quiz consisting of 20 multiplechoice andT/F questions Timwframe for completion 1hourtopics mundel flemming model and solow growth model
Microsoft Word - ECON2003_20170727_U1_v1.docx ECON 2003 Intermediate Macroeconomics II _Unit 1_20170728_v1 1 UNIT 1 Introduction and Revisiting the Open Economy Overview Welcome to the first unit of the course! From your previous courses, you would have learned about important open economy concepts. Remember that in the open economy, countries are connected though international trade and capital flows. Trade is facilitated by each country’s currency and so exchange rates, whether they are fixed or flexible assume greater importance. This also means that each country’s monetary and fiscal policy are influenced by international events. With this background, we can begin to build the open economy model that we will use to analyse the impact of various policies. In this unit, we extend the analysis of aggregate demand from the IS-LM model in a closed economy to the Mundell-Fleming model, which assumes a small open economy. We will first develop the model using key assumptions from the goods market and the money market along with the net exports curve in Section 1.1. Then in Section 1.2, assuming a flexible and then a fixed exchange rate, we will examine how trade policy, monetary policy, and fiscal policy can affect the equilibrium in the economy. Section 1.3 then examines the model in the long run which allows for interest rate differentials and ECON 2003 Intermediate Macroeconomics II _Unit 1_20170728_v1 2 flexible price levels. The Mundell-Fleming model then allows us to see how the exchange rate regime, whether fixed or floating, affects the efficacy of monetary, fiscal and trade policy. Learning Objectives By the end of this Unit you will be able to: 1. Examine the assumptions of the Mundell-Fleming model; 2. Determine equilibrium in the short run; 3. Evaluate the impact of fiscal and monetary policy with floating and fixed exchange rates; 4. Assess the efficacy of trade policies under floating and fixed exchange rates; 5. Examine the impact of including interest rate differentials in the Mundell Fleming model; 6. Assess how the predictions of the Mundell-Fleming model change when prices are flexible. This Unit is divided into three sessions as follows: Session 1.1: The Mundell Fleming Model in the Short Run Session 1.2: The Small Open Economy under Floating and Fixed Exchange Rates Session 1.3: The Mundell Fleming Model in the Long Run ECON 2003 Intermediate Macroeconomics II _Unit 1_20170728_v1 3 Readings and Resources Required Readings Mankiw, N. G. (2010). Chapter 12: The open economy revisited: The Mundell- Fleming model and the exchange-rate regime. In Macroeconomics (7th ed.). New York: Worth Publishers. [Available from UWIlinC]. Chapter 12. The Economist. (January 30, 2015). Peggar thy neighbour – exchange rate regimes in the world. Available at http://www.economist.com/blogs/graphicdetail/2015/01/daily-chart-17 Required Videos ACDCLeadership. (2014, November 10). Floating vs. Fixed Exchange Rates- Macroeconom- ics 5.4. [Video File]. Available at https://www.youtube.com/watch?v=_pL_5trI6YY Lin. X. (2016, May 15). Mundell-Fleming model. [Video File]. Available at https://www.youtube.com/watch?v=3nBfkuDs78I Department of Economics. (2012, April 3). Trilemma. [Video File]. Available at https://www.youtube.com/watch?v=LeC_Ll-7GNc Suggested Readings Bearce, D. (2007). Chapter 2: The monetary convergence hypothesis. In monetary divergence: Domestic policy autonomy in the post-Bretton woods era. Ann Arbor, MI: University of Michigan Press. Available at https://www.press.umich.edu/pdf/9780472099610-ch2.pdf Curtis, D., & Irvine, I. (2015). Chapter 14: International economics. In Macroeconomics: Theory, Markets, and Policy. Lyrlyx Learning. Available at http://lyryx.com/textbooks/CurtisIrvine-Macroe-economics-2015A.pdf Fxtop Company. (n.d.). http://fxtop.com/en/historical-exchange-rates.php Worrell, D., Marshall, D., & Smith, N. (2000). The political economy of exchange rate policy in the Caribbean. (Research Network Working Paper #R-401). Washington, D.C.: The InterAmerican Development Bank. Available at http://www.iadb.org/res/publications/pubfiles/pubR-401.pdf ECON 2003 Intermediate Macroeconomics II _Unit 1_20170728_v1 4 Session 1.1 The Mundell-Fleming Model in the Short Run Introduction In this session, we will construct the Mundell Fleming Model in the short run using some aspects of the ISLM Model. The Mundell-Fleming model was the result of the efforts of Robert Mundell and Marcus Fleming in the 1960s to expand on the Keynesian model of the money market and the goods market by including the Balance of Payments (BP) curve. It has since become one of the main models in Macroeconomics. The Mundell-Fleming Model In order to build the Mundell-Fleming model, we will make a few assumptions: • The economy is small and open – this means that there is trade in goods and services with other countries but the country is too small to affect international prices. • Prices at home and abroad are fixed. • There is perfect capital mobility – the world interest rate is also the country’s interest rate: r= r* Equation (1) Small Open Economy Equilibrium As in the closed economy, equilibrium is achieved by considering both the goods market and the money market. (a) The Goods Market and the IS* curve The open economy goods market is described by: Y = C(Y – T) + I(r) + G+ NX(e) Equation (2) ECON 2003 Intermediate Macroeconomics II _Unit 1_20170728_v1 5 Where Y is aggregate income, C is consumption, I is investment, G is government purchases, NX is net exports, and e is the nominal exchange rate. Remember that the real exchange rate, ϵ, is a function of relative price levels at home (P) and abroad (P*) and the nominal exchange rate: ∈= ? % %∗ Equation (3) The Mundell-Fleming model in the short run assumes fixed prices so that the real exchange rate is proportional to the nominal exchange rate. So, equation (2) represents the IS* curve in the Mundell-Fleming model. The curve is downward sloping because there is a negative relationship between the exchange rate and aggregate income. For further explanations on how the IS* curve is derived from the Net Exports Schedule or the Balance of Payments Schedule and the Keynesian Cross, please see Mankiw 2010, Figure 12-1 on page 342. (b) The Money Market and the LM* curve Recall the condition for equilibrium in the money market where the supply of real money balances, M/P, equals the demand for real money balances L(r, Y): ' % = ? ?, ? Equation (4) In the Mundell-Fleming model, M, the money supply and P, the price level, are fixed. The domestic interest rate, r, equals the world real interest rate r*, equation (4) becomes: ' % = ? ?∗, ? Equation (5) Equation (5) shows then that aggregate income is determined by the real interest rate and not the exchange rate. Hence the LM* curve is vertical as seen in Figure 12-2 on page 344 in the textbook. (c) Equilibrium in the Short-Run Mundell-Fleming model The equilibrium level of aggregate income and the exchange rate are determined by the intersection of the IS* and LM* curves where the both the goods and money markets clear. For a graphical presentation, please see Mankiw 2010, Figure 12-3 on page 345. ECON 2003 Intermediate Macroeconomics II _Unit 1_20170728_v1 6 LEARNING ACTIVITY 1.1 Applying Macroeconomic Concepts Watch the following video on the Mundell-Fleming model in the short run and answer the questions listed below: Lin, X. (2016, May 15). Mundell-Fleming model (c) Xichen Li. Available at https://www.youtube.com/watch?v=3nBfkuDs78I 1. What are the main assumptions of the model? 2. What are the factors which influence Net Exports? 3. What are the factors which influence the LM* and IS* curves? FOOD FOR THOUGHT The Mundell-Fleming Model allows for the simultaneous determination of aggregate output and the exchange rates in an open economy. One of its most poignant takeaways is that to achieve some objectives, the country must be willing to surrender at least one important goal. We will discuss this later in Section 1.3 when we cover the “Impossible Trinity”. Read pages 339 -345 of Chapter 12 of Mankiw (2010) to further your understanding of how equilibrium is determined in the short run Mundell-Fleming model. Mankiw, N.G. (2010). Macroeconomics (7th ed.). New York: Worth Publishers. [Available from UWIlinC]. Session 1.1 Summary We have just expanded the Keynesian IS-LM model by making some additional assumptions and combining the IS-LM curves with the BP curve to arrive at the Mundell-Fleming model. Then we examined how equilibrium is determined in the model. A major difference between the IS-LM model and the Mundell-Fleming model is that the main endogenous variables are now the exchange rate