MACROECONOMICS
Chapter 12
The Open Economy
Revisited: The MundellFleming Model and the
Exchange Rate Regime
1
Robert Mundell
Home Page:
http://www.columbia.edu/~ram15/
1999 Nobel Lecture:
http://www.columbia.edu/~ram15/nobelLecture.html
The Works of R.A. Mundell:
http://www.robertmundell.net/
2
The IS* Curve
NX depends on real exchange rate
but if prices are sticky in the short
run both countries will have fixed prices
and NX will depend on nominal exchange
rate.
Y=C(Y-T)+I(r*)+G+NX(e)
+
-
€/$
The derivation of
IS* curve from
Keynesian Cross
and behavior of
NX.
Observe that IS*
has e instead of r
on the vertical axis.
€/$
3
Small Economies
Smallness means cannot affect price; in
this case, interest rate: r*.
 Perfect mobility implies any deviation from
the r* will instigate capital flows to bring
r=r*.

r>r* => capital inflow => r down.
 r<r* => capital outflow => r up.

4
The LM* Curve
r
M/P
The LM in the upper diagram is derived the
regular way: higher Y shifts money demand
up and with fixed money supply, r has to go up.
But higher r attracts capital inflow and lowers r
back to r*. Capital inflow forces the appreciation
of e and lowering of NX, eliminating the reason
of Y increase. But if money supply were to
increase, then higher Y can be sustained with
constant r.
5
More on LM and LM*
r
r
M/P
r
Y
LM
If r=r*, then the interest rate is determined
outside of the country and given as a
constant. That means we will be at a point
on the LM curve. Y will be the level
corresponding to r*. In the new LM* where
the vertical axis is e, money supply will
determine the level of Y but it can come at
any e: vertical LM*.
r*
IS
Y
e
r* determines Y. If r>r* at the intersection
of IS and LM, capital inflow matches –NX.
The drop in NX shifts IS but it is a movement
along the IS*. Currency appreciates.
IS*
Y
6
Equilibrium Y and e
Under Mundell-Fleming
€/$
7
Fiscal Expansion with Floating FX
Because money supply
is fixed, and income has
to match r* on LM, the
expansionary effect of
fiscal policy is matched
by the contractionary
effect of lower NX as
capital inflow appreciates
the currency.
Refer to slide #6 to see
what is happening to
IS and LM.
8
Fiscal Expansion Under
Floating FX
e
LM*
IS increase raises the interest rate.
Capital inflow into the country.
Currency appreciates.
NX starts to fall until interest rate falls
back to r*.
Y
r
LM
As the IS shifts back because of drop
of NX. But as long as r>r* currency still
appreciates. When IS had shifted all the
way to the original IS, e had risen all the
way to the new intersection of IS* and LM*.
Y
9
Monetary Expansion
Under Floating FX
LM
LM’
r*
Y
e
LM*
LM*’
Y
When r=r* more money
supply in the system will not
affect the real rate of interest.
So Investments will not change. What will make IS* reach a higher Y?
How would you show the effect on IS and LM?
10
Monetary Expansion with
Floating FX
LM
r
Money supply increase will depreciate
the currency and by increasing NX raise
the equilibrium Y.
IS
LM shift lowers the interest rate and
causes capital outflow. This results in
an increase of NX. In the IS-LM
diagram, more NX makes IS increase
until r=r*.
Y
e
LM*
IS*
Y
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Trade Restriction Under Floating
Exchange Rates
Trade restriction is a quota on
imports or tariff on imports. If
the demand for imports is
reduced via trade restriction,
NX will shift to the right.
What happens to Y, r, e, I, C, NX as a result
of the trade restriction that was put to reduce
the trade deficit (or increase the trade surplus)?
12
Trade Restriction Under
Floating FX
LM*
e
Import tariff or quota will restrict imports. NX
goes up and IS shifts right in both ISLM and
IS*LM*.
IS*
Y
Higher r attracts capital inflow and appreciates
the domestic currency. NX falls.
r
LM
IS
Y
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Fixed Exchange Rate
Governs the Money Supply
Equilibrium e is higher
than what the Central
Bank wants it to be:
$1=€1.50 but the Fed
wants it to be $1= €1.
The Fed enters the FX
market and keeps on
buying euros with dollars.
Money supply increases
until the fixed exchange
rate is reached. Of course,
higher demand for euros
appreciates € and
depreciates $.
How easy is this for CB?
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Fixed Exchange Rate
Governs the Money Supply
If the Central Bank wants
to raise the value of the
currency in the FX
market, it will keep
on buying the domestic
currency with foreign
reserves it has. CB is
withdrawing money from
the economy.
If the long run e is the
equilibrium e, what do
you think will happen in
the long run?
How easy is this for CB?
15
Fiscal Expansion Under
Fixed Exchange Rates
Government spending
increases: at each and
every level of e IS* is
larger. IS* shifts right.
But the new IS* forces e
upwards. The Central
Bank, to keep the FX fixed,
has to buy foreign currency
with the domestic currency.
The money supply
increases and LM* shifts
right. Y increases but e
remains constant.
This result holds for any
change that shifts IS* to
the right.
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Fiscal Expansion Under
Fixed FX
LM
r
Fiscal expansion raises the interest rate and
appreciates the currency. However, we are
under fixed exchange rate regime.
IS
In order to bring the currency back, CB will
have to put more currency in the FX
market by buying foreign currency.
Y
e
LM*
Fixed exchange rates require fixed interest
rates. To keep both e and r constant, the
Fed increases the money supply.
IS*
Y
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Monetary Expansion Under
Fixed Exchange Rates
1
2
Increasing money
supply shifts LM* to
the right. Exchange
rate (e) tends to fall to
2. To keep e constant,
CB buys domestic
currency with foreign
reserves it has. The
value of domestic
currency in the FX
market goes back to
the fixed e. In the
process, the CB has
removed domestic
currency from
circulation: money
supply down.
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Monetary Expansion with
Fixed FX
r
LM
Monetary expansion results in lower r
and currency depreciation. To bring the
FX market into the fixed exchange rate,
the central bank has to sell foreign
currency and buy domestic currency.
As the central bank withdraws money
from the economy, interest rate rises
back to the original level, too.
IS
Y
e
LM*
IS*
Y
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Trade Restriction Under
Fixed Exchange Rates
Can you explain why
LM* is shifting to the
right?
Red IS* and Blue LM*
intersects at a higher e
than the fixed e the CB
wants. CB buys foreign
currency with the
domestic currency.
The amount of currency
outstanding increases:
money supply up.
Same as slide # 17.
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During a severe recession (depression) what policy action would be effective to
improve the GDP under floating and fixed FX regimes?
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Monetary Policy is Ineffective
Under Fixed FX Rules

How can a government make monetary
policy effective under fixed exchange rate
regime?

By devaluing the currency and benefiting from
the increase of NX during recessions.
 Northern
European countries during Great
Depression

By revaluing the currency and slowing the
economy during inflationary booms.
 China??
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When r Doesn’t Equal r*
When risk, uncertainty in one country is
higher than the rest, this country will be in
equilibrium at a higher interest rate than
the rest of the world.
 When a country’s currency is expected to
appreciate, the only way capital flow will
stop is if the interest rate is lower than the
rest of the world.

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Increase in the Country
Risk Premium
As the country risk
premium rises, the
local real interest rate
becomes higher than
the world interest rate.
Higher interest rate will
curb some of the
investments, and at
each and every e, IS*
will shift to the left.
Higher interest rate
lowers the demand for
money and forces LM*
to shift right. MAYBE!!
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Increase in the Country
Risk Premium
e
LM*
The top diagram is the same as previous
slide. Higher r reduces IS but increases
LM. In the bottom slide, this should show
as a disequilibrium, since r is on the vertical
axis.
IS*
Y
r
LM
But, wait. Top diagram says e has come
down quite a bit: domestic currency has
depreciated a lot. This should stimulate
NX. It was a movement along the IS*
line at the top diagram but it will be a
shift to the right of IS line at the bottom.
IS
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Y
Increase in the Country
Risk Premium
e
LM*
If risk premium is higher because of
increased uncertainty, instead of lowering
money demand, people might hoard cash.
This would shift LM* left.
IS*
Y
r
But e has come down, so NX must have
increased. This will shift IS to the right in
the bottom diagram.
LM
Likewise, if CB doesn’t want large
depreciation, it might shift LM* left.
IS
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Y
The Impossible Trinity
When a country chooses one of the sides of the triangle, it gives up the opposing
corner. Is it better to live with exchange rate volatility, or to give up independent
monetary policy, or to not participate in the world financial markets?
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Mundell–Fleming as a Theory
of Aggregate Demand
Up until now we dealt with e because in
the short run we can take price levels in
both countries as sticky. In reality, NX
depends on the real exchange rate.
ε=(£/$)(P/P*)
If we want to derive the AD from the M-F
model, we have to change the vertical
axis of IS*LM* to real exchange rate.
When the price level (P) falls, the real
money balances increase, shifting LM*
right. The lower P means the real
exchange rate has fallen as well,
increasing NX along the IS* curve.
r
M/P
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SR (Blue) and LR (Red) Equilibria
in a Small Open Economy
The short run equilibrium takes place at a
recessionary level. High unemployment and
idle capacity forces prices to fall. Lower input
prices increase employment of labor and
capital until the economy is fully employed.
Observe that the vertical axis in IS*-LM* is real
exchange rate. As the domestic price level falls,
so does the real exchange rate [(€/$)(PUS/PEU).
As a result, NX increases along with I because
lower P means lower interest rate (Fisher effect).
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