International macroe.. - Free

8.1. A STATIC MUNDELL-FLEMING MODEL 231expectations 2 i = i ∗ . (8.3)Substitute (8.3) into (8.1) and (8.2). Totally differentiate the resultand rearrange to obtain the two-equation systemdm =dy ="φδ1 − γ ds − λ +φσ#di ∗ +1 − γφ dg, (8.4)1 − γδ1 − γ ds − σ1 − γ di∗ + dg1 − γ . (8.5)All of our comparative statics results come from these two equations.Adjustment under Fixed Exchange RatesDomestic credit expansion. Assume that the monetary authorities arecredibly committed to Þxing the exchange rate. In this environment,the exchange rate is a policy variable. As long as the Þx isineffect,we set ds = 0. Income y and the money supply m are endogenousvariables.Suppose the authorities expand the domestic credit component ofthe money supply. Recall from (1.22) that the monetary base is madeup of the sum of domestic credit and international reserves. In theabsence of any other shocks (di ∗ =0,dg = 0), we see from (8.4) thatthere is no long-run change in the money supply dm = 0 and from (8.5),there is no long-run change in output. The initial attempt to expandthe money supply by increasing domestic credit results in an offsettingloss of international reserves. Upon the initial expansion of domesticcredit, the money supply does increase. The interest rate must remainÞxed at the world rate, however, and domestic residents are unwillingto hold additional money at i ∗ . They eliminate the excess money by accumulatingforeign interest bearing assets and run a temporary balanceof payments deÞcit. The domestic monetary authorities evidently haveno control over the money supply in the long run and monetary policyis said to be ineffective as a stabilization tool under a Þxed exchangerate regime with perfect capital mobility.2 Agents expect no change in the exchange rate.