investors are taken by surprise 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 Mundell-Fleming Model and the Exchange-Rate Regime 32/50

34 12.3) Interest-rate Differentials 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 Mundell-Fleming Model and the Exchange-Rate Regime 33/50

35 12.3) Interest-rate Differentials CASE STUDY: The Southeast Asian Crisis Problems in the banking system eroded international confidence in SE Asian economies. Risk premia 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 Mundell-Fleming Model and the Exchange-Rate Regime 34/50

36 12.3) Interest-rate Differentials Data on the SE Asian Crisis exchange rate % change from 7/97 to 1/98 stock market % change from 7/97 to 1/98 nominal GDP % change 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% Chapter 12: The Mundell-Fleming Model and the Exchange-Rate Regime 35/50

37 Learning Objectives This chapter introduces you to understanding: The Mundell-Fleming model The small open economy under floating and fixed exchange rates Interest rate differentials Arguments for fixed vs. floating exchange rates Deriving the aggregate demand curve Chapter 12: The Mundell-Fleming Model and the Exchange-Rate Regime 36/50

38 12.4) Arguments for Two Exch. Rs 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 Mundell-Fleming Model and the Exchange-Rate Regime 37/50

39 12.4) Arguments for Two Exch. Rs The Impossible Trinity A nation cannot have free capital flows, independent monetary policy, and a fixed exchange rate simultaneously. A nation must choose one side of this triangle and give up the opposite corner. Independent monetary policy Free capital flows Option 1 Option 2 (U.S.) (Hong Kong) Option 3 (China) Fixed exchange rate Chapter 12: The Mundell-Fleming Model and the Exchange-Rate Regime 38/50

40 12.4) Arguments for Two Exch. Rs CASE: The Chinese Currency Controversy : 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 Mundell-Fleming Model and the Exchange-Rate Regime 39/50

41 12.4) Arguments for Two Exch. Rs CASE: 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 Mundell-Fleming Model and the Exchange-Rate Regime 40/50

42 Learning Objectives This chapter introduces you to understanding: The Mundell-Fleming model The small open economy under floating and fixed exchange rates Interest rate differentials Arguments for fixed vs. floating exchange rates Deriving the aggregate demand curve Chapter 12: The Mundell-Fleming Model and the Exchange-Rate Regime 41/50

43 12.5) Deriving the AD Curve 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 12: The Mundell-Fleming Model and the Exchange-Rate Regime 42/50

44 12.5) Deriving the AD Curve Deriving the AD Curve Why AD curve has negative slope: P (M/P) LM shifts left ε NX Y ε ε 2 ε 1 P P 2 P 1 LM*(P 2 ) LM*(P 1 ) Y 2 Y 1 Y 2 Y 1 IS* Y AD Y Chapter 12: The Mundell-Fleming Model and the Exchange-Rate Regime 43/50

45 12.5) Deriving the AD Curve From the Short Run to the Long Run If Y < Y, 1 then there is downward pressure on prices. Over time, P will move down, causing (M/P ) ε NX Y ε ε 1 ε 2 LM*(P 1 ) LM*(P 2 ) Chapter 12: The Mundell-Fleming Model and the Exchange-Rate Regime 44/50 P Y1 IS* P 1 SRAS 1 Y 1 Y LRAS P 2 SRAS 2 Y Y AD Y

46 12.5) Deriving the AD Curve 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, M > 0 r I (though not as much) Like in a small open economy, M > 0 ε NX (though not as much) Chapter 12: The Mundell-Fleming Model and the Exchange-Rate Regime 45/50

47 Economic Text: The time bomb at the heart o Europe 1.Summarize the text in a few sentences. 2.What are the weaknesses of the French economy? 3. What makes it difficult for the French government to implement necessary reforms though it would have enough political sway? 4. Why is a healthy economy in France so important for the Euro(pean project)? 5. What is meant with the phrase You cannot defy economics for long? Chapter 12: The Mundell-Fleming Model and the Exchange-Rate Regime 46/50

48 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 12: The Mundell-Fleming Model and the Exchange-Rate Regime 47/50

49 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 12: The Mundell-Fleming Model and the Exchange-Rate Regime 48/50

50 Chapter Summary 5.Fixed vs. floating exchange rates Under floating rates, monetary policy is available for can purposes other than maintaining exchange rate stability. Fixed exchange rates reduce some of the uncertainty in international transactions. Chapter 12: The Mundell-Fleming Model and the Exchange-Rate Regime 49/50

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