MACROECONOMICS 2010 Worth Publishers, all rights reserved 2010 Worth Publishers, all rights reservedS E V E N T H E D I T I O NN. Gregory MankiwC H A P T E RThe Open Economy:The Mundell-Fleming Model and the Exchange-Rate Regime12In this chapter, you will learn:the Mundell-Fleming model (IS-LM for the small open economy)causes and effects of interest rate differencesarguments for fixed vs. floating exchange rateshow to derive the aggregate demand curve for a small open economy3CHAPTER 12 The Open Economy RevisitedThe Mundell-Fleming modelKey assumption: Small open economy with perfect capital mobility. r = r*Goods market equilibrium the IS* curve:where e = nominal exchange rate = foreign currency per unit domestic currency4CHAPTER 12 The Open Economy RevisitedThe IS* curve: Goods market equilibriumThe IS* curve is drawn for a given value of r*. Intuition for the slope:Y eIS*5CHAPTER 12 The Open Economy RevisitedThe LM* curve: Money market equilibriumThe LM* curve:is drawn for a given value of r*.is vertical because:given r*, there is only one value of Y that equates money demand with supply, regardless of e. Y eLM*6CHAPTER 12 The Open Economy RevisitedEquilibrium in the Mundell-Fleming modelY eLM*IS*equilibriumexchangerateequilibriumlevel ofincome7CHAPTER 12 The Open Economy RevisitedFloating & fixed exchange ratesIn a system of floating exchange rates, e is allowed to fluctuate in response to changing economic conditions.In contrast, under fixed exchange rates, the central bank trades domestic for foreign currency at a predetermined price.Next, policy analysis first, in a floating exchange rate systemthen, in a fixed exchange rate system8CHAPTER 12 The Open Economy RevisitedFiscal policy under floating exchange ratesY eY1 e1 e2 At any given value of e, a fiscal expansion increases Y, shifting IS* to the right. Results: e 0, Y = 09CHAPTER 12 The Open Economy RevisitedLessons about fiscal policyIn a small open economy with perfect capital mobility, fiscal policy cannot affect real GDP. “Crowding out”（挤出）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. 10CHAPTER 12 The Open Economy RevisitedMonetary policy under floating exchange ratesY ee1 Y1 Y2 e2 An increase in M shifts LM* right because Y must rise to restore equilibrium in the money market.Results: e 011CHAPTER 12 The Open Economy RevisitedLessons about monetary policyMonetary policy affects output by affecting the components of aggregate demand: closed economy: M r I Ysmall open economy: M e NX YExpansionary monetary policy does not raise world aggregate 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. 12CHAPTER 12 The Open Economy RevisitedTrade policy under floating exchange ratesY ee1 Y1 e2 At any given value of e, a tariff or quota reduces imports, increases NX, and shifts IS* to the right. Results: e 0, Y = 013CHAPTER 12 The Open Economy RevisitedLessons about trade policyImport 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.”14CHAPTER 12 The Open Economy RevisitedLessons 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. 15CHAPTER 12 The Open Economy RevisitedFixed exchange ratesUnder 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 pre-announced 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.16CHAPTER 12 The Open Economy RevisitedFiscal policy under fixed exchange ratesY eY1 e1 Under floating rates, a fiscal expansion would raise e. Results: e = 0, Y 0Y2 To keep e from rising, the central bank must sell domestic currency, which increases M and shifts LM* right. Under floating rates, fiscal policy is ineffective at changing output.Under fixed rates,fiscal policy is very effective at changing output. 17CHAPTER 12 The Open Economy RevisitedMonetary policy under fixed exchange ratesAn increase in M would shift LM* right and reduce e. Y eY1 e1 To prevent the fall in e, the central bank must buy domestic currency, which reduces M and shifts LM* back left. Results: e = 0, Y = 0Under floating rates, monetary policy is very effective at changing output.Under fixed rates,monetary