N. Gregory Mankiw's 2016 Macroeconomics (9th Ed) - Chapter 13 PDF

CHAPTER 13 The Open Economy Revisited: The Mundell–Fleming Model and the Exchange-Rate Regime The world is still a closed economy, but its regions and countries are b­ ecoming increasing...

CHAPTER 13 The Open Economy Revisited: The Mundell–Fleming Model and the Exchange-Rate Regime The world is still a closed economy, but its regions and countries are b­ ecoming increasingly open.... The international economic climate has changed in the direction of financial integration, and this has important implications for ­economic policy. —Robert Mundell, 1963 W hen conducting monetary and fiscal policy, policymakers often look beyond their own country’s borders. Even if domestic pros- perity is their sole objective, it is necessary for them to consider the rest of the world. The international flow of goods and services and the inter- national flow of capital can affect an economy in profound ways. Policymakers ignore these effects at their peril. In this chapter, we extend our analysis of aggregate demand to include ­international trade and finance. The model developed in this chapter, called the Mundell–Fleming model, has been described as “the dominant policy paradigm for studying open-economy monetary and fiscal policy.” In 1999, ­ Robert Mundell was awarded the Nobel Prize for his work in open-economy macroeconomics, including this model.1 The Mundell–Fleming model is a close relative of the IS–LM model. Both models stress the interaction between the goods market and the money ­market. Both models assume that the price level is fixed and then show what causes ­short-run fluctuations in aggregate income (or, equivalently, shifts in the 1 The quotation is from Maurice Obstfeld and Kenneth Rogoff, Foundations of International Macroeconomics (Cambridge, MA: MIT Press, 1996)—a leading graduate-level textbook in open-­ economy macroeconomics. The Mundell–Fleming model was developed in the early 1960s. Mundell’s contributions are collected in Robert A. Mundell, International Economics (New York: Macmillan, 1968). For Fleming’s contribution, see J. Marcus Fleming, “Domestic Financial Policies Under Fixed and Under Floating Exchange Rates,”’ IMF Staff Papers 9 (November 1962): 369–379. ­Fleming died in 1976, so he was not eligible to share in the Nobel award. 367 368 | P A R T I V Business Cycle Theory: The Economy in the Short Run a­ ggregate demand curve). The key difference is that the IS–LM model assumes a closed economy, whereas the Mundell–Fleming model assumes an open economy. The Mundell–Fleming model extends the short-run model of national income from Chapters 11 and 12 by including the effects of international trade and finance discussed in Chapter 6. The Mundell–Fleming model makes one important and extreme assumption: It assumes that the economy being studied is a small open economy with perfect capital mobility. That is, the economy can borrow or lend as much as it wants in world financial markets and, as a result, the economy’s interest rate is determined by the world interest rate. Here is how Mundell himself, in his original 1963 article, explained why he made this assumption: In order to present my conclusions in the simplest possible way and to bring the implications for policy into sharpest relief, I assume the extreme degree of mobility that prevails when a country cannot maintain an interest rate different from the general level prevailing abroad. This assumption will overstate the case but it has the merit of posing a stereotype towards which international ­financial relations seem to be heading. At the same time it might be argued that the assumption is not far from the truth in those financial centers, of which Zurich, Amsterdam, and Brussels may be taken as examples, where the authorities already recognize their lessening ability to dominate money market conditions and insulate them from foreign influences. It should also have a high degree of relevance to a country like Canada whose financial markets are dominated to a great degree by the vast New York market. As we will see, Mundell’s assumption of a small open economy with perfect capi- tal mobility will prove useful in developing a tractable and illuminating model.2 One lesson from the Mundell–Fleming model is that the behavior of an ­economy depends on the exchange-rate system it has adopted. Indeed, the model was first developed in large part to understand how alternative exchange-rate regimes work and how the choice of exchange-rate regime affects the use of monetary and fiscal policy. We begin by assuming that the economy operates with a floating exchange rate. That is, we assume that the central bank allows the exchange rate to adjust to changing economic conditions. We then examine how the economy operates under a fixed exchange rate. After developing the model, we will be in a position to address an important policy question: What exchange-rate system should a nation adopt? These issues of open-economy macroeconomics have been very much in the news in recent years. As various European nations, most notably Greece, experi- enced severe financial difficulties, many observers wondered whether it was wise for much of the continent to adopt a common currency—the most extreme form of a fixed exchange rate. If each nation had its own currency, monetary 2 This assumption—and thus the Mundell–Fleming model—does not apply exactly to a large open economy such as that of the United States. In the conclusion to this chapter (and more fully in the appendix), we consider what happens in the more complex case in which international capital mobility is less than perfect or a nation is so large that it can influence world financial markets. C HA P TE R 1 3 The Open Economy Revisited: The Mundell–Fleming Model and the Exchange-Rate Regime | 369 policy and the exchange rate could have adjusted more easily to the changing individual circumstances and needs of each nation. Meanwhile, many American policymakers, including Presidents George W. Bush and Barack Obama, were objecting that China did not allow the value of its currency to float freely against the U.S. dollar. They argued that China kept its currency artificially cheap, ­making its goods more competitive on world markets. As we will see, the ­Mundell–Fleming model offers a useful starting point for understanding and evaluating these often heated international policy debates. 13-1 The Mundell–Fleming Model In this section, we construct the Mundell–Fleming model; and in the following sections, we use the model to examine the impact of various policies. As you will see, the Mundell–Fleming model is built from components we have used in previous chapters. But these pieces are put together in a new way to address a new set of questions. The Key Assumption: Small Open Economy With Perfect Capital Mobility Let’s begin with the assumption of a small open economy with perfect capital mobility. As we saw in Chapter 6, this assumption means that the interest rate in this economy r is determined by the world interest rate r *. Mathematically, we write this assumption as r 5 r *. This world interest rate is assumed to be exogenously fixed because the economy is sufficiently small relative to the world economy that it can borrow or lend as much as it wants in world financial markets without affecting the world ­interest rate. Although the idea of perfect capital mobility is expressed with a simple ­equation, it is important not to lose sight of the sophisticated process that this equation represents. Imagine that some event occurred that would normally raise the interest rate (such as a decline in domestic saving). In a small open economy, the domestic interest rate might rise by a little bit for a short time, but as soon as it did, foreigners would see the higher interest rate and start lending to this country (by, for instance, buying this country’s bonds). The capital inflow would drive the domestic interest rate back toward r *. Similarly, if any event started to drive the domestic interest rate downward, capital would flow out of the country to earn a higher return abroad, and this capital outflow would drive the domestic interest rate back up to r *. Hence, the r 5 r * equation represents the assump- tion that the international flow of capital is rapid enough to keep the domestic ­interest rate equal to the world interest rate. 370 | P A R T I V Business Cycle Theory: The Economy in the Short Run The Goods Market and the IS* Curve The Mundell–Fleming model describes the market for goods and services much as the IS–LM model does, but it adds a new term for net exports. In particular, the goods market is represented with the following equation: Y 5 C (Y 2 T ) 1 I (r) 1 G 1 NX (e). This equation states that aggregate income Y is the sum of consumption C, investment I, government purchases G, and net exports NX. Consumption depends positively on disposable income Y 2 T. Investment depends negatively on the interest rate. Net exports depend negatively on the exchange rate e. As before, we define the exchange rate e as the amount of foreign currency per unit of domestic currency—for example, e might be 100 yen per dollar. You may recall that in Chapter 6 we related net exports to the real exchange rate (the relative price of goods at home and abroad) rather than the nominal exchange rate (the relative price of domestic and foreign currencies). If e is the nominal exchange rate, then the real exchange rate e equals eP/P *, where P is the domestic price level and P * is the foreign price level.The Mundell–Fleming model, however, assumes that the price levels at home and abroad are fixed, so the real exchange rate is proportional to the nominal exchange rate. That is, when the domestic cur- rency appreciates and the nominal exchange rate rises (from, say, 100 to 120 yen per dollar), the real exchange rate rises as well; thus, foreign goods become cheaper compared to domestic goods, and this causes exports to fall and imports to rise. The goods market equilibrium condition above has two financial variables that affect expenditure on goods and services (the interest rate and the exchange rate), but we can simplify matters by using the assumption of perfect capital mobility, r 5 r *: Y 5 C (Y 2 T ) 1 I (r *) 1 G 1 NX (e). Let’s call this the IS * equation. (The asterisk reminds us that the equation holds the interest rate constant at the world interest rate r *.) We can illustrate this equa- tion on a graph in which income is on the horizontal axis and the exchange rate is on the vertical axis. This curve is shown in panel (c) of Figure 13-1. The IS * curve slopes downward because a higher exchange rate reduces net exports, which in turn lowers aggregate income. To show how this works, the other panels of Figure 13-1 combine the net-exports schedule and the Keynesian cross to derive the IS * curve. In panel (a), an increase in the exchange rate from e1 to e2 lowers net exports from NX (e1) to NX (e2). In panel ( b), the reduction in net exports shifts the planned-expenditure schedule downward and thus lowers income from Y1 to Y2. The IS * curve summarizes this relationship between the exchange rate e and income Y. The Money Market and the LM* Curve The Mundell–Fleming model represents the money market with an equation that should be familiar from the IS–LM model: M/P 5 L (r, Y ). C HA P TE R 1 3 The Open Economy Revisited: The Mundell–Fleming Model and the Exchange-Rate Regime | 371 FIGURE 1 3-1 The IS* Curve The IS* curve is derived (b) The Keynesian Cross from the net-exports schedule and the Keynesian cross. Panel (a) shows the Expenditure Actual net-exports schedule: an increase in 3.... which expenditure the exchange rate from e1 to e2 ­lowers shifts planned net exports from NX(e1) to NX(e2). expenditure downward... Panel (b) shows the Keynesian cross: a decrease in net exports from NX(e1) to NX NX(e2) shifts the planned-expenditure schedule downward and reduces Planned income from Y1 to Y2. Panel (c) shows expenditure the IS* curve summarizing this relation- 4.... and ship between the exchange rate and lowers income: the higher the exchange rate, income. 45° the lower the level of income. Y2 Y1 Income, output, Y (a) The Net-Exports Schedule (c) The IS* Curve Exchange rate, e Exchange rate, e 5. The IS* curve summarizes these changes in the goods- market equilibrium. 1. An e2 e2 increase in the exchange rate... e1 e1 2.... lowers net exports,... NX IS* NX(e2) NX(e1) Net Y2 Y1 Income, exports, output, Y NX This equation states that the supply of real money balances M/P equals the demand L(r, Y ). The demand for real balances depends negatively on the interest rate and positively on income. The money supply M is an exogenous v­ ariable controlled by the central bank, and because the Mundell–Fleming model is designed to analyze short-run fluctuations, the price level P is also assumed to be exogenously fixed. Once again, we add the assumption that the domestic interest rate equals the world interest rate, so r 5 r *: M/P 5 L (r *, Y ). Let’s call this the LM * equation. We can represent it graphically with a verti- cal line, as in panel (b) of Figure 13-2. The LM * curve is vertical because the exchange rate does not enter into the LM * equation. Given the world inter- est rate, the LM * equation determines aggregate income, regardless of the exchange rate. Figure 13-2 shows how the LM * curve arises from the world interest rate and the LM curve, which relates the interest rate and income. 372 | P A R T I V Business Cycle Theory: The Economy in the Short Run FIGURE 13-2 (a) The LM Curve The LM* Curve Panel (a) shows the ­standard LM curve [which graphs the equation Interest rate, r LM M/P 5 L(r, Y)] together with a horizontal line ­representing the world interest rate r*. The 1. The money market intersection of these two curves determines equilibrium the level of income, regardless of the exchange condition... rate. Therefore, as panel (b) shows, the LM* curve is vertical. r  r* 2.... and the world interest rate... Income, output, Y (b) The LM* Curve Exchange rate, e LM* 3.... determine the level of income. Income, output, Y Putting the Pieces Together According to the Mundell–Fleming model, a small open economy with perfect capital mobility can be described by two equations: Y 5 C (Y 2 T ) 1 I (r *) 1 G 1 NX (e)  IS *, M/P 5 L (r *, Y ) LM *. The first equation describes equilibrium in the goods market; the second describes equilibrium in the money market. The exogenous variables are fiscal policy G and T, monetary policy M, the price level P, and the world interest rate r *. The endogenous variables are income Y and the exchange rate e. C HA P TE R 1 3 The Open Economy Revisited: The Mundell–Fleming Model and the Exchange-Rate Regime | 373 FIGURE 1 3-3 Exchange rate, e The Mundell–Fleming LM* Model This graph of the Mundell–Fleming model plots the goods market equi- librium condition IS* and the money market equilibrium condition LM*. Both curves are drawn holding the inter- Equilibrium exchange rate est rate constant at the world interest rate. The intersec- tion of these two curves shows the level of income and the exchange rate that Equilibrium satisfy equilibrium both in income the goods market and in the IS* money market. Income, output, Y Figure 13-3 illustrates these two relationships. The equilibrium for the econo- my is found where the IS * curve and the LM * curve intersect. This intersection shows the exchange rate and the level of income at which the goods market and the money market are both in equilibrium. With this diagram, we can use the Mundell–Fleming model to show how aggregate income Y and the exchange rate e respond to changes in policy. 13-2 The Small Open Economy Under Floating Exchange Rates Before analyzing the impact of policies in an open economy, we must specify the international monetary system in which the country has chosen to operate. That is, we must consider how people engaged in international trade and finance can convert the currency of one country into the currency of another. We start with the system relevant for most major economies today: fl ­ oating exchange rates. Under a system of floating exchange rates, the exchange rate is set by market forces and is allowed to fluctuate in response to changing ­economic conditions. In this case, the exchange rate e adjusts to achieve simulta- neous equilibrium in the goods market and the money market. When something happens to change that equilibrium, the exchange rate is allowed to move to a new equilibrium value. Let’s now consider three policies that can change the equilibrium: fiscal policy, monetary policy, and trade policy. Our goal is to use the Mundell–Fleming model to show the effects of policy changes and to understand the economic forces at work as the economy moves from one equilibrium to another. 374 | P A R T I V Business Cycle Theory: The Economy in the Short Run Fiscal Policy Suppose that the government stimulates domestic spending by increasing government purchases or by cutting taxes. Because such expansionary fiscal policy increases planned expenditure, it shifts the IS * curve to the right, as in Figure 13-4. As a result, the exchange rate appreciates, while the level of income remains the same. Notice that fiscal policy has very different effects in a small open economy than it does in a closed economy. In the closed-economy IS–LM model, a ­fiscal expansion raises income, whereas in a small open economy with a floating exchange rate, a fiscal expansion leaves income at the same level. Mechanically, the difference arises because the LM * curve is vertical, while the LM curve we used to study a closed economy is upward sloping. But this explanation is not very satisfying. What are the economic forces that lie behind the different out- comes? To answer this question, we must think through what is happening to the international flow of capital and the implications of these capital flows for the domestic economy. The interest rate and the exchange rate are the key variables in the story.When income rises in a closed economy, the interest rate rises because higher income increases the demand for money. That is not possible in a small open economy because, as soon as the interest rate starts to rise above the world interest rate r *, capital quickly flows in from abroad to take advantage of the higher return. As this capital inflow pushes the interest rate back to r *, it also has another effect: because foreign investors need to buy the domestic currency to invest in the domestic economy, the capital inflow increases the demand for the domestic cur- rency in the market for foreign-currency exchange, bidding up the value of the domestic currency. The appreciation of the domestic currency makes domestic FIGURE 13-4 Exchange rate, e A Fiscal Expansion LM* Under Floating Exchange Rates An increase in govern- ment purchases or a decrease 1. Expansionary fiscal in taxes shifts the IS* curve policy shifts the IS* to the right. This raises the curve to the right,... exchange rate but has no Equilibrium effect on income. exchange rate 2.... which raises the IS*2 exchange rate... 3.... and leaves income unchanged. IS*1 Income, output, Y C H A P TE R 1 3 The Open Economy Revisited: The Mundell–Fleming Model and the Exchange-Rate Regime | 375 goods more expensive relative to foreign goods, reducing net exports. The fall in net exports exactly offsets the effects of the expansionary fiscal policy on income. Why is the fall in net exports so great that it renders fiscal policy powerless to influence income? To answer this question, consider the equation that describes the money market: M/P 5 L (r, Y ). In both closed and open economies, the quantity of real money balances sup- plied M/P is fixed by the central bank (which sets M ) and the assumption of sticky prices (which fixes P ). The quantity demanded (determined by r and Y ) must equal this fixed supply. In a closed economy, a fiscal expansion causes the equilibrium interest rate to rise. This increase in the interest rate (which reduces the quantity of money demanded) is accompanied by an increase in equilib- rium income (which raises the quantity of money demanded); these two effects together maintain equilibrium in the money market. By contrast, in a small open economy, r is fixed at r *, so there is only one level of income that can satisfy this equation, and this level of income does not change when fiscal policy changes. Thus, when the government increases spending or cuts taxes, the appreciation of the currency and the fall in net exports must be large enough to fully offset the expansionary effect of the policy on income. Monetary Policy Suppose now that the central bank increases the money supply. Because the price level is assumed to be fixed, the increase in the money supply means an increase in real money balances. The increase in real balances shifts the LM * curve to the right, as in Figure 13-5. Hence, an increase in the money supply raises income and lowers the exchange rate. FIGURE 1 3- 5 Exchange rate, e A Monetary Expansion LM*1 LM*2 Under Floating Exchange Rates An increase in the 1. A monetary expan- money supply shifts the LM* sion shifts the LM* curve to the right, ­lowering curve to the right,... the exchange rate and ­raising income. 2.... which lowers the exchange rate... 3.... and raises income. IS* Income, output, Y 376 | P A R T I V Business Cycle Theory: The Economy in the Short Run Although monetary policy influences income in an open economy, as it does in a closed economy, the monetary transmission mechanism is different. Recall that in a closed economy an increase in the money supply increases spending because it lowers the interest rate and stimulates investment. In a small open economy, this channel of monetary transmission is not available because the interest rate is fixed by the world interest rate. So how does monetary policy influence spending? To answer this question, we once again need to think about the international flow of capital and its implications for the domestic economy. The interest rate and the exchange rate are again the key variables. As soon as an increase in the money supply starts putting downward pressure on the domestic interest rate, capital flows out of the economy because investors seek a higher return elsewhere. This capital outflow prevents the domestic interest rate from falling below the world interest rate r *. It also has another effect: because investing abroad requires converting domestic currency into foreign currency, the capital outflow increases the supply of the domestic currency in the market for foreign-currency exchange, causing the domestic currency to depreciate in value. This depreciation makes domestic goods less expensive relative to foreign goods, stimulating net exports and thus total income. Hence, in a small open economy, monetary policy influences income by altering the exchange rate rather than the interest rate. Trade Policy Suppose that the government reduces the demand for imported goods by impos- ing an import quota or a tariff. What happens to aggregate income and the exchange rate? How does the economy reach its new equilibrium? Because net exports equal exports minus imports, a reduction in imports means an increase in net exports. That is, the net-exports schedule shifts to the right, as in Figure 13-6. This shift in the net-exports schedule increases planned expenditure and thus moves the IS * curve to the right. Because the LM * curve is vertical, the trade restriction raises the exchange rate but does not affect income. The economic forces behind this transition are similar to the case of expan- sionary fiscal policy. Because net exports are a component of GDP, the rightward shift in the net-exports schedule, other things equal, puts upward pressure on income Y; an increase in Y, in turn, increases money demand and puts upward pressure on the interest rate r. Foreign capital quickly responds by flowing into the domestic economy, pushing the interest rate back to the world interest rate r * and causing the domestic currency to appreciate in value. Finally, the apprecia- tion of the currency makes domestic goods more expensive relative to foreign goods, which decreases net exports NX and returns income Y to its initial level. Restrictive trade policies often have the goal of changing the trade balance NX. Yet, as we first saw in Chapter 6, such policies do not necessarily have that effect. The same conclusion holds in the Mundell–Fleming model under floating exchange rates. Recall that NX (e) 5 Y 2 C (Y 2 T ) 2 I (r *) 2 G. C H A P TE R 1 3 The Open Economy Revisited: The Mundell–Fleming Model and the Exchange-Rate Regime | 377 FIGURE 13- 6 (a) The Shift in the (b) The Change in the Net-Exports Schedule Economy’s Equilibrium Exchange Exchange rate, e rate, e LM* 1. A trade restriction 3.... increasing shifts the NX curve the exchange 2.... which shifts the outward,... rate... IS* curve outward,... NX2 4.... and IS*2 leaving income NX1 the same. IS*1 Net exports, NX Income, output, Y A Trade Restriction Under Floating Exchange Rates A tariff or an import quota shifts the net-exports schedule in panel (a) to the right. As a result, the IS* curve in panel (b) shifts to the right, raising the exchange rate and leaving income unchanged. Because a trade restriction does not affect income, consumption, investment, or government purchases, it does not affect the trade balance. Although the shift in the net-exports schedule tends to raise NX, the increase in the exchange rate reduces NX by the same amount. The overall effect is simply less trade. The domestic economy imports less than it did before the trade restriction, but it exports less as well. 13-3 The Small Open Economy Under Fixed Exchange Rates We now turn to the second type of exchange-rate system: fixed exchange rates. Under a fixed exchange rate, the central bank announces a value for the exchange rate and stands ready to buy and sell the domestic currency to keep the exchange rate at its announced level. This type of system has been used in many historical periods. From 1944 to 1971, most of the world’s major econo- mies, including that of the United States, operated within the Bretton Woods system—an international monetary system under which most governments ­ agreed to fix exchange rates. From 1995 to 2005, China fixed the value of its currency against the U.S. dollar—a policy that, as we will see, was a source of some tension between the two countries. In this section we discuss how such a system works, and we examine the impact of economic policies on an economy with a fixed exchange rate. Later in the chapter we examine the pros and cons of fixed exchange rates. 378 | P A R T I V Business Cycle Theory: The Economy in the Short Run How a Fixed-Exchange-Rate System Works Under a system of fixed exchange rates, a central bank stands ready to buy or sell the domestic currency for foreign currencies at a predetermined price. For example, suppose the Fed announced that it was going to fix the yen/dollar exchange rate at 100 yen per dollar. It would then stand ready to give $1 in exchange for 100 yen or to give 100 yen in exchange for $1. To carry out this policy, the Fed would need a reserve of dollars (which it can print) and a reserve of yen (which it must have purchased previously). A fixed exchange rate dedicates a country’s monetary policy to the single goal of keeping the exchange rate at the announced level. In other words, the essence of a fixed-exchange-rate system is the commitment of the central bank to allow the money supply to adjust to whatever level will ensure that the equi- librium exchange rate in the market for foreign-currency exchange equals the announced exchange rate. Moreover, as long as the central bank stands ready to buy or sell foreign currency at the fixed exchange rate, the money supply adjusts automatically to the necessary level. To see how fixing the exchange rate determines the money supply, consider the following example. Suppose the Fed decides to fix the exchange rate at 100 yen per dollar, but, in the current equilibrium with the current money supply, the market exchange rate is 150 yen per dollar. This situation is illus- trated in panel (a) of Figure 13-7. Notice that there is a profit opportunity: an arbitrageur could buy 300 yen in the foreign-exchange market for $2 and then sell the yen to the Fed for $3, making a $1 profit. When the Fed buys these yen from the arbitrageur, the dollars it pays for them automatically increase the money supply. The rise in the money supply shifts the LM * curve to the right, lowering the equilibrium exchange rate. In this way, the money supply continues to rise until the equilibrium exchange rate falls to the level the Fed has announced. Conversely, suppose that when the Fed decides to fix the exchange rate at 100 yen per dollar, the equilibrium has a market exchange rate of 50 yen per dollar. Panel (b) of Figure 13-7 shows this situation. In this case, an arbitrageur could make a profit by buying 100 yen from the Fed for $1 and then selling the yen in the marketplace for $2. When the Fed sells these yen, the $1 it receives automatically reduces the money supply. The fall in the money supply shifts the LM * curve to the left, raising the equilibrium exchange rate. The money supply continues to fall until the equilibrium exchange rate rises to the announced level. It is important to understand that this exchange-rate system fixes the nominal exchange rate. Whether it also fixes the real exchange rate depends on the time horizon under consideration. If prices are flexible, as they are in the long run, then the real exchange rate can change even while the nominal exchange rate is fixed. Therefore, in the long run described in Chapter 6, a policy to fix the nominal exchange rate would not influence any real variable, including the real exchange rate. A fixed nominal exchange rate would influence only the money supply and the price level.Yet in the short run described by the Mundell–Flem- ing model, prices are fixed, so a fixed nominal exchange rate implies a fixed real exchange rate as well. C HA P TE R 1 3 The Open Economy Revisited: The Mundell–Fleming Model and the Exchange-Rate Regime | 379 FIGURE 1 3-7 (a) The Equilibrium Exchange Rate Is (b) The Equilibrium Exchange Rate Is Greater Than the Fixed Exchange Rate Less Than the Fixed Exchange Rate Exchange rate, e Exchange rate, e LM*1 LM*2 LM*2 LM*1 Equilibrium exchange rate Fixed exchange Fixed exchange rate rate IS* Equilibrium exchange rate IS* Income, output, Y Income, output, Y How a Fixed Exchange Rate Governs the Money Supply In panel (a), the equilib- rium exchange rate initially exceeds the fixed level. Arbitrageurs will buy foreign currency in foreign-exchange markets and sell it to the Fed for a profit. This process automatically increases the money supply, shifting the LM* curve to the right and lowering the exchange rate. In panel (b), the equilibrium exchange rate is initially below the fixed level. Arbitrageurs will buy foreign currency from the Fed and sell it in foreign-exchange markets for a profit. This process automatically reduces the money supply, shifting the LM* curve to the left and raising the exchange rate. CASE STUDY The International Gold Standard During the late nineteenth and early twentieth centuries, most of the world’s major economies operated under the gold standard. Each country maintained a reserve of gold and agreed to exchange one unit of its currency for a specified amount of gold. Through the gold standard, the world’s economies maintained a system of fixed exchange rates. To see how an international gold standard fixes exchange rates, suppose that the U.S. Treasury stands ready to buy or sell 1 ounce of gold for $100, and the Bank of England stands ready to buy or sell 1 ounce of gold for 100 pounds. Together, these policies fix the rate of exchange between dol- lars and pounds: $1 must trade for 1 pound. Otherwise, the law of one price would be violated, and it would be profitable to buy gold in one country and sell it in the other. For example, suppose that the market exchange rate is 2 pounds per dollar. In this case, an arbitrageur could buy 200 pounds for $100, use the pounds to buy 2 ounces of gold from the Bank of England, bring the gold to the United States, and sell it to the Treasury for $200—making a $100 profit. Moreover, by bringing the gold to the United States from England, the arbitrageur would 380 | P A R T I V Business Cycle Theory: The Economy in the Short Run increase the money supply in the United States and decrease the money supply in England. Thus, during the era of the gold standard, the international transport of gold by arbitrageurs was an automatic mechanism adjusting the money supply and stabilizing exchange rates. This system did not completely fix exchange rates, because shipping gold across the Atlantic was costly. Yet the interna- tional gold standard did keep the exchange rate within a range dictated by transportation costs. It thereby prevented large and persistent movements in exchange rates.3 n Fiscal Policy Let’s now examine how economic policies affect a small open economy with a fixed exchange rate. Suppose that the government stimulates domestic spending by increasing government purchases or by cutting taxes. This policy shifts the IS * curve to the right, as in Figure 13-8, putting upward pressure on the market exchange rate. But because the central bank stands ready to trade foreign and domestic currency at the fixed exchange rate, arbitrageurs quickly respond to the rising exchange rate by selling foreign currency to the central bank, leading to FIGURE 13- 8 Exchange rate, e A Fiscal Expansion LM*1 LM*2 Under Fixed Exchange 2.... a fiscal 3.... which expansion shifts induces a shift Rates A fiscal expansion the IS* curve in the LM* shifts the IS* curve to the to the right,... curve... right. To maintain the fixed exchange rate, the Fed must increase the money supply, thereby shifting the LM* curve to the right. Hence, in contrast to the case of floating exchange rates, under fixed exchange rates a fiscal expansion raises income. 1. With a fixed exchange rate... IS*2 4.... and IS*1 raises income. Y1 Y2 Income, output, Y 3 For more on how the gold standard worked, see the essays in Barry Eichengreen, ed., The Gold Standard in Theory and History (New York: Methuen, 1985). C H A P TE R 1 3 The Open Economy Revisited: The Mundell–Fleming Model and the Exchange-Rate Regime | 381 an automatic monetary expansion. The rise in the money supply shifts the LM * curve to the right. Thus, under a fixed exchange rate, a fiscal expansion raises aggregate income. Monetary Policy Imagine that a central bank operating with a fixed exchange rate tries to increase the money supply—for example, by buying bonds from the public. What would happen? The initial impact of this policy is to shift the LM * curve to the right, lowering the exchange rate, as in Figure 13-9. But, because the central bank is committed to trading foreign and domestic currency at a fixed exchange rate, arbitrageurs quickly respond to the falling exchange rate by selling the domestic currency to the central bank, causing the money supply and the LM * curve to return to their initial positions. Hence, mon- etary policy as usually conducted is ineffectual under a fixed exchange rate. By agreeing to fix the exchange rate, the central bank gives up its control over the money supply. A country with a fixed exchange rate can, however, conduct a type of mon- etary policy: it can decide to change the level at which the exchange rate is fixed. A reduction in the official value of the currency is called a devaluation, and an increase in its official value is called a revaluation. In the Mundell–Fleming model, a devaluation shifts the LM * curve to the right; it acts like an increase in the money supply under a floating exchange rate. A devaluation thus expands net exports and raises aggregate income. Conversely, a revaluation shifts the LM * curve to the left, reduces net exports, and lowers aggregate income. FIGURE 13-9 Exchange rate, e A Monetary Expansion Under LM* Fixed Exchange Rates If the Fed tries to increase the money supply—for example, by buying bonds from the public—it will put downward pressure on the Fixed exchange rate. To maintain the exchange fixed exchange rate, the money rate supply and the LM* curve must return to their i­nitial positions. Hence, under fixed exchange rates, normal m ­ onetary policy is ineffectual. IS* Income, output, Y 382 | P A R T I V Business Cycle Theory: The Economy in the Short Run CASE STUDY Devaluation and the Recovery from the Great Depression The Great Depression of the 1930s was a global problem. Although events in the United States may have precipitated the downturn, all of the world’s major economies experienced huge declines in production and employment. Yet not all governments responded to this calamity in the same way. One key difference among governments was how committed they were to the fixed exchange rate set by the international gold standard. Some countries, such as France, Germany, Italy, and the Netherlands, maintained the old rate of exchange between gold and currency. Other countries, such as Denmark, Finland, Norway, Sweden, and the United Kingdom, reduced the amount of gold they would pay for each unit of currency by about 50 percent. By reducing the gold content of their currencies, these governments devalued their currencies relative to those of other countries. The subsequent experience of these two groups of countries confirms the prediction of the Mundell–Fleming model. Those countries that pursued a policy of devaluation recovered quickly from the Depression. The lower value of the currency raised the money supply, stimulated exports, and expanded production. By contrast, those countries that maintained the old exchange rate suffered longer with a depressed level of economic activity. What about the United States? President Herbert Hoover kept the United States on the gold standard, but in a controversial move, President Franklin Roosevelt took the nation off it in June 1933, just three months after taking office. That date roughly coincides with the end of the deflation and the begin- ning of recovery. Many economic historians believe that removing the nation from the gold standard was the most significant policy action that President Roosevelt took to end the Great Depression.4 n Trade Policy Suppose that the government reduces imports by imposing an import quota or a tariff. This policy shifts the net-exports schedule to the right and thus shifts the IS * curve to the right, as in Figure 13-10. The shift in the IS * curve tends to raise the exchange rate. To keep the exchange rate at the fixed level, the money supply must rise, shifting the LM * curve to the right. The result of a trade restriction under a fixed exchange rate is very different from that under a floating exchange rate. In both cases, a trade restriction shifts the net-exports schedule to the right, but only under a fixed exchange rate does 4 Barry Eichengreen and Jeffrey Sachs, “Exchange Rates and Economic Recovery in the 1930s,” Journal of Economic History 45 (December 1985): 925–946. C HA P TE R 1 3 The Open Economy Revisited: The Mundell–Fleming Model and the Exchange-Rate Regime | 383 FIGURE 1 3-1 0 Exchange rate, e A Trade Restriction 2.... a trade LM*1 LM*2 Under Fixed Exchange restriction shifts Rates A tariff or an import the IS* curve quota shifts the IS* curve to the right,... 3.... which to the right. This induces induces a shift an increase in the money in the LM* curve... supply to maintain the fixed exchange rate. Hence, aggregate income increases. 1. With a fixed exchange rate,... IS*2 IS*1 4.... and raises income. Y1 Y2 Income, output, Y a trade restriction increase net exports NX. The reason is that a trade restriction under a fixed exchange rate induces monetary expansion rather than an appreci- ation of the currency. The monetary expansion, in turn, raises aggregate income. Recall the accounting identity NX 5 S 2 I. When income rises, saving also rises, and this implies an increase in net exports. Policy in the Mundell–Fleming Model: A Summary The Mundell–Fleming model shows that the effect of almost any economic policy on a small open economy depends on whether the exchange rate is float- ing or fixed. Table 13-1 summarizes our analysis of the short-run effects of fiscal, monetary, and trade policies on income, the exchange rate, and the trade balance. What is most striking is that all of the results are different under floating and fixed exchange rates. To be more specific, the Mundell–Fleming model shows that the power of monetary and fiscal policy to influence aggregate income depends on the exchange-rate regime. Under floating exchange rates, only monetary policy can affect income. The usual expansionary impact of fiscal policy is offset by a rise in the value of the currency and a decrease in net exports. Under fixed exchange rates, only fiscal policy can affect income. The normal potency of monetary policy is lost because the money supply is dedicated to maintaining the exchange rate at the announced level. 384 | P A R T I V Business Cycle Theory: The Economy in the Short Run TABLE 1 3-1 The Mundell–Fleming Model: Summary of Policy Effect EXCHANGE-RATE REGIME FLOATING FIXED IMPACT ON: Policy Y e NX Y e NX Fiscal expansion 0 ↑ ↓ ↑ 0 0 Monetary expansion ↑ ↓ ↑ 0 0 0 Import restriction 0 ↑ 0 ↑ 0 ↑ Note: This table shows the direction of impact of various economic policies on income Y, the exchange rate e, and the trade balance NX. A “↑” indicates that the variable increases; a “↓” indicates that it decreases; a “0’’ indicates no effect. Remember that the exchange rate is defined as the amount of foreign currency per unit of domestic currency (for example, 100 yen per dollar). 13-4 Interest Rate Differentials So far, our analysis has assumed that the interest rate in a small open economy is equal to the world interest rate: r 5 r *. To some extent, however, interest rates differ around the world. We now extend our analysis by considering the causes and effects of international interest rate differentials. Country Risk and Exchange-Rate Expectations When we assumed earlier that the interest rate in our small open economy is determined by the world interest rate, we were applying the law of one price. We reasoned that if the domestic interest rate was above the world interest rate, people from abroad would lend to that country, driving the domestic inter- est rate down. And if the domestic interest rate was below the world interest rate, domestic residents would lend abroad to earn a higher return, driving the domestic interest rate up. In the end, the domestic interest rate would equal the world interest rate. Why doesn’t this logic always apply? There are two reasons. One reason is country risk. When investors buy U.S. government bonds or make loans to U.S. corporations, they are fairly confident that they will be repaid with interest. By contrast, in some less-developed countries, it is plausible to fear that a revolution or other political upheaval might lead to a default on loan repayments. Borrowers in such countries often have to pay higher interest rates to compensate lenders for this risk. Another reason interest rates differ across countries is expected changes in the exchange rate. For example, suppose that people expect the Mexican peso to C HA P TE R 1 3 The Open Economy Revisited: The Mundell–Fleming Model and the Exchange-Rate Regime | 385 fall in value relative to the U.S. dollar. Then loans made in pesos will be repaid in a less valuable currency than loans made in dollars. To compensate for this expected fall in the Mexican currency, the interest rate in Mexico will be higher than the interest rate in the United States. Thus, because of country risk and expectations about future exchange-rate changes, the interest rate of a small open economy can differ from interest rates in other economies around the world. Let’s see how this fact affects our analysis. Differentials in the Mundell–Fleming Model Consider again the Mundell–Fleming model with a floating exchange rate. To incorporate interest rate differentials into the model, we assume that the interest rate in our small open economy is determined by the world interest rate plus a risk premium u: r 5 r * 1 u. The risk premium is determined by the perceived political risk of making loans in a country and the expected change in the real exchange rate. For our pur- poses here, we can take the risk premium as exogenous in order to examine how changes in the risk premium affect the economy. The model is largely the same as before. The two equations are Y 5 C (Y 2 T ) 1 I (r * 1 u) 1 G 1 NX (e) IS *, M/P 5 L (r * 1 u, Y ) LM *. For any given fiscal policy, monetary policy, price level, and risk premium, these two equations determine the level of income and exchange rate that equilibrate the goods market and the money market. Holding constant the risk premium, the tools of monetary, fiscal, and trade policy work as we have already seen. Now suppose that political turmoil causes the country’s risk premium u to rise. Because r 5 r * 1 u, the most direct effect is that the domestic interest rate r rises. The higher interest rate, in turn, has two effects. First, the IS * curve shifts to the left because the higher interest rate reduces investment. Second, the LM * curve shifts to the right because the higher interest rate reduces the demand for money, which in turn implies a higher level of income for any given money supply. [Recall that Y must satisfy the equation M/P 5 L (r * 1 u, Y ).] As Figure 13-11 shows, these two shifts cause income to rise and the currency to depreciate. This analysis has an important implication: expectations about the exchange rate are partially self-fulfilling. For example, suppose that for some reason people reduce their expectations of the future value of the Mexican peso. Investors will place a larger risk premium on Mexican assets: u will rise in Mexico. This expectation will drive up Mexican interest rates and, as we have just seen, will 386 | P A R T I V Business Cycle Theory: The Economy in the Short Run FIGURE 1 3-1 1 An Increase in the Risk 1. When an increase Exchange rate, e in the risk premium Premium An increase in LM*1 LM*2 the risk premium associ- drives up the interest rate, the IS* curve ated with a country drives shifts to the left... up its interest rate. Because 2.... and the the higher interest rate LM* curve shifts reduces investment, the to the right,... IS* curve shifts to the left. Because it also reduces money demand, the LM* curve shifts to the right. Income rises, and the cur- rency depreciates. IS*1 3.... resulting IS*2 in a depreciation. Income, output, Y drive down the value of the Mexican currency. Thus, the expectation that a currency will lose value in the future causes it to lose value today. One surprising—and perhaps inaccurate—prediction of this analysis is that an increase in country risk as measured by u will cause the economy’s income to increase. This occurs in Figure 13-11 because of the rightward shift in the LM* curve. Although higher interest rates depress investment, the depreciation of the currency stimulates net exports by an even greater amount. As a result, aggregate income rises. There are three reasons why, in practice, such a boom in income does not occur. First, the central bank might want to avoid the large depreciation of the domestic currency and, therefore, may respond by decreasing the money supply M. Second, the depreciation of the domestic currency may suddenly increase the price of imported goods, causing an increase in the price level P. Third, when some event increases the country risk premium u, residents of the country might respond to the same event by increasing their demand for money (for any given income and interest rate) because money is often the safest asset available. All three of these changes would tend to shift the LM * curve toward the left, which mitigates the fall in the exchange rate but also tends to depress income. Thus, increases in country risk are not desirable. In the short run, they typically lead to a depreciating currency and, through the three channels just described, falling aggregate income. In addition, because a higher interest rate reduces investment, the long-run implication is reduced capital accumulation and lower economic growth. C H A P TE R 1 3 The Open Economy Revisited: The Mundell–Fleming Model and the Exchange-Rate Regime | 387 CASE STUDY International Financial Crisis: Mexico 1994–1995 In August 1994, a Mexican peso was worth 30 cents. A year later, it was worth only 16 cents. What explains this massive fall in the value of the Mexican currency? Country risk is a large part of the story. At the beginning of 1994, Mexico was a country on the rise. The recent passage of the North American Free Trade Agreement (NAFTA), which reduced trade barriers among the United States, Canada, and Mexico, made many people confident about the future of the Mexican economy. Investors around the world were eager to make loans to the Mexican government and to Mexican corporations. Political developments soon changed that perception. A violent uprising in the Chiapas region of Mexico made the political situation in Mexico seem precarious. Then Luis Donaldo Colosio, the leading presidential candidate, was assassinated. The political future looked less certain, and many investors started placing a larger risk premium on Mexican assets. At first, the rising risk premium did not affect the value of the peso because Mexico was operating with a fixed exchange rate. As we have seen, under a fixed exchange rate, the central bank agrees to trade the domestic currency (pesos) for a foreign currency (dollars) at a predetermined rate. Thus, when an increase in the country risk premium put downward pressure on the value of the peso, the Mexican central bank had to accept pesos and pay out dollars. This automatic exchange-market intervention contracted the Mexican money supply (shifting the LM * curve to the left) when the currency might otherwise have depreciated. Yet Mexico’s foreign-currency reserves were too small to maintain its fixed exchange rate. When Mexico ran out of dollars at the end of 1994, the Mexican government announced a devaluation of the peso. This decision had repercus- sions, however, because the government had repeatedly promised that it would not devalue. Investors became even more distrustful of Mexican policymakers and feared further Mexican devaluations. Investors around the world (including those in Mexico) avoided buying Mexican assets.The country risk premium rose once again, adding to the upward pressure on interest rates and the downward pressure on the peso. The Mexican stock market plummeted. When the Mexican government needed to roll over some of its debt that was coming due, investors were unwilling to buy the new debt. Default appeared to be the government’s only option. In just a few months, Mexico had gone from being a promising emerging economy to being a risky economy with a government on the verge of bankruptcy. Then the United States stepped in. The U.S. government had three motives: to help its neighbor to the south, to prevent the massive illegal immigration that might follow government default and economic collapse, and to prevent the investor pessimism regarding Mexico from spreading to other developing countries. The U.S. government, together with the International Monetary Fund (IMF), led an international effort to bail out the Mexican government. In partic- ular, the United States provided loan guarantees for Mexican government debt, C H A P TE R 1 3 The Open Economy Revisited: The Mundell–Fleming Model and the Exchange-Rate Regime | 389 3. Rising interest rates, together with the loss of confidence, depressed the prices of stock and other assets. 4. Falling asset prices reduced the value of collateral being used for bank loans. 5. Reduced collateral increased default rates on bank loans. 6. Greater defaults exacerbated problems in the banking system. Now return to step 1 to complete and continue the circle. Some economists have used this vicious-circle argument to suggest that the Asian crisis was a self-fulfilling prophecy: bad things happened merely because people expected bad things to happen. Most economists, however, thought the political corruption of the banking system was a real problem, which was then compounded by this vicious circle of reduced confidence. Exacerbating the situation was a currency mismatch between the assets and liabili- ties of financial institutions. Banks in these emerging economies had a tendency to borrow from abroad in foreign currencies, such as the U.S. dollar, and make loans to residents of their own countries in their domestic currencies, such as the rupiah. As a result, they had assets denominated in the domestic currency but liabilities denominated in a foreign currency. When the domestic currency depre- ciated in value on foreign-exchange markets, the value of the banks’ assets fell relative to their liabilities, making the problems of the banking system even worse. As the Asian crisis developed, the IMF and the United States tried to restore confidence, much as they had with Mexico a few years earlier. In particular, the IMF made loans to the Asian countries to help them through the crisis; in exchange for these loans, it exacted promises that the governments would reform their banking systems and eliminate crony capitalism. The IMF’s hope was that the short-term loans and longer-term reforms would restore confidence, lower the risk premium, and turn the vicious circle into a virtuous one. This policy seems to have worked: the Asian economies recovered quickly from their crisis. n 13-5 Should Exchange Rates Be Floating or Fixed? Having analyzed how an economy works under floating and fixed exchange rates, let’s consider which exchange-rate regime is better. Pros and Cons of Different Exchange-Rate Systems The primary argument for a floating exchange rate is that it allows a nation to use its monetary policy for other purposes. Under fixed rates, monetary policy is committed to the single goal of maintaining the exchange rate at its announced level. Yet the exchange rate is only one of many macroeconomic variables that monetary policy can influence. A system of floating exchange rates leaves ­monetary policymakers free to pursue other goals, such as stabilizing employment or prices. 390 | P A R T I V Business Cycle Theory: The Economy in the Short Run Advocates of fixed exchange rates argue that exchange-rate uncertainty makes international trade more diffi- cult. After the world abandoned the Bretton Woods system of fixed exchange rates in the early 1970s, both real and nominal exchange rates became (and have remained) much more volatile than anyone had expected. Some econo- Ed Fisher, The New Yorker Collection/Cartoon Bank mists attribute this volatility to irrational and destabilizing speculation by inter- national investors. Business executives often claim that this volatility is harm- ful because it increases the uncertainty that accompanies international business transactions. Despite this exchange-rate volatility, however, the amount of world trade has continued to rise under floating exchange rates. “Then it’s agreed. Until the dollar firms up, we let the clamshell Advocates of fixed exchange rates float.” sometimes argue that a commitment to a fixed exchange rate is one way to discipline a nation’s monetary authority and prevent excessive growth in the money supply. Yet there are many other policy rules to which the central bank could be committed. In Chapter 18, for instance, we discuss policy rules such as targets for nominal GDP or the inflation rate. Fixing the exchange rate has the advantage of being simpler to implement than these other policy rules because the money supply adjusts automatically, but this policy may lead to greater volatility in income and employment. In practice, the choice between floating and fixed rates is not as stark as it may seem at first. Under systems of fixed exchange rates, countries can change the value of their currency if maintaining the exchange rate conflicts too severely with other goals. Under systems of floating exchange rates, countries often use formal or informal targets for the exchange rate when deciding whether to expand or contract the money supply. We rarely observe exchange rates that are completely fixed or completely floating. Instead, under both systems, stability of the exchange rate is usually one among many objectives of the central bank. CASE STUDY The Debate Over the Euro If you have ever driven the 3,000 miles from New York City to San Francisco, you may recall that you never needed to change your money from one form of currency to another. In all 50 U.S. states, local residents are happy to accept the U.S. dollar for the items you buy. Such a monetary union is the most extreme form of a fixed exchange rate. The exchange rate between New York dollars and 392 | P A R T I V Business Cycle Theory: The Economy in the Short Run United States has a common language and in part because most Americans are descended from immigrants, who have shown a willingness to move. Therefore, when a regional recession occurs, U.S. workers are more likely to move from high-unemployment states to low-unemployment states. Second, the United States has a strong central government that can use fiscal policy—such as the federal income tax—to redistribute resources among regions. Because Europe does not have these two advantages, it bears a larger cost when it restricts itself to a single monetary policy. Advocates of a common currency believe that the loss of national mon- etary policy is more than offset by other gains. With a single currency in all of Europe, travelers and businesses no longer need to worry about exchange rates, and this encourages more international trade. In addition, a common currency may have the political advantage of making Europeans feel more connected to one another. The twentieth century was marked by two world wars, both of which were sparked by European discord. If a common currency makes the nations of Europe more harmonious, euro advocates argue, it benefits the entire world. n Speculative Attacks, Currency Boards, and Dollarization Imagine that you are a central banker of a small country. You and your fellow policymakers decide to fix your currency—let’s call it the peso—against the U.S. dollar. From now on, one peso will sell for one dollar. As we discussed earlier, you now have to stand ready to buy and sell pesos for a dollar each. The money supply will adjust automatically to make the equilibrium exchange rate equal your target. There is, however, one potential problem with this plan: you might run out of dollars. If people come to the central bank to sell large quantities of pesos, the central bank’s dollar reserves might dwindle to zero. In this case, the central bank has no choice but to abandon the fixed exchange rate and let the peso depreciate. This fact raises the possibility of a speculative attack—a change in investors’ per- ceptions that makes the fixed exchange rate untenable. Suppose that, for no good reason, a rumor spreads that the central bank is going to abandon the exchange- rate peg. People would respond by rushing to the central bank to convert pesos into dollars before the pesos lose value. This rush would drain the central bank’s reserves and could force the central bank to abandon the peg. In this case, the rumor would prove self-fulfilling. To avoid this possibility, some economists argue that a fixed exchange rate should be supported by a currency board, such as that used by Argentina in the 1990s. A currency board is an arrangement by which the central bank holds enough foreign currency to back each unit of the domestic currency. In our example, the central bank would hold one U.S. dollar (or one dollar invested in a U.S. government bond) for every peso. No matter how many pesos turned up at the central bank to be exchanged, the central bank would never run out of dollars. C H A P TE R 1 3 The Open Economy Revisited: The Mundell–Fleming Model and the Exchange-Rate Regime | 393 Once a central bank has adopted a currency board, it might consider the natu- ral next step: it can abandon the peso altogether and let its country use the U.S. dollar. Such a plan is called dollarization. It happens on its own in high-inflation economies, where foreign currencies offer a more reliable store of value than the domestic currency. But it can also occur as a matter of public policy, as in Panama. If a country really wants its currency to be irrevocably fixed to the dollar, the most reliable method is to make its currency the dollar. The only loss from dol- larization is the seigniorage revenue that a government gives up by relinquishing its control over the printing press. The U.S. government then gets the revenue that is generated by growth in the money supply.5 The Impossible Trinity The analysis of exchange-rate regimes leads to a simple conclusion: you can’t have it all. To be more precise, it is impossible for a nation to have free capital flows, a fixed exchange rate, and independent monetary policy. This fact, often called the impossible trinity (or sometimes the trilemma of international finance), is illustrated in Figure 13-12. A nation must choose one side of this triangle, giving up the institutional feature at the opposite corner. The first option is to allow free flows of capital and to conduct an indepen- dent monetary policy, as the United States has done in recent years. In this case, it is impossible to have a fixed exchange rate. Instead, the exchange rate must float to equilibrate the market for foreign-currency exchange. FIGURE 1 3-1 2 Free capital The Impossible Trinity It is flows impossible for a nation to have free capital flows, a fixed exchange rate, and independent monetary policy. A nation must choose one side of this triangle, giving up the Option 1 Option 2 opposite corner. (United States) (Hong Kong) Independent Fixed exchange monetary Option 3 rate policy (China) 5 Dollarization may also lead to a loss in national pride from seeing American portraits on the cur- rency. If it wanted, the U.S. government could fix this problem by leaving blank the center space that now has portraits of George Washington, Abraham Lincoln, and others. Each nation using U.S. currency could insert the faces of its own local heroes. 394 | P A R T I V Business Cycle Theory: The Economy in the Short Run The second option is to allow free flows of capital and to fix the exchange rate, as Hong Kong has done in recent years. In this case, the nation loses the abil- ity to conduct an independent monetary policy. The money supply must adjust to keep the exchange rate at its predetermined level. In a sense, when a nation fixes its currency to that of another nation, it is adopting that other nation’s monetary policy. The third option is to restrict the international flow of capital in and out of the country, as China has done in recent years. In this case, the interest rate is no longer fixed by world interest rates but is determined by domestic forces, much as is the case in a completely closed economy. It is then possible to both fix the exchange rate and conduct an independent monetary policy. History has shown that nations can, and do, choose different sides of the trinity. Every nation must ask itself the following question: Does it want to live with exchange-rate volatility (option 1), does it want to give up the use of mon- etary policy for purposes of domestic stabilization (option 2), or does it want to restrict its citizens from participating in world financial markets (option 3)? The impossible trinity says that no nation can avoid making one of these choices. CASE STUDY The Chinese Currency Controversy From 1995 to 2005 the Chinese currency, the yuan, was pegged to the dollar at an exchange rate of 8.28 yuan per U.S. dollar. In other words, the Chinese central bank stood ready to buy and sell yuan at this price. This policy of fixing the exchange rate was combined with a policy of restricting international capital flows. Chinese citizens were not allowed to convert their savings into dollars or euros and invest abroad. By the early 2000s, many observers believed that the yuan was significantly undervalued. They suggested that if the yuan were allowed to float, it would increase in value relative to the dollar. The evidence in favor of this hypothesis was that China was accumulating large dollar reserves in its efforts to maintain the fixed exchange rate. That is, the Chinese central bank had to supply yuan and demand dollars in foreign-exchange markets to keep the yuan at the pegged level. If this intervention in the currency market ceased, the yuan would rise in value compared to the dollar. The pegged yuan became a contentious political issue in the United States. U.S. producers that competed against Chinese imports complained that the undervalued yuan made Chinese goods cheaper, putting the U.S. producers at a disadvantage. (Of course, U.S. consumers benefited from inexpensive imports, but in the politics of international trade, producers usually shout louder than consumers.) In response to these concerns, President George W. Bush called on China to let its currency float. Several senators proposed a more drastic step—a steep tariff on Chinese imports until China adjusted the value of its currency. C H A P TE R 1 3 The Open Economy Revisited: The Mundell–Fleming Model and the Exchange-Rate Regime | 395 China no longer completely fixes the exchange rate. In July 2005 China announced a new policy: it would still intervene in foreign-exchange markets to prevent large and sudden movements in the exchange rate, but it would permit gradual changes. Moreover, it would judge the value of the yuan not just relative to the dollar but also relative to a broad basket of currencies. By October 2014, the exchange rate had moved to 6.12 yuan per dollar—a 35 percent appreciation of the yuan. China’s critics, including President Barack Obama, at times still complain about that nation’s intervention in foreign-exchange markets, but today China’s exchange-rate policy is a less pressing issue on the international economic agenda than it was in the past. n 13-6 From the Short Run to the Long Run: The Mundell–Fleming Model With a Changing Price Level So far we have used the Mundell–Fleming model to study the small open economy in the short run when the price level is fixed. We now consider what happens when the price level changes. Doing so will show how the Mundell– Fleming model provides a theory of the aggregate demand curve in a small open economy. It will also show how this short-run model relates to the long-run model of the open economy we examined in Chapter 6. Because we now want to consider changes in the price level, the nominal and real exchange rates in the economy will no longer be moving in tandem. Thus, we must distinguish between these two variables. The nominal exchange rate is e and the real exchange rate is , which equals eP/P *, as you should recall from Chapter 6. We can write the Mundell–Fleming model as Y 5 C (Y 2 T ) 1 I (r *) 1 G 1 NX () IS *, M/P 5 L (r *, Y ) LM *. These equations should be familiar by now. The first equation describes the IS * curve; and the second describes the LM * curve. Note that net exports depend on the real exchange rate. Figure 13-13 shows what happens when the price level falls. Because a lower price level raises the level of real money balances, the LM * curve shifts to the right, as in panel (a). The real exchange rate falls, and the equilibrium level of income rises. The aggregate demand curve summarizes this negative relationship between the price level and the level of income, as shown in panel ( b). Thus, just as the IS-LM model explains the aggregate demand curve in a closed economy, the Mundell–Fleming model explains the aggregate demand curve for a small open economy. In both cases, the aggregate demand curve shows the set of equilibria in the goods and money markets that arise as the price level varies. And in both cases, anything that changes equilibrium income, other 396 | P A R T I V Business Cycle Theory: The Economy in the Short Run FIGURE 1 3-1 3 (a) The Mundell–Fleming Model Mundell–Fleming as a Theory of Aggregate Real exchange Demand Panel (a) shows rate,  LM*(P1) LM*(P2) 1. A fall in the price that when the price level falls, level P shifts the LM* curve to the right,... the LM* curve shifts to the right. The equilibrium level 2.... of income rises. Panel (b) lowering 1 shows that this negative rela- the real tionship between P and Y is exchange summarized by the aggregate rate... demand curve. 2 3.... and raising IS* income Y. Y1 Y2 Income, output, Y (b) The Aggregate Demand Curve Price level, P P1 4. The AD curve summarizes the relationship between P and Y. P2 AD Y1 Y2 Income, output, Y than a change in the price level, shifts the aggregate demand curve. Policies and events that raise income for a given price level shift the aggregate demand curve to the right; policies and events that lower income for a given price level shift the aggregate demand curve to the left. We can use this diagram to show how the short-run model in this chapter is related to the long-run model in Chapter 6. Figure 13-14 shows the short- run and long-run equilibria. In both panels of the figure, point K describes the short-run equilibrium because it assumes a fixed price level. At this equi- libri