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EC201 Intermediate Macroeconomics
EC201 Intermediate Macroeconomics

Lecture 25-26: Fiscal and Monetary Policy in Open
Economies: the Mundell-Fleming Model
Lecture Outline:
- Fiscal and Monetary policy in a small open economy;
- Flexible and Fixed Exchange Rates;
Essential reading:
Mankiw: Ch
...
In this particular lecture note we will consider only the case of a small-open
economy
...

We make two main assumptions to derive our model:
1) Perfect Capital Mobility: there are no restrictions on international trade in assets
...
This means that
they have the same features in terms of risk, maturity etc
...

2) Small-open economy definition: a small-open economy is an economy that is too
small to affect the world prices of any good
...
Furthermore, since a small-open economy
cannot affect the world prices, it cannot affect also the world interest rate
...
Assumption 2) implies
that a small-open economy takes the world interest rate as given (= exogenous)
...
Therefore, in the Mundell-Fleming model we take the prices as
fixed as in the classical IS-LM model
...
Since the prices are fixed (in the domestic economy and also in the
international markets), the nominal exchange rate moves in the same direction as the
real exchange rate
...

P*
This implies that we can write the Net Exports as a function of the nominal exchange
rate instead of the real exchange rate: NX (e) , with

dNX (e)
< 0 , an increase
de

(decrease) in the nominal exchange rate will decrease (increase) the Trade Balance
...
Differently from the standard IS-LM model that was derived in the

(r-Y)-space, the Mundell-Fleming model is derived in the (e-Y) space
...
Under those assumptions the domestic
interest rate (r) is always equal to the world interest rate (r*), therefore it cannot be
determined in the domestic country
...
The first building block is given by the IS curve in an
open economy
...
The main ingredients of this open
economy IS curve are:
Real Interest Rate: r = r *
Consumption function: C = C (Y − T )
Investment function: I = I ( r * )
Government expenditure exogenous: G
Net Exports function: NX (e)
The National Identity in an open economy gives us:
Y = C + I + G + NX

Using the function defined above into that we obtain:

Y = C (Y − T ) + I (r * ) + G + NX (e)

1)

Equation 1) implicitly defines a relationship between the nominal exchange rate and
the level of Real Income in the goods market (implicitly because we are working with
general functional form, for example we do not know explicitly the consumption
function or the net exports function)
...
What is the relationship
between e and Y implied by 1)? Negative or positive? We know it is going to be

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negative since an increase in e (an appreciation of the domestic currency compared to
the currency of the rest of the world) will decrease NX and therefore Y will decrease
...
Rewrite that
equation as:

Y − C (Y − T ) − I (r * ) − G − NX (e) ≡ F (Y , e) = 0
∂C
1−
∂e
FY
∂Y
≡−
=−
dNX (e)
∂Y
Fe
−
de
Notice that

2)

∂C
is the marginal propensity to consume that by assumption is positive
∂Y

and less than 1
...

We know that

∂NX (e)
∂NX (e)
< 0 , therefore −
> 0
...
Given those facts the derivative in 2) is negative and therefore equation 1)
implies a negative relationship between e and Y
...

Graphically:

e

IS*
Y
Notice that we have e in the vertical axis
...
An increase in G (or a
decrease in T) will shift the IS* to the right
...

Example: suppose a decrease in T
...
At this point, initially, Y = C + I + G + NX
...
At the initial value of Y, disposable income (Y-T) is higher, causing

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consumption to be higher
...
An increase in Y (of just the right amount) would
restore equilibrium
...

OR, a decrease in NX of just the right amount would restore equilibrium at the initial
value of Y
...
Hence, each value of Y
is associated with a higher value of e
...

The LM* curve in a small open economy
The LM* curve is very similar to the usual one
...
The reason is because given r*,

there is

only one value of Y that equates money demand with supply, regardless of e
...
Since P is fixed and
r* is exogenous, if the central bank increases M, then Y must increase to equate
money demand (L) with money supply (M/P)
...
In contrast, under fixed exchange rates, the central
bank trades domestic for foreign currency at a predetermined price
...

Let’s focus only on the trade balance (NX):
Exports from UK to US increases: in this case UK citizens receive dollars that they
need to convert into pounds
...

Imports to UK from US: in this case UK importers convert their pounds into dollars
to pay for the US goods imported
...

Sterilisation to keep Fixed the Exchange Rate
If a country wants to keep a fixed exchange rate regime the central bank must
intervene in the foreign exchange market every time there is a tendency for the
exchange rate to move away from the fixed rate
...

Now, suppose that at the exchange rate e0 we have that in UK, NX<0
...
In terms of
demand and supply of pounds: now there is an excess of supply for pounds (and an
excess of demand for dollars)
...
If the UK central bank wants to keep the
exchange rate fixed at e0 where NX<0 it must buy this excess supply of pounds by
selling dollars in the foreign market
...
This operation made by the central bank is called Sterilization
...
The amount of foreign currencies hold by the central bank is called
Reserves
...

Notice that in this setting a situation where NX<0 at the fixed exchange rate cannot be
sustained forever since the amount of Reserves cannot be infinite
...
In some cases devaluation is
the result of what we call a currency crisis (for example the UK Pound and the
Italian Lira crisis in September 1992 when the two currencies were forced to leave the
European Exchange Rate Mechanism)
...
In this case the reserves of the domestic central bank will increase
...
In general, it is the deficit of the Balance of
Payments (and not only of the trade balance) that determines if the reserves will be
reduced and it is the surplus of the Balance of Payments that determines if the
reserves of a country will increase
...
Notice that under a fixed exchange rate regime the
monetary policy is restricted to maintain the predetermined exchange rate and
therefore cannot be used for others goals (like increasing real output, etc
...
)

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The Mundell-Fleming model under Floating Exchange Rate: Fiscal and
Monetary Policy
a) Fiscal Policy:
Suppose an increase in G or a decrease in T in the domestic country:

e

LM 1*

e2
e1
IS 2*
IS 1*

Y1

Y

The IS* curve shifts upward
...
Intuition for the results:
A fiscal expansion puts upward pressure on the country’s interest rate
...
But in order for foreigners to buy these U
...

bonds, they must first acquire U
...
pounds
...
This appreciation makes exports more expensive to foreigners
and imports cheaper to people at home, and thus causes NX to fall
...
How do we know that ∆Y = 0? In order to
maintain the equilibrium in the money market we need Y to be unchanged: the fiscal
expansion does not affect either the real money supply (M/P) or the world interest rate
(because this economy is “small”)
...
So, the exchange rate has to rise until NX has
fallen enough to perfectly offset the expansionary impact of the fiscal policy on
output
...


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Crowding out Effect:
closed economy: Fiscal policy crowds out investment by causing the interest rate to
rise
...

b) Monetary Policy:
Suppose an increase in M
...


(In a closed economy, the interest rate would fall
...
This capital outflow causes the exchange rate to fall, which causes NX and
hence Y to increase
...

The monetary transmission mechanism is now:
small open economy: ↑M ⇒↓ e ⇒ ↑NX ⇒ ↑Y
Notice the difference with the closed economy case:
closed economy: ↑M ⇒↓ r ⇒ ↑I ⇒ ↑Y
The Mundell-Fleming model under Fixed Exchange Rate: Fiscal and Monetary
Policy
a) Fiscal Policy
Suppose an increase in G or a decrease in T
...
An upward shift of the IS* will put a pressure on
the nominal exchange rate to increase
...


e

LM 1*LM 2*

e1
IS 2*
IS 1*

Y1 Y2

Y

In this case the final result from an increase in G is an increase in Y, from Y1 to Y2
while the nominal exchange rate does not change
...

The basic idea is that given that the nominal exchange rate is fixed, then NX is fixed
and therefore there is not the crowding out effect we had with a floating exchange rate
regime
...
Since the IS* does not change this increase in M will shift
the LM* to the right
...
However, if the central bank wants to keep the nominal exchange rate fixed
it must decrease M by the same amount to restore the initial equilibrium
...


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e

LM 1*LM 2*

e1
IS 1*

Y1

Y

Result: In a small open economy with perfect capital mobility and fixed exchange
rate, monetary policy cannot affect real GDP
...
Fixed exchange rates
Argument for floating rates:
A floating exchange rate regime allows monetary policy to be used to pursue other
goals like stable growth and low inflation
...
Speculative attacks on the currency of a
country are not possible if the exchange rate is floating
...
This implies that flexible exchange rate may be subject to
large fluctuations which in turn require large movements in the interest rate
...

Arguments for fixed rates:
A fixed exchange rate regime helps in avoiding uncertainty and volatility in exchange
rate, making international transactions easier
...

Disadvantages of fixed rates:
A country needs to give up monetary policy as a stabilisation tool
...
A fixed exchange rate regime opens
the door to possible speculation, especially when the exchange rate is believed to be
overvalued
...

We can see this using a simple figure:

Free capital flows
Option 2
(Hong Kong)

Option 1
(U
...
)

Independent
monetary policy

Option 3
(China)

Fixed
exchange
rate

A nation must choose one side of this triangle and give up the opposite corner
...
An example of a country that chooses
this option is the United States
...
A country that chooses this option is Hong Kong
...

Doing this requires limiting capital flows
...

Mundell-Fleming Model and the AD curve
Here we consider another possible explanation of why there is a negative relationship
between aggregate prices and aggregate real output as implied by the aggregate
demand function (AD)
...
In this case

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we need to replace the nominal exchange rate in the NX function with the real
exchange rate
...

Graphically:

ε

↑P ⇒ ↓(M/P)

ε2
ε1
IS*

⇒ LM shifts left
⇒ ↑ε
⇒ ↓NX

LM*(P2) LM*(P1)

P

Y2

Y1

Y

P2
P1

⇒ ↓Y

AD
Y2

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Y1

Y



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