Lecture Twenty One
The Mundell-Fleming Model Continued
(Economics 100b; Spring 1996)
Professor of Economics J. Bradford DeLong
601 Evans, University of California at Berkeley
Berkeley, CA 94720
(510) 643-4027 phone (510) 642-6615 fax
delong@econ.berkeley.edu
http://www.j-bradford-delong.net
March 15, 1996
Administration
Basic Mundell-Fleming Summary
Mundell-Fleming with a Changing Price Level
The Large Open Economy
Mundell-Fleming in (Y, r) Diagram
Uncovered Interest Parity and Exchange Rate Volatility
Collapse of the European "Exchange Rate Mechanism": increase in
r*
Administration
Makeup exam: Evans 639 between 2:30 and 3:30 p.m. on Friday,
March 15.
Try hard to finish open economy issues by spring break
Begin by running through the topic list for this lecture:
Basic Mundell-Fleming Summary
Y = C(Y-T) + I(r) + G + NX(e)
M/P = L(i, Y)
i = r (from no expected inflation; no shifts in interest rates
expected to mess up the term structure)
r = r* (where r* is the real interest rate "out there" in the world,
set by forces removed from the domestic economy)
Note that the international economy impinges on the model in two
places--in the goods market (with the net exports function) and in
the asset markets (with the interest rate equilibrium condition)
IS*: Y = C(Y-T) + I(r*) + G +NX(e) downward sloping in Y-e space,
with e on the vertical axis, and:
LM*: M/P = L(r*, Y) a vertical curve at equilibrium output.
MF Under Flexible Exchange Rates
A fiscal expansion rates shifts the IS* curve outwards
on the Y-e diagram, producing higher exchange rate, no change in
output, and a fall in the balance of trade.
A monetary expansion causes a fall in the exchange rate, an
increase in output, and an improvement in the balance of trade
A trade policy to restrict imports fails to affect the trade balance,
raises the exchange rate (improving terms of trade), and has no
effect on production or employment.
An increase in the foreign interest rate r* (a) moves the IS* curve
to the left and (b) moves the LM* curve to the right, so lowers the
exchange rate, boosts output, and leads to a rise in the balance of
trade.
MF Under Fixed Exchange Rates
Monetary policy is forced to do whatever is
necessary to make sure that e = e*; you don't have an independent
monetary policy
A fiscal expansion rates shifts the IS* curve outwards on the Y-e
diagram, the money supply has to shift out too to keep the exchange
rate from rising, so higher output (and no change in exchange rate;
and no change in net exports) (unless you want to allow net exports
to depend on total demand as well as on the exchange rate),
A monetary expansion is immediately undone by international currency
traders.
A trade policy to restrict imports shifts the IS* curve out as
well--and since the money supply has to follow, protection is
expansionary and does lead to an increase in the balance of
trade.
An increase in the foreign interest rate r* (a) moves the IS* curve
to the left, so (b) the money stock must fall if the exchange rate is
to be maintained--and so causes recession... There is no effect on
the balance of trade... (Do the collapse of the ERM here).
Mundell-Fleming with a Changing Price Level
Suppose output low relative to potential; then inflation less than
expected (and less than in other countries); hence relative price
level falls (and relative real money stock rises); this price-level
adjustment continues until you are back to potential output (under
floating exchange rates).
Under fixed exchange rates the story is different: if output below
potential, your relative price level and costs fall--and you all of a
sudden find your producers more competitive: NX(e) shifts outward,
and you find the IS* curve shifting out (and the LM* curve shifting
out along with it) because the exchange rate is fixed in
nominal terms--hence shifts in the price level cause changes
in competitiveness and in net exports
The Large Open Economy
As I said last time, best thought of as an average of closed-economy
and small open economy. But Greg has a formal appendix.
Mundell-Fleming in (Y, r) Diagram
Note that the Mundell-Fleming model is, in sense, just our old IS-LM
model with an extra NX(e) term in the IS equation, and an extra
restriction--r=r*--imposed by world capital markets.
So what happens to force r = r*? Suppose that, at current exchange
rates, the IS curve (augmented by NX(e), but note: no *: IS, not IS*)
and the LM curve intersect at r > r*?
U.S. interest rates exceed world interest rates; money flows in;
people bid up the price of U.S. assets--which is the same thing as
the exchange rate rising. And as the exchange rate rises, the IS
curve shifts in and to the left because the trade balance
deteriorates. Equilibrium? When the exchange rate has risen enough to
move IS back far enough that there is no desired short-term
speculative capital inflow. (Distinguish between "speculative" and
"fundamental" capital inflows).
Uncovered Interest Parity and Exchange Rate Volatility
Exchange rates, since the early-1970s breakdown of the Bretton Woods
fixed exchange rate system, have been much more volatile than anyone
had predicted. Why? A bunch of reasons--one that governments were let
loose to pursue independent monetary policies. But here I want to
focus on expectations and exchange rate dynamics.
Begin by noting that so far we have assumed a fixed exchange rate
that sometimes jumps in response to shocks. This seems inconsistent.
Allow for differences in interest rates supported by expected
exchange rate movements:
r - r* = -De
And suppose that we call e* the "long run" value of the exchange
rate, and say that De = (e* - e)
So: r - r* = -(e* - e)
Our LM* curve changes: it becomes: M/P = L(r* + (e - e*), Y)
the higher is the exchange rate e, the higher are domestic interest
rates--and so the LM* curve is upward sloping...
Now let's consider a monetary expansion--something that raises the
real money supply, and lowers domestic interest rates and raises
output. In the long run such a monetary expansion will generate
higher inflation and eventually push the economy back to its long-run
equilibrium position--with the same real money stock, a higher
nominal money stock, a higher price level, and a lower exchange rate.
So e* falls as well as r falling and Y rising in response to a
monetary expansion...
Stare at r-r* = -(e*-e) and convince yourself that a monetary
expansion has to cause a fall in the nominal exchange rate e
today that is greater than the long-run fall in the exchange
rate.
Collapse of the European "Exchange Rate Mechanism": increase in
r*
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