Global Environment. The Mundell-Fleming Model. Francesco Franco. October 22, Nova SBE. Francesco Franco Global Environment 1/31
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1 Global Environment The Mundell-Fleming Model Francesco Franco Nova SBE October 22, 2014 Francesco Franco Global Environment 1/31
2 Object of study Portugal Francesco Franco Global Environment 2/31 Figure : Portugal since 1995
3 Object of study Germany Francesco Franco Global Environment 3/31 Figure : Germany since 1995
4 The Real Exchange Rate Key relative price for NX We now have several elements to form expectations on exchange rate. We think of the REER as the price that influences domestic versus foreign demand (goods) NX 3 EP ú 4 P, Y d, Yd ú, z where Y d is disposable income and z other elements such as preferences. Francesco Franco Global Environment 4/31
5 The Real Exchange Rate Key relative price for NX the EPú P the EPú P a ects exports, a depreciation increases exports a ects imports, a depreciation decreases volume of imports but increases value of imports today production shifts are important overall we think of a real depreciation a improving the CA (NX). Francesco Franco Global Environment 5/31
6 The Real Exchange Rate Figure : The US real echange rate and current account Francesco Franco Global Environment 6/31
7 Diposable income increase in disposable income worsens the current account An increase in Y d has no e ect on export demand because we are holding foreign income constant and not allowing Y d to a ect it Francesco Franco Global Environment 7/31
8 Putting pieces together Goods markets and exchange rate Remember that the goods market equilibrium is given by supply Y equals demand D Y = D = C + I + G + NX 1 we can conveniently write D = D EP ú P, Y d, Yd 2,whereI ú, G, I, z is a simplification for everything that a ects investment (interest rates, uncertainty,etc) Francesco Franco Global Environment 8/31
9 Putting pieces together Goods markets and exchange rate in the short run P fixed A real depreciation of the home currency raises aggregate demand for home output, other things equal; a real appreciation lowers aggregate demand for home output. A rise in domestic real income raises aggregate demand for home output, other things equal, and a fall in domestic real income lowers aggre- gate demand for home output. Francesco Franco Global Environment 9/31
10 Putting pieces together Output determination in the short run P fixed Figure : Goods market Francesco Franco Global Environment 10/31
11 Putting pieces together Goods markets and exchange rate in the short run P fixed Figure : Goods market Francesco Franco Global Environment 11/31
12 Putting pieces together Goods markets and exchange rate Any rise in the real exchange rate EP*/P (whether due to a rise in E, a rise in P*, or a fall in P) will cause an upward shift in the aggregate demand function and an expansion of output, all else equal. A rise in P*, for example, has e ects qualitatively identical to those of a rise in E. Similarly, any fall in EP*/P, regardless of its cause (a fall in E, a fall in P*, or a rise in P), will cause output to contract, all else equal. They just happen at di erent speed. Francesco Franco Global Environment 12/31
13 Putting pieces together Goods markets and exchange rate the DD schedule, which shows all combinations of output and the exchange rate for which the output market is in short-run equilibrium (aggregate demand = aggregate output). Francesco Franco Global Environment 13/31
14 Putting pieces together Goods markets and exchange rate in the short run P fixed Francesco Franco Figure : Goos market Global and Environment exchange rate 14/31
15 Putting pieces together Goods markets and exchange rate Shifters of DD: A change in G A change in T A change in I A change in P ú /P A shift between foreign and domestic goods/conumption function Francesco Franco Global Environment 15/31
16 Putting pieces together Money versus interest rates In most textbooks the analysis is presented in terms of money management but modern MP is more about interest rates M s = P L(Y, i) 2 i = TR 1Y, Pe P The analysis is similar with a few caveats. Francesco Franco Global Environment 16/31
17 Putting pieces together Money versus interest rates Think of a transitory increase in the money supply: the expectation on the LR exchange rate does not change Think of a permanent increase in the money supply: we expect the price level to increase, namely to have inflation so that the expectation of the exchange rate changes Francesco Franco Global Environment 17/31
18 Putting pieces together Exchange rate and Money: asset market equilibrium in the short run Figure : Francesco Franco Global Environment 18/31
19 Putting pieces together Exchange rate and Money: asset market equilibrium in the short run For asset markets to remain in equilibrium, a rise in domestic output must be accompanied by an appreciation of the domestic currency, all else equal, and a fall in domestic output must be accompanied by a depreciation. Francesco Franco Global Environment 19/31
20 Putting pieces together Exchange rate and Money: asset market equilibrium in the short run Figure : The Asset market an exchange rate Francesco Franco Global Environment 20/31
21 Putting pieces together Exchange rate an Money: asset market equilibrium Shifters of the AA: A change in M s A change in P A change in E e A change in i ú A change in L Francesco Franco Global Environment 21/31
22 Short run equilibrium in open economy Self equilibrating forces Exchange rate, E E 2 2 DD E 3 3 E 1 1 AA Y 1 Output, Y Figure : Short run equilibrium in open economy Francesco Franco Global Environment 22/31
23 Short run equilibrium in open economy Temporary changes Figure : Short run equilibrium in open economy: monetary policy Francesco Franco Global Environment 23/31
24 Short run equilibrium in open economy Temporary changes Figure : Short run equilibrium in open economy: fiscal policy Francesco Franco Global Environment 24/31
25 Short run equilibrium in open economy Permanent changes Now the Medium run - Long run is important, namely the tendency to return to full employment Y f The notion of full employment: full utilization of productive capacity Deviations in the short run, deviations produce prices pressions and adjsutment to long term Francesco Franco Global Environment 25/31
26 Short run equilibrium in open economy Permanent changes Figure : Short run equilibrium in open economy: permanent monetary policy Francesco Franco Global Environment 26/31
27 Long run equilibrium in open economy Permanent changes Figure : Long run equilibrium in open economy: permanent monetary policy Francesco Franco Global Environment 27/31
28 Long run equilibrium in open economy Permanent changes Figure : Long run equilibrium in open economy: permanent fiscal policy Francesco Franco Global Environment 28/31
29 Equilibrium in open economy Current account Figure : Current account Francesco Franco Global Environment 29/31
30 Equilibrium in open economy Liquidity trap Figure : Liquidity trap Francesco Franco Global Environment 30/31
31 Readings **Krugman, Obstfeld and Melitz, chapter 17 Francesco Franco Global Environment 31/31
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