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,Feb18,200212:44User 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