《宏观经济学》课程教学资源（英文版）Lecture 4-12 Aggregate Demand in the Open Economy

Worth: Mankiw Economics 5e CHAPTER T ELVE Aggregate Demand in the Open Economy When conducting monetary and fiscal policy, policymakers often look be- yond their own country's borders Even if domestic prosperity is their sole ob jective, it is necessary for them to consider the rest of the world. The international flow of goods and services and the international flow of capital can affect an economy in profound ways. Policymakers ignore these effects at In this chapter we extend our analysis of aggregate demand to include inter- national trade and finance. The model developed in this chapter, called the Mundell-Fleming model, is an open-economy version of the IS-LM model. Both models stress the interaction between the goods market and the money market. Both models assume that the price level is fixed and then show what causes short-run fuctuations in aggregate income(or, equivalently, shifts in the aggregate demand curve). The key difference is that the IS-LM model assumes a closed economy, whereas the Mundell-Fleming model assumes an open econ- omy. The Mundell-Fleming model extends the short-run model of national in come from Chapters 10 and 11 by including the effects of international trade and finance from Chapter 5 The Mundell-Fleming model makes one important and extreme assump- tion: it assumes that the economy being studied is a small open economy with perfect capital mobility. That is, the economy can borrow or lend as much as it wants in world financial markets and, as a result, the economy's interest rate is determined by the world interest rate. One virtue of this assumption is that simplifies the analysis: once the interest rate is determined,we can concentrate our attention on the role of the exchange rate. In addition, for some economies, such as Belgium or the Netherlands, the assumption of a small open economy with perfect capital mobility is a good one. Yet this assump- tion-and thus the Mundell-Fleming model--does not apply exactly to a large open economy such as the United States. In the conclusion to this chap- ter(and more fully in the appendix), we consider what happens in the more omplex case in which international capital mobility is less than perfect or a nation is so large it can influence world financial markets One lesson from the Mundell-Fleming model is that the behavior of an econ omy depends on the exchange-rate system it has adopted. We begin by assuming that the economy operates with a floating exchange rate. That is, we assume that he central bank allows the exchange rate to adjust to changing economic condi- tions. We then examine how the economy operates under a fixed exchange rate, 312 User JONA:JobE0128:6264ch12:pg312:25875#/epat1004ul卿ⅢⅢ Mon,Feb18,200212:44

User JOEWA:Job EFF01428:6264_ch12:Pg 312:25875#/eps at 100% *25875* Mon, Feb 18, 2002 12:44 AM When conducting monetary and fiscal policy, policymakers often look be￾yond their own country’s borders. Even if domestic prosperity is their sole ob￾jective, it is necessary for them to consider the rest of the world. The international flow of goods and services and the international flow of capital can affect an economy in profound ways. Policymakers ignore these effects at their peril. In this chapter we extend our analysis of aggregate demand to include inter￾national trade and finance. The model developed in this chapter, called the Mundell–Fleming model, is an open-economy version of the IS–LM model. Both models stress the interaction between the goods market and the money market. Both models assume that the price level is fixed and then show what causes short-run fluctuations in aggregate income (or, equivalently, shifts in the aggregate demand curve).The key difference is that the IS–LM model assumes a closed economy, whereas the Mundell–Fleming model assumes an open econ￾omy.The Mundell–Fleming model extends the short-run model of national in￾come from Chapters 10 and 11 by including the effects of international trade and finance from Chapter 5. The Mundell–Fleming model makes one important and extreme assump￾tion: it assumes that the economy being studied is a small open economy with perfect capital mobility.That is, the economy can borrow or lend as much as it wants in world financial markets and, as a result, the economy’s interest rate is determined by the world interest rate. One virtue of this assumption is that it simplifies the analysis: once the interest rate is determined, we can concentrate our attention on the role of the exchange rate. In addition, for some economies, such as Belgium or the Netherlands, the assumption of a small open economy with perfect capital mobility is a good one.Yet this assump￾tion—and thus the Mundell–Fleming model—does not apply exactly to a large open economy such as the United States. In the conclusion to this chap￾ter (and more fully in the appendix), we consider what happens in the more complex case in which international capital mobility is less than perfect or a nation is so large it can influence world financial markets. One lesson from the Mundell–Fleming model is that the behavior of an econ￾omy depends on the exchange-rate system it has adopted.We begin by assuming that the economy operates with a floating exchange rate.That is, we assume that the central bank allows the exchange rate to adjust to changing economic condi￾tions.We then examine how the economy operates under a fixed exchange rate, Aggregate Demand in the Open Economy 12 CHAPTER TWELVE 312 |

Worth: Mankiw Economics 5e CHAPTER 12 Aggregate Demand in the Open Economy 313 and we discuss whether a floating or fixed exchange rate is better. This question has been important in recent years, as many nations around the world have de- bated what exchange-rate system to adopt 12-1 The Mundell-Fleming Model In this section we build the Mundell-Fleming model, and in the following sec- tions we use the model to examine the impact of various policies. As you will see,the Mundell-Fleming model is built from components we have used in pre- vious chapters. But these pieces are put together in a new way to address a new set of questions The Key Assumption: Small Open Economy With Perfect Capital Mobility Let's begin with the assumption of a small open economy with perfect capital mobility. As we saw in Chapter 5, this assumption means that the interest rate his economy r is determined by the world interest rate r*. Mathematically, we can write this assumption as This world interest rate is assumed to be exogenously fixed because the economy is sufficiently small relative to the world economy that it can borrow or lend as much as it wants in world financial markets without affecting the world interest rate Although the idea of perfect capital mobility is expressed with a simple equa- tion, it is important not to lose sight of the sophisticated process that this equa tion represents. Imagine that some event were to occur that would normally raise the interest rate(such as a decline in domestic saving). In a small open economy, the domestic interest rate might rise by a little bit for a short time, but as soon as it did, foreigners would see the higher interest rate and start lending to this coun- try(by, for instance, buying this country 's bonds). The capital inflow would drive the domestic interest rate back toward r*. Similarly, if any event were ever to start driving the domestic interest rate downward, capital would flow out of the country to earn a higher return abroad, and this capital outflow would drive the stic interest rate back upward toward r. Hence, the r=r sents the assumption that the international flow of capital is rapid enough to domestic interest rate equal to the world interest rate I The Mundell-Fleming model was developed in the early 1960s. Mundell's contributions are col- lected in Robert A Mundell, International Economics(New York: Macmillan, 1968). For Flemings ontribution, see J. Marcus Fleming, " Domestic Financial Policies Under Fixed and Under Floating Exchange Rates IMF Staff Papers 9(November 1962): 369-379. In 1999, Robert Mundell was awarded the Nobel Prize for his work in open-economy macroeco User JoEkA: Job EFFo1428: 6264_ch12: Pg 313: 27508#/eps at 1004g Mon,Feb18,200212:44

User JOEWA:Job EFF01428:6264_ch12:Pg 313:27508#/eps at 100% *27508* Mon, Feb 18, 2002 12:44 AM and we discuss whether a floating or fixed exchange rate is better.This question has been important in recent years, as many nations around the world have de￾bated what exchange-rate system to adopt. 12-1 The Mundell–Fleming Model In this section we build the Mundell–Fleming model, and in the following sec￾tions we use the model to examine the impact of various policies. As you will see, the Mundell–Fleming model is built from components we have used in pre￾vious chapters. But these pieces are put together in a new way to address a new set of questions.1 The Key Assumption: Small Open Economy With Perfect Capital Mobility Let’s begin with the assumption of a small open economy with perfect capital mobility. As we saw in Chapter 5, this assumption means that the interest rate in this economy r is determined by the world interest rate r*. Mathematically, we can write this assumption as r = r*. This world interest rate is assumed to be exogenously fixed because the economy is sufficiently small relative to the world economy that it can borrow or lend as much as it wants in world financial markets without affecting the world interest rate. Although the idea of perfect capital mobility is expressed with a simple equa￾tion, it is important not to lose sight of the sophisticated process that this equa￾tion represents. Imagine that some event were to occur that would normally raise the interest rate (such as a decline in domestic saving). In a small open economy, the domestic interest rate might rise by a little bit for a short time, but as soon as it did, foreigners would see the higher interest rate and start lending to this coun￾try (by, for instance, buying this country’s bonds).The capital inflow would drive the domestic interest rate back toward r*. Similarly, if any event were ever to start driving the domestic interest rate downward, capital would flow out of the country to earn a higher return abroad, and this capital outflow would drive the domestic interest rate back upward toward r*. Hence, the r = r* equation repre￾sents the assumption that the international flow of capital is rapid enough to keep the domestic interest rate equal to the world interest rate. CHAPTER 12 Aggregate Demand in the Open Economy | 313 1 The Mundell–Fleming model was developed in the early 1960s. Mundell’s contributions are col￾lected in Robert A. Mundell, International Economics (New York: Macmillan, 1968). For Fleming’s contribution, see J. Marcus Fleming,“Domestic Financial Policies Under Fixed and Under Floating Exchange Rates,’’ IMF Staff Papers 9 (November 1962): 369–379. In 1999, Robert Mundell was awarded the Nobel Prize for his work in open-economy macroeconomics

Worth: Mankiw Economics 5e 314 PART IV Business Cycle Theory: The Economy in the Short Run The Goods market and the / s* curve The Mundell-Fleming model describes the market for goods and services much as the IS-LM model does, but it adds a new term for net exports. In particular, the goods market is represented with the following equation Y=C(Y-T)+I(r)+G+ NX(e) This equation states that aggregate income Y is the sum of consumption C, in- vestment I, government purchases G, and net exports NX. Consumption de pends positively on disposable income Y- T. Investment depends negatively on the interest rate, which equals the world interest rate r*. Net exports depend negatively on the exchange rate e. As before, we define the exchange rate e as the amount of foreign currency per unit of domestic currency-for example, e cht be 100 yen per dollar. You may recall that in Chapter 5 we related net exports to the real exchange rate(the relative price of goods at home and abroad)rather than the nominal ex- change rate(the relative price of domestic and foreign currencies). If e is the ominal exchange rate, then the real exchange rate e equals ep/pa, where P the domestic price level and P* is the foreign price level. The Mundell-Fleming model, however, assumes that the price levels at home and abroad are fixed,so he real exchange rate is proportional to the nominal exchange rate. That when the nominal exchange rate appreciates(say, from 100 to 120 yen per dol lar), foreign goods become cheaper compared to domestic goods, and this causes exports to fall and imports to rise. We can illustrate this equation for goods market equilibrium on a graph in hich income is on the horizontal axis and the exchange rate is on the vertical axis. This curve is shown in panel (c)of Figure 12-1 and is called the IS"curve The new label reminds us that the curve is drawn holding the interest rate con stant at the world interest rate r*k The IS" curve slopes downward because a higher exchange rate reduces net exports, which in turn lowers aggregate income. To show how this works, the other panels of Figure 12-1 combine the net-exports schedule and the Keynes an cross to derive the Is curve In panel (a), an increase in the exchange rate from e1 to e2 lowers net exports from NX(e,to NX(e2).In panel(b), the reduc tion in net exports shifts the planned-expenditure schedule downward and thus lowers income from Y to Y2. The IS curves summarizes this relationship be- tween the exchange rate e and income Y. The Money Market and the lM curve The Mundell-Fleming model represents the money market with an equation that should be familiar from the IS-LM model, with the additional assumption that the domestic interest rate equals the world interest rate M/P=L(, Y User JoEkA: Job EFPo1428: 6264_ch12: Pg 314: 27509#/eps at 1004gg Mon,Feb18,200212:44

User JOEWA:Job EFF01428:6264_ch12:Pg 314:27509#/eps at 100% *27509* Mon, Feb 18, 2002 12:44 AM The Goods Market and the IS* Curve The Mundell–Fleming model describes the market for goods and services much as the IS–LM model does, but it adds a new term for net exports. In particular, the goods market is represented with the following equation: Y = C(Y − T) + I(r*) + G + NX(e). This equation states that aggregate income Y is the sum of consumption C, in￾vestment I, government purchases G, and net exports NX. Consumption de￾pends positively on disposable income Y − T. Investment depends negatively on the interest rate, which equals the world interest rate r*. Net exports depend negatively on the exchange rate e.As before, we define the exchange rate e as the amount of foreign currency per unit of domestic currency—for example, e might be 100 yen per dollar. You may recall that in Chapter 5 we related net exports to the real exchange rate (the relative price of goods at home and abroad) rather than the nominal ex￾change rate (the relative price of domestic and foreign currencies). If e is the nominal exchange rate, then the real exchange rate e equals eP/P*, where P is the domestic price level and P* is the foreign price level.The Mundell–Fleming model, however, assumes that the price levels at home and abroad are fixed, so the real exchange rate is proportional to the nominal exchange rate. That is, when the nominal exchange rate appreciates (say, from 100 to 120 yen per dol￾lar), foreign goods become cheaper compared to domestic goods, and this causes exports to fall and imports to rise. We can illustrate this equation for goods market equilibrium on a graph in which income is on the horizontal axis and the exchange rate is on the vertical axis.This curve is shown in panel (c) of Figure 12-1 and is called the IS* curve. The new label reminds us that the curve is drawn holding the interest rate con￾stant at the world interest rate r*. The IS* curve slopes downward because a higher exchange rate reduces net exports, which in turn lowers aggregate income. To show how this works, the other panels of Figure 12-1 combine the net-exports schedule and the Keynes￾ian cross to derive the IS* curve. In panel (a), an increase in the exchange rate from e1 to e2 lowers net exports from NX(e1) to NX(e2). In panel (b), the reduc￾tion in net exports shifts the planned-expenditure schedule downward and thus lowers income from Y1 to Y2.The IS* curves summarizes this relationship be￾tween the exchange rate e and income Y. The Money Market and the LM* Curve The Mundell–Fleming model represents the money market with an equation that should be familiar from the IS–LM model, with the additional assumption that the domestic interest rate equals the world interest rate: M/P = L(r*, Y). 314 | PART IV Business Cycle Theory: The Economy in the Short Run

Worth: Mankiw Economics 5e CHAPTER 12 Aggregate Demand in the Open Economy 315 The /S Curve The /S* curve is derived from the net-exports (b)The Keynesian Cross hedule and the Keynesian cross. Expenditure,E Panel (a) shows the net-exports 3. which schedule. an increase in the exchange rate from en to e2 lowers shifts planned net exports from NX(e1) to NX(e2) Panel (b) shows the Key nesian △NX cross: a decrease in net exports from IX(e,)to NX(e2)shifts the planned xpenditure schedule downward and reduces income from Y, to y2 4 Panel(c)shows the /S*curve summarizing this relationship between the exchange rate and 45° income: the higher the exchange rate. the lower the level of income (a)The Net-Exports Schedule (c) The IS*Curve Exchange rate, e Exchange rate. e 5. The /S* curve market equilibrium. 1. An rate △NX NX(e,)*NX(e,) Net exports This equation states that the supply of real money balances, M/P, equals the demand, L(r, Y). The demand for real balances depends negatively on the in- terest rate, which is now set equal to the world interest rate r, and positively on income Y. The money supply M is an exogenous variable controlled by the central bank, and because the Mundell-Fleming model is designed to an- alyze short-run fluctuations, the price level P is also assumed to be exoge- nously fixed We can represent this equation graphically with a vertical LM curve, as in panel(b) of Figure 12-2. The LM curve is vertical because the exchange rate does not enter into the LM equation. Given the world interest rate, the LM- equation determines aggregate income, regardless of the exchange rate. Figure 12-2 shows how the lm curve arises from the world interest rate and the La curve which relates the interest rate and income. User JoENA: Job EFFo1428: 6264_ch12: Pg 315: 27510#/eps at 100sm Mon,Feb18,200212:44

User JOEWA:Job EFF01428:6264_ch12:Pg 315:27510#/eps at 100% *27510* Mon, Feb 18, 2002 12:44 AM This equation states that the supply of real money balances, M/P, equals the demand, L(r, Y ).The demand for real balances depends negatively on the in￾terest rate, which is now set equal to the world interest rate r*, and positively on income Y. The money supply M is an exogenous variable controlled by the central bank, and because the Mundell–Fleming model is designed to an￾alyze short-run fluctuations, the price level P is also assumed to be exoge￾nously fixed. We can represent this equation graphically with a vertical LM* curve, as in panel (b) of Figure 12-2.The LM* curve is vertical because the exchange rate does not enter into the LM* equation. Given the world interest rate, the LM* equation determines aggregate income, regardless of the exchange rate. Figure 12-2 shows how the LM* curve arises from the world interest rate and the LM curve, which relates the interest rate and income. CHAPTER 12 Aggregate Demand in the Open Economy | 315 figure 12-1 Expenditure, E Exchange rate, e Exchange rate, e Income, output, Y Income, output, Y Net exports, NX Y1 Y2 IS* NX(e1 NX(e ) 2)
NX
NX e1 e2 Actual expenditure Planned expenditure 45° Y1 Y2 e1 e2 (a) The Net-Exports Schedule (b) The Keynesian Cross (c) The IS* Curve 2. . . . lowers net exports, . . . 3. . . . which shifts planned expenditure downward . . . 5. The IS* curve summarizes these changes in the goods market equilibrium. 1. An increase in the exchange rate . .. 4. . . . and lowers income. The IS* Curve The IS* curve is derived from the net-exports schedule and the Keynesian cross. Panel (a) shows the net-exports schedule: an increase in the exchange rate from e1 to e2 lowers net exports from NX(e1) to NX(e2). Panel (b) shows the Keynesian cross: a decrease in net exports from NX(e1) to NX(e2) shifts the planned￾expenditure schedule downward and reduces income from Y1 to Y2. Panel (c) shows the IS* curve summarizing this relationship between the exchange rate and income: the higher the exchange rate, the lower the level of income

Worth: Mankiw Economics 5e 316 PART IV Business Cycle Theory: The Economy in the Short Run figure 12-2 (a) The LM Curve The LMCurve Panel (a) shows the standard LM Interest rate.r curve which graphs the equation M/P=L( Y)I LM together with a horizontal line representing the 1. The money world interest rate r*. The intersection of these two curves determines the level of income, regardless of the exchange rate. Therefore, as panel (b)shows, the LM* curve is vertical Interest rate Income (b)The LM*Curve Exchange rate, e Putting the Pieces Together According to the Mundell-Fleming model, a small open economy with perfect capital mobility can be described by two equations Y=C(r-T)+I(r)+G+ NX( The first equation describes equilibrium in the goods market, and the second quation describes equilibrium in the money market. The exogenous variables fiscal policy G and T, monetary policy M, the price level P, and the world in- terest rate r. The endogenous variables are income y and the exchange rate e Figure 12-3 illustrates these two relationships. The equilibrium for the econ- omy is found where the IS curve and the LM curve intersect. This intersection User JoENA: Job EFFo1428: 6264_ch12: Pg 316: 27511#/eps at 100sm Mon,Feb18,200212:44

User JOEWA:Job EFF01428:6264_ch12:Pg 316:27511#/eps at 100% *27511* Mon, Feb 18, 2002 12:44 AM Putting the Pieces Together According to the Mundell–Fleming model, a small open economy with perfect capital mobility can be described by two equations: Y = C(Y − T ) + I(r*) + G + NX(e) IS*, M/P = L(r*, Y ) LM*. The first equation describes equilibrium in the goods market, and the second equation describes equilibrium in the money market. The exogenous variables are fiscal policy G and T, monetary policy M, the price level P, and the world in￾terest rate r*.The endogenous variables are income Y and the exchange rate e. Figure 12-3 illustrates these two relationships.The equilibrium for the econ￾omy is found where the IS* curve and the LM* curve intersect.This intersection 316 | PART IV Business Cycle Theory: The Economy in the Short Run figure 12-2 Interest rate, r Exchange rate, e Income, output, Y Income, output, Y 1. The money market equilibrium condition . . . 2. . . . and the world interest rate . . . 3. . . . determine the level of income. (a) The LM Curve (b) The LM* Curve LM r r* LM* The LM* Curve Panel (a) shows the standard LM curve [which graphs the equation M/P = L(r, Y)] together with a horizontal line representing the world interest rate r*. The intersection of these two curves determines the level of income, regardless of the exchange rate. Therefore, as panel (b) shows, the LM* curve is vertical.

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 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￾ment 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 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 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 the money market: M/P = L(r, 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 (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 expan￾sion 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 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 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 ex￾change 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 impos￾ing an import quota or a tariff.What happens to aggregate income and the ex￾change 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 ex￾change 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 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￾change 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 CHAPTER 12 Aggregate Demand in the Open Economy | 321