Open economy macroeconomic policy

ES20013 intermediate macro

Open economy macroeconomic policy


Only looking at the equilibrium point


The Mundell-Fleming model
- In the open economy, macroeconomic equilibrium occurs when the economy is
simultaneously on all of
o The IS curve
o The LM curve
o The FE curve
- We will analyse this using the Mundell-Fleming model
- This is a simple extension of the IS-LM model to the open economy
- The Mundell-Fleming model open economy IS-LM model considers two cases
o Flexible nominal exchange rates
o Fixed nominal exchange rate
- We will only consider flexible exchange rates

The three relationships
- IS
- LM
- FE
- And these will determine
- Output
- Interest rate
- Exchange rate
- These are the three exogenous variables in the flex-MF model



- if the exchange rate is flexible
o the FE curve determines the interest rate
o the LM curve determines output
o the IS curve determines the exchange rate
- the position of the economy is determined by the intersection of the LM and FE
curves
- the real exchange rate will adjust to ensure the IS curve also passes through this
point

, -




FE curve is horizontal as we are assuming perfect capital mobility


- Since the real exchange rate determines the position of the IS curve, it is convenient
to rewrite IS as


o
- Since the LM curve determines output, it is convenient to rewrite LM as



o


- so we can summarise the Mundell-Fleming model as
- the interest rate is determined by the world interest rate
o i = iw
- output is determined by the LM curve



o