C H A P T E R

The Open Economy I :

the Mundell-Fleming Model and
the Exchange-Rate Regime
by
Dr. Ganesh Kawadia
slide 1
In this chapter, we will learn
the Mundell-Fleming model
(IS-LM for the small open economy)
causes and effects of interest rate differentials
arguments for fixed vs. floating exchange rates
how to derive the aggregate demand curve for a
small open economy
slide 2
The Balance of Payments
Balance of payments: the record of the transactions
of the residents of a country with the rest of the
world
Two main accounts:
Current account: records trade in goods and
services, as well as transfer payments
Capital account: records purchases and sales of
assets, such as stocks, bonds, and land

Any transaction that gives rise to a payment by a countrys
residents is a deficit item in that countrys balance of payments.
slide 3
The Balance of Payments
The central point of international payments is very simple:
Individuals and firms have to pay for what they buy abroad
If a person spends more than her income, her deficit needs
to be financed by selling assets or by borrowing
Similarly, if a country runs a deficit in its current account
the deficit needs to be financed by selling assets or by
borrowing abroad

Balance: There is no change of official reserves!
Otherwise,
BP=Current account + Capital account = 0 (1)
Current account surplus+ Capital account surplus =
increase in official exchange reserves (BP Surplus)
Net private
capital inflow
slide 4
The China Balance of payments
slide 5
The Balance of Payments and Capital
Flows
Assume a home country faces a given price of imports, export
demand, and world interest rate, i
f

Additionally, capital flows into the home country when the
interest rate is above the world rate
Balance of payments surplus is:
where CF is the capital account surplus
The trade balance is a function of domestic and foreign income
and the real exchange rate

The capital account depends on the interest differential
With perfect capital mobility, BP will balance only when
) ( ) , , (
f f
i i CF R Y Y NX BP + =
*
f
i i i = =
f
eP
R
P
=
slide 6
The Mundell-Fleming model
Key assumption:
Small open economy with perfect capital mobility.
i = i*
Goods market equilibrium the IS* curve:
where
e = nominal exchange rate
= foreign currency per unit domestic currency
= + + + ( ) ( ) ( ) * Y C YD I i G NX e
slide 7
The IS* curve: Goods market eqm
The IS* curve is drawn
for a given value of i*.
Intuition for the slope:
Y
e
IS*
e NX Y + | |
= + + + ( ) ( ) ( ) * Y C YD I i G NX e
slide 8
The LM* curve: Money market eqm
The LM* curve
is drawn for a given
value of i*.
is vertical because:
given i*, there is
only one value of Y
that equates money
demand with supply,
regardless of e.
Y
e
LM*
= ( , ) * M P L i Y
slide 9
Equilibrium in the Mundell-Fleming
model
Y
e
LM*
IS*
equilibrium
exchange
rate
equilibrium
level of
income
= ( , ) * M P L i Y
= + + + ( ) ( ) ( ) * Y C YD I i G NX e
slide 10
Floating & fixed exchange rates
In contrast, under fixed exchange rates,
the central bank trades domestic for foreign
currency at a predetermined price.
In a system of floating exchange rates,
e is allowed to fluctuate in response to changing
economic conditions.
Next, policy analysis
First, in a fixed exchange rate system
Then, in a floating exchange rate system
slide 11
Fixed exchange rates
Under fixed exchange rates, the central bank
stands ready to buy or sell the domestic currency
for foreign currency at a predetermined rate.
In the Mundell-Fleming model, the central bank
shifts the LM* curve as required to keep e at its
preannounced rate.
This system fixes the nominal exchange rate.
In the long run, when prices are flexible,
the real exchange rate can move even if the
nominal rate is fixed.
slide 12
Monetary policy under fixed
exchange rates
2
*
LM
An increase in M would
shift LM* right and reduce e.
Y
e
Y
1

1
*
LM
1
*
IS
e
1

To prevent the fall in e,
the central bank must
buy domestic currency,
which reduces M and
shifts LM* back left.
Results:
Ae = 0, AY = 0

Under fixed rates,
monetary policy cannot
be used to affect output.
2
*
LM
slide 13
Monetary Expansion under fixed ER
slide 14
Fiscal policy under fixed exchange
rates
Y
e
Y
1

e
1

1
*
LM
1
*
IS
2
*
IS
Under floating rates,
a fiscal expansion
would raise e.
Results:
Ae = 0, AY > 0
Y
2

2
*
LM
To keep e from rising,
the central bank must
sell domestic currency,
which increases M
and shifts LM* right.
Under fixed rates,
fiscal policy is very
effective at changing
output.
slide 15

IS
IS
LM
LM
BP
E
E
E
Y
0
Y Y
i
f

i
Fiscal policy under fixed ER
slide 16
Trade policy under fixed exchange
rates
Y
e
Y
1

e
1

1
*
LM
1
*
IS
2
*
IS
A restriction on imports
puts upward pressure on e.
Results:
Ae = 0, AY > 0 Y
2

2
*
LM
To keep e from rising,
the central bank must
sell domestic currency,
which increases M
and shifts LM* right.
Under fixed rates,
import restrictions
increase Y and NX.

But, these gains come
at the expense of other
countries: the policy
merely shifts demand from
foreign to domestic goods.
slide 17
Fiscal policy under floating exchange
rates
Y
e
Y
1

e
1

1
*
LM
1
*
IS
2
*
IS
e
2

At any given value of e,
a fiscal expansion
increases Y,
shifting IS* to the right.
Results:
Ae > 0, AY = 0
= + + + ( ) ( ) ( ) * Y C YD I i G NX e
= ( *, ) M P L i Y
slide 18
Fiscal policy under floating
exchange rates
slide 19
Lessons about fiscal policy
In a small open economy with perfect capital
mobility, fiscal policy cannot affect real GDP.
Crowding out
closed economy:
Fiscal policy crowds out investment by causing
the interest rate to rise.
small open economy:
Fiscal policy crowds out net exports by causing
the exchange rate to appreciate.
slide 20
Monetary policy under floating
exchange rates
Y
e
e
1

Y
1

1
*
LM
1
*
IS
Y
2

2
*
LM
e
2

An increase in M
shifts LM* right
because Y must rise
to restore eqm in
the money market.
Results:
Ae < 0, AY > 0
= ( , ) * M P L i Y
= + + + ( ) ) ( ) ( * Y C YD I i G NX e
slide 21
Monetary policy under floating
exchange rates
slide 22
Lessons about monetary policy
Monetary policy affects output by affecting
the components of aggregate demand:
closed economy: |M +i |I |Y
small open economy: |M +e |NX |Y
Expansionary mon. policy does not raise world
agg. demand, it merely shifts demand from
foreign to domestic products.
So, the increases in domestic income and
employment are at the expense of losses abroad.
slide 23
Trade policy under floating exchange
rates
Y
e
e
1

Y
1

1
*
LM
1
*
IS
2
*
IS
e
2

At any given value of e,
a tariff or quota reduces
imports, increases NX,
and shifts IS* to the right.
Results:
Ae > 0, AY = 0
= + + + ( ) ( ) ( ) * Y C YD I i G NX e
= ( , ) * M P L i Y
slide 24
Lessons about trade policy
Import restrictions cannot reduce a trade deficit.
Even though NX is unchanged, there is less
trade:
the trade restriction reduces imports.
the exchange rate appreciation reduces exports.
Less trade means fewer gains from trade.
slide 25
Lessons about trade policy, cont.
Import restrictions on specific products save jobs
in the domestic industries that produce those
products, but destroy jobs in export-producing
sectors.
Hence, import restrictions fail to increase total
employment.
Also, import restrictions create sectoral shifts,
which cause frictional unemployment.
slide 26
Summary of policy effects in the
Mundell-Fleming model
type of exchange rate regime:
floating fixed
impact on:
Policy Y e NX Y e NX
fiscal expansion 0 | + | 0 0
mon. expansion | + | 0 0 0
import restriction 0 | 0 | 0 |
C H A P T E R
The Open Economy II :
the Mundell-Fleming Model and
the Exchange-Rate Regime
by
Ganesh Kawadia
12
slide 28
Interest-rate differentials
Two reasons why i may differ from i*
country risk: The risk that the countrys borrowers
will default on their loan repayments because of
political or economic turmoil.
Lenders require a higher interest rate to
compensate them for this risk.
expected exchange rate changes: If a countrys
exchange rate is expected to fall, then its borrowers
must pay a higher interest rate to compensate
lenders for the expected currency depreciation.
slide 29
Differentials in the M-F model
where u (Greek letter theta) is a risk premium,
assumed exogenous.
Substitute the expression for i into the
IS* and LM* equations:
= + * i i u
u = + + + + ( ) ( ) ( ) * Y C YD I i G NX e
u = + ( , ) * M P L i Y
slide 30
The effects of an increase in u
2
*
LM
IS* shifts left, because
|u |i +I
Y
e
Y
1

e
1

1
*
LM
1
*
IS
LM* shifts right, because
|u |i +(M/P)
d
,
so Y must rise to restore
money market eqm.
Results:
Ae < 0, AY > 0
2
*
IS
e
2

Y
2

slide 31
The fall in e is intuitive:
An increase in country risk or an expected
depreciation makes holding the countrys currency
less attractive.
Note: an expected depreciation is a
self-fulfilling prophecy.
The increase in Y occurs because
the boost in NX (from the depreciation)
is greater than the fall in I (from the rise in r ).
The effects of an increase in u
slide 32
Why income might not rise
The central bank may try to prevent the
depreciation by reducing the money supply.
The depreciation might boost the price of
imports enough to increase the price level
(which would reduce the real money supply).
Consumers might respond to the increased risk
by holding more money.
Each of the above would shift LM* leftward.
slide 33
Floating vs. fixed exchange rates
Argument for floating rates:
allows monetary policy to be used to pursue other
goals (stable growth, low inflation).
Arguments for fixed rates:
avoids uncertainty and volatility, making
international transactions easier.
disciplines monetary policy to prevent excessive
money growth & hyperinflation.
slide 34
The Impossible Trinity
A nation cannot have free
capital flows, independent
monetary policy, and a
fixed exchange rate
simultaneously.
A nation must choose
one side of this
triangle and
give up the
opposite
corner.
Free capital
flows
Independent
monetary
policy
Fixed
exchange
rate
Option 1
(U.S.)
Option 3
(China)
Option 2
(Hong Kong)
slide 35
CASE STUDY:
The Chinese Currency Controversy
1995-2005: China fixed its exchange rate at 8.28
yuan per dollar, and restricted capital flows.
Many observers believed that the yuan was
significantly undervalued, as China was
accumulating large dollar reserves.
U.S. producers complained that Chinas cheap
yuan gave Chinese producers an unfair advantage.
President Bush asked China to let its currency float;
Others in the U.S. wanted tariffs on Chinese goods.
slide 36
CASE STUDY:
The Chinese Currency Controversy
Now China allows some flexibility of the exchange
rate. Yuan has indeed appreciated.
If China also allows greater capital mobility, Will
Chinese citizens start moving their savings abroad?
Is it possible that such capital outflows could cause
the Yuan to depreciate rather than appreciate?
slide 37
Mundell-Fleming and the AD curve
So far in M-F model, P has been fixed.
Next: to derive the AD curve, consider the impact of
a change in P in the M-F model.
We now write the M-F equations as:
(Earlier in this chapter, P was fixed, so we
could write NX as a function of e instead of c.)
( *) ( ) ( *) ( )
( *) / ( *, )
IS Y C Y T I i G NX
LM M P L i Y
c = + + +
=
slide 38
Y
1
Y
2
Deriving the AD curve
Y
c
Y
P
IS*
LM*(P
1
)
LM*(P
2
)
AD
P
1
P
2
Y
2
Y
1
c
2
c
1
Why AD curve has
negative slope:
|P
LM shifts left
|c
+NX
+Y
+(M/P)
slide 39
Large: Between small and closed
Many countries including the U.S. are neither
closed nor small open economies.
A large open economy is between the polar
cases of closed & small open.
Consider a monetary expansion:
Like in a closed economy,
AM > 0 +i |I (though not as much)
Like in a small open economy,
AM > 0 +c |NX (though not as much)