Class Slides for EC 204Spring 2006

To Accompany Chapter 12

The Small Open Economyin the Short Run:

The Mundell-Fleming Model

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

M/P = L(r, Y) (LM)

r = r* (Perfect Capital Mobilityand Small Country Assumption)

The Small Open Economy UnderFloating Exchange Rates

• Before analyzing effects of policies we need to specify the international monetary system in which the country operates.

• Floating exchange rates characterize the system relevant for most of today’s major economies.

• The exchange rate is allowed to move in response to changes in economic conditions.

The Small Open Economy Under Fixed Exchange Rates

• Central Bank stands ready to buy or sell foreign currency at the fixed rate of exchange

• Bretton Woods System was fixed exchange rate system

• Gold Standard was a fixed exchange rate system

Interest Rate Differentials

r = r* + (Risk Premium)

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

M/P = L(r* + , Y) (LM*)

can represent either a risk premium and/or expected change in the exchange rate

In Practice, Income Boom does not occur following rise in risk

premium:• Depreciation raises price of imported goods

and the price level

• Central Bank may try to avoid depreciation by tightening monetary policy

• Increase in risk premium may directly cause money demand to rise as people seek “safe” asset

Foreign Exchange Market Intervention

• In practice, governments intervene in foreign exchange markets even under flexible exchange rates in order to move the exchange rate in a desired direction

• Intervention is typically “sterilized” by the Central Bank

• Central Bank “sterilizes” (offsets) the effect on the domestic money supply arising from purchases/sales of foreign currency

Sterilized Intervention

• A purchase (sale) of foreign currency would give rise to an increase (decrease) in the domestic money supply

• To “sterilize” this effect, the Central Bank uses an offsetting open-market operation by selling (buying) domestic Treasury securities, leaving the money supply unchanged

• The small open economy model suggests that this will have no effect on the exchange rate, since the money supply is unchanged

Sterilized Intervention

• But, this sale (purchase) of domestic Treasury securities by the Central Bank will increase (reduce) the amount of Treasury securities held by the public

• The public may require a rise (decline) in the risk premium on domestic securities in order to be willing to hold the changed amount

• A change in the risk premium will shift the LM* and IS* curves, leading to a change in the exchange rate, even though the money supply is unchanged

Evidence on the Effectiveness of Sterilized Intervention

• Very little evidence that intervention operates through this “risk premium” channel

• Some evidence that intervention works by signaling a future change in monetary policy itself

• Accordingly, the exchange rate may adjust today in response to this signal of a future shift in monetary policy

The Mundell-Fleming Model with a Changing Price Level

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

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

where we note the distinction between the real and nominalexchange rates: = e(P/P*)

The Large Open Economyin the Short Run

Y = C(Y-T) + I(r) + G + NX(e) Goods Market Eqm.

M/P = L(r, Y) Money Market Eqm.

NX(e) = CF(r) Balance of Payment Eqm.(Net Capital Outflow = Net Exports)

The Large Open Economyin the Short Run: IS-LM

Y = C(Y-T) + I(r) + G + CF(r) (IS)

M/P = L(r, Y) (LM)