International Economics. Unit 3 Macroeconomic Policy in an Open Economy. Mundell-Fleming model

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1 International Economics Unit 3 Macroeconomic Policy in an pen Economy. Mundell-Fleming model 1

2 Previous conclusion The ultimate effects of a devaluation are in large part dependent upon the economic policies that accompany the devaluation. Economic objectives - Internal Balance: - Price stability - Full employment - External Balance: - Equilibrium in the BP Economic policies - Aggregate supply policies - Aggregate demand policies: - Expenditure changing policies. Aim to influence the level of AD - Expenditure switching policies. Aim to influence the composition of AD 2

3 Internal and external equilibrium: the SWAN diagram RER RER Surplus EB E 0 Inflation CA > 0 E 1 Unemployment E 1 IB E 0 Deficit CA < 0 A A 3

4 The Swan diagram 4

5 Mundell-Fleming model (IS-LM-BP model) Aim: Analyze the effectiveness of fiscal and monetary policy Assumptions: - Domestic and foreign prices are constant - Unemployment - International capital mobility Economic relationships (Equations). 5

6 The goods market Exports and Government expenditure are considered to be autonomous 6

7 Derivation of the IS schedule 7

8 The money market M d = M s M t = M t (Y) M sp = M sp (r) M s = D + R (φ =1) D = Domestic asset (bond) holdings of the monetary authorities = Domestic credit R = Foreign asset holdings (Foreign exchange and any other internationally acceptable assets) of the monetary authorities, valued in domestic currency = International reserves M t +M sp = M s 8

9 Derivation of the LM schedule 9

10 The foreign sector BP = CA + K = 0 X is exogenous K = K(r) 10

11 Derivation of the BP schedule 11

12 Figure 4.5 Equilibrium of the model 12

13 Monetary policy (Example of expansionary MP) The Central Bank purchases bonds from the public and injects newly created money. LM to the right Prices of bonds go up Interest rates go down Investment, consumption and income increase BP goes into deficit or the domestic currency depreciates Fiscal policy (Example of expansionary FP) G increases (The government pays for this increase by selling bonds) and this increases income. IS to the right Price of bonds go down Interest rates go up Investment, consumption and income decrease Final result on Y: increases but by less than the increase in G The CA deteriorates and the K improves: BP changes? Exchange rates? As we will see, the exchange rate regime turns out to be crucial to the behaviour of the economy 13

14 No capital mobility and fixed exchange rates r BP + LM r BP + LM LM LM r 0 A C B r C B r 0 A r IS IS IS Y 0 Y Y Y 0 Y Y MP FP 14

15 Imperfect capital mobility and fixed exchanges rates r LM LM BP A=C r 0 r + B IS Y 0 Y Y MP 15

16 Imperfect capital mobility and fixed exchanges rates r r BP r B LM LM BP r C + LM LM r 0 + A C r 0 A B IS IS IS IS Y 0 Y Y Y 0 Y Y FP 16

17 Perfect capital mobility and fixed exchange rates r r LM LM LM LM r 0 A=C + BP r 0 A C + BP IS IS IS Y 0 Y Y Y 0 Y Y MP FP 17

18 Imperfect capital mobility and flexible exchange rates r BP + BP BP + BP LM r LM LM LM LM A C A C B B IS IS IS IS MP Y 0 Y Y Negligible effect on LM Non-negligible effect on LM 18

19 Imperfect capital mobility and flexible exchange rates r BP BP LM r LM B C C B BP BP + A IS IS + A IS IS IS IS Y 0 Y Y FP 19

20 Perfect capital mobility and flexible exchange rates r r LM LM LM A C + r = r * r = r * BP A=C + BP IS IS IS IS Y 0 Y Y Y 0 Y Y MP FP 20

21 Monetary and fiscal policies: Summary effects ER regime Degree of K mobility Monetary Policy Fiscal Policy SR LR SR LR Fixed ER NKM E I E I (Crowding out) IKM E I E E (the more effective the flatter the BP curve) PKM I (totally) E (totally) Floating ER IKM E S increases E S increases E (the more effective the stepper the BP curve) S increases if BP slope>lm slope. S decreases if BP slope<lm slope E PKM E S increases I (totally) S decreases 21

22 The principle of effective market classification: the assignment problem MP E D M S MP E Inflation MP N A Unemp. MP R M S B C IB FP R FP N FP E FP G G 22

23 The assignment problem MP MP C EB MP E M S Deficit MP E M S Deficit MP N A B MP N A B MP R M S Surplus C EB MP R Surplus FP R G FP N FP E G FP FP R G PF N FP E G FP 23

24 The assignment problem MP D MP MP E Deficit Unemp. Deficit Inflation MP E MP N EP F MP N J EP MP R Surplus Unemp. Surplus Inflation IB EB MP R IB EB FP R FP N FP E FP FP R FP N FP E FP 24

25 The assignment problem MP EB MP E EP MP N MP R IB J FP R FP N FP E FP 25

26 Limitations of the Mundell-Fleming model 1. Marshall-Lerner condition 2. Interaction of stocks and flows 3. Neglect of long run budget constrains 4. Aggregate supply curve is horizontal 5. Treatment of capital flows 6. Monetary and fiscal policies are not that flexible 7. Exchange rate expectations 26

27 AD-AS model in an open economy AD and fixed exchange rates r LM(P 0 ) LM(P 1 ) r 0 r 1 A B IS(P 1, G 1 ) P Y 0 Y 1 IS(P 1, G 0 ) IS(P 0, G 1 ) IS(P 0, G 0 ) Y P 0 P 1 AD AD Y 0 Y 1 Y 27

28 AS and fixed exchange rates AD-AS model in an open economy w P L S P AS LT AS ST AS ST w P 1 w = P P 1 w P 1 0 P 0 L D L FE L 1 L Y FE Y 1 Y 28

29 ST equilibrium AD-AS model in an open economy P AS ST P * E AD Y * Y 29

30 LT equilibrium AD-AS model in an open economy 30

31 AD-AS model in an open economy Is there an automatic adjustment process? 31

32 AD-AS model in an open economy Can we help the adjustment process? 32

33 AD-AS model in an open economy Effects of a devaluation: short-term and long-term 33

34 AD-AS model in an open economy AD and floating exchange rates 34

35 AD-AS model in an open economy Are demand policies effective? 35

36 LT equilibrium AD-AS model in an open economy 36

37 AD-AS model in an open economy Is there an automatic adjustment process? 37

38 AD-AS model in an open economy Can we help the adjustment process? 38

39 Supply shocks AD-AS model in an open economy 39

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