MACROECONOMICS. The Open Economy Revisited: the Mundell-Fleming Model and the Exchange-Rate Regime MANKIW. In this chapter, you will learn

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1 C H A P T E R Th Opn Economy Rvisitd: th undll-flming odl and th Exchang-Rat Rgim ACROECONOICS N. GREGOR ANKIW 007 Worth Publishrs, all rights rsrvd SIXTH EDITION PowrPoint Slids by Ron Cronovich In this chaptr, you will larn th undll-flming modl (-L for th small opn conomy) argumnts for fixd vs. floating xchang rats how to driv th aggrgat dmand curv for a small opn conomy CHAPTER Th Opn Economy Rvisitd slid Th undll-flming modl Th curv: Goods markt q m Ky assumption: Small opn conomy with prfct capital mobility. r = r Goods markt quilibrium th curv: = C( " T )+ I(r # )+G + NX() whr = nominal xchang rat = forign currncy pr unit domstic currncy = C( " T )+ I(r # )+G + NX() Th curv is drawn for a givn valu of r. Intuition for th slop:! " # NX " # CHAPTER Th Opn Economy Rvisitd slid CHAPTER Th Opn Economy Rvisitd slid 3 Th L curv: ony markt q m P = L(r ", ) Th L curv is drawn for a givn valu of r. is vrtical bcaus: givn r, thr is only on valu of that quats mony L dmand with supply, rgardlss of. CHAPTER Th Opn Economy Rvisitd slid 4 Equilibrium in th undll-flming modl = C( " T )+ I(r # )+G + NX() P = L(r ", ) quilibrium xchang rat quilibrium lvl of incom CHAPTER Th Opn Economy Rvisitd slid 5 L

2 Floating & fixd xchang rats In a systm of floating xchang rats, is allowd to fluctuat in rspons to changing conomic conditions. In contrast, undr fixd xchang rats, th cntral bank trads domstic for forign currncy at a prdtrmind pric. Nxt, policy analysis first, in a floating xchang rat systm thn, in a fixd xchang rat systm CHAPTER Th Opn Economy Rvisitd slid 6 Fiscal policy undr floating xchang rats = C( " T ) + I(r # ) + G + NX() P = L(r ", ) At any givn valu of, a fiscal xpansion incrass, shifting to th right. Rsults: Δ > 0, Δ = 0 CHAPTER Th Opn Economy Rvisitd slid 7 L Lssons about fiscal policy In a small opn conomy with prfct capital mobility, fiscal policy cannot affct ral GDP. Crowding out closd conomy: Fiscal policy crowds out invstmnt by causing th intrst rat to ris. small opn conomy: Fiscal policy crowds out nt xports by causing th xchang rat to apprciat. ontary policy undr floating xchang rats = C( " T ) + I(r # ) + G + NX() P = L(r",) L L An incras in shifts L right bcaus must ris to rstor q m in th mony markt. Rsults: Δ < 0, Δ > 0 CHAPTER Th Opn Economy Rvisitd slid 8 CHAPTER Th Opn Economy Rvisitd slid 9 Lssons about montary policy ontary policy affcts output by affcting th componnts of aggrgat dmand: closd conomy: r I small opn conomy: NX Expansionary mon. policy dos not rais world agg. dmand, it mrly shifts dmand from forign to domstic products. So, th incrass in domstic incom and mploymnt ar at th xpns of losss abroad. Trad policy undr floating xchang rats = C( " T ) + I(r # ) + G + NX() P = L(r",) L At any givn valu of, a tariff or quota rducs imports, incrass NX, and shifts to th right. Rsults: Δ > 0, Δ = 0 CHAPTER Th Opn Economy Rvisitd slid 0 CHAPTER Th Opn Economy Rvisitd slid

3 Lssons about trad policy Import rstrictions cannot rduc a trad dficit. Evn though NX is unchangd, thr is lss trad: th trad rstriction rducs imports. th xchang rat apprciation rducs xports. Lss trad mans fwr gains from trad. Lssons about trad policy, cont. Import rstrictions on spcific products sav jobs in th domstic industris that produc thos products, but dstroy jobs in xport-producing sctors. Hnc, import rstrictions fail to incras total mploymnt. Also, import rstrictions crat sctoral shifts, which caus frictional unmploymnt. CHAPTER Th Opn Economy Rvisitd slid CHAPTER Th Opn Economy Rvisitd slid 3 Fixd xchang rats Undr fixd xchang rats, th cntral bank stands rady to buy or sll th domstic currncy for forign currncy at a prdtrmind rat. In th undll-flming modl, th cntral bank shifts th L curv as rquird to kp at its prannouncd rat. This systm fixs th nominal xchang rat. In th long run, whn prics ar flxibl, th ral xchang rat can mov vn if th nominal rat is fixd. CHAPTER Th Opn Economy Rvisitd slid 4 Fiscal policy undr fixd xchang rats Undr floating rats, rats, a fiscal policy xpansion is inffctiv would at changing rais. output. To Undr kp fixd from rats, rising, th fiscal cntral policy bank is vry must sll ffctiv domstic at changing currncy, which output. incrass and shifts L right. Rsults: Δ = 0, Δ > 0 CHAPTER Th Opn Economy Rvisitd slid 5 L L ontary policy undr fixd xchang rats An Undr incras floating rats, would shift montary L right policy and isrduc. To vry prvnt ffctiv th fall at in, th changing cntral output. bank must buy Undr domstic fixd rats, currncy, which montary rducs policy and cannot shifts b usd L to back affct lft. output. Rsults: Δ = 0, Δ = 0 L L CHAPTER Th Opn Economy Rvisitd slid 6 Trad policy undr fixd xchang rats Undr floating rats, A rstriction on imports import rstrictions puts upward prssur on. do not affct or NX. Undr To kp fixd from rats, rising, import th cntral rstrictions bank must incras sll domstic and currncy, NX. But, which ths incrass gains com at and th shifts xpns L of right. othr countris: Rsults: th policy mrly shifts dmand from forign to domstic goods. Δ = 0, Δ > 0 CHAPTER Th Opn Economy Rvisitd slid 7 L L 3

4 Summary of policy ffcts in th undll-flming modl Floating vs. fixd xchang rats Policy fiscal xpansion mon. xpansion import rstriction typ of xchang rat rgim: floating fixd impact on: NX NX Argumnt for floating rats: allows montary policy to b usd to pursu othr goals (stabl growth, low inflation). Argumnts for fixd rats: avoids uncrtainty and volatility, making intrnational transactions asir. disciplins montary policy to prvnt xcssiv mony growth & hyprinflation. CHAPTER Th Opn Economy Rvisitd slid 8 CHAPTER Th Opn Economy Rvisitd slid 34 Th Impossibl Trinity A nation cannot hav fr capital flows, indpndnt montary policy, and a fixd xchang rat simultanously. A nation must choos on sid of this triangl and giv up th opposit cornr. Indpndnt montary policy Option (U.S.) Fr capital flows Option 3 (China) Option (Hong Kong) Fixd xchang rat CHAPTER Th Opn Economy Rvisitd slid 35 undll-flming and th AD curv So far in -F modl, P has bn fixd. Nxt: to driv th AD curv, considr th impact of a chang in P in th -F modl. W now writ th -F quations as: = C( " T ) + I(r # ) + G + NX($) P = L(r",) (Earlir in this chaptr, P was fixd, so w could writ NX as a function of instad of ε.) CHAPTER Th Opn Economy Rvisitd slid 38 Driving th AD curv Why AD curv has ngativ slop: P (/P) L shifts lft ε NX ε ε ε P P P L(P ) L(P ) CHAPTER Th Opn Economy Rvisitd slid 39 AD From th short run to th long run If <, thn thr is downward prssur on prics. Ovr tim, P will mov down, causing (/P ) ε NX ε ε ε P L(P ) L(P ) P SRAS CHAPTER Th Opn Economy Rvisitd slid 40 LRAS P SRAS AD 4

5 Larg: Btwn small and closd any countris including th U.S. ar nithr closd nor small opn conomis. A larg opn conomy is btwn th polar cass of closd & small opn. Considr a montary xpansion: Lik in a closd conomy, Δ > 0 r I (though not as much) Lik in a small opn conomy, Δ > 0 ε NX (though not as much) Chaptr Summary. undll-flming modl th -L modl for a small opn conomy. taks P as givn. can show how policis and shocks affct incom and th xchang rat.. Fiscal policy affcts incom undr fixd xchang rats, but not undr floating xchang rats. CHAPTER Th Opn Economy Rvisitd slid 4 CHAPTER Th Opn Economy Rvisitd slid 4 Chaptr Summary 3. ontary policy affcts incom undr floating xchang rats. undr fixd xchang rats, montary policy is not availabl to affct output. 4. Fixd vs. floating xchang rats Undr floating rats, montary policy is availabl for purposs othr than maintaining xchang rat stability. Fixd xchang rats rduc som of th uncrtainty in intrnational transactions. CHAPTER Th Opn Economy Rvisitd slid 43 5