Here's a handout of the slides - Stephen Kinsella

THE IS* CURVE: GOODS MARKET EQ’MThe IS* curve is drawn for agiven value of r*.eIntuition for the slope:Remember, the IS curve incorporatesthe multiplier effect.IS*YTHE LM* CURVE: MONEY MARKET EQ’MThe LM* curve! is drawn for a givenvalue of r*.eLM*! is vertical because:given r*, there isonly one value of Ythat equates moneydemand with supply,regardless of e.YEQUILIBRIUM IN THE MUNDELL-FLEMING MODELeLM*equilibriumexchangerateequilibriumlevel ofincomeIS*Y

FLOATING & FIXEDEXCHANGE RATES• In a system of floating exchange rates,e is allowed to fluctuate in response to changing economicconditions.• In contrast, under fixed exchange rates,the central bank trades domestic for foreign currency at apredetermined price.• Next, policy analysis –• first, in a floating exchange rate system• then, in a fixed exchange rate systemLESSONS ABOUT FISCALPOLICY• In a small open economy with perfect capital mobility, fiscal policycannot affect real GDP.• “Crowding out”• closed economy:Fiscal policy crowds out investment by causing the interest rate torise.• small open economy:Fiscal policy crowds out net exports by causing the exchange rateto appreciate.MONETARY POLICY UNDER FLOATINGEXCHANGE RATESAn increase in Mshifts LM* rightbecause Y must riseto restore eq’m inthe money market.e 1e 2eResults:!e < 0, !Y > 0Y 1 Y 2Y

! Monetary policy affects output by affectingthe components of aggregate demand:closed economy: "M # $r # "I # "Ysmall open economy: "M # $e # "NX # "Y! Expansionary mon. policy does not raise world agg.demand, it merely shifts demand from foreign todomestic products.! So, the increases in domestic income and employmentare at the expense of losses abroad.TRADE POLICY UNDER FLOATINGEXCHANGE RATESeAt any given value of e,a tariff or quota reducesimports, increases NX,and shifts IS* to the right.NX does not change! Why?Results:!e > 0, !Y = 0e 2e 1Y 1YLESSONS ABOUT TRADEPOLICY• Import restrictions cannot reduce a trade deficit.• Even though NX is unchanged, there is less trade:• the trade restriction reduces imports.• the exchange rate appreciation reduces exports.• Less trade means fewer “gains from trade.”

FIXED EXCHANGE RATES• Under fixed exchange rates, the central bank stands readyto buy or sell the domestic currency for foreign currencyat a predetermined rate.• In the Mundell-Fleming model, the central bank shifts theLM* curve as required to keep e at its preannouncedrate.• This system fixes the nominal exchange rate.In the long run, when prices are flexible,the real exchange rate can move even if the nominal rateis fixed.Under floating rates,a fiscal expansionwould raise e.To keep e from rising,the central bank mustsell domestic currency,which increases Mand shifts LM* right.Results:FISCAL POLICY Under UNDER floating FIXED rates, EXCHANGEfiscal RATES policy is ineffectiveat changing output.!e = 0, !Y > 0Under fixed rates,fiscal policy e is veryeffective at changingoutput.e 1Y 1Y 2YMONETARY POLICY UNDER FIXEDEXCHANGE RATESUnder floating rates,monetary policy isvery effective at changingAn increase in M wouldoutput.shift LM* right and reduce e.To Under prevent fixed the rates, fall in e,the monetary central bank policy must cannot buydomesticbe usedcurrency,to affectwhichoutput.reduces M and shifts LM*back left.Results:!e = 0, !Y = 0e 1eY 1Y

SUMMARY OF POLICY EFFECTS IN THE MUNDELL-FLEMING MODELtype of exchange rate regime:floatingimpact on:fixedPolicy Y e NX Y e NXfiscal expansion 0 " $ " 0 0mon. expansion " $ " 0 0 0import restriction 0 " 0 " 0 "FLOATING VS. FIXED EXCHANGE RATESArgument for floating rates:! allows monetary policy to be used to pursue other goals (stablegrowth, low inflation).Arguments for fixed rates:! avoids uncertainty and volatility, making international transactionseasier.! disciplines monetary policy to prevent excessive money growth &hyperinflation.THE IMPOSSIBLE TRINITYA nation cannot have freecapital flows, independentmonetary policy, and a fixedexchange rate simultaneously.A nation must chooseone side of thistriangle andgive up theoppositecorner.IndependentmonetarypolicyOption 1(U.S.)Free capitalflowsOption 3(China)Option 2(Hong Kong)Fixedexchangerate

INTEREST-RATEDIFFERENTIALSTwo reasons why r may differ from r*! country risk: The risk that the country’s borrowers willdefault on their loan repayments because of political oreconomic turmoil.! Lenders require a higher interest rate to compensatethem for this risk.! expected exchange rate changes: If a country’sexchange rate is expected to fall, then its borrowers mustpay a higher interest rate to compensate lenders for theexpected currency depreciation.EXPECTED CHANGE INEXCHANGE RATES• When a foreigner buys a domestic bond, they really earn more thanjust r, the interest rate.• They are holding a euro asset. Foreigners gain if the euro itself gainsvalue relative to the foreign currency.• The expected appreciation of the euro:INTEREST PARITY• The total expected return for a foreigner is• “Interest parity” says that the return on the home country’s bondsequal the foreign interest rate:

INTEREST RATES ANDEXCHANGE RATES• We can rewrite the interest parity equation to get a relationship thatsays the exchange rate is determined by home and foreign interestrates, and the expected future exchange rate:• Home currency is stronger if:• Home interest rate, r, rises• Foreign interest rate, r*, falls• Expected exchange rate increasesSUMMARY• When we allow for expected changes in the value of the currencyand use interest parity, the model is like the closed economy IS-LM.• The IS curve is flatter because a drop in the interest rate also causese to fall, which stimulates net exports.• The expected exchange rate, e e , and the foreign interest rate, r*, canaffect the IS curve.