Chapter 12:  Aggregate Demand in the Open Economy

 

The Mundell-Fleming Model may be used to understand the influence of monetary and fiscal policies on aggregate income in an open economy.

         

A.  Assumptions of the model

1.     The price level is fixed.

2.     Exchange  rates are allowed to float by the Central Bank in response to changing economic conditions, or

3.     The Central Bank operates in exchange markets to keep exchange rates fixed.

 

B.    Components of the model

 

          Y = C(Y-T) + I(r ) + G + NX(e)                   IS curve

          M/P = L(r,Y)                                               LM curve

          r = r*

 

          Note:

1.     NX (net exports) depends upon the real exchange rate which changes the same amount as nominal exchange rates change since relative price levels do not change. (See handout)

2.     The demand for money depends upon income and the interest rate determined in international markets.

3.     International transactions for the country are so small that it can borrow or lend as much as it wants without affecting the world interest rate, r* (determined in worldwide financial markets.)

 

 

Text Box: eo

       Yo
 

Y
 

   e
 

 LM
 

IS
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

C.    Graphical Representation of Model:    

 

1.     Holding interest rates constant at the world level, r*, allows us to graph the IS and LM curves with only two endogeneous variables, e and Y.  The demand for money only depends upon the level of income and is fixed for a given real money supply.  The IS curve is inversely related to the real exchange rate because a higher value of the dollar reduces exports and increases imports.

2.     The equilibrium level of income, Ye, is the point on the Keynesian Cross diagram that combines a net export schedule with the previous components of spending in the domestic economy, C + I + G.

3.     We can now use this diagram for the Mundell-Fleming model to show how aggregate income and the exchange rate, e, respond to changes in policy.

 

D.   The Small Open Economy Under Floating Exchange Rates

 

 The impact of policies in an open economy depends upon the international monetary system chosen.  We will begin by choosing a system of floating exchange rates that adjust freely to changing economic conditions.

 

1.     Fiscal Policy impact of an increase in government spending or lower taxes to stimulate domestic spending.

a.      This will shift the IS* function to the right but it will only increase the exchange rate and have no impact on income or output.

b.     The higher budget deficit reduces domestic savings resulting in net foreign investment (borrowing from abroad).  This bids up the value of the dollar.

c.      Eventually, the higher exchange rate reduces net exports exactly enough to offset the expansionary impact of fiscal policy.

 

2.     Monetary Policy influences income in an open economy but the transmission mechanism is different than in a closed economy.  Suppose the domestic money supply is increased.

 

a.      This will shift the LM* function to the right increasing income and lowering the exchange rate.

b.     Recall that in a closed domestic economy more money lowered the interest rate and stimulated investment to generate multiplier effects on income.

c.      In a small open economy more money that puts downward pressure on domestic interest rates will result in portfolio managers seeking a higher return elsewhere.  The capital outflow prevents the interest rate from falling and it causes the exchange rate to depreciate.

d.     A lower exchange rate increases net exports by making domestic goods less expensive relative to foreign goods resulting in higher domestic income.

 

3.     Trade Policy attempts to reduce the demand for foreign goods b imposing an import quota or tariff.

 

a.      An increase in net exports shifts the IS* function to the right. 

b.     Without new money the exchange rate will increase but there will be no impact on income. 

c.      The shift in the NX schedule (exogenous effect) is just offset by a movement back along the NX schedule at higher exchange rates (endogenous effect) with no net change in NX.

 

E.    The Small Open Economy Under Fixed Exchange Rates

 

·        Under fixed exchange rates the Central Bank stands ready to buy or sell their domestic currency for foreign currency at a predetermined price. 

·        Under this commitment, the central bank allows the money supply to adjust to whatever level will ensure that the equilibrium exchange rate equals the announced exchange rate.

·        The LM* curve will shift for any change in the IS* curve in order to maintain the fixed level.  Any deviation from this level will result in market transactions (arbitrage by portfolio managers) until this exchange rate is met.

 

1.     Fiscal Policy that shifts the IS* curve to the right will result in the central bank increasing the money supply, shifting the LM* curve to the right resulting in higher income and output.

2.     Monetary Policy that attempts to shift the LM* curve to the right