Chapter 12:

Aggregate Demand

in Open Economy

The Mundell-Fleming Model

Assumption

– Small open economy

– Free capital mobility (r = r*)

– Flexible or fixed foreign exchange rate regime

Flexible Exchange Rate

The IS curve:

Y = C(Y – T) + I(r*) + G + NX(e)

Where e = nominal exchange rate that varies according to

its demand and supply

An increases in e make imports less expensive to

domestic consumer and exports more expensive to foreign

consumer, hence reducing NX

Derivation of IS Curve

Initial equilibrium: Y = E1 with Y1 and e1

Let e increase, NX decreases and E1 falls to E2

New equilibrium: E2 = Y with Y2e1

Line AB is the IS

Derivation of IS Curve

Expenditures

Exchange Rate

Y=E

E1

E2

e2

e1

B

A

IS(e)

Y2 Y1

Income

Y2 Y1

Income

Derivation of LM Curve

M/P = L(r*, Y)

LM is independent of the exchange rate

Shift of LM won’t alter the interest rate because r = r*

Derivation of LM Curve

Interest Rate

Exchange Rate

LM(r*)

LM(e)

r = r*

r

Y

Income

Y

Income

IS-LM Model

Exchange Rate

LM

Aggregate Equilibrium

e

IS

Y

Income

Fiscal Policy

Initial equilibrium: IS1 = LM1 with Y1 and e1

As G increase, IS increases. New equilibrium: IS 2 = LM1

causing Y and e to increase

The rise in e makes NX and Y to fall, offsetting the initial

increase in income

Fiscal Policy

Exchange Rate

LM

Fiscal policy is ineffective

in causing economic growth

e2

e1

IS1

Y

IS2

Income

Monetary Policy

Initial equilibrium: IS1 = LM1 with Y1 and e1

As M increase, LM increases. New equilibrium: IS1 = LM2

causing Y to increase and e to fall

The fall in e makes NX and Y to increase

Monetary Policy

Exchange Rate

LM1 LM2

Monetary policy is effective

in causing economic growth

e1

e2

IS1

Y1

Y2

Income

Trade Protectionism

Initial equilibrium: IS1 = LM1 with Y1 and e1

Let imports decrease, NX and IS decline. New equilibrium:

IS2 = LM1 causing Y and e to increase

The rise in e makes NX and Y to decrease

Trade Protectionism

Exchange Rate

LM

Trade protectionism is ineffective

in causing economic growth

e2

e1

IS1

Y

IS2

Income

Fixed Exchange Rate

Assume: market rate > fixed rate

Arbitrageur buys from the market and sells to the central

bank at the fixed rate and make profits

Money supply and LM increase, causing Y to increase.

The market rate falls to the fixed rate

Fixed Exchange Rate

Exchange Rate

LM1 LM2

em

ef

IS1

Y1

Y2

Income

Fixed Exchange Rate

Assume: market rate < fixed rate

Arbitrageur buys from the central bank market and sells to

the market at the fixed rate to make profits

Money supply and LM decrease, causing Y to fall. The

market rate rises to the fixed rate

Fixed Exchange Rate

Exchange Rate

LM2 LM1

ef

em

IS1

Y2

Y1

Income

Fiscal Policy

Initial equilibrium: IS1 = LM1 with Y1 and e1

As G increase, IS increases, causing e to rise above the

fixed rate.

Exchange rate arbitrage causes Ms and LM to increase, e

falls to the fixed rate

New equilibrium: IS2 = LM2 causing Y to increase

Fixed Exchange Rate

Exchange Rate

LM1 LM2

Fiscal policy is effective

in causing economic growth

em

ef

IS1

Y1

Y2

IS2

Income

Monetary Policy

Initial equilibrium: IS1 = LM1 with Y1 and e1

Let Ms increase, LM increases, causing e to decrease

below the fixed rate.

Exchange rate arbitrage causes Ms and LM to decrease, e

rises to the fixed rate

New equilibrium: IS1 = LM1 causing no increase in Y

Monetary Policy

Exchange Rate

LM1 LM2

Monetary policy is ineffective

in causing economic growth

ef

em

IS1

Y2

Y1

Income

Trade Protectionism

Initial equilibrium: IS1 = LM1 with Y1 and e1

As imports increase NX and IS increase, causing e to

increase above the fixed rate

Exchange rate arbitrage causes Ms and LM to increase,

lowering e to the fixed rate

New equilibrium: IS2 = LM2 causing Y to increase

Trade Protectionism

Exchange Rate

LM1 LM2

Trade protectionism is effective

in causing economic growth

em

ef

IS1

Y1

Y2

IS2

Income

Policy Effectiveness

Policy

Flexible Exchange

Rate

Fixed Exchange

Rate

Fiscal

Monetary

Trade Protectionism

Ineffective

Effective

Ineffective

Effective

Ineffective

Effective

Aggregate Demand

in Open Economy

The Mundell-Fleming Model

Assumption

– Small open economy

– Free capital mobility (r = r*)

– Flexible or fixed foreign exchange rate regime

Flexible Exchange Rate

The IS curve:

Y = C(Y – T) + I(r*) + G + NX(e)

Where e = nominal exchange rate that varies according to

its demand and supply

An increases in e make imports less expensive to

domestic consumer and exports more expensive to foreign

consumer, hence reducing NX

Derivation of IS Curve

Initial equilibrium: Y = E1 with Y1 and e1

Let e increase, NX decreases and E1 falls to E2

New equilibrium: E2 = Y with Y2

Line AB is the IS

Derivation of IS Curve

Expenditures

Exchange Rate

Y=E

E1

E2

e2

e1

B

A

IS(e)

Y2 Y1

Income

Y2 Y1

Income

Derivation of LM Curve

M/P = L(r*, Y)

LM is independent of the exchange rate

Shift of LM won’t alter the interest rate because r = r*

Derivation of LM Curve

Interest Rate

Exchange Rate

LM(r*)

LM(e)

r = r*

r

Y

Income

Y

Income

IS-LM Model

Exchange Rate

LM

Aggregate Equilibrium

e

IS

Y

Income

Fiscal Policy

Initial equilibrium: IS1 = LM1 with Y1 and e1

As G increase, IS increases. New equilibrium: IS 2 = LM1

causing Y and e to increase

The rise in e makes NX and Y to fall, offsetting the initial

increase in income

Fiscal Policy

Exchange Rate

LM

Fiscal policy is ineffective

in causing economic growth

e2

e1

IS1

Y

IS2

Income

Monetary Policy

Initial equilibrium: IS1 = LM1 with Y1 and e1

As M increase, LM increases. New equilibrium: IS1 = LM2

causing Y to increase and e to fall

The fall in e makes NX and Y to increase

Monetary Policy

Exchange Rate

LM1 LM2

Monetary policy is effective

in causing economic growth

e1

e2

IS1

Y1

Y2

Income

Trade Protectionism

Initial equilibrium: IS1 = LM1 with Y1 and e1

Let imports decrease, NX and IS decline. New equilibrium:

IS2 = LM1 causing Y and e to increase

The rise in e makes NX and Y to decrease

Trade Protectionism

Exchange Rate

LM

Trade protectionism is ineffective

in causing economic growth

e2

e1

IS1

Y

IS2

Income

Fixed Exchange Rate

Assume: market rate > fixed rate

Arbitrageur buys from the market and sells to the central

bank at the fixed rate and make profits

Money supply and LM increase, causing Y to increase.

The market rate falls to the fixed rate

Fixed Exchange Rate

Exchange Rate

LM1 LM2

em

ef

IS1

Y1

Y2

Income

Fixed Exchange Rate

Assume: market rate < fixed rate

Arbitrageur buys from the central bank market and sells to

the market at the fixed rate to make profits

Money supply and LM decrease, causing Y to fall. The

market rate rises to the fixed rate

Fixed Exchange Rate

Exchange Rate

LM2 LM1

ef

em

IS1

Y2

Y1

Income

Fiscal Policy

Initial equilibrium: IS1 = LM1 with Y1 and e1

As G increase, IS increases, causing e to rise above the

fixed rate.

Exchange rate arbitrage causes Ms and LM to increase, e

falls to the fixed rate

New equilibrium: IS2 = LM2 causing Y to increase

Fixed Exchange Rate

Exchange Rate

LM1 LM2

Fiscal policy is effective

in causing economic growth

em

ef

IS1

Y1

Y2

IS2

Income

Monetary Policy

Initial equilibrium: IS1 = LM1 with Y1 and e1

Let Ms increase, LM increases, causing e to decrease

below the fixed rate.

Exchange rate arbitrage causes Ms and LM to decrease, e

rises to the fixed rate

New equilibrium: IS1 = LM1 causing no increase in Y

Monetary Policy

Exchange Rate

LM1 LM2

Monetary policy is ineffective

in causing economic growth

ef

em

IS1

Y2

Y1

Income

Trade Protectionism

Initial equilibrium: IS1 = LM1 with Y1 and e1

As imports increase NX and IS increase, causing e to

increase above the fixed rate

Exchange rate arbitrage causes Ms and LM to increase,

lowering e to the fixed rate

New equilibrium: IS2 = LM2 causing Y to increase

Trade Protectionism

Exchange Rate

LM1 LM2

Trade protectionism is effective

in causing economic growth

em

ef

IS1

Y1

Y2

IS2

Income

Policy Effectiveness

Policy

Flexible Exchange

Rate

Fixed Exchange

Rate

Fiscal

Monetary

Trade Protectionism

Ineffective

Effective

Ineffective

Effective

Ineffective

Effective

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