Topic 6 - The Open Economy: The Mundell-Fleming Model and the Exchange-Rate Regime

Question 1

How is the Mundel Fleming model related to the IS-LM model?

Answer 1

• Open economy extension affects both the goods (IS) and the money (LM) markets.
• Both assume fixed price levels and show the causes of short-run fluctuations in aggregate income.
• Key difference: IS-LM is closed and Mundell-Fleming assumes an open economy.

Question 2

What is the key assumption behind the Mundell-Flemming model?

Answer 2

Small open economy with perfect capital mobility

r = r*

Question 3

How do you calculate the Mundell-Flemming model?

Answer 3

Y = C(Y-T) + I(R*) + G + NX(e)

Same as the goods market equilibrium - The IS* Curve

Where:
- e = Nominal Exchange Rate = Foreign currency per unit domestic currency

Question 4

What does the IS* Curve: Goods market equilibrium look like?

Answer 4

SEE GRAPH IN NOTES

Intuition for the slope is that as e decrease = NX up = Y up

Question 5

How do you calculate the LM* Curve: Money Market Equilibrium? And how do you draw it?

Answer 5

M/P = L(r*,Y)

SEE GRAPH IN NOTES

Question 6

What does equilibrium in the Mundell-Flemming Model look like?

Answer 6

SEE GRAPH IN NOTES

Question 7

What happens to e under floating exchange rates and fixed exchange rates?

Answer 7

Floating - e allowed to fluctuate in response to changing economic conditions

Fixed - Central bank trades domestic for foreign currency at a predetermined price

Question 8

How does the equilibrium to the Mundell-Flemming model change as a result of fiscal policy under floaring exchange rates?

Answer 8

At any given value of e, a fiscal expansion increases Y, shifting IS* to the right

Results:
Δe >0, ΔY = 0

SEE GRAPH IN NOTES

Question 9

How does an open economy affect fiscal policy effectiveness?

Answer 9

Under a small open economy with perfect capital mobility, fiscal policy

Question 10

What is Crowding out?

Answer 10

Under a 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.

Question 11

How does the equilibrium to the Mundell-Flemming model change as a result of monetary policy under floaring exchange rates?

Answer 11

An increase in M shifts LM* right because Y must rise to restore equilibrium in the money market

Results:
Δe <0, ΔY >0

SEE GRAPH IN NOTES

Question 12

How does monetary policy affect output in a closed economy and a small open one?

Answer 12

Affects output by affecting components of AD

Closed Economy:
Increase M - Decrease in r - Increase in I - Increase in Y

Small Open Economy:
Increase in M - Decrease in e - Increase in NX - Increase in Y

Expansionary monetary policy does not raise world AD, merely shifts demand from foreign to domestic products

So, increases in domestic income and employment at the expense of losses abroad

Question 13

How does the equilibrium to the Mundell-Flemming model change as a result of trade policy (tariffs and quotas) under floating exchange rates?

Answer 13

At any given value of e, a tariff or quota reduces imports, increase NX and shifts IS* to the right

Results:
Δe> 0, ΔY=0

SEE GRAPH IN NOTES

Question 14

Why is it that import restrictions can’t reduce a trade deficit?

Answer 14

• 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.”
• 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.

Question 15

What do central banks do under a fixed exchange rate?

Answer 15

The central bank stands ready to buy or sell the domestic currency for foreign currency at a predetermined rate.

Question 16

In the Mundell-Fleming model how do banks impose a fixed exchange rate?

Answer 16

, 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.

Question 17

How does the equilibrium to the Mundell-Flemming model change as a result of fiscal policy under fixed exchange rates?

Answer 17

Under floating rates, fiscal expansion would raise e

To keep e from rising, the central bank must sell domestic currency, which increases M and shifts LM* to the right

Results:
Δe= 0, ΔY> 0

Question 18

When is fiscal policy most effective at changing output?

Answer 18

Floating rates - Ineffective

Fixed Rates - Very effective at changing output

Question 19

How does the equilibrium to the Mundell-Flemming model change as a result of monetary policy under fixed exchange rates?

Answer 19

An increase in M would shift LM* right and reduce e

To prevent fall in e, the central bank must buy domestic currency which reduces M and e1 shifts LM* back left

Results:
Δe= 0, ΔY = 0

Question 20

When is Monetary policy most effective at changing output?

Answer 20

Floating rate - Very effective at changing output

Fixed Rates - Monetary policy cannot be used to affect output

Question 21

How does the equilibrium to the Mundell-Flemming model change as a result of trade policy (tariffs and quotas) under fixed exchange rates?

Answer 21

A restriction on imports puts upward pressure on e

To keep e from rising, central bank must sell domestic currency, which increases M and shifts LM* to the right

Results:
Δe= 0, ΔY > 0

Question 22

When is import restrictions most effective at changing Y or NX?

Answer 22

Floating rates - Import restrictions do not affect Y or NX

Fixed Rates - Import restriction increase Y and NX

But these gains come at the expense of other countries: the policy merely shifts demand from foreign goods to domestic goods

Question 23

What is the argument for Floating Rates?

Answer 23

allow monetary policy to be used to pursue other goals (stable growth, low inflation)

Question 24

What is the argument for Fixed Rates?

Answer 24

avoid uncertainty and volatility, making international transactions easier

discipline monetary policy to prevent excessive money growth and hyperinflation

Question 25

What is the impossible trinity?

Answer 25

Free Capital Flows, Independent monetary policy, Fixed exchange rate