MACROECONOMICS
cover art ROW 1 (90)
C H A P T E R
© 2008 Worth Publishers, all rights reserved
SIXTH EDITION
PowerPoint® Slides by Ron Cronovich
N. GREGORY MANKIW
The Open Economy Revisited:
the Mundell-Fleming Model and the Exchange-Rate Regime
12

Chapter 12 covers a lot of material.
First, it develops the Mundell-Fleming open-economy IS-LM model for a small open economy with
perfect capital mobility.  The model is used to analyze the effects of fiscal, monetary, and trade
policy under floating and flexible exchange rates.
Then, the chapter explores interest rate differentials, or risk premia that arise due to country
risk or expected changes in exchange rates. The Mundell-Fleming model is used to analyze the
effects of a change in the risk premium. The 1994-95 Mexican Peso Crisis is an important real-world
example of this.
The chapter summarizes the debate over fixed vs. floating exchange rates.
Following that discussion, the Mundell-Fleming model is used to derive the aggregate demand curve
for a small open economy.
And finally, the chapter discusses how the results it derives would be different in a large open
economy.
To reinforce this material, I strongly recommend you to allow a bit of class time for a few
in-class exercises (I’ve suggested several in the lecture notes accompanying some of the slides in
this presentation), and that you assign a homework consisting of several of the end-of-chapter
“Questions for Review” and “Problems and Applications” in the textbook.

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CHAPTER 12   The Open Economy Revisited
CHAPTER 12   The Open Economy Revisited
In this chapter, you will learn…
§the Mundell-Fleming model
(IS-LM for the small open economy)
§causes and effects of interest rate differentials
§arguments for fixed vs. floating exchange rates
§how to derive the aggregate demand curve for a small open economy

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CHAPTER 12   The Open Economy Revisited
CHAPTER 12   The Open Economy Revisited
The Mundell-Fleming model
§Key assumption:
Small open economy with perfect capital mobility.
§ r  = r*
§Goods market equilibrium – the IS*  curve:
where
e = nominal exchange rate
= foreign currency per unit domestic currency

In this and the following sections (in which we analyze policies with the M-F model), we assume the
price level is fixed---just as we did when we first used the closed economy IS-LM model to do
policy analysis in chapter 11.
As we learned in chapter 5, NX depends on the real exchange rate.  However, with price levels
fixed, the real & nominal exchange rates move together.
So, for simplicity, we write NX as a function of the nominal exchange rate here.
(At the end of this chapter, when we use M-F to derive the aggregate demand curve, we go back to
writing NX as a function of the real exchange rate, because the nominal & real exchange rates may
behave differently when the price level is changing.)
Chapter 5 introduced the notation r* for the world interest rate, and explained why r = r* in a
small open economy with perfect capital mobility.
Perfect capital mobility means that there are no restrictions on the international flow of
financial capital:  the country’s residents can borrow or lend as much as they wish in the world
financial markets; and because the country is small, the amount its residents borrow or lend in the
world financial market has no impact on the world interest rate.
Chapter 5 also explained why net exports depend negatively on the exchange rate.

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CHAPTER 12   The Open Economy Revisited
CHAPTER 12   The Open Economy Revisited
The IS* curve:  Goods market eq’m
§The IS* curve is drawn for a given value of r*.
§Intuition for the slope:
Y
e
IS*

Again, “eq’m” is an abbreviation for “equilibrium.”
The text (p.337) shows how the Keynesian Cross can be used to derive the IS* curve.
Suggestion:   Before continuing, ask your students to figure out what happens to this IS* curve if
taxes are reduced.
Answer:  The IS* curve shifts rightward (i.e., upward).
Explanation:   Start at any point on the initial IS* curve.  At this point, initially, Y = C + I +
G + NX.  Now cut taxes.  At the initial value of Y, disposable income is higher, causing
consumption to be higher.  Other things equal, the goods market is out of whack:  C + I + G + NX >
Y.  An increase in Y (of just the right amount) would restore equilibrium.  Hence, each value of e
is associated with a larger value of Y.  OR, a decrease in NX of just the right amount would
restore equilibrium at the initial value of Y.  But the decrease in NX requires an increase in e.
Hence, each value of Y is associated with a higher value of e.
Rationale:  Doing this exercise now will break up your lecture, and will prepare students for the
fiscal policy experiment that is coming up in just a few slides.

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CHAPTER 12   The Open Economy Revisited
CHAPTER 12   The Open Economy Revisited
The LM* curve:  Money market eq’m
§The LM* curve
§is drawn for a given
value of r*.
§is vertical because:
given r*,  there is
only one value of Y
that equates money demand with supply,
regardless of e.
Y
e
LM*

The text (p.316) shows how the LM curve in (Y,r) space, together with the fixed r*, determines the
value of Y at which the LM* curve here is vertical.
Suggestion:   Before continuing, ask your students to figure out what happens to this LM* curve if
the money supply is increased.
Answer:  LM* shifts to the right.
Explanation:   The equation for the LM* curve is:
    M/P = L(r*, Y)
P is fixed, r* is exogenous, the central bank sets M, then Y must adjust to equate money demand (L)
with money supply (M/P).
Now, if M is raised, then money demand must rise to restore equilibrium (remember:  P is fixed).  A
fall in r would cause money demand to rise, but in a small open economy, r = r* is exogenous.
Hence, the only way to restore equilibrium is for Y to rise.
Rationale:  Doing this exercise now will break up your lecture, and will prepare students for the
monetary policy experiment that is coming up in just a few slides.

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CHAPTER 12   The Open Economy Revisited
CHAPTER 12   The Open Economy Revisited
Equilibrium in the Mundell-Fleming model
Y
e
LM*
IS*
equilibrium
exchange
rate
equilibrium
level of
income

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CHAPTER 12   The Open Economy Revisited
CHAPTER 12   The Open Economy Revisited
Floating & fixed exchange rates
§In a system of floating exchange rates,
e is allowed to fluctuate in response to changing economic conditions.
§In contrast, under fixed exchange rates,
the central bank trades domestic for foreign currency at a predetermined price.
§Next, policy analysis –
§first, in a floating exchange rate system
§then, in a fixed exchange rate system

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CHAPTER 12   The Open Economy Revisited
CHAPTER 12   The Open Economy Revisited
Fiscal policy under floating exchange rates
Y
e
Y1
e1
e2
§At any given value of e,
a fiscal expansion increases Y,
shifting IS* to the right.
Results:
De > 0,  DY = 0

Intuition for the shift in IS*:
At a given value of e (and hence NX), an increase in G causes an increase in the value of Y that
equates planned expenditure with actual expenditure.
Intuition for the results:
As we learned in earlier chapters, a fiscal expansion puts upward pressure on the country’s
interest rate.  In a small open economy with perfect capital mobility, as soon as the domestic
interest rate rises even the tiniest bit about the world rate, tons of foreign (financial) capital
will flow in to take advantage of the rate difference.  But in order for foreigners to buy these
U.S. bonds, they must first acquire U.S. dollars.  Hence, the capital inflows cause an increase in
foreign demand for dollars in the foreign exchange market, causing the dollar to appreciate.  This
appreciation makes exports more expensive to foreigners, and imports cheaper to people at home, and
thus causes NX to fall.  The fall in NX offsets the effect of the fiscal expansion.
How do we know that Y = 0?  Because maintaining equilibrium in the money market requires that Y be
unchanged:  the fiscal expansion does not affect either the real money supply (M/P) or the world
interest rate (because this economy is “small”).  Hence, any change in income would throw the money
market out of whack.  So, the exchange rate has to rise until NX has fallen enough to perfectly
offset the expansionary impact of the fiscal policy on output.

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CHAPTER 12   The Open Economy Revisited
CHAPTER 12   The Open Economy Revisited
Lessons about fiscal policy
§In a small open economy with perfect capital mobility, fiscal policy cannot affect real GDP.
§“Crowding out”
§closed economy:
Fiscal policy crowds out investment by causing the interest rate to rise.
§small open economy:
Fiscal policy crowds out net exports by causing the exchange rate to appreciate.

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CHAPTER 12   The Open Economy Revisited
CHAPTER 12   The Open Economy Revisited
Monetary policy under floating exchange rates
Y
e
e1
Y1
Y2
e2
§An increase in M
shifts LM* right
because Y  must rise
to restore eq’m in
the money market.
Results:
De < 0,  DY  > 0

Suggestion:  Treat this experiment as an in-class exercise.  Display the graph with the initial
equilibrium.  Then give students 2-3 minutes to use the model to determine the effects of an
increase in M on e and Y.
Intuition for the rightward LM* shift:
At the initial (r*,Y), an increase in M throws the money market out of whack.  To restore
equilibrium, either Y must rise or the interest rate must fall, or some combination of the two.  In
a small open economy, though, the interest rate cannot fall.  So Y must rise to restore equilibrium
in the money market.
Intuition for the results:
Initially, the increase in the money supply puts downward pressure on the interest rate.  (In a
closed economy, the interest rate would fall.)  Because the economy is small and open, when the
interest rate tries to fall below r*, savers send their loanable funds to the world financial
market.  This capital outflow causes the exchange rate to fall, which causes NX --- and hence Y ---
to increase.

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CHAPTER 12   The Open Economy Revisited
CHAPTER 12   The Open Economy Revisited
Lessons about monetary policy
§Monetary policy affects output by affecting
the components of aggregate demand:
§      closed economy:   M  r   I  Y
§small open economy:  M  e   NX  Y
§Expansionary mon. policy does not raise world agg. demand, it merely shifts demand from foreign to
domestic products.
§ So, the increases in domestic income and employment are at the expense of losses abroad.

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Suggestion:
Before revealing the text on this slide, ask students to take out a piece of paper and answer this
question:
“Contrast the way in which monetary policy affects output in the closed economy with the small open
economy.”  Or something to that effect.

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CHAPTER 12   The Open Economy Revisited
CHAPTER 12   The Open Economy Revisited
Trade policy under floating exchange rates
Y
e
e1
Y1
e2
§At any given value of e,
a tariff or quota reduces imports, increases NX,
and shifts IS*  to the right.
Results:
De > 0,  DY = 0

Intuition for results:
At the initial exchange rate, the tariff or quota shifts domestic residents’ demand from foreign to
domestic goods.  The reduction in their demand for foreign goods causes a corresponding reduction
in the supply of the country’s currency in the foreign exchange market.  This causes the exchange
rate to rise. The appreciation reduces NX, offsetting the import restriction’s initial expansion of
NX.
How do we know that the effect of the appreciation on NX exactly cancels out the effect of the
import restriction on NX?  There is only one value of Y that allows the money market to clear;
since Y, C, I, and G are all unchanged, NX = Y-(C+I+G) must also be unchanged.
Or looking at it differently:   As we learned in chapter 5, the accounting identities say that NX =
S - I.  The import restriction does not affect S or I, so it cannot affect the equilibrium value of
NX.

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CHAPTER 12   The Open Economy Revisited
CHAPTER 12   The Open Economy Revisited
Lessons about trade policy
§Import restrictions cannot reduce a trade deficit.
§Even though NX  is unchanged, there is less trade:
§the trade restriction reduces imports.
§the exchange rate appreciation reduces exports.
§Less trade means fewer “gains from trade.”

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CHAPTER 12   The Open Economy Revisited
CHAPTER 12   The Open Economy Revisited
Lessons about trade policy, cont.
§Import restrictions on specific products save jobs in the domestic industries that produce those
products, but destroy jobs in export-producing sectors.
§Hence, import restrictions fail to increase total employment.
§Also, import restrictions create “sectoral shifts,” which cause frictional unemployment.

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Import restrictions cause a sectoral shift, a shift in demand from export-producing sectors to
import-competing sectors.  As we learned in chapter 6, sectoral shifts contribute to the natural
rate of unemployment, because displaced workers in declining sectors take time to be matched with
appropriate jobs in other sectors.

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CHAPTER 12   The Open Economy Revisited
CHAPTER 12   The Open Economy Revisited
Fixed exchange rates
§Under fixed exchange rates, the central bank stands ready to buy or sell the domestic currency for
foreign currency at a predetermined rate.
§In the Mundell-Fleming model, the central bank shifts the LM* curve as required to keep e  at its
preannounced rate.
§This system fixes the nominal exchange rate.
In the long run, when prices are flexible,
the real exchange rate can move even if the nominal rate is fixed.

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CHAPTER 12   The Open Economy Revisited
CHAPTER 12   The Open Economy Revisited
Fiscal policy under fixed exchange rates
Y
e
Y1
e1
§Under floating rates,
a fiscal expansion
would raise e.
Results:
De = 0,  DY  > 0
Y2
To keep e from rising,
the central bank must
sell domestic currency,
which increases M
and shifts LM* right.
Under floating rates,
fiscal policy is ineffective
at changing output.
Under fixed rates,
fiscal policy is very effective at changing output.

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CHAPTER 12   The Open Economy Revisited
CHAPTER 12   The Open Economy Revisited
Monetary policy under fixed exchange rates
§An increase in M would
shift LM* right and reduce e.
Y
e
Y1
e1
To prevent the fall in e, the central bank must buy domestic currency, which reduces M and shifts
LM* back left.
Results:
De = 0,  DY  = 0
Under floating rates,
monetary policy is
very effective at changing output.
Under fixed rates,
monetary policy cannot be used to affect output.

The monetary expansion puts downward pressure on the exchange rate.  To prevent it from falling,
the central bank starts buying domestic currency in greater quantities to “prop up” the value of
the currency in foreign exchange markets.  This buying removes domestic currency from circulation,
causing the money supply to fall, which shifts the LM* curve back.
Another way of looking at it:  To keep the exchange rate fixed, the central bank must use monetary
policy to shift LM* as required so that the intersection of LM* and IS* always occurs at the
desired exchange rate.  Unless the IS* curve shifts right (an experiment we are not considering
now), the central bank simply cannot increase the money supply.

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CHAPTER 12   The Open Economy Revisited
CHAPTER 12   The Open Economy Revisited
Trade policy under fixed exchange rates
Y
e
Y1
e1
§A restriction on imports puts upward pressure on e.
Results:
De = 0,  DY  > 0
Y2
To keep e from rising,
the central bank must
sell domestic currency,
which increases M
and shifts LM* right.
Under floating rates,
import restrictions
do not affect Y or NX.
Under fixed rates,
import restrictions
increase Y and NX.
But, these gains come
at the expense of other countries:  the policy merely shifts demand from foreign to domestic goods.

Suggestion:  Assign this experiment as an in-class exercise.  Give students 3 minutes to work on it
before displaying the answer on the screen.

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CHAPTER 12   The Open Economy Revisited
CHAPTER 12   The Open Economy Revisited
Summary of policy effects in the Mundell-Fleming model
type of exchange rate regime:
floating
fixed
impact on:
Policy
Y
e
NX
Y
e
NX
fiscal expansion
0



0
0
mon. expansion



0
0
0
import restriction
0

0

0


Table 12-1 on p.351.   (“M-F” = “Mundell-Fleming”)
This table makes it easy to see that the effects of policies depend very much on whether exchange
rates are fixed or flexible.

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CHAPTER 12   The Open Economy Revisited
CHAPTER 12   The Open Economy Revisited
Interest-rate differentials
§Two reasons why r may differ from r*
§country risk:  The risk that the country’s borrowers will default on their loan repayments because
of political or economic turmoil.
§ Lenders require a higher interest rate to compensate them for this risk.
§expected exchange rate changes:  If a country’s exchange rate is expected to fall, then its
borrowers must pay a higher interest rate to compensate lenders for the expected currency
depreciation.

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CHAPTER 12   The Open Economy Revisited
CHAPTER 12   The Open Economy Revisited
Differentials in the M-F model
§where q  (Greek letter “theta”) is a risk premium, assumed exogenous.
§Substitute the expression for r  into the
IS* and LM* equations:

The first equation says that a country’s interest rate equals the world interest rate plus a risk
premium (whose size depends on investors’ perceptions of the political & economic risk of holding
that country’s assets and on the expected rate of depreciation or appreciation of the country’s
currency.
We can now use the M-F model to analyze the effects of a change in the risk premium.  The next few
slides present this analysis, then discuss an important real-world example (the Mexican peso
crisis).

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CHAPTER 12   The Open Economy Revisited
CHAPTER 12   The Open Economy Revisited
The effects of an increase in q
§IS* shifts left, because
§q   r    I
Y
e
Y1
e1
LM* shifts right, because
q   r    (M/P)d,
so Y  must rise to restore money market eq’m.
Results:
De < 0,  DY  > 0
e2
Y2

Intuition:
If prospective lenders expect the country’s currency to depreciation, or if they perceive that the
country’s assets are especially risky, then they will demand that borrowers in that country pay
them a higher interest rate (over and above r*).
The higher interest rate reduces investment and shifts the IS* curve to the left.
But it also lowers money demand, so income must rise to restore money market equilibrium.
Why does the exchange rate fall?  The increase in the risk premium causes foreign investors to sell
some of their holdings of domestic assets and pull their ‘loanable funds’ out of the country.  The
capital outflow causes an increase in the supply of domestic currency in the foreign exchange
market, which causes the fall in the exchange rate.  Or, in simpler terms, an increase in country
risk or an expected depreciation makes holding the country’s currency less desirable.

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CHAPTER 12   The Open Economy Revisited
CHAPTER 12   The Open Economy Revisited
§The fall in e  is intuitive:
An increase in country risk or an expected depreciation makes holding the country’s currency less
attractive.
§ Note:  an expected depreciation is a
self-fulfilling prophecy.
§The increase in Y  occurs because
§the boost in NX (from the depreciation)
§is greater than the fall in I  (from the rise in r ).
The effects of an increase in q

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CHAPTER 12   The Open Economy Revisited
CHAPTER 12   The Open Economy Revisited
Why income might not rise
§The central bank may try to prevent the depreciation by reducing the money supply.
§The depreciation might boost the price of imports enough to increase the price level (which would
reduce the real money supply).
§Consumers might respond to the increased risk by holding more money.
§Each of the above would shift LM* leftward.

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The result that income rises when the risk premium rises seems counter-intuitive and inaccurate.
This slide explains why the increase in the risk premium may cause other things to occur that
prevent income from rising, and may even cause income to fall.

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CHAPTER 12   The Open Economy Revisited
CHAPTER 12   The Open Economy Revisited
CASE STUDY:
The Mexican peso crisis

Mexico’s central bank had maintained a fixed exchange rate with the U.S. dollar at about 29 cents
per peso.

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CHAPTER 12   The Open Economy Revisited
CHAPTER 12   The Open Economy Revisited
CASE STUDY:
The Mexican peso crisis

In the week before Christmas 1994, the central bank abandoned the fixed exchange rate, allowing the
peso’s value to “float.”  In just one week, the peso lost nearly 40% of its value, and fell further
during the following months.

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CHAPTER 12   The Open Economy Revisited
CHAPTER 12   The Open Economy Revisited
The Peso crisis didn’t just hurt Mexico
§U.S. goods more expensive to Mexicans
§U.S. firms lost revenue
§Hundreds of bankruptcies along
U.S.-Mexican border
§Mexican assets worth less in dollars
§Reduced wealth of millions of U.S. citizens
§

The purpose of this slide is to motivate the topic.  Even though this occurred in another country
some years ago, it was very important for the U.S.   The parents of many of your students probably
held Mexican assets (indirectly through mutual funds in their 401k accounts and pension funds,
which viewed Mexico very favorably prior to the crisis) and took losses when the crisis occurred.

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CHAPTER 12   The Open Economy Revisited
Understanding the crisis
§In the early 1990s, Mexico was an attractive place for foreign investment.
§During 1994, political developments caused an increase in Mexico’s risk premium (q ):
§peasant uprising in Chiapas
§assassination of leading presidential candidate
§Another factor:
The Federal Reserve raised U.S. interest rates several times during 1994 to prevent U.S.
inflation.   (r* > 0)

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When the last line displays, it might be helpful to note that, from Mexico’s viewpoint, the U.S.
interest rate is r*.

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CHAPTER 12   The Open Economy Revisited
CHAPTER 12   The Open Economy Revisited
Understanding the crisis
§These events put downward pressure on the peso.
§Mexico’s central bank had repeatedly promised foreign investors that it would not allow the peso’s
value to fall,
§ so it bought pesos and sold dollars to
“prop up” the peso exchange rate.
§Doing this requires that Mexico’s central bank have adequate reserves of dollars.
Did it?

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We have already seen why an increase in a country’s risk premium causes its exchange rate to fall.
One could also use the M-F model to show that an increase in r* also causes the exchange rate to
fall.  The intuition is as follows:  An increase in foreign interest rates causes capital
outflows:  investors shift some of their funds out of the country to take advantage of higher
returns abroad.  This capital outflow causes the exchange rate to fall as it implies an increase in
the supply of the country’s currency in the foreign exchange market.

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CHAPTER 12   The Open Economy Revisited
Dollar reserves of Mexico’s central bank
§December 1993 ……………… $28 billion
§August 17, 1994 ……………… $17 billion
§December 1, 1994 …………… $ 9 billion
§December 15, 1994 ………… $ 7 billion
During 1994, Mexico’s central bank hid the fact that its reserves were being depleted.

Defending the peso in the face of large capital outflows was draining the reserves of Mexico’s
central bank.
(August 17, 1994 was the date of the presidential election.)
Ask your students if they can figure out why Mexico’s central bank didn’t tell anybody it was
running out of reserves.
The answer:
If people had known that the reserves were dwindling, then they would also have known that the
central bank would soon have to devalue or abandon the fixed exchange rate altogether.  They would
have expected the peso to fall, which would have caused a further increase in Mexico’s risk
premium, which would have put even more downward pressure on Mexico’s exchange rate and made it
even harder for the central bank to “defend the peso.”
Source (not only for the data on this slide, but some of the other information in this case
study):  Washington Post National Weekly Edition, pp8‑9, Feb 20‑26 1995,  various issues of The
Economist in Jan & Feb '95.

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CHAPTER 12   The Open Economy Revisited
 M the disaster  M
§Dec. 20:  Mexico devalues the peso by 13%
§ (fixes e at 25 cents instead of 29 cents)
§Investors are SHOCKED! – they had no idea Mexico was running out of reserves.
§q,  investors dump their Mexican assets and pull their capital out of Mexico.
§Dec. 22:  central bank’s reserves nearly gone.
It abandons the fixed rate and lets e float.
§In a week, e  falls another 30%.

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CHAPTER 12   The Open Economy Revisited
The rescue package
§1995:  U.S. & IMF set up $50b line of credit to provide loan guarantees to Mexico’s govt.
§This helped restore confidence in Mexico, reduced the risk premium.
§After a hard recession in 1995, Mexico began a strong recovery from the crisis.

The case study on pp.353-355 gives more detail on the peso crisis.

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CHAPTER 12   The Open Economy Revisited
CHAPTER 12   The Open Economy Revisited
CASE STUDY:
The Southeast Asian crisis 1997-98
§Problems in the banking system eroded international confidence in SE Asian economies.
§Risk premiums and interest rates rose.
§Stock prices fell as foreign investors sold assets and pulled their capital out.
§Falling stock prices reduced the value of collateral used for bank loans, increasing default
rates, which exacerbated the crisis.
§Capital outflows depressed exchange rates.

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This and the following slide correspond to the case study on pp.355-356.

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CHAPTER 12   The Open Economy Revisited
Data on the SE Asian crisis
exchange rate
% change from 7/97 to 1/98
stock market
% change from 7/97 to 1/98
nominal GDP
% change 1997-98
Indonesia
-59.4%
-32.6%
-16.2%
Japan
-12.0%
-18.2%
-4.3%
Malaysia
-36.4%
-43.8%
-6.8%
Singapore
-15.6%
-36.0%
-0.1%
S. Korea
-47.5%
-21.9%
-7.3%
Taiwan
-14.6%
-19.7%
n.a.
Thailand
-48.3%
-25.6%
-1.2%
U.S.
n.a.
2.7%
2.3%

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CHAPTER 12   The Open Economy Revisited
CHAPTER 12   The Open Economy Revisited
Floating vs. fixed exchange rates
§Argument for floating rates:
§allows monetary policy to be used to pursue other goals (stable growth, low inflation).
§Arguments for fixed rates:
§avoids uncertainty and volatility, making international transactions easier.
§disciplines monetary policy to prevent excessive money growth & hyperinflation.

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CHAPTER 12   The Open Economy Revisited
The Impossible Trinity
§A nation cannot have free capital flows, independent monetary policy, and a fixed exchange rate
simultaneously.
§A nation must choose
one side of this
triangle and
give up the
opposite
corner.
Free capital flows
Independent monetary policy
Fixed exchange
rate
Option 1
(U.S.)
Option 3
(China)
Option 2
(Hong Kong)

This slide corresponds to new material in the 6^th edition, on pp.359-360.
“Option 1” is allowing free capital flows and maintaining independent monetary policy, but giving
up a fixed exchange rate.  An example of a country that chooses this option is the United States.
“Option 2” is allowing free capital flows keeping a fixed exchange rate, but giving up independent
monetary policy.  A country that chooses this option is Hong Kong.
“Option 3” is keeping monetary policy independent, yet fixing the exchange rate.  Doing this
requires limiting capital flows.  An example of a country that practices this option is China.

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CHAPTER 12   The Open Economy Revisited
CHAPTER 12   The Open Economy Revisited
CASE STUDY:
The Chinese Currency Controversy
§1995-2005:  China fixed its exchange rate at 8.28 yuan per dollar, and restricted capital flows.
§Many observers believed that the yuan was significantly undervalued, as China was accumulating
large dollar reserves.
§U.S. producers complained that China’s cheap
yuan gave Chinese producers an unfair advantage.
§President Bush asked China to let its currency float; Others in the U.S. wanted tariffs on Chinese
goods.

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This slide corresponds to new material in the 6^th edition, on pp.360-361.

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CHAPTER 12   The Open Economy Revisited
CHAPTER 12   The Open Economy Revisited
CASE STUDY:
The Chinese Currency Controversy
§If China lets the yuan float, it may indeed appreciate.
§However, if China also allows greater capital mobility, then Chinese citizens may start moving
their savings abroad.
§Such capital outflows could cause the yuan to depreciate rather than appreciate.

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This slide corresponds to new material in the 6^th edition, on pp.360-361.

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CHAPTER 12   The Open Economy Revisited
CHAPTER 12   The Open Economy Revisited
Mundell-Fleming and the AD curve
§So far in M-F model, P  has been fixed.
§Next:  to derive the AD curve, consider the impact of a change in P  in the M-F model.
§We now write the M-F equations as:
(Earlier in this chapter, P was fixed, so we
could write NX as a function of e instead of e.)

Net exports really depend on the real exchange rate, not the nominal exchange rate.  Earlier in the
chapter, we wrote NX as a function of the nominal rate, because the price level was assumed fixed,
so the nominal & real rates always moved together.  But now, with the price level changing also, we
need to write NX as a function of the real exchange rate.

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CHAPTER 12   The Open Economy Revisited
CHAPTER 12   The Open Economy Revisited
Y1
Y2
Deriving the AD curve
Y
e
Y
P
IS*
LM*(P1)
LM*(P2)
AD
P1
P2
Y2
Y1
e2
e1
Why AD  curve has negative slope:
P
Þ LM shifts left
Þ e
Þ ¯NX
Þ ¯Y
Þ ¯(M/P)

Like figure 12-13 on p.362, except here we are showing what happens to Y when P increases (not
falls).
The derivation of the open economy AD curve is very similar to that of the closed economy AD curve
(see chapter 11).

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CHAPTER 12   The Open Economy Revisited
CHAPTER 12   The Open Economy Revisited
From the short run to the long run
LM*(P1)
e1
e2
then there is downward pressure
on prices.
Over time, P will
move down, causing
(M/P )
e ¯
NX
Y
P1
SRAS1
Y
e
Y
P
IS*
AD
LRAS
LM*(P2)
P2
SRAS2

Figure 12-14 on p.363.
Suggestion:
Have your students draw the two panels of the diagram on this screen, with the economy in an
initial equilibrium with output equal to its natural rate.  Then, have them use their diagrams to
analyze the short-run and long-run effects of a negative IS* shock.

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CHAPTER 12   The Open Economy Revisited
CHAPTER 12   The Open Economy Revisited
Large:  Between small and closed
§Many countries – including the U.S. – are neither closed nor small open economies.
§A large open economy is between the polar cases of closed & small open.
§Consider a monetary expansion:
§Like in a closed economy,
DM  > 0  Þ  ¯r  Þ I  (though not as much)
§Like in a small open economy,
DM  > 0  Þ  ¯e  Þ NX  (though not as much)

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For more details, see the Appendix to chapter 12 (not included in this PowerPoint presentation).

Chapter Summary
§1. Mundell-Fleming model
§the IS-LM model for a small open economy.
§takes P as given.
§can show how policies and shocks affect income and the exchange rate.
§2. Fiscal policy
§affects income under fixed exchange rates, but not under floating exchange rates.
CHAPTER 12   The Open Economy Revisited
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Chapter Summary
§3. Monetary policy
§affects income under floating exchange rates.
§under fixed exchange rates, monetary policy is not available to affect output.
§4. Interest rate differentials
§exist if investors require a risk premium to hold a country’s assets.
§An increase in this risk premium raises domestic interest rates and causes the country’s exchange
rate to depreciate.
CHAPTER 12   The Open Economy Revisited
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Chapter Summary
§5. Fixed vs. floating exchange rates
§Under floating rates, monetary policy is available for can purposes other than maintaining
exchange rate stability.
§Fixed exchange rates reduce some of the uncertainty in international transactions.
CHAPTER 12   The Open Economy Revisited
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