Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Capitolo 10
Domanda Aggregata, Prodotto,
e Tasso di Interesse
©EGEA 2006
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Cyclical fluctuations
©EGEA 2006
Figure 10.01
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.01
Changes we see, and how we decompose them.
(+) cyclical deviation
Long-term growth trend
Real GDP
Actual real GDP
(-) cyclical deviation
0
©EGEA 2006
Time
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Openness and size (%)
Poland
Belgium
Sweden
Share of world
GDP
0.6
0.8
0.7
Openness
29.7
80.3
40.2
Switzerland
Netherlands
Korea, Rep.
0.8
1.3
1.5
40.9
59.1
39.3
Brazil
Canada
China
1.4
2.2
3.9
14.7
14.7
27.4
United Kingdom
Germany
Japan
4.8
6.1
12.4
26.7
33.5
10.5
European Monetary Union
United States
20.6
32.1
11.1
11.8
Source: World Development Indicators , The World Bank, 2004
©EGEA 2006
Table 10.01
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
General macroeconomic equilibrium
in the open economy
©EGEA 2006
Figure 10.02
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.02
Interaction of markets in the closed economy
Income influences
demand for money
Goods
Market
Money
Market
Interest rates affect
aggregate demand
©EGEA 2006
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.02
Now we open the economy…
Income influences
demand for money
Goods
Market
Money
Market
Interest rates affect
aggregate demand
Real exchange
rates affect
aggregate
demand
©EGEA 2006
Foreign
Exchange
Market
Interest rates
influence
the exchange rate
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
♦ Identità contabile fondamentale (equazione
delle risorse-impieghi)
Y = C + I + G + XZ
C = C(, Y-T), con  e T dati o esogeni (*
e T*)
I = I(i, q), q esogeno (animal spirits), q*
G esogena G*
SPPC =X-Z=SPPC(Y, Y, ), Y* reddito
estero
©EGEA 2006
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
The 45° diagram
©EGEA 2006
Figure 10.03
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.03
Ceteris paribus


DD  C ,Y  T  I  i , q   G  PCA Y ,Y , 
*
Desired demand
varies
DD
0
©EGEA 2006
varies
Output
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.03
Equilibrium condition
DD  Y
Desired demand
45°
equilibrium in
the goods market
i.e. Y =0
DD
DD  Y 
excess supply
of goods
Y  0
0
©EGEA 2006
Y
Y´
Output
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.03
The 45° Diagram, a.k.a. “The Keynesian Cross”
Desired demand
45°
DD
A
Y


Y  C ,Y  T  I  i , q 
G  PCA Y ,Y * , 
0
©EGEA 2006
Y
Output
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
The multiplier
©EGEA 2006
Figure 10.04
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.04
Start from an equilibrium in the goods market
Desired demand
45°
DD(Y)
DD
0
©EGEA 2006
A
Y
Output
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA

Figure 10.04

DD´ C  ,Y  T   I  i ,q   G  G  PCA Y ,Y * , 
G´
Desired demand
45°
DD´(Y)
DD(Y)
DD
0
©EGEA 2006
Government
expenditures
increase
G
A
Y
Output
Output
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.04
Output increases to match increase in demand
Desired demand
45°
DD´(Y)
B
Y
0
©EGEA 2006
A´
DD(Y)
G
A
Y
Output
Output
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.04
BA´ increase in income means DD´ increases too
Desired demand
45°
DD´(Y)
B´
B
Y
0
©EGEA 2006
A´
DD(Y)
G
A
Y
Output
Output
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Output increases again
to meet induced demand, A´B´
Desired demand
45°
DD´(Y)
B´
B
Y
0
©EGEA 2006
A´´
A´
DD(Y)
G
A
Y
Output
Output
Figure 10.04
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.04
The government spending multiplier  Y G
Desired demand
45°
E
B´ A´´
B
Y
A´
DD´(Y)
DD(Y)
G
A
Y
0
©EGEA 2006
Y
Y*
Output
Output
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Table 10.02
Demand Multipliers: Five Examples
Years after change
1
2
3
Euro Area
1.43
1.31
0.41
UK
0.75
0.33
0.01
USA
1.05
0.49
-0.38
Canada
1.24
0.52
-0.17
Japan
1.85
1.58
-0.09
The numbers represent the effect of a change in government expenditure of 1%
of real GDP in 2000 and 2001 in all five regions on each economy's output (as
percentage deviation from baseline).
©EGEA 2006
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Deriving the IS curve
©EGEA 2006
Figure 10.05
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.05
Identifying an equilibrium combination of i and Y
DD(i )
DD
A
i
A
Y
©EGEA 2006
Interest rate
Desired demand
Y=DD
Output
Y
Output
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.05
Equilibrium output will change if the interest rate
changes
DD
B
DD
i  i
DD(i )
A
i
B
i
A
Y
©EGEA 2006
DD(i )
Interest rate
Desired demand
Y=DD
Y
Output
Y
Y
Output
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.05
IS curve derived by finding Y’s for all i’s
DD
B
i  i
DD
DD(i )
A
i
B
i
A
Y
©EGEA 2006
DD(i )
IS
Interest rate
Desired demand
Y=DD
Y
Output
Y
Y
Output
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.05
To the right of the IS curve supply of goods
exceeds their demand
i 
DD(i )
B
DD
i  i
C
DD
©EGEA 2006
IS
D
A
i
C
Excess
supply of
goods
B
i
DD(i )
A
D
Y
DD(i )
Interest rate
Desired demand
Y=DD
Y
Output
Y
Y
Output
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.05
To the left of the IS curve demand for goods
exceeds their supply
Hint: interest rates
are lower than
along the IS curve
where Y=DD(i)
©EGEA 2006
Interest rate
Convince
yourself
that this is
true!
IS
A
Excess
demand
for goods
Excess
supply of
goods
B
Output
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.06
Exogenous increase in aggregate demand
©EGEA 2006
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.06
Start from equilibrium in the goods market...
DD(G,i )
DD
IS
i
A
A
Y
©EGEA 2006
Interest rate
Desired demand
Y=DD
Output
Y
Output
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.06
Exogenous increase in aggregate demand
(e.g. G increases, but hold i constant at first)
B
DD
DD
DD(G,i )
IS
i
A
B
A
Y
©EGEA 2006
DD(G,i )
Interest rate
Desired demand
Y=DD
Y
Output
Y
Y
Output
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.06
Similar shift to that from A to B would occur for all
other values of the interest rate
B
DD
DD
DD(G,i )
IS
i
IS´
A
B
A
Y
©EGEA 2006
DD(G,i )
Interest rate
Desired demand
Y=DD
Y
Output
Y
Y
Output
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.07
GDP growth and Tobin’s q in the USA
110
6
100
5
90
4
80
3
70
2
60
1
50
0
40
-1
30
-2
Jan/95 Jan/96 Jan/97 Jan/98 Jan/99 Jan/00 Jan/01 Jan/02 Jan/03
Tobin's q (left scale: 2000=100)
©EGEA 2006
GDP growth (right scale)
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Deriving the LM curve
©EGEA 2006
Figure 10.08
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.08
Nominal nterest rate
Nominal nterest rate
Holding the real money supply constant, we
determine i for some given level of output...
Real
money
supply
A
i
i
A
L (Y,i,c)
MP
©EGEA 2006
Real money
stock
Y
Output
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.08
Nominal nterest rate
Nominal nterest rate
Same question for a higher level of output...
Real
money
supply
B
i
B
i
A
i
A
L (Y ,i,c)
i
L (Y,i,c)
MP
©EGEA 2006
Real money
stock
Y
Y
Output
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.08
Nominal nterest rate
Nominal nterest rate
LM curve derived by finding i’s for all Y’s
Real
money
supply
B
i
LM
B
i
A
i
A
L (Y ,i,c)
i
L (Y,i,c)
MP
©EGEA 2006
Real money
stock
Y
Y
Output
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.08
Nominal nterest rate
Nominal nterest rate
To the right of the LM curve demand for real
balances exceeds their supply
Real
money
supply
B
i
LM
i
C
i
A
L (Y ,i,c)
B
A
i
Excess
demand
for money
C
L (Y,i,c)
MP
©EGEA 2006
Real money
stock
Y
Y
Output
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.08
Nominal nterest rate
Nominal nterest rate
To the left of the LM curve supply of real balances
exceeds their demand
Real
money
supply
i
C
B
Excess
supply of
money
C
i
LM
B
A
i
A
L (Y ,i,c)
i
L (Y,i,c)
MP
©EGEA 2006
Real money
stock
Y
Y
Output
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.08
Nominal nterest rate
Money market equilibrium on the LM curve
Excess
supply of
money
LM
Excess
demand
for money
Output
©EGEA 2006
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.09
Increasing money supply shifts LM outward
©EGEA 2006
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.09
Increasing money supply shifts LM outward
Nominal nterest rate
Nominal nterest rate
(at the same interest rate, we need Y to go up for greater D)
Real
money
supply
i
A
B
LM
LM´
i
A
B
D= L (Y´,i,c)
D= L (Y,i,c)
MP
©EGEA 2006
Real money
stock
Y
Y
Output
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.09
Increasing money supply shifts LM outward
Nominal nterest rate
Nominal nterest rate
(at the same Y, we need i to go down)
Real
money
supply
i
A
LM
LM´
i
A
C
C
D= L (Y,i,c)
MP
©EGEA 2006
Real money
stock
Y
Output
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.10
Interest rate
The balance of payments line
i*
Financial
integration
line
Output
©EGEA 2006
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
General equilibrium
©EGEA 2006
Figure 10.11
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.11
Interest rate
Equilibrium in the goods market
Changes in output will occur when
we are not on the IS curve (as
response to shortage to the left of
IS and surplus to the right).
IS
Output
©EGEA 2006
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.11
Equilibrium in the money market
Interest rate
LM
Changes in the interest rate will
occur when we are not on the LM
curve. Below LM there is an
excess demand for money (bonds
chase money). Above the LM
there is an excess supply of
money (money chases bonds).
Output
©EGEA 2006
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.11
Equilibrium in international capital markets
Interest rate
When domestic and foreign rates of
return are not the same, capital will
flow towards the higher returns until
returns are equalized.
i*
Financial
integration
line
Output
©EGEA 2006
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.11
General equilibrium
Interest rate
LM
Financial
integration
line
A
i*
IS
Output
©EGEA 2006
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.12
Money policy under fixed exchange rates
©EGEA 2006
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.12
Starting from general equilibrium, there is an
unanticipated increase in the supply of money
Interest rate
LM
Financial
integration
line
A
i*
IS
Output
©EGEA 2006
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.12
Starting from general equilibrium, there is an
unanticipated increase in the supply of money
Interest rate
LM
LM´
Financial
integration
line
A
i*
IS
Output
©EGEA 2006
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.12
Note: points A,B,C each satisfy only two
of three equilibrium conditions
Interest rate
LM´
A
Financial
integration
line
C
i*
B
IS
This condition is
not moving!
Output
©EGEA 2006
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.12
Implication of fixed exchange rates in this case:
No reason for the IS curve to move.
Interest rate
LM´
A
Financial
integration
line
C
i*
B
IS
This condition is
not moving either!
Output
©EGEA 2006
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.12
The central bank has to bring LM back to the
original position to keep the exchange rate fixed.
Interest rate
LM´
Financial
integration
line
A
i*
IS
Output
©EGEA 2006
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.12
The central bank has to bring LM back to the
original position to keep the exchange rate fixed.
Interest rate
LM
LM´
Financial
integration
line
A
i*
IS
Monetary policy is
ineffective for
changing output.
Output
©EGEA 2006
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Table 10.04
The Mundell-Fleming model: Summary
Effect on real GDP
Exogenous change
Fixed exchange
rates
Flexible exchange
rates
Expansionary demand disturbance
Increase
No effect
Expansionary monetary disturbance
No effect
Increase
Increase in foreign interest rates
Decrease
Increase
©EGEA 2006
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Table 10.3
Sterilized and unsterilized
foreign exchange market interventions
Unsterilized interventions
Step 1
M0
F
DC
M0
F
DC
–
–
=
–
–
–
=
–
+
=
=
+
+
Step 2
Overall
©EGEA 2006
Sterilized interventions
–
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.13
Demand disturbance, fixed exchange rates
©EGEA 2006
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.13
Starting from general equilibrium, there is an
unanticipated increase in the demand for goods
Interest rate
LM
Financial
integration
line
A
i*
IS
Output
©EGEA 2006
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.13
Starting from general equilibrium, there is an
unanticipated increase in the demand for goods
Interest rate
LM
Financial
integration
line
A
i*
IS
IS´
Output
©EGEA 2006
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.13
Note: points A,B,C each satisfy only two
of three equilibrium conditions
Interest rate
LM
B
A
i*
Financial
integration
line
C
IS´
This condition is
not moving!
Output
©EGEA 2006
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.13
Implication of fixed exchange rates in this case:
No reason for the IS curve to move (further).
Interest rate
LM
B
A
i*
Financial
integration
line
C
This condition is
not moving either!
IS´
Output
©EGEA 2006
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.13
The central bank has to move LM to the right to
maintain the fixed exchange rate.
Interest rate
LM
i*
Financial
integration
line
C
IS´
Output
©EGEA 2006
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.13
The central bank has to move LM to the right to
maintain the fixed exchange rate.
Interest rate
LM
i*
LM´
Note: M0 increased
by forex purchases
of the central bank.
Financial
integration
line
C
IS´
Fiscal policy is
effective for
changing
output.
Output
©EGEA 2006
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.13
Review: Demand disturbance, fixed exchange
rate, no capital controls
Interest rate
LM
Financial
integration
line
A
i*
IS
Output
©EGEA 2006
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.13
Review: Demand disturbance, fixed exchange
rate, no capital controls
Interest rate
LM
A
i*
Financial
integration
line
C
IS
IS´
Output
©EGEA 2006
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.13
Review: Demand disturbance, fixed exchange
rate, no capital controls
Interest rate
LM
A
i*
LM´
Financial
integration
line
C
IS
IS´
Output
©EGEA 2006
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Table 10.04
The Mundell-Fleming model: Summary
Effect on real GDP
Exogenous change
Fixed exchange
rates
Flexible exchange
rates
Expansionary demand disturbance
Increase
No effect
Expansionary monetary disturbance
No effect
Increase
Increase in foreign interest rates
Decrease
Increase
©EGEA 2006
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.13
Compare: Demand disturbance, fixed exchange
rate, with capital controls
Interest rate
LM
Financial
integration
line
A
i*
IS
Output
©EGEA 2006
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.13
Compare: Demand disturbance, fixed exchange
rate, with capital controls
Interest rate
LM
B
Note: central bank
independence is possible
for a short-time now
Financial
integration
line
A
i*
IS
IS´
Output
©EGEA 2006
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.14
Argentina 1993-2003
50
45
1
40
35
0.8
30
25
20
0.6
15
10
0.4
5
0
-5
1992Q1
0.2
1994Q1
1996Q1
Inflation (left scale)
©EGEA 2006
1998Q1
2000Q1
2002Q1
Dollar per peso (right scale)
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Policy mix
©EGEA 2006
Figure 10.15
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.15
Policy mix: monetary policy moves with fiscal
policy deliberately to change output holding i=i*
Interest rate
LM
Financial
integration
line
A
i*
IS
Output
©EGEA 2006
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.15
Policy mix: monetary policy moves with fiscal
policy deliberately to change output holding i=i*
Interest rate
LM
A
i*
LM´
M0 increased by
securities purchases
by central bank.
Financial
integration
line
B
IS
IS´
Output
©EGEA 2006
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.16
Financial disturbance, fixed exchange rate
©EGEA 2006
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.16
Increase in rate of return on foreign assets,
fixed exchange rate
Interest rate
LM
i*
A
IS
Output
©EGEA 2006
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.16
Increase in rate of return on foreign assets,
fixed exchange rate
Interest rate
LM
Note: M0 will fall
due to forex sales
by central bank.
i*´
i*
A
IS
This condition is
not moving!
Output
©EGEA 2006
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.16
Increase in rate of return on foreign assets,
fixed exchange rate
Interest rate
LM´
LM
B
Note: M0 will fall
due to forex sales
by central bank.
i*´
i*
A
IS
This condition is
not moving!
Output
©EGEA 2006
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Table 10.04
The Mundell-Fleming model: Summary
Effect on real GDP
Exogenous change
Fixed exchange
rates
Flexible exchange
rates
Expansionary demand disturbance
Increase
No effect
Expansionary monetary disturbance
No effect
Increase
Increase in foreign interest rates
Decrease
Increase
©EGEA 2006
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
A devaluation
©EGEA 2006
Figure 10.17
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.17
To devalue the currency the central bank will bid
up the price of foreign money, creating more M0
Interest rate
LM
Financial
integration
line
A
i*
IS
Output
©EGEA 2006
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.17
To devalue the currency the central bank will bid
up the price of foreign money, creating more M0
LM
Interest rate
LM´
Financial
integration
line
A
i*
IS
Output
©EGEA 2006
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.17
To devalue the currency the central bank will bid
up the price of foreign money, creating more M0
LM
Interest rate
LM´
A
Financial
integration
line
C
i*
IS´
IS
Lower S
increases
demand for
goods.
Output
©EGEA 2006
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.18
Demand disturbance, flexible exchange rates
©EGEA 2006
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.18
Real demand increases…
Interest rate
LM
Financial
integration
line
A
i*
IS
Output
©EGEA 2006
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.18
Real demand increases…
However, the
resulting increase
in S will reduce
the demand for
goods.
Interest rate
LM
B
Financial
integration
line
A
i*
IS
IS´
Output
©EGEA 2006
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.18
…i>i* will attract capital inflows, so S appreciates
However, the
resulting increase
in S will reduce
the demand for
goods.
Interest rate
LM
B
Financial
integration
line
A
i*
IS
IS´
Output
©EGEA 2006
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Table 10.04
The Mundell-Fleming model: Summary
Effect on real GDP
Exogenous change
Fixed exchange
rates
Flexible exchange
rates
Expansionary demand disturbance
Increase
No effect
Expansionary monetary disturbance
No effect
Increase
Increase in foreign interest rates
Decrease
Increase
©EGEA 2006
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.19
Monetary policy under flexible exchange rates
©EGEA 2006
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Figure 10.19
Increase in money supply lowers the interest rate
LM
Interest rate
LM´
A
Exchange rate
depreciates
increasing the
demand for goods.
Financial
integration
line
C
i*
B
IS´
IS
Output
©EGEA 2006
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Table 10.04
The Mundell-Fleming model: Summary
Effect on real GDP
Exogenous change
Fixed exchange
rates
Flexible exchange
rates
Expansionary demand disturbance
Increase
No effect
Expansionary monetary disturbance
No effect
Increase
Increase in foreign interest rates
Decrease
Increase
©EGEA 2006
Burda, Wyplosz
MACROECONOMIA: UNA PROSPETTIVA EUROPEA
Table 10.04
The Mundell-Fleming model: Summary
Effect on real GDP
Exogenous change
Fixed exchange
rates
Flexible exchange
rates
Expansionary demand disturbance
Increase
No effect
Expansionary monetary disturbance
No effect
Increase
Increase in foreign interest rates
Decrease
Increase
Fixed exchange
rates
Flexible exchange
rates
Exogenous monetary instrument
Exchange rate
Money supply
Endogenous monetary instrument
Money supply
Exchange rate
©EGEA 2006