2.2.

2 The Fixed Exchange Rate Regime

We shall now develop the Mundell-Fleming model for the fixed exchange rate regime. We
assume that the central bank keeps the exchange rate fixed at e through its intervention in the
foreign currency market. Incorporating it in the goods market equilibrium condition (2.2), we
rewrite it as

P *e

Y C Y T I r G NX
,Y ;Y *
P

0 C 1

(2.31)

(2.31) gives the goods market equilibrium condition in the fixed exchange rate regime. We have
already specified that the financial sector equilibrium in the fixed exchange rate regime is given
by (2.10) and (2.13A). In (2.13A), F denotes value of excess supply of foreign currency at e in
terms of domestic goods. We now know that the excess supply of foreign currency at e is given
by the value of (NX + K) at e in foreign currency. Hence,

P *e

NX
, Y ; Y * K gives the

e
P

excess supply of foreign currency at e . To maintain the exchange rate peg, i.e., to keep e at e ,
the central bank will have to buy up this excess supply of foreign currency with domestic
currency at the exchange rate peg e with

P *e

NX
, Y ; Y * K amount of domestic

e
P

P *e

currency creating P NX
, Y ; Y * K amount of high-powered money in the given period.
P

We thus have

P *e

P NX
, Y ; Y * K H
P

where H gives the amount of high-powered money created in the period under consideration.
Dividing the two sides of the above equation by P, we rewrite it as

H
P *e

NX
, Y ; Y * K

P
P

Note that

(2.32)

H
H
for F into (2.13A), we rewrite it as
F . Hence, substituting
P
P

H 0 H

L r , Y
P
P

(2.33)

The specification of the model is now complete. It is given by the four key equations, (2.10),
(2.31), (2.32) and (2.33) in four endogenous variables: Y , r ,

H
and K. The equilibrium value of
P

r is given by (2.10). Substituting (2.10) into (2.31) and (2.33), we rewrite them as

P *e

Y C Y T I r * G NX
, Y ;Y *
P

0 C 1

(2.34)

and
H 0 H

L r * ,Y
P
P

(2.35)

We can solve (2.34) for the equilibrium value of Y. Substituting the equilibrium value of Y in
(2.35), we get the equilibrium value of

H
. Again, substituting the equilibrium value of Y and
P

H
in (2.32), we get the equilibrium value of K. The solutions of (2.34) and (2.35) are
P

Determination of Y and

H
under Fixed Exchange Rate
P

AD

450 Line
AD

H0
P

Y0

H
P

L r * ,Y0

L r * , Y

Figure 2.7

Determination of K under Fixed Exchange Rate

NX + K,

P *e

, Y0 ; Y * K
NX
P

H
P

P 0

K0

Figure 2.8

illustrated in Figure 2.7 where in the upper panel AD schedule gives the aggregate demand for
domestic output as given by the RHS of (2.34) corresponding to every different Y.

The

equilibrium Y, obviously, corresponds to the point of intersection of the AD schedule and the 450
line. In the lower panel, L r * , Y schedule represents the RHS of (2.35) and it gives the value of
L corresponding to every different value of Y, when r is fixed at r*. The equilibrium L
corresponds to the equilibrium value of Y on the L r * , Y schedule. The excess of the

equilibrium value of L over the initial stock of real balance given by

value of

H0
gives the equilibrium
P

H
- see (2.35). The equilibrium value of K is shown in Figure 2.8 where
P

NX K schedule gives the value of NX K corresponding to every different K, when Y is fixed

at its equilibrium value Y0. H schedule is horizontal at the equilibrium value of

H
. The
P

equilibrium K, as follows from (2.32) corresponds to the point of intersection of these two
schedules. The equilibrium K is denoted by K0.
We are now in a position to examine the impact of fiscal policy in this model.
2.2.2 Fiscal Policy: The Effect of an Increase in G

We shall now examine how an increase in G by dG affects the endogenous variables in this
model. We shall first derive the results using Figures 2.9 and 2.10, where the initial equilibrium

values of Y, L and K are denoted by Y0 L r * ,Y0 and K0 respectively. Let us now examine how

the AD and the L r * , Y schedules are affected by the given increase in G in Figure 2.9.

Effect of an Increase in G on Y and

H
under Fixed Exchange Rate
P

AD

450 Line
AD1
AD

H0
P
H

P 1

Y0

P 0

L r * ,Y0

L r * ,Y1

L r * , Y

L
Figure 2.9

Effect of an Increase in G on K under Fixed Exchange Rate

NX + K,

P *e

NX
, Y0 ; Y * K

H
P

P 1

H 1

P 0

P *e

, Y1 ; Y * K
NX
P

K0
Figure 2.10

K1

Corresponding to every different Y aggregate demand for domestic goods rises by dG . Hence
AD schedule shifts upward. The new AD schedule is labeled AD1 in Figure 2.9. The value of L
corresponding to any given Y, with r equal to r * remains unaffected following the increase in G ,
as it not a determinant of demand for real balance. So L r * , Y schedule remains unaffected.

Thus, it is clear from Figure 2.9 that in the new equilibrium Y is larger and so are L and

The new equilibrium values of Y, L and

H
P

are denoted/given by Y , L r * , Y1

H
.
P

and

H
respectively. Now, focus on figure 2.10 where the initial equilibrium K denoted K0

P 1

P *e

corresponds to the point of intersection of the NX

, Y0 ; Y * K schedule and
P

H schedule. Corresponding to any given K, the value of NX + K becomes less following the

increase in Y from its initial equilibrium value Y0 to its new equilibrium value Y1. Thus the

P *e
, Y1 ; Y * K schedule that gives the value of NX + K corresponding to every K,
NX

P *e

when Y is fixed at Y1. Clearly, it will be below the NX

, Y0 ; Y * K schedule. H
P

H H
schedule now corresponds to
. The new H schedule labeled H 1 will,

P 1 P 0

therefore, be above the initial H line. The new equilibrium K, denoted K1, will be
unambiguously larger.

To sum up our finding, following an increase in G , all the three key endogenous variables Y, K
and

H
go up.
P

Mathematical Derivation of the Results

Let us now derive the results mathematically. For this, we have to take total differential of
(2.32), (2.34) and (2.35) treating all exogenous variables other than G as fixed. This yields the
following equations
dY C dY dG NX Y dY

(2.36)

H
d
L y dY
P

(2.37)

H
NX Y dY dK d

(2.38)

H
The three equations (2.36), (2.37) and (2.38) contain three unknowns: dY, d
P

representing changes in Y,

and dK

H
and K respectively from the initial equilibrium to the new
P

equilibrium. (Explain (2.36), (2.37) and (2.38). Why do they contain only three unknowns?)
Solving (2.36), we get

dY

dG
0
1 C NX Y

Substituting (2.39) into (2.37), we get

(2.39)

dG
H
d
0
Ly .
1 C NX Y
P

(2.40)

Again, substituting (2.39) and (2.40) into (2.38) and solving for dK, we get

1 C dG NX 0

dK L y NX Y .

(2.41)

Let us explain (2.39). Focus on the RHS. The numerator gives the excess demand for domestic
goods that emerges at the initial equilibrium Y following the increase in G by dG . Producers
will begin to increase Y to meet this excess demand. However, an increase in Y will raise demand
of domestic goods also. A unit increase in Y will raise aggregate planned consumption demand
by C . But the whole of C does not represent additional demand for domestic goods alone. It is
allocated between both domestic and foreign goods. A unit increase in Y raises import demand
by NX Y . Of C , therefore, NX Y represents additional demand for foreign goods. Hence, as
Y rises, per unit increase in Y demand for domestic goods goes up by C NX Y and,
therefore, excess demand for domestic goods falls by 1 C NX Y . As excess demand
falls by 1 C NX Y , when Y rises by 1 unit, excess demand will fall by dG when Y
increases by

dG
. This explains (2.39). Since Y increases from the initial

1 C NX Y

equilibrium to the new one by

dG
and r remains unchanged at r * , demand for

1 C NX Y

real balance increases from the initial equilibrium to the new one by L y .

dG
.
1 C NX Y

Accordingly supply of real balance from the initial equilibrium to the new one has to increase by

Ly

dG
dG
H
, i.e., d
. This explains
has to be equal to L y
1 C NX Y
1 C NX Y
P

(2.40). As Y rises from the initial equilibrium to the new one by

dG
and other
1 C NX Y

determinants of NX remains unchanged, the fall in NX from the initial equilibrium to the new one
is given by NX Y

H
dG
. On the other hand,
increases from the initial
P
1 C NX Y

equilibrium to the new one by L y

increase by NX Y

dG
. Hence, as follows from (2.32), K has to

1 C NX Y

dG
dG
+ Ly
. This explains (2,41).

1 C NX Y
1 C NX Y

Adjustment Process

We shall now describe one plausible mode of behavior on the part of the economic agents as
implied by this model that will bring about the changes in Y,

H
and K as given in (2.39),
P

(2.40) and (2.41) respectively following the given increase in G by dG . The increase in G
will create excess demand of dG in the goods market. Producers will expand output by dG to
meet this excess demand. The increase in Y by dG will produce two effects. First, import
demand will go up by NX Y dG . Second, demand for real balance will increase by L y dG . If
the domestic agents whose demand for real balance has gone up try to sell domestic bonds to
increase their holding of real balance, price of domestic bonds will fall raising the rate of return
on domestic bonds. This will make domestic bonds more attractive than foreign bonds. Hence,
they will sell foreign bonds and use the foreign currency received to buy domestic currency.

Thus, importers will want to purchase an additional NX Y dG

P
amount of foreign currency
e

and those who have sold foreign bonds will want to sell an additional L y dG

P
amount of
e

foreign currency. Importers know that if they sell NX Y dG .P amount of domestic currency to
secure NX Y dG

P
amount of foreign currency, their stock of real balance will go down by
e

NX Y dG and they will have to sell foreign bonds to replenish their stock of real balance. So,

they will sell off foreign bonds right at the beginning to finance their import. Thus, in the foreign
currency market there will emerge an excess supply of foreign currency of L y dG

P
. The central
e

bank will buy up this excess supply with L y dG P amount of domestic currency. Therefore, the
supply of real balance will increase by L y dG . Domestic economic agents have sold
L y dG

P
P
+ NX Y dG worth of foreign bonds either to augment their stocks of domestic
e
e

money or to prevent their stocks of domestic money from declining below their desired levels.
Therefore, they have sold L y dG

P
P
+ NX Y dG worth of foreign bonds to invest their sales
e
e

proceeds in domestic money. Hence L y dG

P
P
+ NX Y dG
constitutes an increase in the
e
e

inflow of capital in terms of foreign currency. Thus, K goes up by L y dG + NX Y dG . This is

the end of the first round. As Y increases by dG in the first round, peoples disposable income
rises by dG . Hence their consumption demand for domestic goods will go up by

C NX Y dG . There will thus emerge an excess demand in the domestic goods market and
producers will increase Y by

C NX Y dG .

This increase in Y, as before, will raise the

supply of real balance by L y C NX Y dG and K by L y NX Y C NX Y dG . This

process of expansion will continue until the increase in Y falls to zero. When that happens, the
economy achieves the new equilibrium. Thus, the total increase in Y,

H
and K are given
P

respectively by
dY dG + C NX Y dG + C NX Y dG + C NX Y dG +
2

dG
1 C NX Y

H
2
d
= L y dG + L y C NX Y dG + L y C NX Y dG +.
P

Ly

dG
1 C NX Y

L NX dG

dK

L NX C NX dG
2

= L y NX Y

L NX C NX dG +
y

+ ..

dG
1 C NX Y

This explains the adjustment process.