Introducing. CHAPTER TWELVE Aggregate Demand in the Open Economy: The Mundell-Fleming Model LM* Equilibrium exchange rate. IS* Income, Output, Y

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1 CHAPTER TWELVE Aggrgat Dmand in th Opn Economy: Th Mundll-Flming Modl 1 Introducing LM* Equilibrium xchang rat Equilibrium Incom 2 1

2 Start with ths two quations: Assumption 1: Th domstic intrst rat is qual to th world intrst rat (r = r*). Assumption 2: Th pric lvl is xognously fixd sinc th modl is usd to analyz th short run (P). This implis that th nominal xchang rat is proportional to th ral xchang rat. Assumption 3: Th mony supply is also st xognously by th cntral bank (M). Assumption 4: Our LM* curv will b vrtical bcaus th xchang rat dos not ntr into our LM* quation. : Y = C(Y-T) + I(r*) + G + NX() LM*: M/P = L (r*,y) 3 An incras in th xchang rat, lowrs nt xports, which shifts plannd xpnditur downward and lowrs incom. Th curv summarizs ths changs in th goods markt quilibrium. (a) (c) E r (b) Y=E Plannd Expnditur, E = C + I + G + NX NX() Nt Exports, NX 4 2

3 r LM Th LM curv and th world intrst rat togthr dtrmin th lvl of incom. LM* r = r* 5 Th Mundll-Flming Modl Undr Floating Exchang Rats LM* + G, or T +, no Y LM* LM*' + M -, + Y ' Whn incom riss in a small opn conomy, du to th fiscal xpansion, th intrst rat tris to ris but capital inflows from abroad put downward prssur on th intrst rat.this inflow causs an incras in th dmand for th currncy pushing up its valu and thus making domstic goods mor xpnsiv to forignrs (causing a NX). Th NX offsts th xpansionary fiscal policy and th ffct on Y. Whn th incras in th mony supply puts downward prssur on th domstic intrst rat, capital flows out as invstors sk a highr rturn lswhr. Th capital outflow prvnts th intrst rat from falling. Th outflow also causs th xchang rat to dprciat making domstic goods lss xpnsiv rlativ to forign goods, and stimulats NX. Hnc, montary policy influncs th rathr than r. 6 3

4 Th Mundll-Flming Modl Undr Fixd Exchang Rats + G, or T + Y LM* LM*' + Μ Μ no Y LM* ' A fiscal xpansion shifts to th right. To maintain th fixd xchang rat, th Fd must incras th mony supply, thus incrasing LM* to th right. Unlik th cas with flxibl xchang rats, thr is no crowding out ffct on NX du to a highr xchang rat. If th Fd trid to incras th mony supply by buying bonds from th public, that would put downward prssur on th intrst rat. Arbitragrs rspond by slling th domstic currncy to th cntral bank, causing th mony supply and th LM curv to contract to thir initial positions. 7 Fixd vs. Floating Exchang Rat Conclusions Fixd Exchang Rats Fiscal Policy is Powrful. Montary Policy is Powrlss. Hint: (Fixd and Fiscal sound alik). Floating Exchang Rats Fiscal Policy is Powrlss. Montary Policy is Powrful. Hint: (Think of floating mony.) Th Mundll-Flming modl shows that fiscal policy dos not influnc aggrgat incom undr floating xchang rats. A fiscal xpansion causs th currncy to apprciat, rducing nt xports and offstting th usual xpansionary impact on aggrgat dmand. Th Mundll Flming modl shows that montary policy dos not influnc aggrgat incom undr fixd xchang rats. Any attmpt to xpand th mony supply is futil, bcaus th mony supply must adjust to nsur that th xchang rat stays at its announcd lvl. 8 4

5 Policy in th Mundll-Flming Modl: A Summary Th Mundll-Flming modl shows that th ffct of almost any conomic policy on a small opn conomy dpnds on whthr th xchang rat is floating or fixd. Th Mundll-Flming modl shows that th powr of montary and fiscal policy to influnc aggrgat dmand dpnds on th xchang rat rgim. 9 What if th domstic intrst rat wr abov th world intrst rat? Th highr rturn will attract funds from th rst of th world, driving th US intrst rat back down. And, if th intrst rat wr blow th world intrst rat, domstic rsidnts would lnd abroad to arn a highr rturn, driving th domstic intrst rat back up. In th nd, th domstic intrst rat would qual th world intrst rat. 10 5

6 Why dosn t this logic always apply? Thr ar two rasons why intrst rats diffr across countris: 1) Country Risk: whn invstors buy US govrnmnt bonds, or mak loans to US corporations, thy ar fairly confidnt that thy will b rpaid with intrst. By contrast, in som lss dvlopd countris, it is plausibl to far that political uphaval may lad to a dfault on loan rpaymnts. Borrowrs in such countris oftn hav to pay highr intrst rats to compnsat lndrs for this risk. 2) Exchang Rat Expctations: suppos that popl xpct th UK pound to fall in valu rlativ to th US dollar. Thn loans mad in pounds will b rpaid in a lss valuabl currncy than loans mad in dollars. To compnsat for th xpctd fall in th UK currncy, th intrst rat in th UK will b highr than th intrst rat in th US. 11 Diffrntials in th Mundll-Flming Modl To incorporat intrst-rat diffrntials into th Mundll-Flming modl, w assum that th intrst rat in our small opn conomy is dtrmind by th world intrst rat plus a risk prmium θ. r = r* + θ Th risk prmium is dtrmind by th prcivd political risk of making loans in a country and th xpctd chang in th nominal xchang rat. W ll tak th risk prmium θ as xognously dtrmind. : Y = C(Y-T) + I(r* + θ) + G + NX() LM*: M/P = L (r* + θ,y) For any givn fiscal policy, montary policy, pric lvl, and risk prmium, ths two quations dtrmin th lvl of incom and xchang rat that quilibrat th goods markt and th mony markt. 12 6

7 RISK PREMIUM Now suppos that political turmoil causs th country s risk prmium θ to ris. Th most dirct ffct is that th domstic intrst rat r riss. Th highr intrst rat has two ffcts: 1. curv shifts to th lft, bcaus th highr intrst rat rducs invstmnt. 2. LM* shifts to th right, bcaus th highr intrst rat rducs th dmand for mony, and this allows a highr lvl of incom for any givn mony supply. Ths two shifts caus incom to ris and thus push down th quilibrium xchang rat on world markts. Th important implication: xpctations of th xchang rat ar partially slf-fulfilling. For xampl, suppos that popl com to bliv that th UK pound will not b valuabl in th futur. Invstors will plac a largr risk prmium on UK pound assts: θ will ris in UK. This xpctation will driv up UK intrst rats and will driv down th valu of th UK pound. Thus, th xpctation that a currncy will los valu in th futur causs it to los valu today. Th nxt slid will dmonstrat th mchanics. 13 An Incras in th Risk Prmium LM* LM*' Is this rally is whr th conomy nds up? In th nxt slid, w ll s that incrass in country risk ar not dsirabl. ' An incras in th risk prmium associatd with a country drivs up its intrst rat. Bcaus th highr intrst rat rducs invstmnt, th curv shifts to th lft. Bcaus it also rducs mony dmand, th LM* curv shifts to th right. Incom riss, and th xchang rat dprciats. 14 7

8 Thr ar thr rasons why, in practic, such a boom in incom dos not occur. 1. First, th cntral bank might want to avoid th larg dprciation of th domstic currncy and, thrfor, may rspond by dcrasing th mony supply M. 2. Scond, th dprciation of th domstic currncy may suddnly incras th pric of importd goods, causing an incras in th ovrall pric lvl P. 3. Third, whn som vnt incras th country risk prmium θ, rsidnts of th country might rspond to th sam vnt by incrasing thir dmand for mony (for any givn incom and intrst rat), bcaus mony is oftn th safst asst availabl. All thr of ths changs would tnd to shift th LM* curv toward th lft, which mitigats th fall in th xchang rat but also tnds to dprss incom. 15 Rcall th two quations of th Mundll-Flming modl: : Y=C(Y-T) + I(r*) + G + NX() LM*: M/P=L (r*,y) LM* LM*' Whn th pric lvl falls th LM* curv shifts to th right. Th quilibrium lvl of incom riss. Th scond graph displays th ngativ rlationship btwn P and Y, which is summarizd by th aggrgat dmand curv. P Incom, Output,Y AD Incom, Output,Y16 8

9 Mundll-Flming Modl Floating xchang rats Fixd xchang rats Dvaluation Rvaluation 17 9