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Review of the Previous Lecture

Review of the Previous Lecture. IS-LM and Aggregate Demand IS-LM and AD in Short-run and Long-run Shocks to IS Curve Shocks to LM Curve. Topics under Discussion. The Mundell-Fleming Model IS-LM curve for Small Open Economy Floating vs Fixed Exchange Rate Fiscal Policies

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Review of the Previous Lecture

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  1. Review of the Previous Lecture • IS-LM and Aggregate Demand • IS-LM and AD in Short-run and Long-run • Shocks to IS Curve • Shocks to LM Curve

  2. Topics under Discussion • The Mundell-Fleming Model • IS-LM curve for Small Open Economy • Floating vs Fixed Exchange Rate • Fiscal Policies • Monetary Policies • Trade Policies

  3. The Mundell-Fleming Model • Key assumption: Small open economy with perfect capital mobility. r = r* (given) • Goods market equilibrium---the IS* curve: where e = nominal exchange rate = foreign currency per unit of domestic currency (eg, 110 yen per dollar)

  4. e IS* Y The IS* curve: Goods Market Equilibrium The IS* curve is drawn for a given value of r*. Intuition for the slope:

  5. e LM* Y The LM* curve: Money Market Equilibrium The LM* curve • is drawn for a given value of r* • is vertical because:given r*, there is only one value of Y that equates money demand with supply, regardless of e.

  6. e LM* IS* Y Equilibrium in the Mundell-Fleming model equilibrium exchange rate equilibrium level of income

  7. Floating & fixed exchange rates • In a system of floating exchange rates, e is allowed to fluctuate in response to changing economic conditions. • In contrast, under fixed exchange rates, the central bank trades domestic for foreign currency at a predetermined price. • We now consider fiscal, monetary, and trade policy: first in a floating exchange rate system, then in a fixed exchange rate system.

  8. e * LM 1 e2 e1 * IS 2 * IS 1 Y Fiscal policy under floating exchange rates At any given value of e, a fiscal expansion increases Y, shifting IS* to the right. Results: e > 0, Y = 0 Y1

  9. Lessons about fiscal policy • In a small open economy with perfect capital mobility, fiscal policy is utterly incapable of affecting real GDP. • “Crowding out” • closed economy:Fiscal policy crowds out investment by causing the interest rate to rise. • small open economy:Fiscal policy crowds outnet exports by causing the exchange rate to appreciate.

  10. e * * LM LM 1 2 e1 e2 * IS 1 Y Mon. policy under floating exchange rates An increase in M shifts LM* right because Y must rise to restore equilibrium in the money market. Y1 Y2 Results: e < 0, Y > 0

  11. Lessons about monetary policy • Monetary policy affects output by affecting one (or more) of the components of aggregate demand: closed economy: M rI Y small open economy: M eNX Y • Expansionary monetary policy does not raise world aggregate demand, it shifts demand from foreign to domestic products. Thus, the increases in income and employment at home come at the expense of losses abroad.

  12. Summary • The Mundell-Fleming Model • IS-LM curve for Small Open Economy • Floating vs Fixed Exchange Rate • Fiscal Policies • Monetary Policies • Trade Policies

  13. Upcoming Topics • Interest Rate Differentials • South East Asian Crisis • Mundell Fleming and the AD Curve

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