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ECON 2003 Intermediate Macroeconomics II _Unit 1_20170728_v1 1
UNIT 1
Introduction and Revisiting the Open
Economy
Overview
Welcome to the first unit of the course! From your previous courses, you would have
learned about important open economy concepts. Remember that in the open economy,
countries are connected though international trade and capital flows. Trade is facilitated
y each country’s cu
ency and so exchange rates, whether they are fixed or flexible
assume greater importance. This also means that each country’s monetary and fiscal
policy are influenced by international events. With this background, we can begin to
uild the open economy model that we will use to analyse the impact of various policies.
In this unit, we extend the analysis of aggregate demand from the IS-LM model in a
closed economy to the Mundell-Fleming model, which assumes a small open economy.
We will first develop the model using key assumptions from the goods market and the
money market along with the net exports curve in Section 1.1. Then in Section 1.2,
assuming a flexible and then a fixed exchange rate, we will examine how trade policy,
monetary policy, and fiscal policy can affect the equili
ium in the economy. Section 1.3
then examines the model in the long run which allows for interest rate differentials and
ECON 2003 Intermediate Macroeconomics II _Unit 1_20170728_v1 2
flexible price levels. The Mundell-Fleming model then allows us to see how the
exchange rate regime, whether fixed or floating, affects the efficacy of monetary, fiscal
and trade policy.
Learning Objectives
By the end of this Unit you will be able to:
1. Examine the assumptions of the Mundell-Fleming model;
2. Determine equili
ium in the short run;
3. Evaluate the impact of fiscal and monetary policy with floating and fixed
exchange rates;
4. Assess the efficacy of trade policies under floating and fixed exchange rates;
5. Examine the impact of including interest rate differentials in the Mundell
Fleming model;
6. Assess how the predictions of the Mundell-Fleming model change when
prices are flexible.
This Unit is divided into three sessions as follows:
Session 1.1: The Mundell Fleming Model in the Short Run
Session 1.2: The Small Open Economy under Floating and Fixed Exchange
Rates
Session 1.3: The Mundell Fleming Model in the Long Run
ECON 2003 Intermediate Macroeconomics II _Unit 1_20170728_v1 3
Readings and Resources
Required Readings
Mankiw, N. G XXXXXXXXXXChapter 12: The open economy revisited: The Mundell-
Fleming model and the exchange-rate regime. In Macroeconomics (7th ed.). New
York: Worth Publishers. [Available from UWIlinC]. Chapter 12.
The Economist. (January 30, XXXXXXXXXXPeggar thy neighbour – exchange rate regimes in
the world. Available at
http:
www.economist.com
logs/graphicdetail/2015/01/daily-chart-17
Required Videos
ACDCLeadership. (2014, November 10). Floating vs. Fixed Exchange Rates- Macroeconom-
ics 5.4. [Video File]. Available at
https:
www.youtube.com/watch?v=_pL_5trI6YY
Lin. X. (2016, May 15). Mundell-Fleming model. [Video File]. Available at
https:
www.youtube.com/watch?v=3nBfkuDs78I
Department of Economics. (2012, April 3). Trilemma. [Video File]. Available at
https:
www.youtube.com/watch?v=LeC_Ll-7GNc
Suggested Readings
Bearce, D XXXXXXXXXXChapter 2: The monetary convergence hypothesis. In monetary
divergence: Domestic policy autonomy in the post-Bretton woods era. Ann A
or,
MI: University of Michigan Press. Available at
https:
www.press.umich.edu/pdf/ XXXXXXXXXXch2.pdf
Curtis, D., & Irvine, I XXXXXXXXXXChapter 14: International economics. In
Macroeconomics: Theory, Markets, and Policy. Lyrlyx Learning. Available at
http:
lyryx.com/textbooks/CurtisIrvine-Macroe-economics-2015A.pdf
Fxtop Company. (n.d.). http:
fxtop.com/en/historical-exchange-rates.php
Wo
ell, D., Marshall, D., & Smith, N XXXXXXXXXXThe political economy of exchange rate
policy in the Cari
ean. (Research Network Working Paper #R-401). Washington,
D.C.: The InterAmerican Development Bank. Available at
http:
www.iadb.org
es/publications/pubfiles/pubR-401.pdf
ECON 2003 Intermediate Macroeconomics II _Unit 1_20170728_v1 4
Session 1.1
The Mundell-Fleming Model in the
Short Run
Introduction
In this session, we will construct the Mundell Fleming Model in the short run using
some aspects of the ISLM Model. The Mundell-Fleming model was the result of the
efforts of Robert Mundell and Marcus Fleming in the 1960s to expand on the Keynesian
model of the money market and the goods market by including the Balance of Payments
(BP) curve. It has since become one of the main models in Macroeconomics.
The Mundell-Fleming Model
In order to build the Mundell-Fleming model, we will make a few assumptions:
• The economy is small and open – this means that there is trade in goods and
services with other countries but the country is too small to affect international
prices.
• Prices at home and a
oad are fixed.
• There is perfect capital mobility – the world interest rate is also the country’s
interest rate:
XXXXXXXXXXr= r* XXXXXXXXXXEquation (1)
Small Open Economy Equili
ium
As in the closed economy, equili
ium is achieved by considering both the goods market
and the money market.
(a) The Goods Market and the IS* curve
The open economy goods market is described by:
Y = C(Y – T) + I(r) + G+ NX(e) XXXXXXXXXXEquation (2)
ECON 2003 Intermediate Macroeconomics II _Unit 1_20170728_v1 5
Where Y is aggregate income, C is consumption, I is investment, G is government
purchases, NX is net exports, and e is the nominal exchange rate.
Remember that the real exchange rate, ϵ, is a function of relative price levels at home (P)
and a
oad (P*) and the nominal exchange rate:
∈ = ? %
%∗
XXXXXXXXXXEquation (3)
The Mundell-Fleming model in the short run assumes fixed prices so that the real
exchange rate is proportional to the nominal exchange rate.
So, equation (2) represents the IS* curve in the Mundell-Fleming model. The curve is
downward sloping because there is a negative relationship between the exchange rate
and aggregate income. For further explanations on how the IS* curve is derived from the
Net Exports Schedule or the Balance of Payments Schedule and the Keynesian Cross,
please see Mankiw 2010, Figure 12-1 on page 342.
(b) The Money Market and the LM* curve
Recall the condition for equili
ium in the money market where the supply of real
money balances, M/P, equals the demand for real money balances L(r, Y):
'
%
= ? ?, ? XXXXXXXXXXEquation (4)
In the Mundell-Fleming model, M, the money supply and P, the price level, are fixed.
The domestic interest rate, r, equals the world real interest rate r*, equation (4) becomes:
'
%
= ? ?∗, ? XXXXXXXXXXEquation (5)
Equation (5) shows then that aggregate income is determined by the real interest rate
and not the exchange rate. Hence the LM* curve is vertical as seen in Figure 12-2 on page
344 in the textbook.
(c) Equili
ium in the Short-Run Mundell-Fleming model
The equili
ium level of aggregate income and the exchange rate are determined by the
intersection of the IS* and LM* curves where the both the goods and money markets
clear. For a graphical presentation, please see Mankiw 2010, Figure 12-3 on page 345.
ECON 2003 Intermediate Macroeconomics II _Unit 1_20170728_v1 6
LEARNING ACTIVITY 1.1
Applying Macroeconomic Concepts
Watch the following video on the Mundell-Fleming model in the short run
and answer the questions listed below:
Lin, X. (2016, May 15). Mundell-Fleming model (c) Xichen Li. Available at
https:
www.youtube.com/watch?v=3nBfkuDs78I
1. What are the main assumptions of the model?
2. What are the factors which influence Net Exports?
3. What are the factors which influence the LM* and IS* curves?
FOOD FOR THOUGHT
The Mundell-Fleming Model allows for the simultaneous determination of
aggregate output and the exchange rates in an open economy. One of its most
poignant takeaways is that to achieve some objectives, the country must be
willing to su
ender at least one important goal. We will discuss this later in
Section 1.3 when we cover the “Impossible Trinity”.
Read pages XXXXXXXXXXof Chapter 12 of Mankiw XXXXXXXXXXto further your
understanding of how equili
ium is determined in the short run
Mundell-Fleming model.
Mankiw, N.G XXXXXXXXXXMacroeconomics (7th ed.). New York: Worth
Publishers. [Available from UWIlinC].
Session 1.1 Summary
We have just expanded the Keynesian IS-LM model by making some additional
assumptions and combining the IS-LM curves with the BP curve to a
ive at the
Mundell-Fleming model. Then we examined how equili
ium is determined in the
model. A major difference between the IS-LM model and the Mundell-Fleming model is
that the main endogenous variables are now the exchange rate