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CHAPTER
N. GREGORY MANKIW
PowerPoint® Slides by Ron Cronovich
© 2007 Worth Publishers, all rights reserved
In this chapter, you will learn…
Key assumption:
Small open economy with perfect capital mobility.
r = r*
Goods market equilibrium – the IS* curve:
Y C (Y T ) I (r *) G NX (e )
where
e = nominal exchange rate
= foreign currency per unit domestic currency
e NX Y
IS*
Y
equilibrium
exchange
rate
IS*
equilibrium Y
level of
income
CHAPTER 12 The Open Economy Revisited slide 5
Floating & fixed exchange rates
Under
Underfloating
floatingrates,
rates,
afiscal
fiscalpolicy
expansion
is ineffective
e LM 1*LM 2*
would raise e.output.
at changing
To keepfixed
Under e from rising,
rates,
the central
fiscal bank
policy must
is very
sell domestic currency, e1
effective at changing
which
output.increases M IS 2*
and shifts LM* right.
IS 1*
Results: Y
Y1 Y2
e = 0, Y > 0
CHAPTER 12 The Open Economy Revisited slide 15
Monetary policy under fixed
exchange rates
An increase
Under in Mrates,
floating would
monetary
shift policy
LM* right andisreduce e.
very effective at e LM 1*LM 2*
To prevent the fall in e,
changing
the central output.
bank must
buy
Underdomestic currency,
fixed rates,
which reduces
monetary M and
policy cannot e1
shifts LM*toback
be used left.output.
affect
Results: IS 1*
Y
e = 0, Y = 0 Y1
Policy Y e NX Y e NX
fiscal expansion 0 0 0
mon. expansion 0 0 0
import restriction 0 0 0
Y C (Y T ) I (r * ) G NX (e )
M P L(r * ,Y )
30
25
20
15
10
7/10/94 8/29/94 10/18/94 12/7/94 1/26/95 3/17/95 5/6/95
30
25
20
15
10
7/10/94 8/29/94 10/18/94 12/7/94 1/26/95 3/17/95 5/6/95
1. Mundell-Fleming model
the IS-LM model for a small open economy.
takes P as given.
can show how policies and shocks affect income
and the exchange rate.
2. Fiscal policy
affects income under fixed exchange rates, but not
under floating exchange rates.
3. Monetary policy
affects income under floating exchange rates.
under fixed exchange rates, monetary policy is not
available to affect output.
4. Interest rate differentials
exist if investors require a risk premium to hold a
country’s assets.
An increase in this risk premium raises domestic
interest rates and causes the country’s exchange
rate to depreciate.