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Econ 100b

Created 4/30/1996
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Lecture Twenty

International Economics; the Mundell-Fleming Model
(Economics 100b; Spring 1996)

Professor of Economics J. Bradford DeLong
601 Evans, University of California at Berkeley
Berkeley, CA 94720
(510) 643-4027 phone (510) 642-6615 fax
delong@econ.berkeley.edu
http://www.j-bradford-delong.net

March 13, 1996


Administration
Small Open Economy
The Mundell-Fleming Model
MF Under Flexible Exchange Rates
MF Under Fixed Exchange Rates


Administration

Makeup exam: Evans 639 between 2:30 and 3:30 p.m. on Friday.


Small Open Economy

Up until now we have dealt only with "closed economies": economies that do not trade with the rest of the world. This may be a mistake, because there are few "closed economies" left in the world: international trade and international finance are at the heart of most of economic policy, and much of macroeconomic events even in the United States--the most closed economy in the world, by some measures.

But even in the United States:

All out of a 1995 GDP of about $7,246 billion

and with some $2.77 trillion of U.S.-owned assets abroad, and some $3.35 trillion of foreign-owned assets here in the U.S.

What we do first is a "small open economy" version of the IS-LM model. Key assumptions: the country being analyzed is "small" in the sense that it doesn't affect world prices but is affected by them. And we are going to start out in a "timeless" fashion: just look at short-run equilibria; don't think about how such equilibria will evolve over time; assume domestic (and international) inflation are zero; assume no expected exchange rate changes


The Mundell-Fleming Model

Start with our IS curve:

(1) Y = C(Y-T) + I(r) + G

and add a "net exports" (NX) term:

(2) Y = C(Y-T) + I(r) + G + NX(e)

where e is the exchange rate, and the lower is e, the higher are net exports--the greater are exports relative to imports.
Brief digression on Lerner stability conditions and the J-curve. How do we know that NX(e) slopes the "right" way? Answer: we don't--in the short run. But we are certain it does in the long run.

We also have:

(3) M/P = L(i, Y)

(4) i = r (from no expected inflation; no shifts in interest rates expected to mess up the term structure)

and finally:

(5) r = r*, where r* is the real interest rate "out there" in the world, set by forces removed from the domestic economy.

Note that if you remember that on the savings-expenditure side:

(6) Y = C + Sp + T

(1) is equivalent to the loanable-funds equilibrium condition:

(7) Sp - I(r) - DEF = NX(e)

Now let's fix everything domestic--fix G, fix T, fix the parameters of the consumption function, and substitute r* in for r in (1) and (2) to obtain what Mankiw calls the IS* and LM* curves:

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

downward sloping in Y-e space, with e on the vertical axis,
and:

(9) M/P = L(r*, Y)

a vertical curve at equilibrium output... Why? What makes the LM curve upward sloping is that as income rises (and transactions demand for money rises along with it), a rise in the interest rate causes households and businesses to economize on their stocks of liquid assets.

Here the interest rate doesn't rise--pegged by international markets. Hence output is pinned by the LM* curve--the exchange rate rises instead.



That there is some truth in this can be seen in the reaction to the Reagan tax cuts; 63% increase in dollar.


MF Under Flexible Exchange Rates

A fiscal expansion under flexible exchange rates shifts the IS* curve outwards on the Y-e diagram..
A monetary expansion under flexible exchange rates causes a fall in the exchange rate, and an increase in output.

A tariff to alter the trade balance?


MF Under Fixed Exchange Rates

Suppose that you adopt a fixed exchange rate system: e = e*; buy and sell dollars for yen, marks, whatever to keep the exchange rate perfectly fixed. What happens?
If equilibrium exchange rate is higher than fixed rate, then dollars are a good deal: everyone tries to sell yen for dollars, wait for the exchange rate to rise, and then collect a profit. But as long as the Federal Reserve maintains the fixed parity, it can't refuse to sell dollars for yen--hence the money stock rises. And as the money stock rises the LM* curve shifts out. Where does it end? Where all three curves cross.
So: maintaining a fixed exchange rate means you give up control over your money supply.

So should exchange rates be floating or fixed. Fixed--because it makes international trade easier (and keeps monetary authorities from messing up). Floating--because then you can use monetary policy to stabilize the economy. And floating--because no one believes that fixed exchange rates will be maintained, and an erratic system of "punctuated equilibrium" has all the disadvantages of both.


>

Econ 100b

Created 4/30/1996
Go to
Brad De Long's Home Page


Professor of Economics J. Bradford DeLong, 601 Evans
University of California at Berkeley
Berkeley, CA 94720-3880
(510) 643-4027 phone (510) 642-6615 fax
delong@econ.berkeley.edu
http://www.j-bradford-delong.net/