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,Feb18,200212:44User 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