Macroeconomics IIThe Small Open Economy IS-LM -

Mundell-Fleming Model

Vahagn Jerbashian

Ch. 12 from Mankiw (2010, 2003)

Spring 2019

Where we are and where we are heading to

I Today we will consider the IS-LM model in a small openeconomy setting, Mundell-Fleming model. We will

I see the implications of floating and fixed exchange rateregimes for the effi ciency of policies; and

I introduce the theory of interest rate parity

Mundell-Fleming model/Key assumptions

I Consider a small open economy ⇒ world interest rate r ∗ isexogenous for it

I There is a perfect capital mobility ⇒ the interest rate in smallopen economy r = r ∗

I If r < r∗ ⇒ the lenders would avoid lending in the small openeconomy ⇒ I ↓⇒ r ↑

I Goods market equilibrium, i.e., the IS curve

Y = C (Y − T ) + I (r ∗) + G +NX (e),

I where e is the real exchange rate

I In short run the prices are fixed ⇒ the e is equiv. to nominalexchange rate e (e = eP/P∗)

From goods market equilibrium to IS curve

I Higher e implies lower NX , similar to higher r implies lower I

I e ↑⇒ e ↑ (given P/P∗ = const)⇒ IM ↑ and EX ↓⇒ NX ↓

I To be fully rigorous we have to go to Keynesian cross,however,

I the notions and steps are the same as before

I In short, the IS curve is similar to the one before

I The only difference is that here instead of I the NX changes,and with e instead of r

I Here the IS curve draws the relationship between e and the Y ,which arises in the real economy

I On a graph...

IS curve in small open economy

IS curve:Y = C (Y − T ) + I (r ∗) + G +NX (e)

The IS* curve is drawnfor a given value of r*

Intuition for the slope:e ↑⇒ NX ↓⇒ Y ↓

From money market equilibrium to LM curve

I The LM curve is the similar to the one before

M/P = L (r ∗,Y ) ,

I the differences are (1) r = r∗ = const; and (2) the LM drawsthe relation of Y and e, instead of Y and r

The LM* curve is drawnfor a given value of r*

Intuition for the slope:

It is vertical since, given r ∗,∃!Y that equates (M/P)dwith (M/P)s , regardless of e

Mundell-Fleming model/IS-LM in small open economy

IS* curve: Y = C (Y − T ) + I (r ∗) + G +NX (e)LM* curve: M/P = L (r ∗,Y )

Floating and fixed exchange rate regimes

The government sets the exchange rate regime/system

Floating exchange rate The e is allowed to fluctuate in responseto changing economic conditions

Fixed exchange rate The central bank (commits and) tradesdomestic currency for foreign currencyat a predetermined rate e

I We now consider fiscal, monetary, and trade policy

I First we consider floating exchange rate system, then the fixedexchange rate system

Fiscal policy - Floating ex. rate regime

Consider fiscal expansion, i.e., G ↑∆GI G ↑∆G⇒ higher Y for any e ⇒ IS∗ shifts to the right

I G ↑∆G⇒ e ↑∆e and ∆Y = 0. Intuition behind...

Fiscal policy - Floating ex. rate regime/Intuition

In a small open economy with perfect capital mobility, fiscal policycannot affect the real GDP

I “Crowding out” revisited

I Closed economy: Fiscal policy crowds out investment bycausing the interest rate to rise

I Small open economy: Fiscal policy crowds out net exports bycausing the exchange rate to appreciate

I According to this model ∆G = −∆NX ⇒ ∆Y = 0

Monetary policy - Floating ex. rate regime

Consider monetary expansion, i.e., M ↑∆MI M ↑∆M⇒ higher Y for any e ⇒ LM∗ shifts to the right

I M ↑∆M⇒ e ↓∆e and Y ↑∆Y . Intuition behind...

Monetary policy - Floating ex. rate regime/Intuition

The effect of expansionary monetary policy

I Closed ec.: M ↑∆M⇒ r ↓∆r⇒ I ↑∆I⇒ Y ↑∆YI Small open ec.: M ↑∆M⇒ e ↓∆e⇒ NX ↑∆NX⇒ Y ↑∆Y

I e is the USD/EUR ⇒ if in Spain/EU M ↑∆M⇒ e ↓∆e

I M ↑∆M⇒ the foreign products become more expensive andIM ↓⇒ NX .↑∆NX

I ⇒ M ↑∆M does not increase the world Y , but it decreases theimports in small open economy

I ⇒ M ↑∆M increases the Y in small open economy in expenseof losses abroad

Think and read about trade tariffs yourself

Fixed exchange rate regime - A closer look

I Under a system of fixed exchange rates,

I the country’s central bank (CB) stands ready to buy or sell thedomestic currency for foreign currency at a predetermined rate

I Let the currency of country X be z

I If z becomes more worthy in the market, the arbitrageurs buyz at the rate e from the CB with foreign currency and sell it inthe market ⇒ M ↑ and z looses its value

I ⇒ fixed exchange rate matters for monetary policy (a lot!)

Fixed exchange rate regime - A closer look

I In the context of the Mundell-Fleming model,

I the CB shifts the LM* curve as required to keep e at itspre-announced rate

I This system fixes the nominal exchange rate

I In the long run, when prices are flexible, the real exchange ratee can move even if the nominal rate e is fixed

Fiscal policy - Fixed ex. rate regime

Let the CB’s pre-anounced exchange rate be e1. Consider fiscalexpansion, i.e., G ↑∆G

1. G ↑∆G⇒ higher Y for any e ⇒ IS∗ shifts to the right (as infloating case)

2. IS∗ shifts to the right ⇒ e ↑ and e > e1 ⇒ e.g., market paysmore USD for 1 EUR than CB

3. Arbitrageurs buy USD with EUR in the market sell it to CBfor EUR

I Process continues till e = e1

I M ↑ and LM* shifts to the rightI On a graph...

Fiscal policy - Fixed ex. rate regime/graph

Under floating rates,G ineffective in changing Y

Under fixed rates,G is very effective in changing Y

G ↑∆G⇒ Y ↑∆Y and ∆e = 0

Monetary policy - Fixed ex. rate regime

Let the CB’s pre-anounced exchange rate be e1. Considermonetary expansion, i.e., M ↑∆M

1. M ↑∆M⇒ higher Y for any e ⇒ LM∗ shifts to the right (as infloating case)

2. LM∗ shifts to the right ⇒ e ↓ and e < e1 ⇒ e.g., marketpays less USD for 1 EUR than CB

3. Arbitrageurs buy EUR with USD in the market sell it to CBfor USD

I Process continues till e = e1

I M ↓ and LM* shifts left, back to where it was beforeI On a graph...

Fiscal policy - Fixed ex. rate regime/graph

Under floating rates,M is very effective in changing Y

Under fixed rates,M is ineffective in changing Y

M ↑∆M⇒ ∆Y = ∆e = 0

Floating exchange rate vs. Fixed exchange rate

Summary of effects

Floating exchange rate vs. Fixed exchange rate

Supporting the floating exchange rate

I allows monetary policy to be used to pursue other goals(stable growth, low inflation)

I is more market based

I if negative shock happens, the CB may run out of foreigncurrency reserves under fixed exchange rate regime

Floating exchange rate vs. Fixed exchange rate

Supporting the fixed exchange rate

I can avoid uncertainty and volatility, making internationaltransactions easier

I examples: EURO in EURO area, USD in US, etc

I disciplines monetary policy to prevent excessive money growth& hyperinflation

I changing the level at which the exchange rate is fixed providesscope for monetary policy

I A reduction in the offi cial value of the currency is called adevaluation, and an increase in the value is called a revaluation

Interest rate differentials

So far we have assumed that r = r ∗

I We were applying the law of one price, i.e.,

I if, e.g., r < r∗ ⇒ lenders would prefer lending abroad⇒ r ↑= r∗

There are instances, however, that this logic does not work

Interest rate differentials - 2 reasons

Why r can be different than r ∗

I Country risk

I The risk that the country’s borrowers will default on their loanrepayments because of political or economic turmoil

I Due to country risk the lenders require a higher interest rate tocompensate them for this risk (risk premium)

Interest rate differentials - 2 reasons

Why r can be different than r ∗

I Exchange rate uncertainty

I If a country’s exchange rate is expected to fall, then itsborrowers must pay a higher interest rate to compensatelenders for the expected currency depreciation

I e.g., market expects that EUR will increase relative to USD ⇒loans in EUR will repay more than loans in USD ⇒ r is lowerin Spain/EU in order to compensate the difference

Interest rate differentials - IS*-LM* model

Let r = r ∗ + θ, where θ is the risk premium. The IS*-LM* modelis then

IS∗ : Y = C (Y − T ) + I (r ∗ + θ) + G +NX (e),LM∗ : M/P = L (r ∗ + θ,Y )

Interest rate differentials - IS*-LM* model

Let the interest rate differential increase (i.e., country becomesmore risky or markets expect devaluation of currency)

I θ ↑⇒ r = r ∗ + θ ↑⇒ I ↓⇒ IS∗ shifts to the left and LM∗shifts to the right⇒ e ↓ and Y ↑

I On a graph...

Interest rate differentials - IS*-LM* model/graph

θ ↑⇒

IS∗ shifts to the leftLM∗ shifts to the right⇒e ↓ and Y ↑

More intuition...

Interest rate differentials - IS*-LM* model/intuition

I The fall in e is intuitive

I An increase in country risk or an expected depreciation makesholding the country’s currency less attractive

I Note: an expected depreciation is a self-fulfilling prophecy

I The increase in Y occurs because

I the boost in NX (from the depreciation, e ↓) is even greaterthan the fall in I (from r ↑)

I θ ↑⇒ Y ↑ is not intuitive at all. In such cases mainly

I CB tries to reduce the shift in LM by reducing the moneysupply,

I Fixed ex. rate: CB has to buy its currency

I Consumers start holding more money, etc

From small open economy IS*-LM* to AD

Consider the case when the price level P∗ in the small openeconomy decreases

I remember that given that price level is fixed we have replacede with e, reverse that

I let P and P∗ ↑⇒ IS∗ remains the same and LM∗ shifts to theleft ⇒ Y ↓

I On a graph...

From small open economy IS*-LM* to AD/graph

Slope of AD is negative since

P ↑⇒ (M/P) ↓⇒

LM∗ shifts to the left⇒

e ↑⇒ NX ↓⇒ Y ↓

The transition from short run to long run is similar to what we hadfor closed economy IS*-LM*

General discussion/Mundell-Fleming modelWhere we are and where we are heading toMundell-Fleming model/Key assumptionsFrom goods market equilibrium to IS curveFrom money market equilibrium to LM curveMundell-Fleming model/IS-LM in small open economy

Exchange rate regimes/Implications for policiesFloating and fixed exchange rate regimesFiscal policy - Floating ex. rate regimeMonetary policy - Floating ex. rate regimeFixed exchange rate regime - A closer look 1-2Fiscal policy - Fixed ex. rate regime

Monetary policy/Fixed vs. Floating/Int. rate differentialsMonetary policy - Fixed ex. rate regimeFloating exchange rate vs. Fixed exchange rate 1-3Interest rate differentialsInterest rate differentials - reasons 1-2Interest rate differentials - IS*-LM* model 1-4

IS*-LM* to ADFrom small open economy IS*-LM* to AD