Worth: Mankiw Economics 5e CHAPTER 12 Aggregate Demand in the Open Economy 317 figure 12-3 Exchange rate, e The Mundell-Fleming Model This graph of the Mundell- Fleming model plots the goods market equilibrium condition /S* and the money market equilibrium cond LM*. Both curves are drawn holding the interest rate exchange rate constant at the world interest rate. The intersection of these two curves shows the level of income and the exchange rate hat satisfy equilibrium both in the goods market and in the Income, output, shows the exchange rate and the level of income at which both the goods market and the money market are in equilibrium. With this diagram, we can use the Mundell-Fleming model to show how aggregate income Y and the exchange te e respond to changes in policy. 12-2 The Small Open Economy Under Floating Exchange Rates Before analyzing the impact of policies in an open economy, we must specify the international monetary system in which the country has chosen to operate. We start with the system relevant for most major economies today: floating ex- change rates. Under floating exchange rates, the exchange rate is allowed to Fluctuate in response to changing economic conditions Fiscal Policy Suppose that the government stimulates domestic spending by increasing govern- nent purchases or by cutting taxes. Because such expansionary fiscal policy in- creases planned expenditure, it shifts the IS" curve to the right, as in Figure 12-4 As a result, the exchange rate appreciates, whereas the level of income remains the Notice that fiscal policy has very different effects in a small open economy than it does in a closed economy. In the closed-economy IS-LM model,a fiscal expansion raises income, whereas in a small open economy with a floating exchange rate, a fiscal expansion leaves income at the same level. Why the User JoENA: Job EFFo1428: 6264_ch12: Pg 317: 27512#/eps at 100sm Mon,Feb18,200212:44
User JOEWA:Job EFF01428:6264_ch12:Pg 317:27512#/eps at 100% *27512* Mon, Feb 18, 2002 12:44 AM shows the exchange rate and the level of income at which both the goods market and the money market are in equilibrium. With this diagram, we can use the Mundell–Fleming model to show how aggregate income Y and the exchange rate e respond to changes in policy. 12-2 The Small Open Economy Under Floating Exchange Rates Before analyzing the impact of policies in an open economy, we must specify the international monetary system in which the country has chosen to operate.We start with the system relevant for most major economies today: floating exchange rates. Under floating exchange rates, the exchange rate is allowed to fluctuate in response to changing economic conditions. Fiscal Policy Suppose that the government stimulates domestic spending by increasing government purchases or by cutting taxes. Because such expansionary fiscal policy increases planned expenditure, it shifts the IS* curve to the right, as in Figure 12-4. As a result, the exchange rate appreciates, whereas the level of income remains the same. Notice that fiscal policy has very different effects in a small open economy than it does in a closed economy. In the closed-economy IS–LM model, a fiscal expansion raises income, whereas in a small open economy with a floating exchange rate, a fiscal expansion leaves income at the same level. Why the CHAPTER 12 Aggregate Demand in the Open Economy | 317 figure 12-3 Exchange rate, e Income, output, Y Equilibrium exchange rate Equilibrium income LM* IS* The Mundell–Fleming Model This graph of the Mundell– Fleming model plots the goods market equilibrium condition IS* and the money market equilibrium condition LM*. Both curves are drawn holding the interest rate constant at the world interest rate. The intersection of these two curves shows the level of income and the exchange rate that satisfy equilibrium both in the goods market and in the money market
Worth: Mankiw Economics 5e 318 PART IV Business Cycle Theory: The Economy in the Short Run figure 12-4 Exchange rate, e A Fiscal Expans Increase in government purchases or a decrease in taxes shifts the /S* curve to the right. ifts the /S This the exchange rate but 3....and leaves income come, output, difference? When income rises in a closed economy, the interest rate rises, because higher income increases the demand for money. That is not possible in a small open economy: as soon as the interest rate tries to rise above the world interest rate r*, capital flows in from abroad. This capital inflow increases the de mand for the domestic currency in the market for foreign-currency exchange and, thus, bids up the value of the domestic currency. The appreciation of the ex- change rate makes domestic goods expensive relative to foreign goods, and this reduces net exports. The fall in net exports offsets the effects of the expansionary fiscal policy on income. Why is the fall in net exports so great that it renders fiscal policy powerless to influence income? To answer this question, consider the equation that describes che money market: M/P=L(, y In both closed and open economies, the quantity of real money balances sup- plied M/P is fixed, and the quantity demanded(determined by r and Y)must equal this fixed supply. In a closed economy, a fiscal expansion causes the equilibrium interest rate to rise. This increase in the interest rate(which re- duces the quantity of money demanded) allows equilibrium income to rise ich increases the quantity of money demanded). By contrast, in a small economy,ris fixed at r*, so there is only one level of income that an satisfy this equation, and this level of income does not change when fiscal olicy changes. Thus, when the government increases spending or cuts taxes, the appreciation of the exchange rate and the fall in net exports must be large enough to offset fully the normal expansionary effect of the policy on Income. User JoENA: Job EFFo1428: 6264_ch12: Pg 318: 27513#/eps at 100sl Mon,Feb18,200212:44
User JOEWA:Job EFF01428:6264_ch12:Pg 318:27513#/eps at 100% *27513* Mon, Feb 18, 2002 12:44 AM difference? When income rises in a closed economy, the interest rate rises, because higher income increases the demand for money.That is not possible in a small open economy: as soon as the interest rate tries to rise above the world interest rate r*, capital flows in from abroad.This capital inflow increases the demand for the domestic currency in the market for foreign-currency exchange and, thus, bids up the value of the domestic currency.The appreciation of the exchange rate makes domestic goods expensive relative to foreign goods, and this reduces net exports.The fall in net exports offsets the effects of the expansionary fiscal policy on income. Why is the fall in net exports so great that it renders fiscal policy powerless to influence income? To answer this question, consider the equation that describes the money market: M/P = L(r, Y). In both closed and open economies, the quantity of real money balances supplied M/P is fixed, and the quantity demanded (determined by r and Y ) must equal this fixed supply. In a closed economy, a fiscal expansion causes the equilibrium interest rate to rise. This increase in the interest rate (which reduces the quantity of money demanded) allows equilibrium income to rise (which increases the quantity of money demanded). By contrast, in a small open economy, r is fixed at r*, so there is only one level of income that can satisfy this equation, and this level of income does not change when fiscal policy changes.Thus, when the government increases spending or cuts taxes, the appreciation of the exchange rate and the fall in net exports must be large enough to offset fully the normal expansionary effect of the policy on income. 318 | PART IV Business Cycle Theory: The Economy in the Short Run figure 12-4 Exchange rate, e Income, output, Y Equilibrium exchange rate LM* IS*2 IS*1 2. . . . which raises the exchange rate . . . 3. . . . and leaves income unchanged. 1. Expansionary fiscal policy shifts the IS* curve to the right, ... A Fiscal Expansion Under Floating Exchange Rates An increase in government purchases or a decrease in taxes shifts the IS* curve to the right. This raises the exchange rate but has no effect on income
Worth: Mankiw Economics 5e CHAPTER 12 Aggregate Demand in the Open Economy 319 Monetary Policy Suppose now that the central bank increases the money supply. Because the price level is assumed to be fixed, the increase in the money supply means an increase in real balances. The increase in real balances shifts the LM curve to the right, as in Figure 12-5. Hence, an increase in the money supply raises income and lowers the exchange rate. figure 12-5 Exchange rate, e A M ry Expansion Under LMA Floating Exchange Rates An ncrease in the money supply 1. A monetary expan- shifts the LM* curve to the sion shifts the LM right, lowe curve to the rig rate and raising income rarses Income Although monetary policy influences income in an open eco nomy, as it does in a closed economy, the monetary transmission mechanism is different. Recall that in a closed economy an increase in the money supply increases spending be- cause it lowers the interest rate and stimulates investment. In a small open econ- omy, the interest rate is fixed by the world interest rate. As soon as an increase in the money supply puts downward pressure on the domestic interest rate, capital Aows out of the economy as investors seek a higher return elsewhere. This capital outflow prevents the domestic interest rate from falling. In addition, because the capital outhow increases the supply of the domestic currency in the market for foreign-currency exchange, the exchange rate depreciates. The fall in the ex change rate makes domestic goods inexpensive relative to foreign goods and hereby, stimulates net exports. Hence, in a small open economy, monetary policy influences income by altering the exchange rate rather than the interest rate Trade Policy Suppose that the government reduces the demand for imported goods by impos- ing an import quota or a tariff. What happens to aggregate income and the ex hange rate? Because net exports equal exports minus imports, a reduction in imports means an increase in net exports. That is, the net-exports schedule shifts to the User JoENA: Job EFFo1428: 6264_ch12: Pg 319: 27514#/eps at 100sm Mon,Feb18,200212:44
User JOEWA:Job EFF01428:6264_ch12:Pg 319:27514#/eps at 100% *27514* Mon, Feb 18, 2002 12:44 AM Monetary Policy Suppose now that the central bank increases the money supply. Because the price level is assumed to be fixed, the increase in the money supply means an increase in real balances.The increase in real balances shifts the LM* curve to the right, as in Figure 12-5. Hence, an increase in the money supply raises income and lowers the exchange rate. CHAPTER 12 Aggregate Demand in the Open Economy | 319 figure 12-5 Exchange rate, e Income, output, Y 2. . . . which lowers the exchange rate . . . 3. . . . and raises income. 1. A monetary expansion shifts the LM* curve to the right, ... LM*1 IS* LM*2 A Monetary Expansion Under Floating Exchange Rates An increase in the money supply shifts the LM* curve to the right, lowering the exchange rate and raising income. Although monetary policy influences income in an open economy, as it does in a closed economy, the monetary transmission mechanism is different. Recall that in a closed economy an increase in the money supply increases spending because it lowers the interest rate and stimulates investment. In a small open economy, the interest rate is fixed by the world interest rate.As soon as an increase in the money supply puts downward pressure on the domestic interest rate, capital flows out of the economy as investors seek a higher return elsewhere.This capital outflow prevents the domestic interest rate from falling. In addition, because the capital outflow increases the supply of the domestic currency in the market for foreign-currency exchange, the exchange rate depreciates. The fall in the exchange rate makes domestic goods inexpensive relative to foreign goods and, thereby, stimulates net exports. Hence, in a small open economy, monetary policy influences income by altering the exchange rate rather than the interest rate. Trade Policy Suppose that the government reduces the demand for imported goods by imposing an import quota or a tariff.What happens to aggregate income and the exchange rate? Because net exports equal exports minus imports, a reduction in imports means an increase in net exports.That is, the net-exports schedule shifts to the
Worth: Mankiw Economics 5e 320 PART IV Business Cycle Theory: The Economy in the Short Run (a) The Shift in the Net-Exports Schedule A Trade restriction Under Exchange rate, e Floating Exchange Rates A tariff or an import quota shifts the net-exports 1. A trade restriction schedule in panel (a) to the shifts the NX curve right. As a result, the /S* outward curve in panel (b)shifts to he right, raising the exchange Net exports, NX b)The Change in the Economys Equilibrium Exchange rate, e 3... increasi the exchange 2.... which shifts the right, as in Figure 12-6. This shift in the net-exports schedule increases planned expenditure and thus moves the IS curve to the right. Because the LM curve is vertical, the trade restriction raises the exchange rate but does not affect in Often a stated goal of policies to restrict trade is to alter the trade balance NX Yet, as we first saw in Chapter 5, such policies do not necessarily have that effect. The same conclusion holds in the Mundell-Fleming model under floating e Recall that NX(e=r-c(r-T)-I(r)-G User JoENA: Job EFFo1428: 6264_ch12: Pg 320: 27515 #/eps at 100smml Mon,Feb18,200212:44
User JOEWA:Job EFF01428:6264_ch12:Pg 320:27515#/eps at 100% *27515* Mon, Feb 18, 2002 12:44 AM right, as in Figure 12-6. This shift in the net-exports schedule increases planned expenditure and thus moves the IS* curve to the right. Because the LM* curve is vertical, the trade restriction raises the exchange rate but does not affect income. Often a stated goal of policies to restrict trade is to alter the trade balance NX. Yet, as we first saw in Chapter 5, such policies do not necessarily have that effect. The same conclusion holds in the Mundell–Fleming model under floating exchange rates. Recall that NX(e) = Y − C(Y − T) − I(r*) − G. 320 | PART IV Business Cycle Theory: The Economy in the Short Run figure 12-6 Exchange rate, e Exchange rate, e Net exports, NX Income, output, Y NX2 NX1 IS*2 LM* IS*1 3. . . . increasing the exchange rate . . . 4. . . . and leaving income the same. (a) The Shift in the Net-Exports Schedule 1. A trade restriction shifts the NX curve outward, ... (b) The Change in the Economy, s Equilibrium 2. . . . which shifts the IS* curve outward, ... A Trade Restriction Under Floating Exchange Rates A tariff or an import quota shifts the net-exports schedule in panel (a) to the right. As a result, the IS* curve in panel (b) shifts to the right, raising the exchange rate and leaving income unchanged
Worth: Mankiw Economics 5e CHAPTER 12 Aggregate Demand in the Open Economy 321 Because a trade restriction does not affect income, consumption, investment,or government purchases, it does not affect the trade balance. Although the shift in the net-exports schedule tends to raise NX, the increase in the exchange rate re- duces NX by the same amount 12-3 The Small Open Economy Under Fixed Exchange Rates We now turn to the second type of exchange-rate system: fixed exchange rates. In the 1950s and 1960s, most of the world's major economies, including the United States, operated within the Bretton Woods system-an international monetary system under which most governments agreed to fix exchange rates The world abandoned this system in the early 1970s, and exchange rates were al- lowed to float. Some European countries later reinstated a system of fixed ex change rates among themselves, and some economists have advocated a return to a worldwide system of fixed exchange rates. In this section we discuss how such a system works, and we examine the impact of economic policies on an econ- omy with a fixed exchange rate How a Fixed-Exchange-Rate System Works Under a system of fixed exchange rates, a central bank stands ready to buy or sell the domestic currency for foreign currencies at a predetermined price. For ex- ample, suppose that the Fed announced that it was going to fix the exchange rate at 100 yen per dollar. It would then stand ready to give $1 in exchange for 100 yen or to give 100 yen in exchange for $1. To carry out this policy, the Fed would need a reserve of dollars(which it can print) and a reserve of yen(which it must have purchased previously) A fixed exchange rate dedicates a country's monetary policy to the single goal of keeping the exchange rate at the announced level. In other words, the essence of a fixed-exchange-rate system is the commitment of the central bank to allow the money supply to adjust to whatever level will ensure that the equilibrium exchange rate equals the announced exchange rate More- over, as long as the central bank stands ready to buy or sell foreign currency at the fixed exchange rate, the money supply adjusts automatically to the neces- sary level To see how fixing the exchange rate determines the money supply, consider the following example. Suppose that the Fed announces that it will fix the ex- hange rate at 100 yen per dollar, but, in the current equilibrium with the cur- rent money supply, the exchange rate is 150 yen per dollar. This situation is illustrated in panel (a)of Figure 12-7. Notice that there is a profit opportunity: an arbitrageur could buy 300 yen in the marketplace for $2, and then sell the yen to the Fed for $3, making a $1 profit. When the Fed buys these yen from the arbi trageur, the dollars it pays for them automatically increase the money supply. The User JoENA: Job EFFo1428: 6264_ch12: Pg 321: 27516#/eps at 100sl Mon,Feb18,200212:44
User JOEWA:Job EFF01428:6264_ch12:Pg 321:27516#/eps at 100% *27516* Mon, Feb 18, 2002 12:44 AM Because a trade restriction does not affect income, consumption, investment, or government purchases, it does not affect the trade balance.Although the shift in the net-exports schedule tends to raise NX, the increase in the exchange rate reduces NX by the same amount. 12-3 The Small Open Economy Under Fixed Exchange Rates We now turn to the second type of exchange-rate system: fixed exchange rates. In the 1950s and 1960s, most of the world’s major economies, including the United States, operated within the Bretton Woods system—an international monetary system under which most governments agreed to fix exchange rates. The world abandoned this system in the early 1970s, and exchange rates were allowed to float. Some European countries later reinstated a system of fixed exchange rates among themselves, and some economists have advocated a return to a worldwide system of fixed exchange rates. In this section we discuss how such a system works, and we examine the impact of economic policies on an economy with a fixed exchange rate. How a Fixed-Exchange-Rate System Works Under a system of fixed exchange rates, a central bank stands ready to buy or sell the domestic currency for foreign currencies at a predetermined price. For example, suppose that the Fed announced that it was going to fix the exchange rate at 100 yen per dollar. It would then stand ready to give $1 in exchange for 100 yen or to give 100 yen in exchange for $1. To carry out this policy, the Fed would need a reserve of dollars (which it can print) and a reserve of yen (which it must have purchased previously). A fixed exchange rate dedicates a country’s monetary policy to the single goal of keeping the exchange rate at the announced level. In other words, the essence of a fixed-exchange-rate system is the commitment of the central bank to allow the money supply to adjust to whatever level will ensure that the equilibrium exchange rate equals the announced exchange rate. Moreover, as long as the central bank stands ready to buy or sell foreign currency at the fixed exchange rate, the money supply adjusts automatically to the necessary level. To see how fixing the exchange rate determines the money supply, consider the following example. Suppose that the Fed announces that it will fix the exchange rate at 100 yen per dollar, but, in the current equilibrium with the current money supply, the exchange rate is 150 yen per dollar. This situation is illustrated in panel (a) of Figure 12-7. Notice that there is a profit opportunity: an arbitrageur could buy 300 yen in the marketplace for $2, and then sell the yen to the Fed for $3, making a $1 profit.When the Fed buys these yen from the arbitrageur, the dollars it pays for them automatically increase the money supply. The CHAPTER 12 Aggregate Demand in the Open Economy | 321