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,Feb18,200212:44User 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