Chapter 12: AD in Open Economy
 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
 The aggregate demand curve for the small open
economy
Ch. 12
AD in Open Economy
slide 0
The MundellMundell-Fleming Model
 Key assumption:
Small open economy with perfect capital mobility.
r = r*
 Goods market equilibrium---the IS* curve:
Y  C (Y  T )  I (r *)  G  NX (e )
where
e = nominal exchange rate
= foreign currency per unit of domestic
currency
Ch. 12
AD in Open Economy
slide 1
The IS* curve
Y  C (Y  T )  I (r *)  G  NX (e )
e
 e   NX   Y
IS*
Y
Ch. 12
AD in Open Economy
slide 2
1
NX(e)
NX(e)
A weaker dollar (low e) increases net exports. In recent months
the trend in NX in the US has reversed (weak $)
Below: x: Euro-USD exchange rate
y: changes in real net exports, 1999-2007
50
40
30
20
10
0
-10 0.8
0.9
1
1.1
1.2
1.3
1.4
-20
-30
-40
-50
Ch. 12
AD in Open Economy
slide 3
The LM* curve
M P  L (r *,Y )
e
LM*
Y
Ch. 12
AD in Open Economy
slide 4
Equilibrium
Y  C (Y  T )  I (r *)  G  NX (e )
M P  L (r *,Y )
e
LM*
IS*
Ch. 12
AD in Open Economy
Y
slide 5
2
Floating & fixed exchange rates
 Floating exchange rates,
e is allowed to fluctuate in response to
changing economic conditions.
 Fixed exchange rates, the central bank
trades domestic for foreign currency at a
predetermined price.
 We now consider fiscal, monetary, and trade
policy: first in a floating exchange rate
system, then in a fixed exchange rate system.
Ch. 12
AD in Open Economy
slide 6
Fiscal policy under flexible e
Y  C (Y  T )  I (r *)  G  NX (e )
M P  L (r *,Y )
e
LM 1*
e2
At any given value of e,
a fiscal expansion
increases demand,
shifting IS* to the right.
Ch. 12
e1
IS 2*
IS 1*
Y1
AD in Open Economy
Y
slide 7
Lessons about fiscal policy
 In a small open economy with perfect capital
mobility, fiscal policy does not affect 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.
Ch. 12
AD in Open Economy
slide 8
3
Mon. policy under flexible e
Y  C (Y  T )  I (r *)  G  NX (e )
M P  L (r *,Y )
e
An increase in M shifts LM*
right because Y must rise to
restore eq’m in the money
market.
LM 1*LM 2*
e1
e2
IS 1*
Y1 Y2
Ch. 12
AD in Open Economy
Y
slide 9
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 shifts demand from
foreign to domestic products.
Thus, the increases in income and employment
at home come at the expense of losses abroad.
Ch. 12
AD in Open Economy
slide 10
Trade policy under floating exchange rates
Y  C (Y  T )  I (r *)  G  NX (e )
M P  L (r *,Y )
e
At any given value of e,
a tariff or quota reduces
imports, increases NX,
and shifts IS* to the right.
LM 1*
e2
e1
IS 2*
IS 1*
Y1
Ch. 12
AD in Open Economy
Y
slide 11
4
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  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.
Import restrictions create “sectoral shifts,” which cause
frictional unemployment.
Ch. 12
AD in Open Economy
slide 12
Fixed exchange rates
 CB stands ready to buy or sell the domestic
currency at a predetermined rate.
 CB 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.
Ch. 12
AD in Open Economy
slide 13
Fiscal policy under fixed e
Under floating rates, a
fiscal expansion would
raise e.
To keep e from rising,
the central bank must
sell domestic currency,
which increases M
and shifts LM* right.
Ch. 12
AD in Open Economy
e
LM 1*LM 2*
e1
IS 2*
IS 1*
Y1 Y2
Y
slide 14
5
Monetary policy under fixed e
An increase in M would shift
LM* right and reduce e.
To prevent the fall in e,
the central bank must
buy domestic currency,
which reduces M and
shifts LM* back left.
e
LM 1*LM 2*
e1
IS 1*
Y
Y1
Ch. 12
AD in Open Economy
slide 15
Trade policy under fixed e
A restriction on imports
puts upward pressure on
e.
To keep e from rising,
the central bank must
sell domestic currency,
which increases M
and shifts LM* right.
e
LM 1*LM 2*
e1
IS 2*
IS 1*
Y
Y1 Y2
Ch. 12
AD in Open Economy
slide 16
Differentials in the MM-F model
r may differ from r*. Why?
country risk: borrowers might default on loan repayments
Lenders require higher r to compensate them for this risk.
expected exchange rate changes:
Ee)<0  borrowers must pay a higher r to compensate
lenders for expected currency depreciation.
r  r * 
where  is a risk premium.
Substitute back into IS* and LM* equations:
Y  C (Y  T )  I (r *   )  G  NX (e )
M P  L (r *   ,Y )
Ch. 12
AD in Open Economy
slide 17
6
The effects of an increase in  (flexible)
IS* shifts left
   r  I
LM* shifts right
   r  (M/P )d,
so Y must rise to restore
e
LM 1*LM 2*
e1
money market eq’m.
e2
Y1 Y2
Ch. 12
IS 1*
IS 2*
Y
AD in Open Economy
slide 18
The effects of an increase in 
 The fall in e: domestic currency less attractive.
 The increase in Y :boost in NX (from the depreciation)
greater than the fall in I (from the rise in r ).
BUT Y could not rise if:
 CB prevents depreciation reducing M (question: what
would happen under fixed e ?)
 Depreciation boosts import prices so to increase the
price level (which would reduce the real money supply)
 Consumers respond to higher riskholding more money.
Ch. 12
AD in Open Economy
slide 19
Floating vs. Fixed Exchange Rates
Argument for floating rates:
 allows monetary policy to be used to pursue other
goals (stable growth, low inflation)
Arguments for fixed rates:
 avoids uncertainty and volatility, making
international transactions easier
 disciplines monetary policy to prevent excessive
money growth & hyperinflation
Ch. 12
AD in Open Economy
slide 20
7
Which system is best?
FIXED
Preferable if shocks come
from the money market
(LM)
FLEXIBLE
Preferable if shocks come
from the goods market (IS)
or from abroad (r*)
Preferable if large importer If prices move slowly, less
of exporter of primary
costly to move e in response
products
to shock that requires
adjustment in the real
exchange rate.
Preferable if borrower from
abroad.
Ch. 12
AD in Open Economy
slide 21
The impossible trinity
Free capital flows +
Independent monetary
policy
USA
Independent monetary
policy + Fixed rates
China
Fixed exchange rate +
Free capital flows
Hong Kong
Ch. 12
AD in Open Economy
slide 22
MundellMundell-Fleming and the AD curve
 Previously, we examined the M-F model with a fixed
price level. To derive the AD curve, consider impact
of a change in P in the M-F model.
 We now write the M-F equations as:
(IS* )
(LM* )
Y  C (Y  T )  I (r *)  G  NX (ε )
M P  L (r *,Y )
(Earlier, we could write NX as a function of e since
e and  move in same direction when P is fixed.)
Ch. 12
AD in Open Economy
slide 23
8
Deriving the AD curve
Why AD curve has
negative slope:
P  (M/P )

IS*
 LM shifts left
 
P
 NX
P2
 Y
Ch. 12
LM*(P2) LM*(P1)
2
1
Y2
Y1
Y2
Y1
Y
P1
AD
Y
AD in Open Economy
slide 24
From the short run to the long run
If Y1  Y ,
then there is
downward pressure on
prices.
Over time, P will
move down, causing
(M/P )

LM*(P1) LM*(P2)
1
2
IS*
P
Y1
Y
LRAS
Y

P1
SRAS1
NX 
P2
SRAS2
Y
AD
Y1
Ch. 12
Y
Y
AD in Open Economy
slide 25
Large: between small and closed
 Many countries - including the U.S. - are neither
closed nor small open economies.
 A large open economy is in between the
polar cases of closed & small open.
 Consider a monetary expansion:
• Like
M
• Like
M
Ch. 12
in a closed economy,
> 0  r  I (though not as much)
in a small open economy,
> 0    NX (though not as much)
AD in Open Economy
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