CH-13 The Open Economy Revisited: The Mundell–Fleming Model and the Exchange-Rate Regime – Macroeconomics : Book Guide

Answers to Textbook Questions and Problems CHAPTER 13 The Open Economy Revisited: The Mundell–Fleming Model and the Exchange-Rate Regime Questions for Review 1. In the Mundell–Fleming model, an increase in taxes shifts the IS* curve to the left. If the exchange rate floats freely, then the LM* curve is unaffected. As shown in Figure 13-1, the exchange rate falls while aggregate income remains unchanged. The fall in the exchange rate causes the trade balance to increase. Now suppose there are fixed exchange rates. When the IS* curve shifts to the left in Figure 13-2, the money supply has to fall to keep the exchange rate constant, shifting the LM* curve from LM*1 to LM*2. As shown in the figure, output falls while the exchange rate remains fixed. Net exports can only change if the exchange rate changes or the net exports schedule shifts. Neither occurs here, so net exports do not change. We conclude that in an open economy, fiscal policy is effective at influencing output under fixed exchange rates but ineffective under floating exchange rates. 2. In the Mundell–Fleming model with floating exchange rates, a reduction in the money supply reduces real balances M/P, causing the LM* curve to shift to the left. As shown in Figure 13-3, this leads to a new equilibrium with lower income and a higher exchange rate. The increase in the exchange rate reduces the trade balance. If exchange rates are fixed, then the upward pressure on the exchange rate forces the Fed to sell dollars and buy foreign exchange. This increases the money supply M and shifts the LM* curve back to the right until it reaches LM*1 again, as shown in Figure 13-4. In equilibrium, income, the exchange rate, and the trade balance are unchanged. We conclude that in an open economy, monetary policy is effective at influencing output under floating exchange rates but impossible under fixed exchange rates. 3. In the Mundell–Fleming model under floating exchange rates, removing a quota on imported cars shifts the net exports schedule inward, as shown in Figure 13-5. As in the figure, for any given exchange rate, such as e, net exports fall. This is because it now becomes possible for Americans to buy more Toyotas, Volkswagens, and other foreign cars than they could when there was a quota. This inward shift in the net-exports schedule causes the IS* schedule to shift inward as well, as shown in Figure 13-6. The exchange rate falls while income remains unchanged. The trade balance is also unchanged. The decline in net exports caused by the removal of the quota is exactly offset by the increase in net exports caused by the decline in the value of the exchange rate such that total income Y remains at the same level. If there are fixed exchange rates, then the shift in the IS* curve puts downward pressure on the exchange rate, as above. In order to keep the exchange rate fixed, the Fed is forced to buy dollars and sell foreign exchange. This shifts the LM* curve to the left, as shown in Figure 13-7. In equilibrium, income is lower and the exchange rate is unchanged. The fall in income is brought about by the fall in the trade balance as the import bill rises because of the removal of the quota. 4. The following table lists some of the advantages and disadvantages of floating vs. fixed exchange rates. Table 13-1 Floating Exchange Rates Advantages: Allows monetary policy to pursue goals other than just exchange-rate stabilization, for example, the stability of prices and employment. Disadvantages: Exchange-rate uncertainty is higher, and this might make international trade more difficult. Fixed Exchange Rates Advantages: Makes international trade easier by reducing exchange rate uncertainty. It disciplines the monetary authority, preventing excessive growth in M. As a monetary rule, it is easy to implement. Disadvantages: Monetary policy cannot be used to pursue policy goals other than maintaining the exchange rate. As a way to discipline the monetary authority, it may lead to greater instability in income and employment. 5. The impossible trinity states that it is impossible for a nation to have free capital flows, a fixed exchange rate, and independent monetary policy all at the same time. In other words, you can only have two of the three at any given point in time. If you want free capital flows and an independent monetary policy, then you cannot also peg the exchange rate. If you want a fixed exchange rate and free capital flows, then you cannot have independent monetary policy. If you want to have independent monetary policy and a fixed exchange rate, then you need to restrict capital flows. Problems and Applications 1. The following three equations describe the Mundell–Fleming model: Y = C(Y – T) + I(r) + G + NX(e) (IS*) M/P = L(r, Y) (LM*) r = r*. In addition, we assume that the price level is fixed in the short run, both at home and abroad. This means that the nominal exchange rate e equals the real exchange rate. a. If consumers decide to spend less and save more, then the IS* curve shifts to the left. Figure 13-8 shows the case of floating exchange rates. Since the money supply does not adjust, the LM* curve does not shift. Since the LM* curve is unchanged, output Y is also unchanged. The exchange rate falls (depreciates), which causes an increase in the trade balance equal to the fall in consumption. Figure 13-9 shows the case of fixed exchange rates. The IS* curve shifts to the left, but the exchange rate cannot fall. Instead, output falls because the central bank has to reduce the money supply in order to maintain the fixed exchange rate. Since the exchange rate does not change, we know that the trade balance does not change either. In essence, the fall in desired spending puts downward pressure on the interest rate and, hence, on the exchange rate. If there are fixed exchange rates, then the central bank buys the domestic currency that investors seek to exchange, and provides foreign currency, shifting LM* to the left. As a result, the exchange rate does not change, so the trade balance does not change. Hence, there is nothing to offset the fall in consumption, and output falls. b. If some consumers decide they prefer stylish Toyotas to Fords and Chryslers, then the net-exports schedule, shown in Figure 13-10, shifts to the left. That is, at any level of the exchange rate, net exports are lower than they were before. This shifts the IS* curve to the left as well, as shown in Figure 13-11 for the case of floating exchange rates. Since the LM* curve is fixed, output does not change, while the exchange rate falls (depreciates). When consumers prefer to buy foreign cars, this will decrease net exports because imports will increase. The resulting decline in the value of the exchange rate will increase net exports because exports are now relatively cheaper, and this offsets the decline in net exports, such that net exports remains unchanged. Figure 13-12 shows the case of fixed exchange rates. The leftward shift in the IS* curve puts downward pressure on the exchange rate. The central bank buys dollars and sells foreign exchange to keep e fixed: this reduces M and shifts the LM* curve to the left. As a result, output falls. The trade balance falls, because for any given level of the exchange rate, more cars are imported, which means the total import bill is now higher while total export earnings are unchanged. As a result, net exports decreases. c. The introduction of ATMs reduces the demand for money. We know that equilibrium in the money market requires that the supply of real balances M/P must equal demand: M/P = L(r*, Y). A fall in money demand means that for unchanged income and interest rates, the right side of this equation falls. Intuitively, the decline in money demand will put downward pressure on the interest rate. This will cause capital outflow until balance is restored because in this model the interest rate will remain equal to the world interest rate. As capital flows out of the economy, the exchange rate will fall. This will increase net exports and output. Figure 13-13 shows the case with floating exchange rates. Income rises, the exchange rate falls (depreciates), and the trade balance rises. Figure 13-14 shows the case of fixed exchange rates. The LM* schedule shifts to the right; as before, this tends to push domestic interest rates down and cause the currency to depreciate. However, the central bank buys dollars and sells foreign currency in order to keep the exchange rate from falling. This reduces the money supply and shifts the LM* schedule back to the left. The LM* curve continues to shift back until the original equilibrium is restored. In the end, income, the exchange rate, and the trade balance are unchanged. 2. a. In the Mundell-Fleming model, a small open economy with perfect capital mobility has an IS* equation given by Y = C(Y – T) + I(r) + G + NX(e). If we substitute in the given information, then we get Y = 50 + 0.75(Y – 200) + 200 – 20r + 200 + 200 – 50 Y = 500 + 0.75Y –20r – 50 We know the interest rate is equal to the world rate of 5 percent, so the IS* equation becomes Y = 1,600 – 200 Equilibrium in the money market requires that the supply of real balances M/P must equal demand: M/P = L(r*, Y). Therefore, the LM* equation is given by 3,000/3 = Y – 40r Y = 1,000 + 40r. b. Given the interest rate is equal to the world rate of 5 percent, equilibrium income Y is equal to 1,200. Once we know equilibrium income, we find the equilibrium exchange rate is 2 from the IS* equation. Substituting the equilibrium exchange rate into the net export function we find net exports are 100. c. If government spending increases by 50, then the IS* equation becomes Y = 50 + 0.75(Y – 200) + 200 – 20r + 250 + 200 – 50 Y = 550 + 0.75Y –20r – 50 We know the interest rate is equal to the world rate of 5 percent, so the IS* equation becomes Y = 1,800 – 200 The LM* curve is unchanged because there is no change in the money supply, price level, or world interest rate. Therefore, equilibrium income remains at 1,200. From the new IS* equation, we find the new equilibrium exchange rate is 3. The exchange rate has appreciated because the increase in government spending will put upward pressure on the interest rate, and this will increase capital inflow and the exchange rate value of the currency. Given the currency has appreciated, net exports will fall to 50. Since income did not change, the increase in government spending is matched by a fall in net exports. Graphically, the IS* curve shifts to the right, as illustrated in Figure 13-15. Figure 13-15 d. If government spending increases by 50, the new IS* equation is Y = 1,800 – 200as derived in part (c) above. If the exchange rate is fixed at a value of 2, then income must increase to a value of 1,400. We know that the LM* equation is given by M/3 = Y – 40r, so substituting in the values for income Y and the world interest rate r*, we find the money supply must increase to 3,600. To prevent the currency from appreciating, the central bank must sell dollars and buy foreign currency. This will shift the LM* curve to the right, as illustrated in Figure 13-16. Figure 13-16 3. The economy is in recession, at point A in Figure 13-17 To increase income, the central bank should increase the money supply, thereby shifting the LM* curve to the right. If only that happened, the economy would move to point B, with a depreciated exchange rate that would stimulate exports and raise the trade balance. To keep the exchange rate from depreciating and the trade balance from rising, the fiscal authorities should cut taxes or increase government spending. That would shift the IS* curve to the right, so that the economy would move to point C. Under the assumption in the chapter that net exports depend only on the exchange rate, this would keep the trade balance from changing. The increase in output and income would, instead, reflect an increase in domestic demand. (Note that without the monetary expansion, a fiscal expansion by itself would lead to a higher exchange rate—so the increase in domestic demand would be offset by a reduction in the trade balance. 4. a. The Mundell–Fleming model takes the world interest rate r* as an exogenous variable. However, there is no reason to expect the world interest rate to be constant. In the closed-economy model of Chapter 3, the equilibrium of saving and investment determines the real interest rate. In an open economy in the long run, the world real interest rate is the rate that equilibrates world saving and world investment demand. Anything that reduces world saving or increases world investment demand increases the world interest rate. In addition, in the short run with fixed prices, anything that increases the worldwide demand for goods or reduces the worldwide supply of money causes the world interest rate to rise. b. Figure 13-18 shows the effect of an increase in the world interest rate under floating exchange rates. Both the IS* and the LM* curves shift. The IS* curve shifts to the left, because the higher interest rate causes investment I(r*) to fall. The LM* curve shifts to the right because the higher interest rate reduces money demand. Intuitively, when the world interest rate rises, capital outflow will increase as the interest rate in the small country adjusts to the new higher level of the world interest rate. The increase in capital outflow causes the exchange rate to fall, causing net exports and hence output to increase, which increases money demand. We see from the figure that output rises and the exchange rate falls (depreciates). Hence, the trade balance increases. c. Figure 13-19 shows the effect of an increase in the world interest rate if exchange rates are fixed. Both the IS* and LM* curves shift. As in part (b), the IS* curve shifts to the left since the higher interest rate causes investment demand to fall. The LM* schedule, however, shifts to the left instead of to the right. This is because the downward pressure on the exchange rate causes the central bank to buy dollars and sell foreign exchange. This reduces the supply of money M and shifts the LM* schedule to the left. The LM* curve must shift all the way back to LM*2 in the figure, where the fixed-exchange-rate line crosses the new IS* curve. In equilibrium, output falls while the exchange rate remains unchanged. Since the exchange rate does not change, neither does the trade balance. 5. a. A depreciation of the currency makes American goods more competitive. This is because a depreciation means that the same price in dollars translates into fewer units of foreign currency. That is, in terms of foreign currency, American goods become cheaper so that foreigners can buy more of them. For example, suppose the exchange rate between yen and dollars falls from 200 yen/dollar to 100 yen/dollar. If an American can of tennis balls costs $2.50, its price in yen falls from 500 yen to 250 yen. This fall in price increases the quantity of American-made tennis balls demanded in Japan. That is, American tennis balls are more competitive. b. Consider first the case of floating exchange rates. We know that the position of the LM* curve determines output. Hence, we know that we want to keep the money supply fixed. As shown in Figure 13-20A, we want to use fiscal policy to shift the IS* curve to the left to cause the exchange rate to fall (depreciate). We can do this by reducing government spending or increasing taxes. Now suppose that the exchange rate is fixed at some level. If we want to increase competitiveness, we need to reduce the exchange rate; that is, we need to fix it at a lower level. The first step is to devalue the dollar, fixing the exchange rate at the desired lower level. This increases net exports and tends to increase output, as shown in Figure 13-20B. We can offset this rise in output with contractionary fiscal policy that shifts the IS* curve to the left, as shown in the figure. 6. In the text, we assumed that net exports depend only on the exchange rate. This is analogous to the usual story in microeconomics in which the demand for any good (in this case, net exports) depends on the price of that good. The “price” of net exports is the exchange rate. However, we also expect that the demand for any good depends on income, and this may be true here as well: as income rises, we want to buy more of all goods, both domestic and imported. Hence, as income rises, imports increase, so net exports fall. Thus, we can write net exports as a function of both the exchange rate and income: NX = NX(e, Y). Figure 13-21 shows the net exports schedule as a function of the exchange rate. As before, the net exports schedule is downward sloping, so an increase in the exchange rate reduces net exports. We have drawn this schedule for a given level of income. If income increases from Y1 to Y2, the net exports schedule shifts inward from NX(Y1) to NX(Y2). a. Figure 13-22 shows the effect of a fiscal expansion under floating exchange rates. The fiscal expansion (an increase in government expenditure or a cut in taxes) shifts the IS* schedule to the right. This increases income (Y) and shifts the net export curve to the left. However, the rise in the exchange rate causes net exports to fall such that it offsets the effect of the rise in income due to the expansionary fiscal policy and returns income to the original level. Figure 13-22 The final result is that income does not change, and the exchange rate appreciates from e1 to e2. Net exports fall because of the appreciation of the currency. Thus, our answer is the same as that given in Table 13–1. b. Figure 13-23 shows the effect of a fiscal expansion under fixed exchange rates. The fiscal expansion shifts the IS* curve to the right, from IS*1 to IS*2. As in part (a), for unchanged real balances, this tends to push the exchange rate up. To prevent this appreciation, however, the central bank intervenes in currency markets, selling dollars and buying foreign exchange. This increases the money supply and shifts the LM* curve to the right, from LM*1 to LM*2. Output rises while the exchange rate remains fixed. Despite the unchanged exchange rate, the higher level of income reduces net exports because the net-exports schedule shifts inward. Thus, our answer differs from the answer in Table 13-1 only in that under fixed exchange rates, a fiscal expansion reduces the trade balance. 7. We want to consider the effects of a tax cut when the LM* curve depends on disposable income instead of income: M/P = L[r, Y – T]. A tax cut now shifts both the IS* and the LM* curves. Figure 13-24 shows the case of floating exchange rates. The IS* curve shifts to the right, from IS*1 to IS*2. The LM* curve shifts to the left, however, from LM*1 to LM*2. We know that real balances M/P are fixed in the short run, while the interest rate is fixed at the level of the world interest rate r*. Disposable income is the only variable that can adjust to bring the money market into equilibrium: hence, the LM* equation determines the level of disposable income. If taxes T fall, then income Y must also fall to keep disposable income fixed. In Figure 13-24, we move from an original equilibrium at point A to a new equilibrium at point B. Income falls by the amount of the tax cut, and the exchange rate appreciates. If there are fixed exchange rates, the IS* curve still shifts to the right; but the initial shift in the LM* curve no longer matters. That is, the upward pressure on the exchange rate causes the central bank to sell dollars and buy foreign exchange; this increases the money supply and shifts the LM* curve to the right, as shown in Figure 13-25. The new equilibrium, at point B, is at the intersection of the new IS* curve, IS*2, and the horizontal line at the level of the fixed exchange rate. There is no difference between this case and the standard case where money demand depends on income. 8. Since people demand money balances in order to buy goods and services, it makes sense to think that the price level that is relevant is the price level of the goods and services they buy. This includes both domestic and foreign goods. But the dollar price of foreign goods depends on the exchange rate. For example, if the dollar rises from 100 yen/dollar to 150 yen/dollar, then a Japanese good that costs 300 yen falls in price from $3 to $2. Hence, we can write the condition for equilibrium in the money market as M/P = L(r, Y), where P = λPd + (1 – λ)Pf /e. a. A higher exchange rate makes foreign goods cheaper. To the extent that people consume foreign goods (a fraction 1 – λ), this lowers the price level P that is relevant for the money market. This lower price level increases the supply of real balances M/P. To keep the money market in equilibrium, we require income to rise to increase money demand as well. Hence, the LM* curve is upward sloping. b. In the standard Mundell–Fleming model, expansionary fiscal policy has no effect on output under floating exchange rates. As shown in Figure 13-26, this is no longer true here. A cut in taxes or an increase in government spending shifts the IS* curve to the right, from IS*1 to IS*2. Since the LM* curve is upward sloping, the result is an increase in output. c. The increase in the risk premium raises the interest rate for this country, lowering money demand at any given exchange rate and thereby shifting the LM* curve to the right. Intuitively, if realmoney balances are fixed, then real-money demand must remain fixed. The decline in money demand caused by the increase in the interest rate must be offset by an increase in money demand caused by an increase in income. The reduction in money demand caused by the increase in the interest rate leads to a higher level of income for any given money supply. The higher interest rate also reduces investment spending at any given exchange rate, shifting the IS* curve to the left. As shown in Figure 13-27, the exchange rate falls and output may either rise or fall depending on the size of the shifts. If money demand is not very sensitive to the interest rate and investment is very sensitive to the interest rate, then IS* will shift by more than LM* and output will decline. Compared to the traditional Mundell–Fleming model, where LM* is vertical, output can fall here, whereas it does not fall in the traditional model but instead always rises. This model gives the more realistic result that both the exchange rate and output are likely to decline when the risk premium rises. 9. a. California is a small open economy, and we assume that it can print dollar bills. Its exchange rate, however, is fixed with the rest of the United States: one dollar can be exchanged for one dollar. b. In the Mundell–Fleming model with fixed exchange rates, California cannot use monetary policy to affect output because this policy is already used to control the exchange rate. Hence, if California wishes to stimulate employment, it should use fiscal policy. c. In the short run, the import prohibition shifts the IS* curve out. This increases demand for Californian goods and puts upward pressure on the exchange rate. To counteract this, the Californian money supply increases, so the LM* curve shifts out as well. The new short-run equilibrium is at point K in Figures 13-28(A) and (B). Assuming that we started with the economy producing at its natural rate, the increase in demand for Californian goods tends to raise their prices. This rise in the price level lowers real money balances, shifting the short-run AS curve upward and the LM* curve inward. Eventually, the Californian economy ends up at point C, with no change in output or the trade balance, but with a higher real exchange rate relative to Washington. d. Unlike Canada, California is part of a large monetary union where each of the 50 states readily accepts each other’s currency. When a country chooses to be part of a monetary union, it is unable to conduct its own independent monetary policy. In the event of a recession, its only option is to use fiscal policy. Since Canada is not part of a monetary union, it has the option of maintaining a floating or fixed exchange rate, and it has the flexibility of using monetary or fiscal policy to influence economic activity. More Problems and Applications to Chapter 13 1. a. Higher taxes shift the IS curve inward. To keep output unchanged, the central bank must increase the money supply, shifting the LM curve to the right. At the new equilibrium (point C in Figure 13-29), the interest rate is lower, the exchange rate has depreciated, and the trade balance has risen. Figure 13-29 b. Restricting the import of foreign cars shifts the NX(e) schedule outward [see panel (C)]. This has no effect on either the IS curve or the LM curve, however, because the CF schedule is unaffected. Hence, output doesn’t change and there is no need for any change in monetary policy. As shown in Figure 13-30, interest rates and the trade balance don’t change, but the exchange rate appreciates. Figure 13-30 2. a. The CF curve becomes flatter because a small change in the interest rate now has a larger effect on capital flows. b. As argued in the text, a flatter CF curve makes the IS curve flatter, as well. c. Figure 13-31 shows the effect of a shift in the LM curve for both a steep and a flat IS curve. It is clear that the flatter the IS curve is, the less effect any change in the money supply has on interest rates. Hence, the Fed has less control over the interest rate when investors are more willing to substitute foreign and domestic assets. d. It is clear from Figure 13-31 that the flatter the IS curve is, the greater effect any change in the money supply has on output. Hence, the Fed has more control over output. 3. a. No. It is impossible to raise investment without affecting income or the exchange rate just by using monetary and fiscal policies. Investment can only be increased through a lower interest rate. Regardless of what policy is used to lower the interest rate (e.g., expansionary monetary policy and contractionary fiscal policy), net foreign investment will decrease, lowering total investment and raising final interest rates. b. Yes. Policymakers can raise investment without affecting income or the exchange rate with a combination of expansionary monetary policy and contractionary fiscal policy, and protection against imports can raise investment without affecting the other variables. Both the monetary expansion and the fiscal contraction would put downward pressure on interest rates and stimulate investment. It is necessary to combine these two policies so that their effects on income exactly offset each other. The lower interest rates will, as in part (a), increase net capital outflow, which will put downward pressure on the exchange rate. The protectionist policies, however, shift the net-exports curve out; this puts countervailing upward pressure on the exchange rate and offsets the effect of the fall in interest rates. Figure 13-32 shows this combination of policies. c. Yes. Policymakers can raise investment without affecting income or the exchange rate through a home monetary expansion and fiscal contraction, combined with a lower foreign interest rate either through a foreign monetary expansion or fiscal contraction. The domestic policy lowers the interest rate, stimulating investment. The foreign policy shifts the CF curve inward. Even with lower interest rates, the quantity of capital outflow would be unchanged and there would be no pressure on the exchange rate. This combination of policies is shown in Figure 13-33. 4. a. Figure 13-34 shows the effect of a fiscal expansion on a large open economy with a fixed exchange rate. The fiscal expansion shifts the IS curve to the right in panel (A), which puts upward pressure on the interest rate. This tends to decrease net capital outflow and cause the exchange rate to appreciate [see panels (B) and (C)]. To avoid this, the central bank intervenes and sells dollars. This keeps the exchange rate from appreciating; it also shifts the LM curve to the right. The new equilibrium, at point C, has an unchanged interest rate and exchange rate, but higher output. This effect is the same as in a small open economy. Figure 13-34 b. A monetary expansion tends to shift the LM curve to the right, lowering the interest rate [panel (A) in Figure 13-35]. This tends to increase net capital outflow and cause the exchange rate to depreciate [see panels (B) and (C)]. To avoid this depreciation, the central bank must buy its currency and sell foreign exchange. This reduces the money supply and shifts the LM curve back to its original position. As in the model of a small open economy, monetary policy is ineffectual under a fixed exchange rate. IN THIS CHAPTER, YOU WILL LEARN: ▪ the Mundell-Fleming model (IS-LM for the small open economy) ▪ causes and effects of interest rate differentials ▪ arguments for fixed vs. floating exchange rates ▪ how to derive the aggregate demand curve for a small open economy The Mundell-Fleming model ▪Key assumption: Small open economy with perfect capital mobility. r = r* ▪Goods market equilibrium—the IS* curve: Y CY T Ir G NXe= ( − +) ( *)+ + ( ) where e = nominal exchange rate = foreign currency per unit domestic currency The IS* curve: goods market equilibrium Y CY T Ir G NXe= ( − +) ( *)+ + ( ) The IS* curve is drawn e for a given value of r*. Intuition for the slope:   e NX Y  The LM* curve: money market equilibrium MP Lr Y= ( *, ) The LM* curve: ▪ is drawn for a given e LM* value of r*. ▪ is vertical because given r*, there is only one value of Y that equates money demand with supply, regardless of e. Equilibrium in the Mundell-Fleming model Y CY T Ir G NXe= ( − +) ( *)+ + ( ) MP Lr Y= ( *, ) Floating & fixed exchange rates ▪ 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: ▪ in a floating exchange rate system ▪ in a fixed exchange rate system Fiscal policy under floating exchange rates Y CY T Ir G NXe= ( − +) ( *)+ + ( ) MP Lr Y= ( *, ) At any given value of e, e2 a fiscal expansion increases Y, e1 shifting IS* to the right. Results: Δe > 0, ΔY = 0Y Y1 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. Monetary policy under floating exchange rates Y CY T Ir G NXe= ( − +) ( *)+ + ( ) MP Lr Y= ( *, ) An increase in M shifts LM* right because Y must rise to restore eq’m in the money market. Results: Δe 0 Lessons about monetary policy ▪ 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. Trade policy under floating exchange rates Y CY T Ir G NXe= ( − +) ( *)+ + ( ) MP Lr Y= ( *, ) At any given value of e, a tariff or quota reduces imports, increases NX, and shifts IS* to the right. Results: Δe > 0, ΔY = 0 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.” Lessons about trade policy, cont. ▪ 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. 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. Fiscal policy under fixed exchange rates Under floating rates, Under floating rates, a fiscal expansion fiscal policy is ineffective would raise at changing output.e. e To keep Under fixed rates,e from rising, the central bank must fiscal policy is very sell domestic currency, effective at changing e1 which increases output. M and shifts LM* right. Results: Y Y1 Y2 Δe = 0, ΔY > 0 Monetary policy under fixed exchange rates An increase Under floating rates, M would shift monetary policy is LM* right and reduce e. Tvery effectiveo prevent the fall in at e, e * * the central bank must changing output. buy domestic currency, Under fixed rates, which reduces monetary policy M and cannot e1 sbe used to affect outputhifts LM* back left. . Results: Δe = 0, ΔY = 0 Y1 Trade policy under fixed exchange rates Under floating rates, import restrictions A res riction on imports do not affect puts upward pressure on Y or NX. e. Under fixed rates,To keep e from rising, import restrictions the central bank must increase Y and NX. sell domestic currency, But, these gains come which increases M e1 at the expense of other and shifts LM* right. countries: the policy merely shifts demand from Results: Y foreign to domestic goods. Δe = 0, ΔY > 0 Y1 Y2 Summary of policy effects in the Mundell-Fleming model type of exchange rate regime: floating fixed impact on: Policy Y e NX Y e NX fiscal expansion 0    0 0 mon. expansion    0 0 0 import restriction 0  0  0  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. Differentials in the M-F model r = r*+ where θ (Greek letter “theta”) is a risk premium, assumed exogenous. Substitute the expression for r into the IS* and LM* equations: Y CY T Ir= ( − +) ( *+ + +) G NXe( ) MP Lr= ( *+,Y) The effects of an increase in θ IS* shifts left, because θ  r  I LM* shifts right, because θ  r  (M/P)d, so Y must rise to restore money market eq’m. Results: Δe 0 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 ). Why income may 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. CASE STUDY: The Mexican peso crisis CASE STUDY: The Mexican peso crisis The Peso crisis didn’t just hurt Mexico ▪ U.S. goods became expensive to Mexicans, so: ▪ U.S. firms lost revenue ▪ Hundreds of bankruptcies along U.S.-Mexican border ▪ Mexican assets lost value (measured in dollars) ▪ Reduced wealth of millions of U.S. citizens 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. (Δr* > 0) Understanding the crisis ▪ These events put downward pressure on the peso. ▪ Mexico’s central bank had repeatedly promised foreign investors 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 have adequate reserves of dollars. Did it? 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.  the disaster  ▪ Dec. 20: Mexico devalues the peso by 13% (fixes e at 25 cents instead of 29 cents) ▪ Investors are SHOCKED! – 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%. 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. CASE STUDY: The Southeast Asian crisis 1997–98 ▪ Problems in the banking system eroded international confidence in SE Asian economies. ▪ Risk premiums 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. Floating vs. fixed exchange rates Argument for floating rates: ▪ allow monetary policy to be used to pursue other goals (stable growth, low inflation). Arguments for fixed rates: ▪ avoid uncertainty and volatility, making international transactions easier. ▪ discipline monetary policy to prevent excessive money growth & hyperinflation. The Impossible Trinity A nation cannot have free capital flows, independent Free capital monetary policy, and a flows fixed exchange rate simultaneously. Option 2 A nation must choose (Hong Kong) one side of this triangle and give up the Independent Fixed opposite monetary Option 3 exchange corner. policy (China) rate CASE STUDY: The Chinese Currency Controversy ▪ 1995–2005: China fixed its exchange rate at 8.28 yuan per dollar and restricted capital flows. ▪ Many observers believed the yuan was significantly undervalued. U.S. producers complained the cheap yuan gave Chinese producers an unfair advantage. ▪ President Bush called on China to let its currency float; others wanted tariffs on Chinese goods. ▪ July 2005: China began to allow gradual changes in the yuan/dollar rate. By June 2013, the yuan had appreciated 35 percent. 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 CY T Ir G NX= ( − +) ( *) + + ( )ε (LM*) MP Lr Y= ( *, ) (Earlier in this chapter, P was fixed, so we could write NX as a function of e instead of ε.) Deriving the AD curve Why AD curve has negative slope: ε2 ε1 P  (M/P)  LM shifts left Y P  ε P2  NX P1  Y From the short run to the long run If Y Y1  , then there is downward pressure on prices. Over time, P will move down, causing (M/P)  ε  NX  Y  Y1 Y Y 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 and small open. ▪ Consider a monetary expansion: ▪ As in a closed economy, M  r  I (though not as much) ▪ As in a small open economy, M  ε  NX (though not as much) 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. 3. Monetary policy: ▪ affects income under floating exchange rates. ▪ under fixed exchange rates 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. 5. Fixed vs. floating exchange rates ▪ Under floating rates, monetary policy is available for purposes other than maintaining exchange rate stability. ▪ Fixed exchange rates reduce some of the uncertainty in international transactions. Solution Manual for Macroeconomics Gregory N. Mankiw 9781464182891, 9781319106058