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The Mundell-Fleming Model

The Mundell-Fleming Model. Mainstream Thinking on Open Macroeconomics. Exchange Rates. E nominal exchange rate between the euro and the dollar (eg. 1,17 euro/$ = 0,85 $/euro) ε real exchange rate (epsilon) measured in purchasing power our pespective: from USA to EU

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The Mundell-Fleming Model

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  1. The Mundell-Fleming Model Mainstream Thinking on Open Macroeconomics

  2. Exchange Rates E nominal exchange rate between the euro and the dollar (eg. 1,17 euro/$ = 0,85 $/euro) ε real exchange rate (epsilon) measured in purchasing power our pespective: from USA to EU E = number of units of domestic currency you can get for one unit of foreign currgency example: EUSD/EUR = 1,19 $/Euro domestic foreign Thomas Dürmeier Regulating Global Finance

  3. Exchange Rate 2 example: EUSD/EUR = 1,19 $/Euro depreciation E  ε  (value of currency decreases) appreciation E  ε  (value of currency increases) Real exchange rate: exchange between commodities one Volkswagen P* vs. one Cadillac P 1. Volkswagen with US-price: P* x E 2. In comparison to Cadillac: (P* x E)/P = ε Thomas Dürmeier Regulating Global Finance

  4. Investement/Savings - Liquidity/Money: IS-LM IS: Y = C(Y-T) + I (Y,i) + G LM: M/P = Y L(i) - only commodity and captial market - price level is constant - Keynesian bias - short-run IS i LM T, G nominal interest rate M  Y social product Thomas Dürmeier Regulating Global Finance

  5. Aggregated Supply and Demand: AS-AD AD: Yt = Y(M/Pt, G, T) AS: Pt = Pt-1 (1+μ) F(1-(Yt/L), z) - IS-LM plus labor market - neutrality of money - monetaristic bias - long-run P AS M , T, G In the long-run:only AS determines Y price level μ , L, z  AD Y social product Thomas Dürmeier Regulating Global Finance

  6. AS-AD: Neutrality of Money AD: Yt = Y(M/Pt, G, T) AS: Pt = Pt-1 (1+μ) F(1-(Yt/L), z) M , T, G In the long-run:only AS determines Y P AS Monetary policy has NO influence on output, only inflation. Only under certain circumstances. price level AD Y social product Thomas Dürmeier Regulating Global Finance

  7. Balance of Payment Commodity flows • Current account • Exports - Imports = Trade balance • Investment • Capital account • Increase in foreign holdings of US assets • Increase in US holding of foreign assets • Statistical discrepancy Capital flows

  8. Exchange Rate Regimes • Free floating: no central bank intervention • Managed floating: no fixed exchange rate goal, but central bank interventionb • Target zones: exchange rate around a band with • Crawling pegs: no fixed rate, but alinment rate and process • Adjustable peg: exchangre rate fixed, no alienment • Currency board: autonom body, which controls exchange rate target • Fixed or peeged exchange rate: constant exchange rate • Dollarisierung (dollarization), Euroisierung (euroization) or currency union • World currency • (Privatization of money) • Source: Frankel, Jeffrey A., Sergio Schmukler und Luis Serven (2002), ”Verifiability and the Vanishing Intermediate Exchange Rate Regime”, in: Susan M. Collins und Dani Rodrik (Hrsg.): Brookings Trade Forum, The Brookings Institution. http://muse.jhu.edu/demolbtf Thomas Dürmeier Regulating Global Finance

  9. Elements of Open Macroeconomics • Interest rate parity (Mundell-Fleming) • Purchasing power parity (monetaristic open macro) • Expectations • Policy credibility Thomas Dürmeier Regulating Global Finance

  10. Mundell-Fleming Modell IS: Y = C(Y-T) + I (Y,i) + G LM: M/P = Y L(i) E=Ee/(1+i-i*) interest rate parity IS LM i i nominal interest rate E Y social product E Exchange rate Thomas Dürmeier Regulating Global Finance

  11. Mundell-Fleming Modell: flexible exchange rate and fiscal policy IS: Y = C(Y-T) + I (Y,i) + G LM: M/P = Y L(i) E=Ee/(1+i-i*) interest rate parity IS LM i i G appreciation nominal interest rate E Y social product E Exchange rate Thomas Dürmeier Regulating Global Finance

  12. Fixed exchange rate and fiscal policy IS: Y = C(Y-T) + I (Y,i) + G LM: M/P = Y L(i) E=Ee/(1+i-i*) interest rate parity IS LM IS‘ i i G LM‘‘ Pressure on exchange rate nominal interest rate Y social product E E Exchange rate Thomas Dürmeier Regulating Global Finance

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