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,Feb18,200212:44User 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.