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 = 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 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 Effect of Political Risk Define r = r*+ Θ where Θ is the risk premium for political instability IS curve: Y = C(Y-T) + I(r*+ Θ) + G + NX(e) LM curve: (M/P) = L(r*+ Θ, Y) Let Θ increase, causing LM to increase and e to decrease Effect of Political Risk An increases in r reduces investment and the IS, but exchange rate depreciation increases NX Reasons for lack of economic growth – Reaction of the central bank to reduce LM in order to offset depreciation – Depreciation causes import prices to rise, reducing NX and Y – People increase the money demand, reducing LM Effect of Political Risk Exchange Rate LM1 LM2 e1 e2 IS2 Y1 Y2 IS1 Income