Aggregate Demand

The Mundell-Fleming Model and the Exchange-Rate Regime.

The Key Assumption: Small Open Economy With Perfect Capital Mobility.

This world interest rate is assumed to be exogenously fixed because the economy is sufficiently small relative to the world economy that it can borrow or lend as much as it wants in world financial markets without affecting the world interest rate.

The Goods Market and the IS* Curve The Mundell–Fleming model describes the market for goods and services much as the IS–LM model does, but it adds a new term for net exports. In particular, the goods market is represented with the following equation: Y = C(Y – T) + I(r) + G + NX(e).

The Money Market and the LM* Curve The Mundell–Fleming model represents the money market with an equation that should be familiar from the IS–LM model: M/P = L(r,Y).

Trade Policy: Suppose that the government reduces the demand for imported goods by imposing an import quota or a tariff.

How a Fixed-Exchange-Rate System Works Under a system of fixed exchange rates, a central bank stands ready to buy or sell the domestic currency for foreign currencies at a predetermined price.

Fiscal Policy: Let’s now examine how economic policies affect a small open economy with a fixed exchange rate. Suppose that the government stimulates domestic spending by increasing government purchases or by cutting taxes.

Monetary Policy: Imagine that a central bank operating with a fixed exchange rate tries to increase the money supply—for example, by buying bonds from the public.

Devaluation and the Recovery From the Great Depression The Great Depression of the 1930s was a global problem. Although events in the United States may have precipitated the downturn, all of the world’s major economies experienced huge declines in production and employment. Yet not all governments responded to this calamity in the same way.

International Financial Crisis: Asia 1997–1998.

What sparked this firestorm? The problem began in the Asian banking systems. For many years, the governments in the Asian nations had been more involved in managing the allocation of resources—in particular, financial resources—than is true in the United States and other developed countries.

The risk premiums for Asian assets rose, causing interest rates to skyrocket and currencies to collapse. International crises of confidence often involve a vicious circle that can amplify the problem. Here is a brief account about what happened in Asia: 1. Problems in the banking system eroded international confidence in these economies. 2. Loss of confidence raised risk premiums and interest rates. 3. Rising interest rates, together with the loss of confidence, depressed the prices of stock and other assets. 4. Falling asset prices reduced the value of collateral being used for bank loans.5. Reduced collateral increased default rates on bank loans. 6. Greater defaults exacerbated problems in the banking system. Now return to step 1 to complete and continue the circle.

Speculative Attacks, Currency Boards, and Dollarization Imagine that you are a central banker of a small country. You and your fellow policymakers decide to fix your currency—let’s call it the peso—against the U.S. dollar. From now on, one peso will sell for one dollar. As we discussed earlier, you now have to stand ready to buy and sell pesos for a dollar each. The money supply will adjust automatically to make the equilibrium exchange rate equal your target. There is, however, one potential problem with this plan: you might run out of dollars.

The Impossible Trinity The analysis of exchange-rate regimes leads to a simple conclusion: you can’t have it all.

Floating exchange rate:. There are advantages to both floating and fixed exchange rates. Floating exchange rates leave monetary policymakers free to pursue objectives other than exchange-rate stability. Fixed exchange rates reduce some of the uncertainty in international business transactions. When deciding on an exchange-rate regime, policymakers are constrained by the fact that it is impossible for a nation to have free capital flows, a fixed exchange rate, and independent monetary policy.

A Short-Run Model of the Large Open Economy.

When analyzing policies in an economy such as that of the United States, we need to combine the closed-economy logic of the IS–LM model and the smallopen-economy logic of the Mundell–Fleming model. This appendix presents a model for the intermediate case of a large open economy.

The three equations of the model are Y = C(Y − T) + I(r) + G + NX(e)

 M/P = L(r,Y)   NX(e) = CF(r)

. Y = C(Y − T) + I(r) + G + CF(r) IS, M/P = L(r,Y) LM.