®

CHAPTER 12
The Open Economy Revisited:
The Mundell-Fleming Model and the
Exchange-rate Regime

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MACROECONOMICS, 6th. ed.

N. Gregory Mankiw

Chapter By 1
Twelve
Mannig J. Simidian
 Introducing…
This model is a close relative of the IS-LM model; both stress the
interaction between the goods market and the money market. Price
levels are fixed, and both show short-run fluctuations in aggregate
income. The
Mundell-Fleming Model assumes an open economy in which trade and
finance are added; the IS-LM e assumes a closed economy.
LM*

Equilibrium
IS*
exchange rate
Income, output, Y
Equilibrium income
Chapter 2
Twelve
This model, often described as “the dominant policy paradigm for
studying open-economy monetary and fiscal policy,” makes one
important and extreme assumption: the economy being studied is a
small open economy and there is perfect capital mobility, meaning
that it can borrow or lend as much as it wants in world financial
markets, and therefore, the economy’s interest rate is controlled by
the world interest rate, mathematically denoted as r = r*.

One key lesson about this model is that the behavior of an economy
depends on the exchange rate regime it adopts—floating or fixed.

This model will help answer the question of which exchange rate
regime should a nation adopt?
Chapter 3
Twelve
Under a system of floating exchange rates, the exchange rate is set
by market forces and is allowed to fluctuate in response to changing
economic conditions.

The exchange rate e, adjusts to achieve simultaneous equilibrium in

the goods market and the money market. When something changes
that equilibrium, the exchange rate is allowed to adjust to a new
rate.

Chapter 4
Twelve
 The Small Open Economy Under Floating Exchange Rates
Let’s start with two equations (notice the asterisk next to IS and LM to
remind us that the equations hold the interest rate constant):
IS*: Y = C(Y-T) + I(r*) + G + NX(e) LM*: M/P = L (r*,Y)

Assumption 1:
The domestic interest rate is equal to the world interest rate (r = r*).
Assumption 2:
The price level is exogenously fixed since the model is used to analyze
the short run (P). This implies that the nominal exchange rate is
proportional to the real exchange rate.
Assumption 3:
The money supply is also set exogenously by the central bank (M).
Assumption 4:
Our LM* curve will be vertical because the exchange rate does not enter
Chapter 5
into our LM* equation.
Twelve
The IS* curve slopes downward because a higher exchange rate
reduces net exports (since a currency appreciation makes domestic
goods more expensive to foreigners), which in turn, lowers
aggregate income.
Exchange rate, e

IS*
Chapter Income, output, Y 6
Twelve
 An
Anincrease
increasein inthe
theexchange
exchange (b)

Expenditure, E
rate,
rate,lowers
lowersnetnetexports,
exports, Y=E
which
whichshifts
shiftsplanned
planned Planned expenditure,
expenditure
expendituredownward
downwardand and E = C + I + G + NX
lowers
lowersincome.
income.TheTheIS*
IS*
curve
curvesummarizes
summarizesthesethese
changes
changesin inthe
thegoods
goodsmarket
market
equilibrium.
equilibrium. Income, output, Y
(a) (c)
Exchange rate, e,

Exchange rate, e

NX(e) IS*
Chapter 7
Twelve Net exports, NX Income, output, Y
 Interest rate, r
LM

r = r*
The
TheLM LMcurve
curveandand
the
theworld
worldinterest
interest
rate
ratetogether
togetherdetermine
determine Income, output, Y
the
thelevel
levelof
ofincome.
income.
The
TheLM*LM*curve
curveisis LM*
Exchange rate, e
vertical
verticalbecause
becausethe the
exchange
exchangerateratedoes
does
not
notenter
enterinto
intothe
theLM*
LM*
equation.
equation.
Recall
Recallthe theLM*
LM*equation
equationis:
is:
M/P
M/P==LL(r*,Y)
Chapter (r*,Y) 8
Twelve Income, output, Y
 e LM* LM*'
e LM*
++∆∆ G,
G,or or––∆∆ TT⇒
⇒ ++∆∆ MM⇒ ⇒
++∆∆ e,e,no
no∆∆ YY --∆∆ e,e,++∆∆ YY

IS*
IS* IS*'
Income, output, Y Income, output, Y
When
Whenincome
incomerises
risesininaasmall
smallopen
openeconomy,
economy,due duetoto When
Whenthe theincrease
increaseininthe
themoney
moneysupply
supplyputs
putsdownward
downward
the
thefiscal
fiscalexpansion,
expansion,the theinterest
interestrate
ratetries
triestotorise
risebut
but pressure
pressure on the domestic interest rate, capital flowsout
on the domestic interest rate, capital flows out
capital inflows from abroad put downward
capital inflows from abroad put downward pressure pressure asasinvestors seek a higher return elsewhere. The
investors seek a higher return elsewhere. The capital capital
on
onthetheinterest
interestrate.
rate.This
Thisinflow
inflowcauses
causesananincrease
increaseinin outflow
outflowprevents
preventsthetheinterest
interestrate
ratefrom
fromfalling.
falling. The
The
the
thedemand
demandfor forthe
thecurrency
currencypushing
pushingup upits
itsvalue
value outflow also causes the exchange rate to depreciate,
outflow also causes the exchange rate to depreciate,
and thus making domestic goods more
and thus making domestic goods more expensive expensive making
makingdomestic
domesticgoods
goodslesslessexpensive
expensiverelative
relativetoto
totoforeigners
foreigners (causingaa––∆∆NX).
Chapter(causing The––∆∆NX
NX).The NXoffsets
offsets foreign
foreigngoods,
goods,andandstimulates
stimulatesNX.NX.Hence,
Hence,monetary 9
monetary
the expansionary
expansionary fiscal policy and the effect onY.Y.
theTwelve fiscal policy and the effect on policy influences the e rather than
policy influences the e rather than r. r.
 Fixed Exchange Rates
Under a fixed exchange rate, the central bank announces a value
for the exchange rate and stands ready to buy and sell the domestic
currency at a predetermined price to keep the exchange
rate at its announced level. Fixed exchange rates require a commitment
of a central bank to allow the money supply to adjust to whatever level
will ensure that the equilibrium exchange rate in the market for foreign-
currency exchange equals the announced exchange rate.

Most recently, China fixed the value of its currency against the U.S.
dollar, which has resulted in a lot of tension between the two nations.

It is important to realize that this exchange-rate system fixes the

nominal exchange rate. Whether it fixes the real exchange rate depends
on the time horizon.
Chapter 10
Twelve
 The Mundell-Fleming Model
Under Fixed Exchange Rates

++∆∆ G, or––∆∆ TT⇒

G,or ⇒++∆∆ YY ++∆∆ Μ
Μ⇒ no ∆∆ YY
⇒no
e LM*
e LM* LM*'

IS*
IS* IS*'
Income, output, Y Income, output, Y
AAfiscal
fiscalexpansion
expansionshifts
shiftsIS*
IS*totothe
theright.
right.ToTomaintain
maintain IfIfthe
theFed
Fedtried
triedtotoincrease
increasethe
themoney
moneysupply
supplyby by
the
the fixed exchange rate, the Fed must increasethe
fixed exchange rate, the Fed must increase the buying bonds from the public, that would
buying bonds from the public, that would put down- put down-
money supply, thus increasing LM* to the
money supply, thus increasing LM* to the right. right. ward
wardpressure
pressureon onthe
theinterest
interestrate.
rate.Arbitragers
Arbitragersrespond
respond
Unlike
Unlikethethecase
casewith
withflexible
flexibleexchange
exchangerates,
rates,there
thereisisno
no by
by selling the domestic currency to the centralbank,
selling the domestic currency to the central bank,
crowding out effect on NX due to a higher
crowding out effect on NX due to a higher exchange exchange causing the money supply and the
causing the money supply and the LM curveLM curve
Chapter rate.
rate. totocontract
contracttototheir
theirinitial
initialpositions.
positions.11
Twelve
 Fixed vs.
Exchange Rate Conclusions
Fixed Exchange
Rates
• Fiscal Policy is Powerful.
• Monetary Policy is Powerless.
Hint: (“Fixed” and “Fiscal” sound alike).
Floating Exchange
Rates
• Fiscal Policy is Powerless.
• Monetary Policy is Powerful.
Hint: (Think of “floating” money.)

The Mundell-Fleming model shows that fiscal policy does not influence
aggregate income under floating exchange rates. A fiscal expansion
causes the currency to appreciate, reducing net exports and offsetting
the usual expansionary impact on aggregate demand.

The Mundell-Fleming model shows that monetary policy does not

influence aggregate income under fixed exchange rates. Any attempt
to expand the money supply is futile, because the money supply
mustChapter
adjust to ensure that the exchange rate stays at its announced12level.
Twelve
 Policy in the Mundell-Fleming Model:
A Summary

The
TheMundell-Fleming
Mundell-Flemingmodel modelshows
showsthat
thatthe
theeffect
effectof
ofalmost
almostany
any
economic
economicpolicy
policyon onaasmall
smallopen
openeconomy
economydepends
dependsononwhether
whetherthe
the
exchange
exchangerate
rateisisfloating
floatingor
orfixed.
fixed.

The
TheMundell-Fleming
Mundell-Flemingmodel
modelshows
showsthat
thatthe
thepower
powerof
ofmonetary
monetaryand
and
fiscal
fiscalpolicy
policyto
toinfluence
influenceaggregate
aggregatedemand
demanddepends
dependsononthe
theexchange
exchange
rate
rateregime.
regime.

Chapter 13
Twelve
A country with fixed exchange rates can, however, conduct
a type of monetary policy by deciding to change the level at
which the exchange rate is fixed.

A reduction in the official value of the currency is called a

devaluation, and an increase in the value is called a revaluation.

Chapter 14
Twelve
 What if the domestic
interest rate were above
the world interest rate?

The higher return will attract funds from the rest of the world,
driving the domestic interest rate back down. And, if the
domestic interest rate were below the world interest rate, r*,
domestic residents would lend abroad to earn a higher return,
driving the domestic interest rate back up. In the end, the
domestic interest rate would equal the world interest rate.
Chapter 15
Twelve
Why doesn’t this logic always apply? There are two reasons why interest
rates differ across countries:

1) Country Risk: when investors buy U.S. government bonds, or make

loans to U.S. corporations, they are fairly confident that they will be
repaid with interest. By contrast, in some less developed countries, it
is plausible to fear that political upheaval may lead to a default on loan
repayments. Borrowers in such countries often have to pay higher
interest rates to compensate lenders for this risk.

2) Exchange Rate Expectations: suppose that people expect the French

franc to fall in value relative to the U.S. dollar. Then loans made in francs
will be repaid in a less valuable currency than loans made in dollars. To
compensate for the expected fall in the French currency, the interest rate
in France
Chapterwill be higher than the interest rate in the United States. 16
Twelve
Differentials in the Mundell-Fleming Model
To incorporate interest-rate differentials into the Mundell-Fleming
model, we assume that the interest rate in our small open economy
is determined by the world interest rate plus a risk premium θ .
r = r* + θ
The risk premium is determined by the perceived political risk of
making loans in a country and the expected change in the real interest
rate. We’ll take the risk premium θ as exogenously determined.
IS*: Y = C(Y-T) + I(r* + θ ) + G + NX(e)
LM*: M/P = L (r* + θ ,Y)
For any given fiscal policy, monetary policy, price level, and risk
premium, these two equations determine the level of income and
exchange rate that equilibrate the goods market and the money market.

Chapter 17
Twelve
Now suppose that political turmoil causes the country’s risk premium θ
to rise. The most direct effect is that the domestic interest rate r rises.
The higher interest rate has two effects:
1) IS* curve shifts to the left, because the higher interest rate reduces
investment.
2) LM* shifts to the right, because the higher interest rate reduces the
demand for money, and this allows a higher level of income for any
given money supply.
These two shifts cause income to rise and thus push down the equilibrium
exchange rate on world markets.
The important implication: expectations of the exchange rate are partially
self-fulfilling. For example, suppose that people come to believe that the
French franc will not be valuable in the future. Investors will place a
larger risk premium on French assets: θ will rise in France. This
expectation will drive up French interest rates and will drive down the
value of the French franc. Thus, the expectation that a currency will lose
value in the future causes it to lose value today. The next slide will
Chapter 18
demonstrate
Twelve the mechanics.
 An Increase in the Risk Premium
IsIsthis
thisreally
reallyisiswhere
where
e LM* LM*'
the
theeconomy
economyends ends
up?
up?In Inthe
thenext
nextslide,
slide,
we’ll
we’llsee
seethat
that
increases
increasesin incountry
country
risk
riskare
areundesirable.
undesirable.
IS*
IS*'
Income, output, Y

An
Anincrease
increaseininthe
therisk
riskpremium
premiumassociated
associatedwith
withaacountry
countrydrives
drivesup
up
its
itsinterest
interestrate.
rate. Because
Becausethe thehigher
higherinterest
interestrate
ratereduces
reducesinvestment,
investment,
the
theIS*
IS*curve
curveshifts
shiftsto
tothe
theleft.
left. Because
Becauseititalso
alsoreduces
reducesmoney
money
demand,
demand,the theLM*
LM*curve
curveshifts
shiftsto
tothe
theright.
right. Income
Incomerises,
rises,and
andthe
the
exchange
exchangerate
ratedepreciates.
depreciates.
Chapter 19
Twelve
 There are three reasons why, in practice, such a boom in income
does not occur. First, the central bank might want to avoid the large
depreciation of the domestic currency and therefore, may respond
by decreasing the money supply M. Second, the depreciation of the
domestic currency may suddenly increase the price of domestic goods,
causing an increase in the overall price level P. Third, when some event
increase the country risk premium θ , residents of the country might
respond to the same event by increasing their demand for money (for
any given income and interest rate), because money is often the
safest asset available. All three of these changes would tend to shift
the LM* curve toward the left, which mitigates the fall in the exchange
rate but also tends to depress income.

Chapter 20
Twelve
 1) Exchange-rate volatility
creates uncertainty and
1) Allows monetary policy to be used
makes trade more difficult.
for other purposes such as stabilizing
2) Tempers overuse of
employment or prices.
monetary authority.

1) Monetary policy is committed

1) More speculation and to the single goal of maintaining
volatility expected. the announced level.
2) May lead to greater volatility in
income and employment.
Chapter 21
Twelve
A speculative attack is a case where a change in investors’ perceptions
makes a fixed rate untenable.

To avoid these kinds of attacks, some economists suggest the use of a

currency board, an arrangement by which the central bank holds
enough foreign currency to back each unit of the domestic currency.

The next for a nation is to consider dollarization, a plan in which

the domestic currency is abandoned and the U.S. dollar is used instead.

Chapter 22
Twelve
It is impossible for a nation to have free capital flows, a fixed
exchange rate, and independent monetary policy.
Free capital flows

Option 1: Option 2:
United States Hong Kong

Independent Fixed
Monetary Exchange
Policy Option 3: Rates
Chapter
China 23
Twelve
Recall the two equations of the Mundell-Fleming model:
IS*: Y=C(Y-T) + I(r*) + G + NX(e) e LM* LM*'
LM*: M/P=L (r*,Y)

When
Whenthetheprice
pricelevel
levelfalls,
falls,the
theLM*
LM*
curve
curveshifts
shiftsto
tothe
theright.
right.The
The IS*
equilibrium
equilibriumlevel
levelof
ofincome
incomerises.
rises. Income, output,Y
P
The
Thesecond
secondgraph
graphdisplays
displaysthe
the
negative
negativerelationship
relationshipbetween
betweenPPand
and
Y,
Y,which
whichisissummarized
summarizedby bythe
the
aggregate
aggregatedemand
demandcurve.
curve.
AD
Chapter 24
Twelve Income, output,Y
 Real LM* LM*'
Point K in both panels exchange
shows the equilibrium rate
under the Keynesian e1 K
assumption that prices are e2 C
fixed at P1. Point C in both IS*
diagrams shows the equilibrium Income, output,Y
P
under the classical assumption
that the price level adjusts to
maintain income at its natural level K
P1 SRAS1
Y. SRAS2
P2
C AD
Chapter 25
Twelve Income, output,Y
 Mundell-Fleming
Mundell-FlemingModel
Model
Floating
Floatingexchange
exchangerates
rates
Fixed
Fixedexchange
exchangerates
rates
Devaluation
Devaluation
Revaluation
Revaluation

Chapter 26
Twelve