Macroeconomics The Global Economy Term III Ace Institute

Macroeconomics & The Global Economy -Term III Ace Institute of Management Session 10: The Mundell-Fleming Model and Exchange Rate Regime Instructor Sandeep Basnyat Sandeep_basnyat@yahoz. com Mobile: 9841 892281

IS-LM and Mundell-Fleming Model § IS-LM: relationship between interest rate (r) and output (Y)- IS is the negative relationship where as LM is the positive relationship. § Mundell-Fleming: relationship between nominal exchange rate (e) and output (Y). § Argue that: an economy can not simultaneously maintain fixed exchange rate, free capital movement and independent monetary policy.

Mundell-Fleming Model: The IS* curve: Goods market eq’m Equation for IS Curve: Y = C+I+G+NX (e) The IS* curve is drawn for a given value of r*. e Intuition for the slope: IS* Y CHAPTER 12 The Open Economy Revisited

The LM* curve: Money market eq’m LM represents money supply by central bank, which is fixed for certain level of output. e LM* The LM* curve does not depend on e and is vertical to e. Y CHAPTER 12 The Open Economy Revisited

Equilibrium in the Mundell-Fleming model e LM* equilibrium exchange rate equilibrium level of income CHAPTER 12 IS* The Open Economy Revisited Y

Floating & fixed exchange rates § In 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 foreign currency at a predetermined price. § Next, policy analysis – § first, in a floating exchange rate system § then, in a fixed exchange rate system CHAPTER 12 The Open Economy Revisited

Fiscal policy under floating exchange rates At any given value of e, a fiscal expansion shifts IS* to the right, increasing e. Therefore, in Floating exchange rate system, fiscal policy is ineffective in increasing output CHAPTER 12 e e 2 e 1 The Open Economy Revisited Y 1 Y

Monetary policy under floating exchange rates An increase in M shifts LM* right. e Y increases and e decreases. Therefore, in Floating exchange rate system, monetary policy is effective in increasing output CHAPTER 12 e 1 e 2 The Open Economy Revisited Y 1 Y 2 Y

Fiscal policy under fixed exchange rates Under rates, Underfloating rates, afiscalpolicy expansion is ineffective would raise e. output. at changing To keepfixed e from rising, Under rates, the central bank must fiscal policy is very sell domestic currency, effective at changing which increases M output. and shifts LM* right. e e 1 Y 2 CHAPTER 12 The Open Economy Revisited Y

Monetary policy under fixed exchange rates An increase in Mrates, would Under floating monetary policy shift LM* right andisreduce e. e very effective at changing To prevent the fall in e, output. the central bank must buy domestic currency, Under fixed rates, e 1 which reduces M and monetary policy cannot shifts LM*toback left. output. be used affect Results: e = 0, Y = 0 CHAPTER 12 The Open Economy Revisited Y 1 Y

Floating vs. fixed exchange rates Argument for floating rates: § allows monetary policy to be used to pursue other goals (stable growth, low inflation). Arguments for fixed rates: § avoids uncertainty and volatility, making international transactions easier. § disciplines monetary policy to prevent excessive money growth & hyperinflation. CHAPTER 12 The Open Economy Revisited

The Impossible Trinity A nation cannot have free Free capital flows, independent flows monetary policy, and a fixed exchange rate Option 2 Option 1 simultaneously. (Nepal) (U. S. ) A nation must choose one side of this triangle and Independent give up the monetary opposite policy corner. CHAPTER 12 Option 3 (China) The Open Economy Revisited Fixed exchange rate

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