Ch-4-Open Macroeconomics-Slide Presentation-AAU-2017 (1).pdf

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1. Ch-4: Aggregate Demand in Small Open Economy
In ch-3, we assumed closed economy. However, in
reality, most economies are open, b/s:
oThe export goods and services abroad,
othey import goods and services from abroad, and
othey borrow and lend in world financial markets.
1Reference: N.Gregory Mankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters

2. 4.1: The International Flows of Capital and Goods
The key macroeconomic difference between
open and closed economies is that, in an
open economy:
acountry'sspendinginanygivenyearneednot
equalitsoutputofgoodsandservices.
B/s,acountrycanspendmorethanitproduces
byborrowingfromabroad,oritcanspendless
thanitproducesandlendthedifferenceto
foreigners.
2Reference: N.Gregory Mankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters

3. The International Flows of Capital and Goods.
The Role of Net Exports
oInaclosedeconomy:
alloutputissolddomestically,and
expenditureisdividedintothreecomponents:
i) consumption (C)
ii) investment(I), and
iii) government purchases(G).
oInanopeneconomy:
someoutputissolddomesticallyandsomeisexportedtobesoldabroad,
Expenditureisdividedintofourcomponents:
i) c
d
-consumption of domestic goods and services,
ii) l
d
-investment in domestic goods and services,
iii) G
d
-government purchases of domestic goods and services,
iv) X–export of domestic goods and services
3Reference: N.Gregory Mankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters

4. The International Flows of Capital and Goods
The division of expenditure into these components is
expressed in the identity
Y = c
d
+ I
d
+ c
d
+ X
The sum of the first three terms, C
d
+ I
d
+ C
d
, is
domestic spending on domestic goods & services,
The fourth term, X, is foreign spending on domestic
goods & services.
Note:domesticspendingonallgoods&services=domestic
spendingondomesticgoods&services+domesticspendingonforeign
goods&services,
4Reference: N.Gregory Mankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters

5. The International Flows of Capital and Goods
Hence,totalconsumption(C)equalsconsumptionof
domesticgoods&servicesC
d
plusconsumptionof
foreigngoods&servicesC
f
i.e.C=C
d
+C
f
Totalinvestment(I)equalsinvestmentindomestic
goods&servicesI
d
plusinvestmentinforeigngoods
andservicesI
f,
i.e. I= I
d
+I
f
Total government purchases (G) equals government
purchases of domestic goods and services G
d
plus
government purchases of foreign goods & services G
f
,
i.e. G = G
d
+ G
f
5Reference: N.Gregory Mankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters

6. The International Flows of Capital and Goods…cond.
We substitute these three equations into the
identity above:
Y= ( C-C
f
) + (I -I
f
) + ( G-G
f
) + X
By making some rearrangement, we can
obtain: Y = C + I + G + X-( C
f
+ I
f
+ G
f
)
Thesumofdomesticspendingonforeign
goodsandservices(C
f
+I
f
+G
f
)isexpenditure
onimports(IM),
Wecanthuswritethenationalincome
accountsidentityasY=C+I+G+X-IM.
6Reference: N.Gregory Mankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters

7. The International Flows of Capital and Goods…cond.
Spendingonimportissubtractedfromnationalincome
accountingidentitybecause:
spending on imports is included in total domestic spending (C + I+ G),
and
goods & services imported from abroad are not part of a country's
output.
Hence, net exports is defined as exports minus imports (NX
=X-IM),
Then, the National Accounting Identity becomes
Y = C + I + G + NX
The above equation show that expenditure on domestic output
is the sum of consumption(C), investment(I), government
purchases(G), and net exports(NX).
Hence, NX = Y -(C + l + G)
Net Exports = Output -Domestic Spending.
7Reference: N.Gregory Mankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters

8. The International Flows of Capital and Goods…cond.
Thisequationshowsthatinanopeneconomy,
domesticspendingneednotequaltheoutputof
goodsandservices.
Ifoutputexceedsdomesticspendingi.e.
Y>(C+I+G);,weexportthedifference:net
exportsarepositiveortradesurplus.
Ifoutputfallsshortofdomesticspending,i.e.
Y<(C+I+G),weimportthedifference:net
exportsarenegative,ortradedeficit.
Ifoutputequalsdomesticspending,i.e.
Y=(C+I+G)netexportwillbezero(valueof
exportequalsvalueofimport)orbalancedtrade.
8Reference: N.GregoryMankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters

9. International Capital Flows and the Trade Balance
Inanopeneconomy,asintheclosedeconomy(discussedinCh-3),
financialmarketsandgoodsmarketsarecloselyrelated.
To see the relationship, we must rewrite the national income
accounts identity in terms of saving and investment,
Begin with the identity Y=C+ l + G+ NX,
Subtract C and G from both sides to obtain Y-C –G + NX
But, Y-C -G is national saving S, which equals the sum of private
saving(Y-T-C), and public saving, (T –G), where T stands for taxes.
Therefore,S = I+ NX.
Subtracting Ifrom both sides of the equation, we can write the
national income accounts identity as S-I = NX.
9Reference: N.Gregory Mankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters

10. International Capital Flows and the Trade Balance…cond.
Thisformofthenationalincomeaccountsidentityshowsthat
aneconomy'snetexportsmustalwaysequalthedifferencebetween
itssavinganditsinvestment.
TherighthandsideexpressionisNetExport(NX)alsoknown
astradebalance,tellsushowourtradeingoodsandservices
departsfromthebenchmarkofequalimportsandexports.
The left-hand side of the identity is the difference between
domestic saving and domestic investment, S -1, which we'll call net
capital outflow (net foreign investment)
Net capital outflow equals the amount that domestic residents are
lending abroad minusthe amount that foreigners are lending to us.
10Reference: N.Gregory Mankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters

11. International Capital Flows and the Trade Balance…cond.
If netcapital outflow is positive,
theeconomy'ssavingexceedsitsinvestment,and
itislendingtheexcesstoforeigners.
If the net capital outflow is negative,
theeconomyisexperiencingacapitalinflow:investmentexceeds
saving,and
theeconomyisfinancingthisextrainvestmentbyborrowingfrom
abroad,
Thus,netcapitaloutflowreflectstheinternationalflowoffundsto
financecapitalaccumulation,
The national income accounts identity shows that net capital
outflow always equals the trade balance,
i.e. Net Capital Outflow =Trade Balance
S-1 = NX
11Reference: N.Gregory Mankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters

12. International Capital Flows and the Trade Balance…cond.
If S -I and NX are positive, then:
we have trade surplus,
we are net lenders in world financial markets, and
Our export > our import,
If S-I and NX are negative, then:
we have a trade deficit,
We are net borrowers in world financial markets,
and
Our export < our import
If S -I and NX are exactly zero, then:
wearesaidtohavebalancedtrade
B/svalueofourimports=valueofourexports.
12Reference: N.Gregory Mankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters

13. International Capital Flows and the Trade Balance…cond.
13
Fig 4.1. International Flows of Goods and Capital: Summary
Reference: N.Gregory Mankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters

14. 4.2.Saving and Investment in a Small Open Economy
Capital Mobility and the World Interest Rate
Now let as relax our Ch-3 assumption, which assume that real interest rate
equilibrates saving and investment,
Instead, we allow the economy to run a trade deficit & borrow from other
countries; or to run a trade surplus & lend to other countries,
If the real interest rate does not adjust to equilibrate saving and investmentin this
model, what does determine the real interest rate?
To answer this question, let us consider a simple case of a small open economy
with perfect capital mobility,
By "small" we mean that this economy is a small part of the world market and
thus, by itself, can have only a negligible effect on the world interest rate,
By "perfect capital mobility" we mean that:
residents of the country have full access to world financial markets,
the government does not impede international borrowing or lending.
14Reference: N.Gregory Mankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters

15. Saving and Investment in a Small Open Economy
Becauseofperfectcapitalmobilityassumption,theinterestrateinour
smallopeneconomy(r),mustequaltheworldinterestrate(r*)thereal
interestrateprevailinginworldfinancialmarkets:
r = r*
Residentsofthesmallopeneconomyneedneverborrowatanyinterest
rateabover*,becausetheycanalwaysgetaloanatr*fromabroad,
Similarly,residentsofthiseconomyneedneverlendatanyinterestrate
belowr*becausetheycanalwaysearnr*bylendingabroad,
Thus, the world interest rate determines the interest rate in our small open
economy(hence, it take world interest rate as exogenously given)
The equilibrium of world saving and world investment determines the
world interest rate.
15Reference: N.Gregory Mankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters

16. To build the model of the small open economy, we take the following three assumptions
from chapter-3:
The economy's output Y is fixed by the factors of production and the
production function
i.e.
Consumption (C ) is positively related to disposable income Y –T. We write the consumption function
as : C =C(Y -T)
Investment(I)is negatively related to the real interest rate r. We write the investment function as:
1 = I(r)
These are the three key parts of our model. We can now return to the accounting identity and
write it as:
NX = (Y-C -G)-I
NX= S-I
Substituting the Ch-3 assumptions recapped above, and the assumption that the interest rate
equals the world interest rate,we obtain:
Saving and Investment in a Small Open Economy
16Reference: N.Gregory Mankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters

17. Saving and Investment in a Small Open Economy…cond.
This equation shows that the trade balance
NX depends on those variables that determine
saving (S ) and investment (I ),
Saving(S)dependsonfiscalpolicy
lowergovernmentpurchasesGorhighertaxesT
raisenationalsaving,
Investment(I) depends on the world real
interest rate r*
a higher interest rate makes some investment
projects unprofitable),
•The trade balance depends on these variables
as well.
17Reference: N.Gregory Mankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters

18. Saving and Investment in a Small Open Economy…cond.
Intheclosedeconomy(studiedinCh-3),thereal
interestrateadjuststoequilibratesavingand
investment-thatis,therealinterestrateisfound
wherethesavingandinvestmentcurvescross,
Inthesmallopeneconomy,however,thereal
interestrateequalstheworldrealinterestrate,
Thetradebalanceisdeterminedbythedifference
betweensavingandinvestmentattheworld
interestrate,
when saving falls short of investment, investors borrow from
abroad;
when saving exceeds investment, the excess is lent to other
countries.
18Reference: N.Gregory Mankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters

19. Saving and Investment in a Small Open Economy…cond.
Fig 4.2: Saving & Investment in Small Open Economy
19Reference: N.Gregory Mankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters

20. Saving and Investment in a Small Open Economy…cond.
How Policies Influence the Trade Balance ?
Suppose that the economy begins in a position of
balanced trade. That is:
at the world interest rate, investment I equals saving S, and
Net exports NX equal zero.
Fig 4.3: Effect of Fiscal Expansion at Home on Small Open Economy
20Reference: N.Gregory Mankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters

21. Saving and Investment in a Small Open Economy…cond.
Effects of Increased Gov’tSpending at Home Country( ∆G > 0)
Fiscalexpansionfirstreducenationalsaving(S)(leftwardshiftof
savingcurve),b/sS=Y-C-G.
Withanunchangedworldrealinterestrate,investmentremains
thesame,
Therefore,savingfallsbelowinvestment,andsomeinvestment
mustnowbefinancedbyborrowingfromabroad,
Because NX = S -I, the fall in S implies a fall in NX,
The economy now runs a trade deficit.
21Reference: N.Gregory Mankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters

22. Saving and Investment in a Small Open Economy…cond.
The same logic applies to a decrease in taxes,
AtaxcutlowersT,raisesdisposableincomeY-T,
stimulatesconsumption,andreducesnationalsaving,
Eventhoughsomeofthetaxcutfindsitswayinto
privatesaving,publicsavingfallsbythefullamountof
thetaxcut,intotal,savingfalls)
BecauseNX=S-I,thereductioninnationalsaving
inturnlowersNX.
Hence,startingfrombalancedtrade,achangeinfiscal
policythatreducesnationalsavingleadstoatrade
deficit.
22Reference: N.Gregory Mankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters

23. Saving and Investment in a Small Open Economy…cond.
Fiscal Policy Abroad
Effect of increase in Purchase of Foreign Governments( ∆G
f
>0)
Iftheseforeigncountriesareasmallpartoftheworldeconomy,thentheir
fiscalchangehasanegligibleimpactonothercountries,
Butiftheseforeigncountriesarealargepartoftheworldeconomy,
theirincreaseingovernmentpurchasesreducesworldsaving,
The decrease in world saving causes the world interest rate to rise,
The increase in the world interest rate raises the cost of borrowingand, thus,
reduces investmentin our small open economy.,
Because, there has been no change in domestic saving, saving S now
exceeds investment I, and some of our saving begins to flow abroad,
Because, because NX =S -I, the reduction in I must also increase NX,
Hence, reduced saving abroad leads to a trade surplus at home(see fig 4.4)
23Reference: N.Gregory Mankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters

24. Saving and Investment in a Small Open Economy…cond.
24
Fig 4.4: Effect of Fiscal Expansion Abroad on a Small Open Economy
Reference: N.Gregory Mankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters

25. Saving and Investment in a Small Open Economy…cond.
Because,thepolicychangeoccursabroad,the
domesticsavingandinvestmentschedules
remainthesame,
Theonlychangeisanincreaseintheworld
interestratefromr
1*tor
2*,
Athome,sincesaving(S)>Investment(I)atr
2*,
tradebalance(w/cisthedifferencebetween
thesaving&investment)becometrade
surplus,
Hence,startingfrombalancedtrade,anincrease
intheworldinterestrateduetoafiscal
expansionabroadleadstoatradesurplus.
25Reference: N.Gregory Mankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters

26. Saving and Investment in a Small Open Economy…cond.
Shifts in Investment Demand
Whathappentosmallopeneconomyifitsinvestmentschedule
shiftsoutwardi.e.thatis,ifthedemandforinvestmentgoods
ateveryinterestrateincreases?
Thisshiftwouldoccurif,forexample,thegovernmentchanged
thetaxlawstoencourageinvestmentbyprovidingan
investmenttaxcredit,
At a given world interest rate, investment is now higher,
Because saving is unchanged, some investment must now be
financed by borrowing from abroad,
Becausecapitalflowsintotheeconomytofinancethe
increasedinvestment,thenetcapitaloutflowisnegative,
Put differently, because NX = S -I, the increase in I implies a
decrease in NX.
Hence, starting from balanced trade, an outward shift in the in
investment schedulecauses a trade deficit(see fig 4.5)
26Reference: N.Gregory Mankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters

27. Saving and Investment in a Small Open Economy…cond.
27
Fig 4.5: Effect of aShift In the Investment Schedule In a Small Open Economy
Reference: N.Gregory Mankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters

28. Saving and Investment in a Small Open Economy…cond.
Evaluating Economic Policy
Ourmodeloftheopeneconomyshowsthattheflow
ofgoodsandservicesmeasuredbythetradebalanceis
inextricablyconnectedtotheinternationalflowoffunds
forcapitalaccumulation,
Thenetcapitaloutflowisthedifferencebetween
domesticsaving&domesticinvestment,
Thus,theimpactofeconomicpoliciesonthetrade
balancecanalwaysbefoundbyexaminingtheir
impactondomesticsavinganddomesticinvestment,
policies that increase investment or decrease saving tend to
cause a trade deficit, and
policies that decrease investment or increase saving tend to
cause a trade surplus.
28Reference: N.Gregory Mankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters

29. Saving and Investment in a Small Open Economy…cond.
Note:mostcountriesviewatradedeficitasa
probleminitself/asasymptomofaproblem.
However:
tradedeficitcouldbeareflectionlowsaving,w/c
couldleadtoleadstolowinvestmentandasmaller
futurecapitalstockinthecaseofclosedeconomy,
Inanopeneconomy,lowsavingleadstoatrade
deficitandagrowingforeigndebt,whicheventually
mustberepaid,
Inbothcases,highcurrentconsumptionleadsto
lowerfutureconsumption,implyingthatfuture
generationsbeartheburdenoflownationalsaving.
29Reference: N.Gregory Mankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters

30. Saving and Investment in a Small Open Economy…cond.
Yettradedeficitsarenotalwaysareflectionof
aneconomicproblem,b/s:
Whenpoorruraleconomiesdevelopintomodern
industrialeconomies,theysometimesfinancetheir
highlevelsofinvestmentwithforeignborrowing,
Inthesecases,tradedeficitsareasignofeconomic
development,
Thelessonisthatonecannotjudgeeconomic
performancefromthetradebalancealone,
Instead,onemustlookattheunderlyingcausesof
theinternationalflows.
30
Reference: N.Gregory Mankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters

31. 4.3: Exchange Rate
Theexchangeratebetweentwocountries
isthepriceatwhichresidentsofthose
countriestradewitheachother,
Questions:
What the exchange rate measures ?
How exchange rates are determined ?
oTwo Types of Exchange Rate:
i)Nominal Exchange Rate
ii)Real Exchange Rate
31Reference: N.Gregory Mankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters

32. Exchange Rate…cond.
i) The Nominal Exchange Rate
Thenominalexchangerateistherelativepriceofthecurrenciesof
twocountries,
Forexample,iftheexchangeratebetweentheU.S.dollarandtheEthiopian
Birris20birrperdollar,thenyoucanexchangeonedollarfor20Birrin
worldmarketsforforeigncurrency,
An Ethiopian who wants to obtain dollars would pay 20 Birr for each dollar
he bought,
An American who wants to obtain Birr would get 20 Birr for each dollar he
paid,
When people refer to "the exchange rate" between two countries, they
usually mean the nominal exchange rate.
Reference: N.Gregory Mankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 32

33. Exchange Rate…cond.
The Real Exchange Rate:
Istherelativepriceofthegoodsoftwocountries,
Thatis,therealexchangeratetellsustherateatwhich
wecantradethegoodsofonecountryforthegoodsof
another,
Therealexchangerateissometimescalledthetermsof
trade.
Toseetherelationbetweentherealandnominalexchange
rates,considerasinglegoodproducedinmanycountries:
cars,
SupposeanAmericancarcosts$25,000andasimilarJapanese
carcosts4,000,000yen,
Reference: N.Gregory Mankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 33

34. Exchange Rate…cond.
Tocomparethepricesofthetwocars,wemustconverttheminto
acommoncurrency,
Ifadollarisworth80yen,thentheAmericancarcosts80X
25,000,or2,000,000yen.,
ComparingthepriceoftheAmericancar(2,000,000yen)and
thepriceoftheJapanesecar(4,000,000yen),weconcludethat
theAmericancarcostsone-halfofwhattheJapanesecarcosts,
Inotherwords,atcurrentprices,wecanexchange2American
carsforone(1)Japanesecar.
We can summarize our calculation as follows:
Reference: N.Gregory Mankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 34

35. Exchange Rate…cond.
Atthesepricesandthisexchangerate,weobtainone-
halfofaJapanesecarperAmericancar,
Moregenerally,wecanwritethiscalculationas:
The rate at which we exchange foreign and domestic
goods dependson the :
prices of the goods in the local currencies; and
rate at which the currencies are exchanged.
Thiscalculationoftherealexchangerateforasinglegood
suggestshowweshoulddefinetherealexchangeratefora
broaderbasketofgoods.
Reference: N.Gregory Mankiew, 8th edn.
Ch-6 & 13, and other edn. on Open
Economy Chapters 35

36. Exchange Rate…cond.
Let
e-bethenominalexchangerate(thenumber
ofyenperdollar),
P-bethepricelevelintheUnitedStates
(measuredindollars),and
P*-bethepricelevelinJapan(measuredin
yen).
Then the real exchange rate €is
Reference: N.Gregory Mankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 36

37. Exchange Rate…cond.
Therealexchangeratebetweentwocountriesiscomputed
from:
thenominalexchangerate;and
thepricelevelsinthetwocountries,
lftherealexchangerateishigh:
foreigngoodsarerelativelycheap,and
domesticgoodsarerelativelyexpensive,
Iftherealexchangerateislow:
foreigngoodsarerelativelyexpensive,and
domesticgoodsarerelativelycheap.
Reference: N.Gregory Mankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 37

38. Exchange Rate…cond.
The Real Exchange Rate and the Trade Balance
What macroeconomic influence does the real exchange rate
exert?
Whenrealexchangerateislow:
domesticgoodsarerelativelycheap,
domesticresidentswillnotwanttopurchase
fewerimportedgoods,
Forthesamereason,foreignerswillwanttobuy
manyofourgoods(ourexportedgoods),
Asaresultofbothoftheseactions,thequantityof
ournetexportsdemandedwillbehigh.
Reference: N.Gregory Mankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 38

39. Exchange Rate…cond.
When real the real exchange rate is high:
domesticgoodsareexpensiverelativetoforeigngoods,
domesticresidentswillwanttobuymanyimportedgoods,
and
foreignerswillwanttobuyfewofourgoods,
Therefore,thequantityofournetexportsdemandedwill
below.
Wewritethisrelationshipbetweentherealexchange
rateandnetexportsas:
NX= NX(€).
oThisequationstatesthatnetexportsareafunction
oftherealexchangerate.
Reference: N.Gregory Mankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 39

40. Exchange Rate…cond.
The Determinants of the Real Exchange Rate
The real exchange rate is related to net exports. That is:
When the real exchange rate is lower, domestic goods are
less expensive relative to foreign goods,
net exports are greater,
The trade balance (net exports) must equal the net
capital outflow,
Net capital outflowin turn equals saving minus investment,
Saving is fixed by theconsumption function and fiscal policy;
investment is fixed by the investment function and the
world interest rate.
Reference: N.Gregory Mankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 40

41. Exchange Rate…cond.
Reference: N.Gregory Mankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 41
Fig 4.6: The Relationship b/n Net Export and Real Exchange Rate

42. Exchange Rate…cond.
In fig 4.7, the line showing the relationship between net exports and the real
exchange rate slopes downward:
because a low real exchange rate makes domestic goods relatively inexpensive.,
The line representing the excess of saving over investment, S-I, is vertical
because neither saving nor investment depends on the real exchange rate,
The crossing of these two lines determines the equilibrium real exchange
rate.,
Attheequilibriumrealexchangerate,thesupplyofdollarsavailablefromthenet
capitaloutflowbalancesthedemandfordollarsbyforeignersbuyingournet
exports.
Reference: N.Gregory Mankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 42
Fig 4.7: Real Exchange Rate Determination

43. Exchange Rate…cond.
How Policies Influence the Real Exchange Rate
Fig 4.8: Effect of Fiscal Policy at Home(∆G >0; or Tax Cut)
Reference: N.Gregory Mankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 43

44. Exchange Rate…cond.
Fig 4.9: The Impact of Expansionary Fiscal Policy Abroad on
the Real Exchange Rate
Reference: N.Gregory Mankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 44

45. Exchange Rate…cond.
Fig 4.10. Impact of Shifts in Investment Demand on Real Exchange Rate
Reference: N.Gregory Mankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 45

46. Exchange Rate…cond.
Fig 4.11: The Effects of Trade Policies on Real Exchange Rate
Reference: N.Gregory Mankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 46
NB.
•Think of a tariff or
quota imposed by a
home country that
makes it harder for
home-country people to
import goods
•Unless policy affects S
or I, it cannot affect
S −I = NX,
Hence, protectionist
trade policies can reduce
imports and raise net
exports at any
given real exchange rate.
However, the fall in
import leads to
appreciation of domestic
currency and results in
rise in Exchange Rate.
The rise in exchange
rate reduce export, and
maintain NX at initial
equilibrium level.

47. Exchange Rate…cond.
The Determinants of the Nominal Exchange Rate
Recall the relationship between the real
and the nominal exchange rate is given as:
We can write the nominal exchange rate
as:
Reference: N.Gregory Mankiew, 8th edn.
Ch-6 & 13, and other edn. on Open
Economy Chapters 47

48. Exchange Rate…cond.
Giventhevalueoftherealexchangerate,ifthedomesticpricelevelP
rises,thenthenominalexchangerateewillfall:
becauseaBirrisworthless,aBirrwillbuyfewerdollars.
IftheAmericanpricelevelP*rises,thenthenominalexchangeratewill
increase:
becausethedollarisworthless,aBirrwillbuymoredollars,
The exchange rate equation can be written:
Reference: N.Gregory Mankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 48

49. Exchange Rate…cond.
Thisequationstatesthatthepercentagechangeinthenominal
exchangeratebetweenthecurrenciesoftwocountriesequalsthe
percentagechangeintherealexchangerateplusthedifferenceintheir
inflationrates,
If a given foreign country has a high rate of inflation relative to the Home
country(Ethiopia), the home country currency(say Birr) will buy an
increasing amount of the foreign currency over time,
lf a given foreign country has a low rate of inflation relative to the Home
country(say Ethiopia), the Home country currency(say Birr) will buy a
decreasing amount of the foreign currency over time.
Reference: N.Gregory Mankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 49

50. 4.4: The Mundell-Fleming Model & the Exchange Rate Regime
Whenconductingmonetaryandfiscalpolicy,policymakersoftenlookbeyond
theirowncountry'sborders,
Evenifdomesticprosperityistheirsoleobjective,itisnecessaryforthemto
considertherestoftheworld,
Theinternationalflowofgoodsandservicesandtheinternationalflowofcapital
canaffectaneconomyinprofoundways,
Hence,itisessentialforpolicymakerstotakeintoaccountsuchinternational
effectwhilemakingdomesticpolicy,
Now, let us extend our analysis of aggregate demand to include international
trade and finance,
To this end, we use Mundell-Fleming model, w/c is a popular model in
studying open-economy fiscal & monetary policy,
The Mundell-Fleming modelis a close relative of the 1S-LM model
Reference: N.GregoryMankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 50

51. The Mundell-Fleming Model & the Exchange Rate Regime…cond.
Similarityb/n Mundell-Fleming Model & IS-LM Models:
Bothstresstheinteractionbetweenthegoodsmarket&
themoneymarket,
bothassumethatthepricelevelisfixedintheSR,
bothattempttoshowwhatcausesshort-runfluctuations
inaggregateincome(or,equivalently,shiftsinthe
aggregatedemandcurve),
The key difference b/n the two models is that:
the IS-LM model assumes a closed economy, whereas;
the Mundell-Fleming model assumes an open economy.
Reference: N.GregoryMankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 51

52. The Mundell-Fleming Model & the Exchange Rate Regime…cond.
With a key assumption of Small Open Economy& Perfect Capital
Mobility
domestic interest rate ( r ) determined by the world interest rate (r*)
i.e. r = r*,
Inasmallopeneconomy,thedomesticinterestratemightrise/fall
above/belowworldinterestratealittlebitforshorttime,butitequateto
theworldinterestratequicklyb/s:
When r > r*, then:
foreigners would see the higher interest rate & start lending to this
country (by, for instance, buying this country's bonds),
The capital inflow would drive the domestic interest rate back toward
r*.
Reference: N.GregoryMankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 52

53. The Mundell-Fleming Model & the Exchange Rate Regime…cond.
Whenr<r*,then:
capitalwouldflowoutofthecountrytoearna
higherreturnabroad,and
thiscapitaloutflowwoulddrivethedomestic
interestratebackuptor*,
Thus,ther=r*equation-representstheassumption
thattheinternationalflowofcapitalisrapidenoughto
keepthedomesticinterestrateequaltotheworld
interestrate.
Reference: N.GregoryMankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 53

54. The Mundell-Fleming Model & the Exchange Rate Regime…cond.
The Goods Market and the IS* Curve
TheMundell-Flemingmodeldescribesthe
marketforgoods&servicesmuchasthe1S-
LMmodeldoes,butitaddsanewtermfornet
exports,
Thus, in Mundell-Fleming model, the goods
market is represented with the following
equation: Y= C(Y-T ) + I(r) + G + NX(e); where
e exchange rate.
The Mundell-Fleming model:
Both the price levels at home & abroad are fixed(by
assumption),
so the real exchange rate is proportional to the
nominal exchange rate.
Reference: N.GregoryMankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 54

55. The Mundell-Fleming Model & the Exchange Rate Regime…cond.
In fig 4.12, the IS* curve slopes downward because,
a higher exchange rate reduces net exports,
lower expert in turn lowers aggregate income.
Fig4.12showhowthisworks,theotherbycombiningthenet-
exportsscheduleandtheKeynesiancrosstoderivetheIS*curve.
lnpanel(a),anincreaseintheexchangeratefrome
1toe
2
lowersnetexportsfromNX(e
1)toNX(e
2),
Inpanel(b),thereductioninnetexportsshiftstheplanned-
expenditurescheduledownward,andthuslowersincomefrom
Y
1toY
2,
Panel(c) -the IS* curve summarizes this relationship between the
exchange rate (e) & income (Y ).
The higher the exchange rate, the lower the level of income.
Reference: N.GregoryMankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 55

56. The Mundell-Fleming Model & the Exchange Rate Regime…cond.
Fig 4.12: Driving IS-Curve from Net-Export Schedule and The Keynesian Cross
Reference: N.Gregory Mankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 56

57. The Mundell-Fleming Model & the Exchange Rate Regime…cond.
The Money Market and the LM* Curve
The Mundell-Fleming model represents the money market with an equation that
should be familiar from the 1S-LM model:
upplyof real money balance equals demand for real money balance i.e. M/P = L(r, Y).
r = in demand for real balances ( negatively relationship),
Y = in demand for real money balance ( positive relationship),
The money supply (M) is an exogenous variable controlled by the central bank,
Price level (P) is exogenously fixed, because, the Mundell-Fleming model is designed
to analyze short-run fluctuations,
Since domestic interest rate( r ) is equal to world interest rate (r*) (by assumptions
of small open economy and perfect capital mobility), we can rewrite the real money
balance as: M/P= L(r* , Y ).
Reference: N.GregoryMankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 57

58. The Mundell-Fleming Model & the Exchange Rate Regime…cond.
Reference: N.GregoryMankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 58
AccordingtotheMundell-FlemingModel,asmallopeneconomywithperfect
capitalmobilitycanbedescribedbytwoequations:
Y=C(Y-T)+I(r*)+G+NX(e)(equilibriumingoodsmakret)
M/P=L(r*,Y)(equilibriuminthemoneymarket)
TheexogenousvariablesinMundell-FlemingModelare:
fiscalpolicyCandT,
monetarypolicyM,
thepricelevelP,and
theworldinterestrater*.
TheendogenousvariablesinMundell-FlemingModelare:
incomeY;and
theexchangeratee.

59. The Mundell-Fleming Model & the Exchange Rate Regime…cond.
Reference: N.GregoryMankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 59
Fig 4.13. The Relationship between Exchange rate (e) and LM*
Fig4.13shows,the
equilibriumforthe
economyisfoundwhere
theIS*curveandtheLM*
curveintersect.
Thisintersectionshows
theexchangerateandthe
levelofincomeatwhich
thegoodsmarketandthe
moneymarketarebothin
equilibrium.
Withthisdiagram,we
canusetheMundell-
Flemingmodeltoshow
howaggregateincome(Y)
andtheexchangerate(e)
respondtochangesin
policy

60. 4.5. The Fiscal and Monetary Policies in an Open Economy with perfect Capital Mobility
ExchangeRateRegimesandImpactofPolicies-Small
OpenEconomy
Toanalyzetheimpactofpoliciesinanopen
economy,wemustspecifytheinternationalmonetary
systeminwhichthecountryhaschosentooperate,
Howpeopleengagedininternationaltradeand
financecanconvertthecurrencyofonecountryinto
thecurrencyofanother?
Twomajorexchangerate:
i)FloatingExchangeRate
ii)FixedExchangeRateRegime:
Reference: N.GregoryMankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 60

61. Floating Exchange Rate
Under a system of floating exchange rates,
theexchangerateissetbymarketforces,and
isallowedtofluctuateinresponsetochanging
economicconditions,
Inthiscase,theexchangerateeadjuststo
achievesimultaneousequilibriuminthegoods
marketandthemoneymarket.
Whensomethinghappenstochangethat
equilibrium,theexchangerateisallowedto
movetoanewequilibriumvalue(‘selfcorrecting’).
Reference: N.GregoryMankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 61
The Fiscal and Monetary Policies in an Open Economy with perfect Capital Mobility …cond.

62. The Fiscal and Monetary Policies in an Open Economy with perfect Capital Mobility …cond.
FloatingExchangeRate…cond.
Here,weconsidertheeffectofthreepolicies
ontheequilibriumvalues:
fiscal policy,
monetary policy, and
trade policy.
To this end, we use the Mundell-Fleming
Model:
toseetheeffectofchangesinoneormoreofthese
policymeasures,
tounderstandtheeconomicforcesatworkasthe
economymovesfromoneequilibriumtoanother,
Reference: N.GregoryMankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 62

63. The Fiscal and Monetary Policies in an Open Economy with perfect Capital Mobility …cond.
Fiscal Policy under floating Exchange Rate
Suppose that the government stimulates domestic
spending by increasing government purchases(∆G >0 ; or
by cutting taxes,
Because such expansionary fiscal policy increases planned
expenditure, it shifts the IS* curve to the right(as shown in fig
4.14),
As a result, the exchange rate appreciates, while the level
of income remains the same.
Reference: N.GregoryMankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 63

64. The Fiscal and Monetary Policies in an Open Economy with perfect Capital Mobility …cond.
Fig 4.14: Fiscal Policy under Floating Exchange Rate
Reference: N.GregoryMankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 64

65. The Fiscal and Monetary Policies in an Open Economy with perfect Capital Mobility …cond.
Fiscal Policy under Floating Exchange Rate…cond.
Notice that fiscal policy has very different effects in a small open economy than it does
in a closed economy:
In the closed-economy1S-LM model, a fiscal expansion raises income,
In a small open economy with a floating exchange rate, a fiscal expansion leaves
income at the same level.
Mechanically,thisisbecausetheLM*curveisverticalinopeneconomy,whiletheLM
curveusupwardslopinginclosedeconomy,
But,why?
TheLMcurveusedtostudyaclosedeconomyisupwardsloping;b/swhen
incomerisesinaclosedeconomy,theinterestraterisesbecausehigherincome
increasesthedemandformoney.,
TheLM*curveisverticalinsmallopeneconomy(withperfectcapitalmobility),b/s,as
soonastheinterestratestartstoriseabovetheworldr*capitalquicklyflowsin
fromabroadtotakeadvantageofthehigherreturn.
Reference: N.GregoryMankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 65

66. The Fiscal and Monetary Policies in an Open Economy with perfect Capital Mobility …cond.
Fiscal Policy under Floating Exchange Rate…cond.
As this capital inflow pushes the interest rate back
to r*, it also has another effect:
becauseforeigninvestorsneedtobuythedomesticcurrency
toinvestinthedomesticeconomy,thecapitalinflow
increasesthedemandforthedomesticcurrencyinthe
marketforforeign-currencyexchange,
thisincreaseddemandfordomesticcurrencybid-upthe
valueofthedomesticcurrency,
Theappreciationofthedomesticcurrencymakesdomestic
goodsexpensiverelativetoforeigngoods,reducingnet
exports,
Thefallinnetexportsexactlyoffsetstheeffectsofthe
expansionaryfiscalpolicyonincome.
Reference: N.GregoryMankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 66

67. The Fiscal and Monetary Policies in an Open Economy with perfect Capital Mobility …cond.
Fiscal Policy under Floating Exchange Rate…cond.
Why is the fall in net exports so great that it
renders fiscal policy powerless to influence income?
To answer this question, consider the equation that
describes the money market:
M/ P = L(r, Y).
In both closed and open economies:
the quantity of real money balances supplied M/ P is fixed by
the central bank (which sets M),and
the assumption of sticky prices (which fixes P).
Thequantityofrealmoneydemanded(determinedbyr
&Y)mustequalthisfixedsupply,
Reference: N.GregoryMankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 67

68. The Fiscal and Monetary Policies in an Open Economy with perfect Capital Mobility …cond.
Inaclosedeconomy,
afiscalexpansioncausestheequilibriuminterestratetorise,
Theincreasetheinterestrate(w/creducethequantityofmoneydemanded)is
accompaniedbyincreaseinequilibriumincome(w/cincreasemoneydemand),
thesetwoeffectstogethermaintainequilibriuminthemoneymarket,
InsmallOpenEconomy:
Domesticinterestrate(r)isfixedatr*,
Sothereisonlyonelevelofincomethatcansatisfythisequation,andthislevelofincome
doesnotchangewhenfiscalpolicychanges,
Thus,expansionaryfiscalpolicy(∆G>0,orTaxCut)resultsinappreciationofthe
domesticcurrency,and
Theappreciationofdomesticcurrency,leadtofallinnetexport,
Iflargeenough,theappreciationofdomesticcurrencyandfallinnetexports,couldfully
offsettheeffectofexpansionaryeffectofthepolicyonincome.
Reference: N.GregoryMankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 68

69. The Fiscal and Monetary Policies in an Open Economy with perfect Capital Mobility …cond.
Monetary Policy under Floating Exchange Rate
Suppose now that the central bank increases the money
supply (∆M > 0)
Becausethepricelevelisassumedtobefixed,theincrease
inthemoneysupplymeansanincreaseinrealmoney
balances,
The increase in real balances shifts the LM* curve to the
right, as in Fig 4.15.
Hence, an increase in the money supply raises income
and lowers the exchange rate,
Reference: N.GregoryMankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 69

70. The Fiscal and Monetary Policies in an Open Economy with perfect Capital Mobility …cond.
Reference: N.GregoryMankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 70
Fig4.15: Effect of Monetary Expansion on Exchange Rate-under floating Exchange Rate

71. The Fiscal and Monetary Policies in an Open Economy with perfect Capital Mobility …cond.
Monetary Policy under Floating Exchange Rate
Althoughmonetarypolicyinfluencesincomeinanopeneconomy,asitdoes
inaclosedeconomy,themonetarytransmissionmechanismisdifferent,
Recall that in a closed economy an increase in the money supply increases
spending because:
it lowers the interest rate, and
stimulates investment.
In small open economy, this channel of monetary transmission is not available
because:
the interest rate is fixed by the world interest rate.,
So, how does monetary policy influence spending?
To answer this question, we once again need to think about the international
flow of capital and its implications for the domestic economy.
Reference: N.GregoryMankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 71

72. The Fiscal and Monetary Policies in an Open Economy with perfect Capital Mobility …cond.
Monetary Policy Under Floating Exchange Rate
Theinterestrateandtheexchangerateareagainthekeyvariables,
Assoonasanincreaseinthemoneysupplystartsputtingdownwardpressureonthedomestic
interestrate:
capitalflowsoutoftheeconomybecauseinvestorsseekahigherreturnelsewhere,
Thiscapitaloutflowpreventsthedomesticinterestratefromfallingbelowtheworldinterest
rater*,
Italsohasanothereffect:becauseinvestingabroadrequiresconvertingdomesticcurrency
intoforeigncurrency,
thecapitaloutflowincreasesthesupplyofthedomesticcurrencyinthemarketforforeign-
currencyexchange,
Thiscausingthedomesticcurrencytodepreciateinvalue.
Thisdepreciationmakesdomesticgoodsinexpensiverelativetoforeigngoods,
Depreciationindomesticcurrencystimulatingnetexports,andthus,totalincome
increases,
oHence,inasmallopeneconomy,monetarypolicyinfluencesincomebyalteringthe
exchangerateratherthantheinterestrate.
Reference: N.GregoryMankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 72

73. The Fiscal and Monetary Policies in an Open Economy with perfect Capital Mobility …cond.
Trade Policy Under Floating Exchange Rate
Suppose that the governmentreduces the demand for imported goods
by imposing an import quota or a tariff.
What happens to aggregate income and the exchange rate?
How does the economy reach its new equilibrium?
Reference: N.GregoryMankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 73
Fig. 4.16: The Effect of Trade Policy under Floating Exchange Rate Regime

74. The Fiscal and Monetary Policies in an Open Economy with perfect Capital Mobility …cond.
TradePolicyUnderFloatingExchangeRate
Because,netexportsequalexportsminusimports,areductioninimportsmeansan
increaseinnetexports,
Thatis,thenet-exportsscheduleshiftstotheright,asinfig4.16,
Thisshiftinthenet-exportsscheduleincreasesplannedexpenditure,
IncreaseinplannedexpendituremovestheIS*curvetotheright.,
BecausetheLM*curveisvertical,thetraderestrictionraisestheexchangeratebutdoes
notaffectincome,
Theeconomicforcesbehindthistransitionaresimilartothecaseofexpansionaryfiscal
policy,
BecausenetexportsareacomponentofGDP,therightwardshiftinthenet-exports
schedule,otherthingsequal,putsupwardpressureonincomeY;
Reference: N.GregoryMankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 74

75. The Fiscal and Monetary Policies in an Open Economy with perfect Capital Mobility …cond.
Trade Policy Under Floating Exchange Rate
An increase in Y, in turn, increases money demand and puts upward
pressure on the interest rate r,
Foreigncapitalquicklyrespondsbyflowingintothedomestic
economy,pushingtheinterestratebacktotheworldinterestrater*,
and
Increaseininterestrate(r)causesthedomesticcurrencyto
appreciateinvalue,
Finally,theappreciationofthecurrencymakesdomesticgoods
moreexpensiverelativetoforeigngoods,
Appreciation of domestic currency decreases net exports
NX and returns income Y to its initial level,
Reference: N.GregoryMankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 75

76. The Fiscal and Monetary Policies in an Open Economy with perfect Capital Mobility …cond.
TradePolicyUnderFloatingExchangeRate
From Mundell-Fleming model, under floating exchange rates:
NX(e) = Y-C(Y-T) -l(r*)-G.
Fromthisequation,wecanseethat,underfloatingexchangerates,atrade
restriction:
doesnotaffectincome(Y),
doesnotaffectConsumption(C),
doesnotaffectInvestment(I),or
doesnotaffectgovernmentpurchases(G),
doesnotaffectthetradebalance,
Althoughtheshiftinthenet-exportsscheduletendstoraiseNX,the
increaseintheexchangeratereducesNXbythesameamount,
The overall effect is simply less trade,
Thedomesticeconomyimportslessthanitdidbeforethetrade
restriction,butitexportslessaswell.
Reference: N.GregoryMankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 76

77. The Fiscal and Monetary Policies in an Open Economy with perfect Capital Mobility …cond.
The Small Open Economy Under Fixed Exchange Rates
FloatingExchangeRate-afixed(alsocalledpeggedrate)isaratethe
government(centralbank)setsandmaintainsastheofficialexchange
rate,
Underafixedexchangerate,thecentralbankannouncesavaluefortheexchange
rateandstandsreadytobuyandsellthedomesticcurrencytokeeptheexchange
rateatitsannouncedlevel.,
Inthe1950sand1960s,mostoftheworld'smajoreconomies,includingthatof
theUnitedStates,operatedwithintheBrettonWoodssystem-aninternational
monetarysystemunderwhichmostgovernmentsagreedtofixedexchangerates,
The world abandoned this system in the early 1970s, and most exchange rates
were allowed to float,
Yet, fixed exchange rates are not merely of historical interest. It is still used by
many countries around the world,
In this section, we examine the impact of economic policies on an economy
with a fixed exchange rate.
Reference: N.GregoryMankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 77

78. The Fiscal and Monetary Policies in an Open Economy with perfect Capital Mobility …cond.
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,
Forexample,supposetheNationalBankofEthiopia,
announcedthatitwasgoingtofixetheBirr/dollar
exchangerateat20birrperdollar,
TheNationalBankofEthiopiawouldthenstandreadyto
givebirr20inexchangefor$1,
Tocarryoutthispolicy,theNationalBankwouldneeda
reserveofBirr(whichitcanprint)andareserveofdollar
(whichitmusthavepurchasedpreviously),
Reference: N.GregoryMankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 78

79. The Fiscal and Monetary Policies in an Open Economy with perfect Capital Mobility …cond.
How a Fixed-Exchange-Rate System Works
Afixedexchangeratededicatesacountry'smonetary
policytothesinglegoalofkeepingtheexchangerate
attheannouncedlevel,
In other words, the essence of a fixed-exchange-rate
system is:
thecommitmentofthecentralbanktoallowthemoney
supplytoadjusttowhateverlevelwillensurethattheequilibrium
exchangerateinthemarketforforeign-currencyexchange
equalstheannouncedexchangerate.,
Moreover, as long as the central bank stands ready to buy or
sell foreign currency at the fixed exchange rate, the money
supply adjusts automatically to the necessary level.
Reference: N.GregoryMankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 79

80. The Fiscal and Monetary Policies in an Open Economy with perfect Capital Mobility …cond.
Reference: N.GregoryMankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters
80
How a Fixed-Exchange-Rate System Works
Fig 4.17. Effect of Money Supply Under Fixed Exchange Rate
HowaFixedExchangeRateGovernstheMoneySupply
Inpanel(a),theequilibriumexchangerateinitiallyexceedsthefixedlevel.Arbitrageurswillbuyforeign
currencyinforeign-exchangemarketsandsellittotheNationalBank/centralbank/foraprofit.This
processautomaticallyincreasesthemoneysupply,shiftingtheLM*curvetotherightandloweringthe
exchangerate.
Inpanel(b),theequilibriumexchangerateisinitiallybelowthefixedlevel.Arbitrageurswillbuyforeign
currencyfromtheNationalBank/CentralBank/andsellitinforeign-exchangemarketsforaprofit.This
processautomaticallyreducesthemoneysupply,shiftingtheLM*curvetotheleftandraisingthe
exchangerate.

81. The Fiscal and Monetary Policies in an Open Economy with perfect Capital Mobility …cond.
How a Fixed-Exchange-Rate System Works
It is important to understand that this exchange-rate system fixes the nominal
exchange rate,
Whether it also fixes the real exchange rate depends on the time horizon
under consideration,
Ifpricesareflexible,astheyareinthelongrun,thentherealexchangerate
canchangeevenwhilethenominalexchangerateisfixed,
Therefore, in the long run a policy tofixed the nominal exchange rate would
not influence any real variable, including the real exchange rate,
A fixed nominal exchange rate would influence only the money supply and the
price level,
Yet, in the short run described by the Mundell-Fleming model:
Prices are fixed,
so a fixed nominal exchange rate implies a fixed real exchange rate as well.
Reference: N.GregoryMankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 81

82. The Fiscal and Monetary Policies in an Open Economy with perfect Capital Mobility …cond.
Fiscal Expansion under Fixed Rates
Let'snowexaminehoweconomicpoliciesaffectasmallopeneconomywith
afixedexchangerate,
Supposethatthegovernmentstimulatesdomesticspending(by∆G>0,or
Tax-Cut,)
Fiscalexpansionputsupwardpressureondomesticinterestrate(r)asbeforeduetodecrease
indomesticsaving(S),
ThispolicyshiftstheIS*curvetotheright,asinfig4-18,puttingupwardpressureonthe
marketexchangerate,
But,becausethecentralbankstandsreadytotradeforeign&domesticcurrencyatthe
fixedexchangerate,arbitrageursquicklyrespondtotherisingexchangeratebysellingforeign
currencytothecentralbank,
Thisleadtoanautomaticmonetaryexpansion,
TheriseinthemoneysupplyshiftstheLM*curvetotheright,
Thus,underafixedexchangerate,afiscalexpansionraisesaggregateincome,
Reference: N.GregoryMankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 82

83. The Fiscal and Monetary Policies in an Open Economy with perfect Capital Mobility …cond.
Reference: N.GregoryMankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 83
Fig 4.18:Effect of Fiscal Expansion under Fixed Exchange Rate
A Fiscal Expansion Under
Fixed Exchange Rates
Afiscalexpansionshiftsthe
IS*curvetotheright,
Tomaintainthefixed
exchangerate,theNational
Bank/CentralBank/must
increasethemoneysupply,
therebyshiftingtheLM*curve
totheright,
Hence,incontrastto
thecaseofafloating
exchangerates,underfixed
exchangerates,afiscal
expansionraises
income.

84. The Fiscal and Monetary Policies in an Open Economy with perfect Capital Mobility …cond.
Monetary Policy Under Fixed Exchange Rate
Suppose National Bank/Central Bank/ operating with a fixed exchange rate tries to increase the money
supply-say by buying bonds from the public,
What would happen?
The initial impact of this policy:
shifttheLM*curvetotheright,
loweringtheexchangerate,asinfig4.19,
But,becausethecentralbankiscommittedtotradingforeign&domesticcurrencyata
fixedexchangerate(tomaintainfixedexchangerate),
arbitrageursquicklyrespondtothefallingexchangeratebysellingthedomesticcurrencyto
thecentralbank,
ThiscausesthemoneysupplyandtheLM*curvetoreturntotheirinitialpositions,
Hence,monetarypolicyasusuallyconductedisineffectualunderafixedexchangerate,
Byfixingexchangerate,thecentralbankgivesupitscontroloverthemoneysupply(lose
monetaryautonomy),inthecaseofopeneconomywithperfectcapitalmobility.
Reference: N.GregoryMankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 84

85. The Fiscal and Monetary Policies in an Open Economy with perfect Capital Mobility …cond.
Fig 4.19: Effect of Monetary Expansion Under Fixed Exchange Rate
Reference: N.GregoryMankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 85
A Monetary
Expansion Under
Fixed Exchange Rates
If the National Bank
tries to increase the
money supply-for
example, by buying
bonds from the public-it
will put downward
pressure on the exchange
rate,
To maintain the fixed
exchange rate, the money
supply and the LM* curve
must return to their initial
positions,
Hence, under fixed
exchange rates, normal
monetary policy is
ineffectual.

86. The Fiscal and Monetary Policies in an Open Economy with perfect Capital Mobility …cond.
Note:
A country with a fixed exchange rate can, however, conduct a type of
monetary policy:
it can decide to change the level at which the exchange rate is fixed,
Areductionintheofficialvalueofthecurrencyiscalledadevaluation,
andanincreaseinitsofficialvalueiscalledarevaluation,
IntheMundell-Flemingmodel,adevaluationshiftstheIM*curveto
theright;itactslikeanincreaseinthemoneysupplyunderafloatingexchange
rate,
A devaluation thus expands net exports and raises aggregate income,
Conversely, a revaluation shifts the IM* curve to the left, reduces net
exports, and lowers aggregate income.
Reference: N.GregoryMankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 86

87. The Fiscal and Monetary Policies in an Open Economy with perfect Capital Mobility …cond.
Trade Policy Under Fixed ExchageRate
Suppose that the government reduces imports by imposing an import quota or a tariff.,
This policy shifts the net-exports schedule to the right and thus shifts the IS* curve to the right, as in fig
4.20,
The shift in the IS* curve tends to raise the exchange rate,
To keep the exchange rate at the fixed level, the money supply must rise,shifting the LM* curve to the
right,
The result of a trade restriction under a fixed exchange rate is very different from that under a
floating exchange rate,
In both cases, a trade restriction shifts the net-exports schedule to the right, but only under a fixed
exchange rate does a trade restriction increase net exports NX.,
The reason is that a trade restriction under a fixed exchange rate induces monetary expansion , but
not an appreciation of the currency,
The monetary expansion, in turn, raises aggregate income,
Given the accounting identity NX= S -I., when income rises, saving also rises, and this implies an
increase in net exports.
Reference: N.GregoryMankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 87

88. The Fiscal and Monetary Policies in an Open Economy with perfect Capital Mobility …cond.
Fig 4.20: Effect of Trade Policy Under Fixed Exchange Rate
Reference: N.GregoryMankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 88

89. The Fiscal and Monetary Policies in an Open Economy with perfect Capital Mobility …cond.
Reference: N.GregoryMankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 89

90. Interest Rate Differentials
So far, our analysis has assumed that the interest rate in a small open economy is
equal to the world interest rate: r = r*,
To some extent,however, interest rates differ around the world,
We now extend our analysis by considering the causes and effects of international interest
rate differentials.
Reference: N.GregoryMankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 90

91. Country Risk and Exchange-Rate Expectations-Mudell-Fleming Model
Fig 4.21: Country Risk & Exchange-Rate Expectations
Reference: N.GregoryMankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 91

92. Reference: N.GregoryMankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 92
From Short-Run to Long-Run-The Mundell-Fleming Model Underchanging Price Level

93. From Short-Run to Long-Run-The Mundell-Fleming Model Under changing Price Level
Reference: N.GregoryMankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 93
Fig 4.22: Mundell-Fleming as a Theory of Aggregate Demand

94. From Short -Run to Long-Run-The Mundell-Fleming Model Under changing Price Level
Reference: N.GregoryMankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 94
Fig 4.23: The Short-Run and Long-Run EquilibriaIn a Small Open Economy
As in closed economy,
a recession puts
pressure on SRAS cure
to shift down so that P
falls,
Decline in P raise M/P,
and thereby cause
economy to move along
AD curve, back to
equilibrium output

95. Fiscal and Monetary Policy in Large Open Economy
Fig 4.24.A Short-Run Model of the Large Open Economy
Reference: N.GregoryMankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 95

96. Fiscal and Monetary Policy in Large Open Economy…cond.
Fig 4.25 Fiscal Policy in Large Open Economy
Reference: N.GregoryMankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 96

97. Fiscal and Monetary Policy in Large Open Economy…cond.
Fig 4.26: Monetary Policy Under Large Open Economy
Reference: N.GregoryMankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 97
The Monetary Transmission
Mechanism:
oClosed Economy
M r I Y
oSmall Open Economy:
M e NX Y
oInalargeopeneconomy,
monetary transmission
mechanismtakesplacealong
bothdimensions.

98. The Impossible Trinity/Policy Trilemma
Fig 4.27: Impossible Trinity
Reference: N.GregoryMankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 98

99. Critics of Mundull-Fleming Model
Oneimportantcriticismofthemodelisthatthe
assumptionofperfectcapitalmobilitymightbeextreme,
Themodeliscompletelystaticandthereforenotable
toaddressissuesrelatedtothelongrun,aswellasto
thetransitionaldynamicsofprivatewealthand
governmentfinance,
TheMundell-Flemingmodeltherelationsbetween
economicvariablesarenotexplicitlyderivedfroma
micro-foundationofagents’behavior.Thispreventsan
analysisofthewelfareimpactofmacroeconomicpolicies
basedonautilitymeasure,
Reference: N.GregoryMankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 99

100. Summary of the Mundell-Fleming Model
1.TheMundell-FlerningmodelistheIS-LMmodelforasmallopeneconomy.Ittakesthepricelevelasgivenandthenshows
whatcausesfluctuationsinincomeandtheexchangerate,
2.TheMundell-Flemingmodelshowsthatf1scalpolicydoesnotinfluenceaggregateincomeunderfloatingexchange
rates.Afiscalexpansioncausesthecurrencytoappreciate,reducingnetexportsandoffsettingtheusual.
3.TheMundell-Flemingmodelshowsthatmonetarypolicydoesnotinfluenceaggregateincomeunderfixedexchange
rates.Anyattempttoexpandthemoneysupplyisfutilebecausethemoneysupplymustadjusttoensurethatthe
exchangeratestaysatitsannouncedlevel.Monetarypolicydoesinfluenceaggregateincomeunderfloatingexchange
rates.
4.Ifinvestorsarewaryofholdingassetsinacountry,theinterestrateinthatcountrymayexceedtheworldinterestrate
bysomeriskpremium.AccordingtotheMundell-Flemingmodel,ifacountryhasafloatingexchangerate,anincrease
intheriskpremiumcausestheinterestratetoriseandthecurrencyofthatcountrytodepreciate.
5.Thereareadvantagestobothfloatingandfixedexchangerates.Floatingexchangeratesleavemonetarypolicymakers
freetopursueobjectivesotherthanexchange-ratestability.Fixedexchangeratesreducesomeoftheuncertaintyin
internationalbusinesstransactions,buttheymaybesubjecttospeculativeattackifinternationalinvestorsbelievethe
centralbankdoesnothavesufficientforeign-currencyreservestodefendthefixedexchangerate.Whenchoosingan
exchange-rateregime,policymakersareconstrainedbythefactthatitisimpossibleforanationtohavefreecapital
flows,afixedexchangerate,andindependentmonetarypolicy(‘ImpossibleTrinity’).
Reference: N.GregoryMankiew, 8th edn. Ch-6 & 13, and other edn. on Open Economy Chapters 100