ECON 1110 Lecture Notes 7

ECON 1110 Intermediate Macroeconomics

James R. Maloy
Autumn 2014

Lecture Notes for Topic 7: The Mundell-Fleming Model

Readings: Froyen Chapters 14 and 15 (8th Ed. Ch. 15 & 16). Omit 15.2 on incomplete
capital mobility. You should read all of Ch. 14 on Exchange Rates and the International
Monetary System, although parts will not be discussed in the lectures.
I.

Balance of Payments

The balance of payments (BOP) is set up as a way of measuring international

transactions. The fundamental idea is that these accounts must balancelike a standard
accounting balance sheet, for each credit there must be a corresponding debit somewhere
in the accounts. There are four main categories of the BOP: the current account, the
capital account, statistical discrepancy and official reserves transactions.
The Current Account
The current account records all imports/exports of goods and services. Of considerable
importance here are import and exports of merchandise, although services are becoming
increasing important. The US trade deficit that is often in the news is the result of the
fact that imports more than it exports. As imports are earnings of foreigners in the US
while exports are earnings of US firms abroad, imports are recorded as debits (-) while
exports are recorded as credits (+). The US currently has a current account deficit ($482.9bn as of 2002, although this has since increased).
The Capital Account
The capital account records purchases of US assets by foreigners citizens and firms, and
purchases of foreign assets by US citizens and firms. The purchase of a US asset by a
Japanese citizen (such as buying a stock on the NYSE) is a capital inflow into the US (i.e.
funds are coming into the US) and is recorded as a credit (+). Purchases of foreign assets
by US citizens are a capital outflows and are recorded as a debits (-). Foreigners have
purchased many more US assets in recent years than US citizens have acquired abroad;
the capital account is in surplus ($428.1bn in 2002). Note that this is basically US
borrowing from abroadforeigners now have claims on US assets. The current account
deficit and capital account surplus are indeed related. If the US is buying more from

ECON 1110 Lecture Notes 7

foreigners than they are buying from the US, then the US is paying more out than it is
taking in. Foreigners then use these earnings to buy US assets, thus funding this current
account deficit. Over the past 25 years the US has gone from being the worlds creditor
to being the worlds debtor.
Statistical Discrepancy
Due to the sheer volume of international transactions, it is not possible to accurately
measure everything. The statistical discrepancy is simply the amount that is necessary to
make the accounts balance ($45.8bn in 2002) (if everything could be counted perfectly,
then there would be no discrepancy).
Official Reserve Transactions
All of the above transactions are made by people/firms/the government for some personal
reason, such as the desire to have imported French cheese that smells like feet or the
desire of the US government to give money to some overseas nation. However, central
banks (such as the Fed) conduct transactions not for some separate reason, but rather with
some BOP policy goal in mind. Well see the purpose of these transactions as we discuss
the Mundell-Fleming model. However, it is important to note that central banks hold
reserves of both domestic and foreign assets. The Fed holds US assets, usually treasury
bills, which are US government debt, and US dollars (money is an asset, of course!) as
well as similar assets/money issued by overseas nations. Other central banks do likewise.
Official reserve transactions are changes in a central banks holding of domestic and
foreign assets. If a foreign central bank buys more dollars or other US assets, then it is a
foreign investment in the US and is recorded as a credit (+). If the Fed buys more foreign
currency or foreign assets, then it is an investment in the foreign nation and is recorded as
a debit (-). In 2002 the net official reserves transaction was $98.6bn, indicating that
foreign governments were increasing their holding of US assets relative to the Fed
increasing its holdings of foreign assets. A considerable portion of US government debt
in particular is held by foreign nations, particularly those nations that have a large trade
surplus with the US (such as China). These nations are basically funding the US
government deficit, as well as US current account deficit, by lending money to the US.
There has been some recent concern that some nations might respond to the recent
weakness of the dollar by holding fewer US assets, which could lead to large BOP

ECON 1110 Lecture Notes 7

problems. The current account deficit means that the US is increasingly becoming
indebted to the rest of the world, and such a situation requires these foreigners to be
willing to lend to the US. However, as shall be seen below, the weakening dollar has led
to a reduction in the current account deficit in recent months. You should read
perspectives 15.1 on Froyen p. 313 for further discussion.
II.

Fixed and Flexible Exchange Rates

Suppose that the US is the domestic economy. The demand for foreign currencies is
called the demand for foreign exchange. The foreign exchange (FOREX) market is the
market in which currencies are exchanged. Any purchase of a foreign asset, good,
service, or any other international transaction is considered demand for foreign exchange.
Obviously, if a US citizen purchases a BMW, he or she will be paying in US dollars
(USD), yet the German manufacturer will demand payment in euros. The dollars must be
exchanged for euros through the forex marketthe foreign exchange trader will be
supplying dollars to the market and demanding euros. Likewise, a US citizen buying
shares on the London stock exchange will generate a similar currency exchange: the stock
broker must convert the USD into pounds (GBP) before being able to purchase the stock;
he also will be supplying dollars and demanding pounds. Such transactions make up the
demand for foreign exchange, or, equivalently, the supply of dollars.
Conversely, earnings of US residents/companies abroad involve earnings of
foreign exchange. The purchase of Microsoft software by a Japanese person will result in
an exchange of yen for dollars. Since foreigners must sell their currency to buy dollars,
these transactions constitute the supply of foreign exchange, or equivalently, the demand
for dollars.
The exchange rate is the rate at which currencies can be exchanged for one
another. There are two ways to express exchange rates. It is important to realise which
technique is being used, since an increase in the exchange rate means opposite things for
the two techniques. The first method is to express the value of one unit of foreign
currency in domestic currency, i.e. (USD)/(1 unit of foreign currency). For example, if
the USD/GBP exchange rate is 2 $/, it means that it takes $2 to buy 1. So if you buy a
UK good that costs 20, the purchase will cost you $40. (20 x 2 $/ = $40)

ECON 1110 Lecture Notes 7

If the exchange rate increases to 3 $/, it means that it will now cost you $60 to
buy the same 20 good, thus making it relatively more expensive. When defined as
USD/Foreign, an increase in the exchange rate means the dollar depreciates in value.
Since exchange rates are in terms of each other, a depreciation of the dollar means that
the foreign currency (GBP) has appreciated.
Using this definition of exchange rates, as exchange rates rise US consumers will
be less willing to import. As seen in the example above, the increase in the exchange rate
leads makes the imported 20 good more expensive for US consumers (hence the fall in
imports). Therefore, a depreciation of the dollar will reduce US imports, other things
equal. A similar exercise will show that as this exchange rate increases (i.e. dollar
depreciates), US goods will be less expensive for foreigners to buy since it costs less of
their currency to buy a good priced in dollars, and exports will increase. In summary, an
increase in the exchange rate means that the domestic currency has depreciated relative
to the foreign currency. This will increase net exports (X Z), ceteris paribus. This
definition of exchange rate is used in the text, and in the interest of consistency will be
used in this class.
The other way of measuring exchange rates is to determine the value of $1 in
foreign currency, i.e (Foreign)/(1 USD). Using this measure, if $1 trades for 5 then the
exchange rate is 5. Simple arithmetic can show that in this case, an increase in the
exchange rate means that the dollar has appreciated, not depreciated, (i.e. if the
exchange rate increases to 6, then that means that $1 will now buy 6). This implies that
US goods will be more expensive for foreigners, but foreign goods will be less expensive
for US consumers; exports will decrease and imports increase, so net exports will fall.
You should be aware that both techniques are frequently used and an increase (or
decrease) means opposite things depending on which is being used. Therefore, in general
it is better to say that the dollar has appreciated or depreciated, rather than saying that the
exchange rate goes up or goes down, as the meaning of that depends on which measure is
used. Again, we will use the first technique in this classan increase in the exchange
rate is a depreciation of the dollar and appreciation of the forex.
Naturally, once we have supply and demand we can draw a happy little diagram to
represent the foreign exchange market, and thus the determination of exchange rates. The

ECON 1110 Lecture Notes 7

demand for foreign exchange is downward sloping, since at lower exchange rates, foreign
goods become cheaper relative to domestic goods, (the value of the domestic currency
has appreciated) so people will wish to import more and must therefore demand more
foreign exchange to make these purchases. The supply of foreign exchange is upward
sloping since as exchange rates increase, the value of the domestic currency has
depreciated, and domestic goods become relatively cheaper for foreigners to buy.
Therefore exports will increase as exchange rates increase and more foreign exchange
will be supplied. Equilibrium is where the curves intersect.

ECON 1110 Lecture Notes 7

Flexible (or Floating) Exchange Rate Regimes

A flexible exchange rate regime is simply one in which the market (interaction of demand
for and supply of foreign exchange) determines the exchange rate. Exogenous changes in
demand for imports and exports, and increases or decreases in capital flows will shift the
curves, and a new equilibrium exchange rate will be attained.

ECON 1110 Lecture Notes 7

Fixed Exchange Rate Regimes

A fixed exchange rate regime is one in which the government sets and maintains the
exchange rate at a certain level. Such situations existed under the Bretton Woods system
of fixed exchange rates and previously existed under the European exchange rate
mechanism (and still does for many non-eurozone EU nations) Many nations also peg
their currency to a more stable foreign currency (usually US dollar).
If demand and supply do not intersect at the pegged level, there will be excess
demand or supply of foreign exchange.

A fixed rate system requires the

government/central bank to intervene to correct such situations to maintain the exchange

rate at the fixed level. How does this occur? Central banks hold reserves of both their
own currency and selected foreign currencies--generally US dollars, Euros, Yen, and
Sterling. If there is excess demand for foreign exchange (i.e. excess supply of the
domestic currency), the central bank will sell some of its reserves of the foreign currency
on the market and buy back the excess domestic currency. This will keep the exchange
rate at the fixed level. Conversely, if there is excess supply of foreign exchange (i.e.
excess demand of the domestic currency), the central bank will exchange some of its
reserves of the domestic currency for the foreign currency, thus pushing the market back
to equilibrium and the fixed exchange rate.
The key problem many nations have is that if there is a continual excess supply or
demand for foreign exchange, the central bank will deplete its reserves and will not be
able to intervene to maintain the exchange rate. This happened frequently both under the
Bretton Woods system and the ERM. The nation must either re-value the currency at a
higher or lower exchange rate that is sustainable, or drop out of the fixed exchange rate
mechanism.

ECON 1110 Lecture Notes 7

II. The Mundell-Fleming Model

The Mundell-Fleming model is an open-economy version of the Keynesian ISLM analysis. The LM curve (equilibrium in the money market; money supply equals
money demand) is unchanged in the open economy. It is still given by
M = L(Y, r)
However, recalling that the condition for equilibrium in the product market (i.e. the IS
curve) was given by:
C+S+TY=C+I+G
or simply
S+T=I+G
where S is given by S(Y) and I is a function of interest rates, I(r).
We will see that adding exports and imports to the model will change the IS curve to
Y=C+I+G+XZ
or
S+T+Z=I+G+X
As before, savings and investment are given as functions of income and interest rates
respectively. Imports are given a function of income and the exchange rate e, such that Z
= Z(Y, e). Exports are a function of the foreign income and the exchange rate, X = X(Yf,
e). Graphically, the IS and LM curves are analogous to the previous versions. There is
an important note to make about the IS curve. Without boring you with the mechanics,
we construct the IS curve holding four variables constant: taxes, government spending,
foreign income, and the exchange rate. A change in one of these variables will shift the
IS curve. Recalling that the axes of the IS curve are Y and r, we note that a change in
consumption, investment, or imports that comes from a change in interest rates or
income will cause a movement along the curve, not a shift in the curve.
The open economy model includes a third curve, the BP curve (balance of
payments). This curve plots all income-interest rate combinations that result in balance
of payments (informally this means the value of what is going in equals the value of what
is going out) at a given exchange rate. This curve is given by:
X(Yf, e) - Z(Y, e) + F (r rf) = 0

ECON 1110 Lecture Notes 7

The 3rd term is the net capital inflow. A capital inflow is the purchase of a domestic asset
by a foreigner, and a capital outflow is the purchase of a foreign asset by a domestic
citizen. The net capital inflow is a function of the difference between domestic and
foreign interest rates. If US interest rates are higher than foreign interest rates, it means
assets pay a higher return in the US, so foreigners will want to invest here, thus causing a
capital inflow. The opposite happens if domestic interest rates are too low.
If there is perfect capital mobility then any discrepancy between domestic and
foreign interest rates will result in massive capital inflows/outflows, thus bringing interest
rates back to the world level. In this case, domestic interest rates must equal world
interest rates in equilibrium. We will therefore replace the equation for the BP curve with
the condition that foreign interest rates must equal domestic interest rates. This will
generate a horizontal BP curve at r = rf. The only thing that will shift the perfect capital
mobility BP curve is a change in the foreign interest rate (which we shall assume does not
happen).

ECON 1110 Lecture Notes 7

III. Policy Effects in the Case of Perfect Capital Mobility

Assumptions:
1. Small open economycountry is too small to influence world interest rate
2. Fixed pricesthis is a short-run Keynesian model.
3. Perfect capital mobilitycannot maintain interest rate different from rest of world.
The BP curve is horizontal at the world interest rate
Using these assumptions, we will analyse policy effects under fixed and flexible
exchange rates.
A. Monetary Policy under Fixed Exchange Rates and Perfect Capital Mobility
Assume that the government undertakes an expansionary monetary policy (i.e. increases
the money supply). The LM curve shifts to the right. A new point is reached at the
intersection of the IS and the new LM curves. At this point, we are below the BP curve
domestic interest rates are lower than world interest rates. Since foreign assets command
a higher return than domestic assets, there is a net capital outfloweveryone wants to
buy assets overseas. This capital outflow will increase the demand for foreign exchange,
causing upward pressure on the exchange rate. To maintain exchange rates at the fixed
level, the government has to sell its reserves of foreign currency and buy back the
domestic currency. However, buying back domestic currency is a decrease in the money
supply! So the government has to buy back the entire increase in the money supply, thus
shifting the LM curve back to its original position. Monetary policy with fixed exchange
rates and perfect capital mobility is ineffective, even in the short run.

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ECON 1110 Lecture Notes 7

B. Fiscal Policy with Fixed Exchange Rates and Perfect Capital Mobility
Suppose now that the government chooses to do a fiscal expansion (i.e. an increase in
government spending and/or a decrease in taxes). The IS curve shifts to the right. A new
point (but not an equilibrium) is reached above the BP curvedomestic interest rates are
higher than world interest rates. This in turn will cause a massive capital inflow, putting
downward pressure on the exchange rate (i.e. everyone in the world wants buy assets in
this country, creating excess supply of foreign currency at the fixed exchange rate). To
maintain the exchange rate at the fixed level, the central bank must buy this excess supply
of foreign exchange, and thus put the domestic currency into the economy. This is a
monetary expansion, and the LM curve will shift to the right as wellthe monetary side
accommodates the fiscal expansion. A new short-run equilibrium is attained where the
new LM, IS and BP curves intersect. The economy is at a higher rate of output but back
at the world interest rate. Fiscal policy with a fixed exchange rate and perfect capital
mobility is effective at increasing output in the short run.

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ECON 1110 Lecture Notes 7

C. Monetary Policy with Flexible Exchange Rates and Perfect Capital Mobility
Again, a monetary expansion will shift the LM curve to the right. At the new intersection
with the IS curve, the domestic interest rate is again lower than the world interest rate,
causing a massive capital outflow. As in scenario A, there is excess demand for foreign
exchange at the current exchange rate. However, the exchange rate is flexible, and the
market will correct this equilibrium, resulting in a higher exchange rate (depreciation of
the domestic currency). What happens now? As exchange rates have increased, foreign
goods have become relatively more expensive, so imports will fall. Likewise, foreigners
will find that our products are relatively cheaper, so our exports will rise. This is an
increase in net exportsa rightward shift in the IS curve. A new equilibrium is attained
where the new IS, new LM, and BP curve intersect. This equilibrium is at a higher level
of outputthe product market has accommodated the monetary expansion. Monetary
policy with flexible exchange rates and perfect capital mobility is effective at increasing
output in the short run.

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ECON 1110 Lecture Notes 7

D. Fiscal Policy with Flexible Exchange Rates and Perfect Capital Mobility
Again, suppose that the government tries a fiscal expansion, shifting the IS curve to the
right. Again, this causes a new intersection with the LM curve at an interest rate higher
than the world interest rate, triggering a massive capital inflow. This will create excess
supply of foreign exchange, and the exchange rate will fall. As the exchange rate falls,
our goods become more expensive for foreigners and foreign goods become less
expensive for us. This increase in imports and decrease in exports will cause net exports
to decreasea leftward shift of the IS curve. Therefore, the decrease in net exports
cancels out the increase in government spending and the IS curve immediately shifts back
to the original position. Fiscal policy under flexible exchange rates and perfect capital
mobility is completely ineffective in changing output, even in the short run.

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