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,Feb18,200212:44User 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 |