Lecture2.

Output,interestratesand
exchangerates:
theMundellFlemingmodel.
CarlosLlano(P)
&NuriaGallego(TA)
References: these slides have been developed based on the ones provided by
Beatriz de Blas and Julin Moral (UAM), as well as the official materials from
Mankiw, 2009 and Blanchard, 2007 books. We are grateful for that.
1

Learningobjectives
TheMundellFlemingmodel(ISLM forthesmallopen
economy)
Causesandeffectsofinterestratedifferentials
Argumentsforfixedversusfloatingexchangerates
Howtoderivetheaggregatedemandcurveforasmall
openeconomy

Outline
1. TheMundellFlemingmodel
2. Floatingandfixedexchangerates
1. Fiscalpolicy
2. Monetarypolicy
3. Tradepolicy

3. Interestratedifferentials
4. Floatingvs.Fixedexchangerates
5. MundellFlemingandtheADcurve
3

INTRODUCTION

Introduction
Whatarethedeterminantsoftheexchangerate?
Howcanagovernmentaffecttheexchangerate?
Howareexchangeratesfixed?
Whataretheeffectsofmonetaryandfiscalpolicy
inanopeneconomy?
5

1.THE MUNDELLFLEMINGMODEL

1.TheMundellFlemingmodel

Keyassumption:
Smallopeneconomywithperfectcapital
mobility.
r =r*
GoodsmarketequilibriumtheIS* curve:

Y C (Y TR T ) I (r *) G NX (e )

where
e =nominalexchangerate
=foreigncurrencyperunitofdomestic
currency
7

TheIS*curve:goodsmarketeqm
Y C (Y TR T ) I (r *) G NX (e )

TheIS* curveis
drawnforagiven
valueofr*.
Intuitionforthe
slope:
e NX Y

IS*
Y
8

TheLM*curve:moneymarketeqm
M P L (r *,Y )
TheLM* curve

isdrawnforagiven
valueofr*

isverticalbecause:
givenr*,thereis
onlyonevalueofY
thatequatesmoney
demandwithsupply,
regardlessofe.

LM*

Y
9

EquilibriumintheMundell
Flemingmodel
Y C (Y TR T ) I (r *) G NX (e )
M P L (r *,Y )

LM*

equilibrium
exchange
rate
equilibrium
levelof
income

IS*

10

2.FLOATINGANDFIXEDEXCHANGERATES

11

2.Floating&fixedexchangerates
Inasystemoffloatingexchangerates,
e isallowedtofluctuateinresponsetochangingeconomic
conditions.
Incontrast,underfixedexchangerates,thecentralbank
tradesdomesticforforeigncurrencyatapredeterminedprice.
Wenowconsiderfiscal,monetary,andtradepolicy:firstina
floatingexchangeratesystem,theninafixedexchangerate
system.

12

2.1Fiscalpolicyunderfloating
exchangerates
Y C (Y TR T ) I (r *) G NX (e )
M P L (r *,Y )
Atanygivenvalueof
e,afiscalexpansion
increasesY,
shiftingIS* tothe
right.

Results:
e >0,Y =0

LM 1*

e2
e1
IS 2*
IS 1*

Y1

Y
13

Lessonsaboutfiscalpolicy
Inasmallopeneconomywithperfectcapital
mobility,fiscalpolicyisincapableofaffectingreal
GDP.
Crowdingout
closedeconomy:
Fiscalpolicycrowdsoutinvestmentbycausingthe
interestratetorise.
smallopeneconomy:
Fiscalpolicycrowdsoutnetexportsbycausingthe
exchangeratetoappreciate.
14

2.2Monetarypolicyunderfloatingexchange
rates
Y C (Y TR T ) I (r *) G NX (e )
M P L (r *,Y )
AnincreaseinM
shiftsLM* right
becauseY mustrise
torestoreeqmin
themoneymarket.
Results:

e <0,Y >0

LM 1*LM 2*

e1
e2
IS 1*

Y1 Y2

Y
15

Lessonsaboutmonetarypolicy
Monetarypolicyaffectsoutputbyaffectingone
(ormore)ofthecomponentsofaggregatedemand:
closedeconomy:M r I Y
smallopeneconomy:M e NX Y
Expansionarymonetarypolicydoesnotraiseworldaggregate
demand,itshiftsdemandfromforeigntodomesticproducts.
Thus,theincreasesinincomeandemployment
athomecomeattheexpenseoflossesabroad.

16

2.3Tradepolicyunderfloating
exchangerates
Y C (Y TR T ) I (r *) G NX (e )
M P L (r *,Y )
Atanygivenvalueofe,
atarifforquota
reducesimports,
increasesNX,
andshiftsIS* tothe

LM 1*

e2
e1

IS 2*

right.

IS 1*

Results:

e >0,Y =0

Y1

Y
17

Lessonsabouttradepolicy
Importrestrictionscannotreduceatradedeficit.
EventhoughNX isunchanged,thereislesstrade:
thetraderestrictionreducesimports
theexchangerateappreciationreducesexports
Lesstrademeansfewergainsfromtrade.
Importrestrictionsonspecificproductssavejobsinthe
domesticindustriesthatproducethoseproducts,butdestroy
jobsinexportproducingsectors.
Hence,importrestrictionsfailtoincreasetotalemployment.
Worseyet,importrestrictionscreatesectorial shifts,which
causefrictionalunemployment.
18

3.Fixedexchangerates
Underasystemoffixedexchangerates,thecountryscentral
bankstandsreadytobuyorsellthedomesticcurrencyfor
foreigncurrencyatapredeterminedrate.
InthecontextoftheMundellFlemingmodel,
thecentralbankshiftstheLM* curveasrequiredtokeepe
atitspreannouncedrate.
Thissystemfixesthenominalexchangerate.
Inthelongrun,whenpricesareflexible,
therealexchangeratecanmove
evenifthenominalrateisfixed.

19

Fiscalpolicyunderfixed
exchangerates
Underfloatingrates,
fiscalpolicyis
ineffectiveatchanging
output.
Underfixedrates,
fiscalpolicyisvery
effectiveatchanging
output.

Results:

e =0,Y >0

LM 1*LM 2*

e1

Y1 Y2

IS 2*
IS 1*
Y

20

Monetarypolicyunderfixed
exchangerates
Underfloatingrates,
monetarypolicyisvery
e
effectiveatchanging
output.
Underfixedrates,
monetarypolicycannot
e1
beusedtoaffectoutput.

Results:
e =0,Y =0

LM 1*LM 2*

IS 1*
Y1

21

Tradepolicyunderfixed
exchangerates
Underfloatingrates,
importrestrictionsdo
notaffectY orNX.
Underfixedrates,
importrestrictions
increaseY andNX.
But,thesegainscomeat
theexpenseofother
countries,asthepolicy
merelyshiftsdemand
fromforeigntodomestic
goods.

LM 1*LM 2*

e1

Y1 Y2

IS 2*
IS 1*
Y
22

Summaryofpolicyeffectsinthe
MundellFlemingmodel
type of exchange rate regime:
floating

fixed

impact on:
Policy

NX

NX

fiscal expansion

mon. expansion

import
restriction

23

3.INTERESTRATEDIFFERENTIALS

24

3.Interestratedifferentials
Tworeasonswhyr maydifferfromr*
countryrisk:
Theriskthatthecountrysborrowerswilldefaultontheir
loanrepaymentsbecauseofpoliticaloreconomicturmoil.
Lendersrequireahigherinterestratetocompensatethem
forthisrisk.
expectedexchangeratechanges:
Ifacountrysexchangerateisexpectedtofall,thenits
borrowersmustpayahigherinterestratetocompensate
lendersfortheexpectedcurrencydepreciation.
25

DifferentialsintheMFmodel
r r *
where isariskpremium.
Substitutetheexpressionforr intothe
IS* andLM* equations:

Y C (Y TR T ) I (r * ) G NX (e )
M P L (r * ,Y )

26

Theeffectsofanincreasein
IS* shiftsleft,because
r I
LM* shiftsright,because
r (M/P)d,
soY mustrisetorestore
moneymarketeqm.

LM 1*LM 2*

e1
e2

Results:
e <0,Y >0

Y1 Y2

IS 1*
IS 2*
Y
27

Theeffectsofanincreasein
Thefalline isintuitive:
Anincreaseincountryriskoranexpected
depreciationmakesholdingthecountryscurrency
lessattractive.
Note:anexpecteddepreciationisa
selffulfillingprophecy.
TheincreaseinY occursbecause
theboostinNX (fromthedepreciation)
isevengreaterthanthefallinI (fromtheriseinr).
28

Whyincomemightnotrise
Thecentralbankmaytrytopreventthedepreciation
byreducingthemoneysupply
Thedepreciationmightboostthepriceofimports
enoughtoincreasethepricelevel(whichwould
reducethereal moneysupply)
Consumersmightrespondtotheincreasedriskby
holdingmoremoney.
EachoftheabovewouldshiftLM* leftward

29

4.FLOATINGVS.FIXEDEXCHANGERATES

30

TheMundellFlemingmodeland
theOptimalCurrencyAreas [OCAs]
ConclusionsfromtheMundellFlemingmodel
Underfloatingexchangerates
FPuselesstoexpandoutput
MPveryuseful:liquidityeffect+exportsboom

Underfixedexchangerates
FPveryusefultoexpandoutput
MPuseless

Whatshouldcountrieschoose:floatingorfixedexchange
rates?
Underwhichcircumstancesarefloatingexchangerates
preferredtofixedexchangerates?
31

Floatingvs.FixedExchangeRates
Argumentforfloatingrates:
allowsmonetarypolicytobeusedtopursueother
goals(stablegrowth,lowinflation)
Argumentsforfixedrates:
ifcredible,avoidsuncertaintyandvolatility,making
internationaltransactionseasier
disciplinesmonetarypolicytopreventexcessive
moneygrowth&hyperinflation
(externalanchor)
32

Theimpossibletrinity
Acountrycannotholdfull
Free capital
capitalmobilitytogether
movement
withautonomous
monetarypolicyandfixed
Option 2
Option 1
exchangerates.
(Hong Kong)
(USA.)
Acountryshouldchoose
twoangelsofthe
triaungle,andrejectthe
thirthone.
Fixed
Autonomous
monetary
policy

Option 3
(China)

exchange
rate

Optimumcurrencyareas(OCAs)
R.Mundell(1961):Whatistheappropriatedomainof
acurrencyarea?
Conditionsunderwhichagroupofcountriesmayjoina
fixedexchangerateregimeorevenadoptacommon
currency:
Theymustsuffersimilardemandshocks samepolicies
inresponse(symmetricvs.asymmetricshocks);
Iftheysufferdifferentshocks,theymusthavehighinput
factorsmobility andusefiscalpolicytostabilizetheGDP.
Question:accordingtothistheory,areEuroareacountries
anOCA?
34

Optimumcurrencyareas(OCAs)
Somereasonsinfavorofamonetaryunion:
avoidtransactionscostsandriskininternational
trade;
avoidthetemptationofcompetitivedevaluations;
avoidexcessivegovernmentindebtedness,andavoid
theriskforrisinginflationtoerodethevalueofpublic
debt.

Question:accordingtothistheory,istheStabilityand
GrowthPactagoodidea?
35

CASESTUDY:
TheMexicanPesoCrisis
U.S. Cents per Mexican Peso

35

30

25

20

15

10
7/10/94

8/29/94

10/18/94

12/7/94

1/26/95

3/17/95

5/6/95
36

CASESTUDY:
TheMexicanPesoCrisis
U.S. Cents per Mexican Peso

35

30

25

20

15

10
7/10/94

8/29/94

10/18/94

12/7/94

1/26/95

3/17/95

5/6/95
37

ThePesoCrisisdidntjusthurtMexico
ForeigngoodsmoreexpensivetoMexicans
U.S.firmslostrevenue
Hundredsofbankruptciesalong
U.S.Mexicoborder

Mexicanassetsworthlessindollars
Affectedretirementsavingsof
millionsofcitizensintheU.S.andelsewhere

38

Understandingthecrisis
Intheearly1990s,Mexicowasseenasanattractive
placeforforeigninvestment.
During1994,politicaldevelopments causedan
increaseinMexicosriskpremium( ):
peasantuprisinginChiapas
assassinationofleadingpresidentialcandidate

Anotherfactor:
TheFederalReserveraisedU.S.interestratesseveral
timesduring1994topreventU.S.inflation.(So,r*
>0)
39

Understandingthecrisis
Theseeventsputdownwardpressureonthepeso.
Mexicoscentralbankhadrepeatedlypromised
foreigninvestorsthatit
wouldnotallowthepesosvaluetofall,
soitboughtpesosandsoldU.S.dollarstopropup
thepesoexchangerate.
DoingthisrequiresthatMexicoscentralbankhave
adequatereservesofdollars.
Didit?
40

InternationalReservesof
MexicosCentralBank(inU.S.Dollars)
December1993 $28billion
August17,1994$17billion
December1,1994 $9billion
December15,1994 $7billion

41

 Thedevaluation
Dec.20:Mexicodevalues thepesoby13%
(fixese at25centsinsteadof29cents)
Investorspanic !!!
andrealizethecentralbankmustberunningoutof
reserves
,InvestorsdumptheirMexicanassetsandpulltheircapital
outofMexico.
Dec.22:centralbanksreservesnearlygone.
Itabandonsthefixedrateandletsefloat.
Inaweek,efallsanother30%.
42

Therescuepackage
1995:U.S.&IMFsetup$50billionlineofcredit
toprovideloanguaranteestoMexicosgovt.
ThishelpedrestoreconfidenceinMexico,
reducedtheriskpremium.
Afterahardrecessionin1995,Mexicobegana
strongrecoveryfromthecrisis.

43

CASESTUDY:
TheSoutheastAsiancrisis199798
Problemsinthebankingsystemerodedinternational
confidenceinSEAsianeconomies.
Riskpremiumsandinterestratesrose.
Stockpricesfellasforeigninvestorssoldassetsand
pulledtheircapitalout.
Fallingstockpricesreducedthevalueofcollateralused
forbankloans,increasingdefaultrates,which
exacerbatedthecrisis.
Capitaloutflowsdepressedexchangerates.

44

TheS.E.AsianCrisis
exchangerate
%changefrom
7/97to1/98

stockmarket% nominalGDP
changefrom
%change
7/97to1/98
199798

Indonesia

59.4%

32.6%

16.2%

Japan

12.0%

18.2%

4.3%

Malaysia

36.4%

43.8%

6.8%

Singapore

15.6%

36.0%

0.1%

S.Korea

47.5%

21.9%

7.3%

Taiwan

14.6%

19.7%

n.a.

Thailand

48.3%

25.6%

1.2%
(199697)

U.S.

n.a.

2.7%

2.3%
45

5.MUNDELLFLEMINGANDTHEAD
CURVE

46

MundellFlemingandtheADcurve
Previously,weexaminedtheMFmodelwithafixed
pricelevel.ToderivetheAD curve,wenowconsider
theimpactofachangeinP intheMFmodel.
WenowwritetheMFequationsas:
(IS*) Y C (Y TR T ) I (r *) G NX (e )
(LM* )

M P L (r *,Y )

(Earlierinthischapter,wecouldwriteNXasa
functionofebecauseeand moveinthesame
directionwhenPisfixed.)
47

DerivingtheADcurve

WhyAD curvehas
negativeslope:
P (M/P )
LM shifts
left

LM*(P1)

2
1
IS*

P2

NX

P1

LM*(P2)

Y2

Y1

AD
Y2

Y1

Y
48

Fromtheshortruntothelongrun
If Y1 Y ,

thenthereisdownward
pressureonprices.
Overtime,P willmove
down,causing
(M/P)

NX
Y

LM*(P1) LM*(P2)

1
2
IS*

Y1

Y
LRAS

P1

SRAS1

P2

SRAS2
AD

Y1

Y
49

Large:betweensmallandclosed
Manycountriesareneitherclosednorsmallopen
economies.
Alargeopeneconomy suchastheU.S.orthe
Eurozone areinbetweenthepolarcasesof
closed&smallopen.
Consideramonetaryexpansion:
Likeinaclosedeconomy,
M >0 r I (thoughnotasmuch)
Likeinasmallopeneconomy,
M >0 NX (thoughnotasmuch)
50

Chaptersummary
1. MundellFlemingmodel
theISLM modelforasmallopeneconomy.
takesP asgiven
canshowhowpoliciesandshocksaffectincomeand

theexchangerate

2. Fiscalpolicy
affectsincomeunderfixedexchangerates,butnot

underfloatingexchangerates.

51

Chaptersummary
3. Monetarypolicy
affectsincomeunderfloatingexchangerates.
Underfixedexchangerates,monetarypolicyisnot

availabletoaffectoutput.

4. Interestratedifferentials
existifinvestorsrequireariskpremiumtoholda

countrysassets.
anincreaseinthisriskpremiumraisesdomestic
interestratesandcausesthecountrysexchangerate
todepreciate.
52

Chaptersummary
5. Fixedvs.floatingexchangerates
Underfloatingrates,monetarypolicyisavailablefor

purposesotherthanmaintainingexchangerate
stability.
Fixedexchangeratesreducesomeoftheuncertainty
ininternationaltransactions.

53