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Mundell-Fleming Model and Aggregate Supply: Income and Exchange Rate Adjustments, Study notes of Macroeconomics

The mundell-fleming model's implications for income and exchange rates, discussing why income might not rise despite a depreciation and the impact of the southeast asian crisis on various countries. It also compares floating and fixed exchange rates and derives the ad curve in the context of the mundell-fleming model. Lastly, it introduces three models of aggregate supply: sticky-wage, imperfect-information, and sticky-price.

Typology: Study notes

2011/2012

Uploaded on 08/04/2012

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Lesson 32
THE MUNDELL-FLEMING MODEL (CONTINUED) & THE THREE MODELS OF
AGGREGATE SUPPLY
WHY INCOME MIGHT NOT RISE?
x The central bank may try to prevent the depreciation by reducing the money supply.
x The depreciation might boost the price of imports enough to increase the price level
(which would reduce the real money supply).
x Consumers might respond to the increased risk by holding more money.
Each of the above would shift LM* leftward.
THE SOUTH EAST 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% (1996-97)
U.S. n.a. 2.7% 2.3%
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.
MUNDELL-FLEMING AND THE AD CURVE
Previously, we examined the M-F model with a fixed price level. To derive the AD curve, we
now consider the impact of a change in P in the M-F model. We now write the M-F equations
as:
(Earlier, we could write NX as a function of e because e and
H
move in the same direction
when P is fixed.)
DERIVING THE AD CURVE
AD curve has negative slope because:
As P ๎˜„ p(M/P) ๎˜„ LM shifts left ๎˜„
H
๎˜„ pNX ๎˜„ pY
( ) ( ) ( ) ( )*
YCYTIr GNX๎˜‚
๎˜‡๎˜ˆ ๎˜ˆ๎˜ˆ
IS*
( ) ( , )*
MP Lr Y
LM*
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Download Mundell-Fleming Model and Aggregate Supply: Income and Exchange Rate Adjustments and more Study notes Macroeconomics in PDF only on Docsity!

Lesson 32 THE MUNDELL-FLEMING MODEL (CONTINUED) & THE THREE MODELS OF AGGREGATE SUPPLY

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.

THE SOUTH EAST ASIAN CRISIS Exchange rate% change from 7/97 to 1/

Stock market % change from 7/ to 1/

Nominal GDP% change 1997-

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% (1996-97) U.S. n.a. 2.7% 2.3%

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.

MUNDELL-FLEMING AND THE AD CURVE

Previously, we examined the M-F model with a fixed price level. To derive the AD curve, we now consider the impact of a change in P in the M-F model. We now write the M-F equations as:

(Earlier, we could write NX as a function of e because e and  move in the same direction when P is fixed.)

DERIVING THE AD CURVE

AD curve has negative slope because:

As P  (M/P )  LM shifts left    NX  Y

( IS*) Y  C ( Y  T )  I ( r * )  G  NX (  )

( LM *) M P  L ( r * , Y )

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FROM SHORT RUN TO THE LONG RUN

If Y1 < Y then there is downward pressure on prices. Over time, P will move down, causing

( M/P)     NX  Y

LARGE: BETWEEN SMALL AND CLOSED

Many countries - including the U.S. - are neither closed nor small open economies. A large open economy is in between the polar cases of closed & small open. Consider a monetary expansion: Like in a closed economy, M > 0  r  I (though not as much) Like in a small open economy, M > 0    NX (though not as much)

Y 2 Y 1 Y



Y

P

IS*

LM* ( P 2 ) LM* ( P 1 )

AD

P 1

P 2

Y 2 Y 1

 2

 1

LM* ( P 1 )

 1

 2

P 1 SRAS 1

Y



Y

P

IS*

AD

LRAS

LM* ( P 2 )

P 2 SRAS 2

Y

Y1 (^) Y

Y

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This model implies that the real wage should be counter-cyclical, it should move in the opposite direction as output over the course of business cycles:  In booms, when P typically rises, the real wage should fall.  In recessions, when P typically falls, the real wage should rise. This prediction does not come true in the real world:

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