The Mundell-Fleming Model

Mainstream Thinking on Open Macroeconomics

Thomas Dürmeier

Exchange Rates

Regulating Global Finance

E nominal exchange ratebetween the euro and the dollar (eg. 1,17 euro/$ = 0,85 $/euro)

ε real exchange rate (epsilon)measured in purchasing power

our pespective: from USA to EU

E = number of units of domestic currency you can get for one unit of foreign currgency

example: EUSD/EUR = 1,19 $/Euro

domesticforeign

Thomas Dürmeier

Exchange Rate 2

Regulating Global Finance

example: EUSD/EUR = 1,19 $/Euro

depreciation E ε (value of currency decreases)appreciation E ε (value of currency increases)

Real exchange rate: exchange between commoditiesone Volkswagen P* vs. one Cadillac P1. Volkswagen with US-price: P* x E2. In comparison to Cadillac: (P* x E)/P = ε

Thomas Dürmeier

Investement/Savings - Liquidity/Money: IS-LM

Regulating Global Finance

IS: Y = C(Y-T) + I (Y,i) + GLM: M/P = Y L(i)

LMIS

T, G

M

i

Y social product

nom

inal

inte

rest

rat

e

- only commodity and captial market- price level is constant- Keynesian bias- short-run

Thomas Dürmeier

Aggregated Supply and Demand: AS-AD

Regulating Global Finance

AD: Yt = Y(M/Pt, G, T)AS: Pt = Pt-1 (1+μ) F(1-(Yt/L), z)

AS

μ , L, z

M , T, GP

Y social product

pric

e le

vel

AD

In the long-run:only AS determines Y

- IS-LM plus labor market- neutrality of money- monetaristic bias- long-run

Thomas Dürmeier

AS-AD: Neutrality of Money

Regulating Global Finance

AD: Yt = Y(M/Pt, G, T)AS: Pt = Pt-1 (1+μ) F(1-(Yt/L), z)

ASM , T, GP

Y social product

pric

e le

vel

AD

In the long-run:only AS determines Y

Monetary policy has NO influence on output, only inflation.Only under certain circumstances.

Balance of Payment

• Current account– Exports - Imports = Trade balance– Investment

• Capital account– Increase in foreign holdings of US assets– Increase in US holding of foreign assets– Statistical discrepancy

Commodity flows

Capital flows

Thomas Dürmeier

Exchange Rate Regimes

Regulating Global Finance

• Free floating: no central bank intervention• Managed floating: no fixed exchange rate goal, but central bank interventionb• Target zones: exchange rate around a band with• Crawling pegs: no fixed rate, but alinment rate and process• Adjustable peg: exchangre rate fixed, no alienment• Currency board: autonom body, which controls exchange rate target• Fixed or peeged exchange rate: constant exchange rate• Dollarisierung (dollarization), Euroisierung (euroization) or currency union• World currency

• (Privatization of money)

Source: Frankel, Jeffrey A., Sergio Schmukler und Luis Serven (2002), ”Verifiability and the Vanishing Intermediate Exchange Rate Regime”, in: Susan M. Collins und Dani Rodrik (Hrsg.): Brookings Trade Forum, The Brookings Institution. http://muse.jhu.edu/demolbtf

Thomas Dürmeier

Elements of Open Macroeconomics

Regulating Global Finance

• Interest rate parity (Mundell-Fleming)

• Purchasing power parity (monetaristic open macro)

• Expectations

• Policy credibility

Thomas Dürmeier

Mundell-Fleming Modell

Regulating Global Finance

IS: Y = C(Y-T) + I (Y,i) + GLM: M/P = Y L(i)

LMISi

Y social product

nom

inal

inte

rest

rat

e

E=Ee/(1+i-i*)interest rate parityi

E Exchange rateE

Thomas Dürmeier

Mundell-Fleming Modell: flexible exchange rate and fiscal policy

Regulating Global Finance

IS: Y = C(Y-T) + I (Y,i) + GLM: M/P = Y L(i)

LMIS

Gi

Y social product

nom

inal

inte

rest

rat

e

E=Ee/(1+i-i*)interest rate parityi

E Exchange rateE

appreciation

Thomas Dürmeier

Fixed exchange rate and fiscal policy

Regulating Global Finance

IS: Y = C(Y-T) + I (Y,i) + GLM: M/P = Y L(i)

LMIS

Gi

Y social product

nom

inal

inte

rest

rat

e

E=Ee/(1+i-i*)interest rate parityi

E Exchange rateE

IS‘

LM‘‘Pressure on exchange rate