small open economy version
DESCRIPTION
WEEKS 9-10 SUMMARY 0. The Closed Economy IS-LM model 1. The Open Economy IS-LM model (‘Mundell-Fleming’ model) 2. Flexible (floating) exchange rates 3. Using the closed and open IS-LM models CHAPTER 12 The Open Economy RevisitedTRANSCRIPT
slide 1
WEEK 9-10
OPEN ECONOMY IS-LM FRAMEWORK
THE ‘MUNDELL-FLEMING’ MODEL
G. Mankiw Macroeconomics CH12 slides edited and modified by C. Fuller
slide 2CHAPTER 11 Aggregate Demand II
IS- LM MODEL Closed economyversion
IS CURVE
LM CURVE
Goods market
equilibrium
Small open economy version
Money market
equilibriumL(Y, r) = M/P
Income = planned spending
Money supply = money demandL(Y, r) = M/P
Y = C + I + G Y = C + I + G + NX
OVERALL EQUILIBRIUMDetermines Y and national interest rate r
Determines Y and exchange rate Given world interest rate (r*) determines national level of r
MAIN DIFFERENCES
from closed economy case:
r
Y
IS
LM
Y
E
IS*
LM*
slide 3CHAPTER 12 The Open Economy Revisited
WEEKS 9-10 SUMMARY
0. The Closed Economy IS-LM model
1. The Open Economy IS-LM model (‘Mundell-Fleming’ model)
2. Flexible (floating) exchange rates
3. Using the closed and open IS-LM models
slide 4
0.Closed Economy IS-LM model: POLICY
CHAPTER 12 The Open Economy Revisited
r
Y
r
Y
LM
IS
LM
IS
r1r1
Y* Y*
FISCAL POLICY
MONETARY POLICY
Rise in GFall in T
Shift in
ISTo
right
IS’
Predict:Rise in rRise in Y
Y**
r2
Rise in money supply
Shift in
LM
To right
Predict:Fall in r
Rise in Y
LM’
Y**
r0
slide 5CHAPTER 12 The Open Economy Revisited
1.The Mundell-Fleming model:Open Economy IS-LM
Key assumption: Small open economy (SOE) with perfect capital mobility.
r = r* [because SOE forced to accept world 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
We could use E instead of e as prices are fixed anyway.An exam question might have either – won’t make any difference.
slide 6CHAPTER 12 The Open Economy Revisited
The IS* curve: Goods market eq’m
The IS* curve is drawn for a given value of r*.
Intuition for the slope:
Y
e
IS*
( ) ( ) ( )*Y C Y T I r G NX e
e NX Y
slide 7CHAPTER 12 The Open Economy Revisited
The LM* curve: Money market eq’m
The LM* curve 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, regardless of e.
Y
e LM*
( , )*M P L r Y
slide 8CHAPTER 12 The Open Economy Revisited
Equilibrium in the Mundell-Fleming model
Y
e LM*( , )*M P L r Y
IS*
( ) ( ) ( )*Y C Y T I r G NX e
equilibriumexchange
rate
equilibriumlevel ofincome
slide 9CHAPTER 12 The Open Economy Revisited
2. Floating exchange rates
In a system of floating exchange rates, e is allowed to fluctuate in response to changing economic conditions.
WE FOCUS ON THIS
slide 10CHAPTER 12 The Open Economy Revisited
FLOATING EXCHANGE RATES: Fiscal policy
Y
e( , )*M P L r Y
( ) ( ) ( )*Y C Y T I r G NX e
Y1
e1
1*LM
1*IS2*IS
e2 At any given value of e, a fiscal expansion increases Y, shifting IS* to the right.
Results: e goes up, no change in Y
WHY IS FISCAL POLICY INEFFECTIVE?
slide 11CHAPTER 12 The Open Economy Revisited
FLOATING EXCHANGE RATES: Fiscal policy
Y
e( , )*M P L r Y
( ) ( ) ( )*Y C Y T I r G NX e
Y1
e1
1*LM
1*IS2*IS
e2 Results [from last slide]
e goes up, no change inY
WHY does e rise?[1] In CLOSED economy:Fiscal expansion rise in Y , rise in r
[2] butIn SMALL OPEN economy:
A rise of domestic ‘r’ above r*..
...causes HUGE CAPITAL INFLOW [3] Big rise in demand for UK currency
IS
r
Y
LM
IS’
reminder
slide 12CHAPTER 12 The Open Economy Revisited
FLOATING EXCHANGE RATES: Lessons about fiscal policy
In a small open economy with perfect capital mobility, fiscal policy cannot affect Y.
“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.
slide 13CHAPTER 12 The Open Economy Revisited
FLOATING EXCHANGE RATES: Monetary policy
Y
e
e1
Y1
1*LM
1*IS
Y2
2*LM
e2
An increase in M shifts LM* right
Results: e falls, Y goes up
( , )*M P L r Y
( ) ( ) ( )*Y C Y T I r G NX e
WHY IS MONETARY POLICY SO EFFECTIVE?
slide 14CHAPTER 12 The Open Economy Revisited
FLOATING EXCHANGE RATES: Monetary policy
Y
e
e1
Y1
1*LM
1*IS
Y2
2*LM
e2
Results (from last slide) e falls, Y goes up
( , )*M P L r Y
( ) ( ) ( )*Y C Y T I r G NX e
WHY does e fall?
[1] In CLOSED economyRise in M rise in Y, fall in r
[2] BUT
In SMALL OPEN economy..
If domestic ‘r’ falls below r*..
...this causes a HUGE CAPITAL OUTFLOW
[3] Big fall in demand for UK currency
r
Y
LM
ISreminder
slide 15CHAPTER 12 The Open Economy Revisited
FLOATING EXCHANGE RATES: Lessons about monetary policy
Monetary policy is very effective at changing Y
Monetary policy affects output by affecting the components of aggregate demand: closed economy: M r I Ysmall open economy: M e NX Y