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## CHAPTER 16 MONETARY AND FISCAL POLICY IN THE OPEN ECONOMY

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**CHAPTER 16MONETARY AND FISCAL POLICY IN THE OPEN ECONOMY**FIXED VS FLEXIBLE REGIMES**is an economic model first set forth by Robert Mundell and**Marcus Fleming. • an extension of the IS-LM model: whereas IS-LM deals with economy under autarky, the Mundell-Fleming model tries to describe a small open economy. • portrays the relationship between the nominal exchange rate and the economy output (unlike the relationship between interest rate and the output in the IS-LM model) in the short run. • frequently referred to as "the Unholy Trinity," the "Irreconcilable Trinity," the "Inconsistent trinity" or the Mundell-Fleming "trilemma." The Mundell-Fleming Model**Closed economy IS-LM model:**• S(Y) + T = I(r) + G • Open economy IS-LM model: • S(Y) + T + Z(Y, π) = I(r) + G + X(Yf, π) • IS – combinations of r and Y that clear goods market • LM – combinations of r and Y that clear money market • BP – combinations of r and Y that balance BoP at a given exchange rate: • X(Yf,π) – Z (Yf,π)+ F (r-rf) = 0 IS-LM Model**Capital Mobility**Imperfect Perfect Policy versus Capital Mobility Monetary Policy Fiscal Policy Monetary Policy Fiscal Policy Fixed Flexi Fixed Flexi Fixed Flexi Fixed Flexi**Imperfect Capital Mobility - Fixed**• Increase money supply: • shifts LM to the right • r falls, Y increases • BoP deficits • Increase government spending: • shifts IS to the right • r rises, Y increases • BoP surplus**Imperfect Capital Mobility - Flexi**• Increase money supply: • shifts LM to the right, BoP deficit • π increases, BP shifts to the right • IS shifts to the right, higher Y • Increase government expenditure: • shifts IS to the right, BoP surplus • π falls, BP shifts to the left • IS shifts to the left, lower Y**Perfect Capital Mobility - Fixed**• Increase money supply: • shifts LM to the right • r falls capital outflow • central bank intervention shifts LM to the left • r restored, initial Y • Increase government spending: • shifts IS to the right • r rises, Y increases • central bank intervention shifts LM to the right • r restored, higher Y**Perfect Capital Mobility - Flexi**• Increase money supply: • shifts LM to the right • r falls capital outflow • π rises shifts IS to the right • r restored, higher Y • Increase government expenditure: • shifts IS to the right • r rises capital inflow • π falls shifts IS to the left • r restored, initial Y**High capital mobility = less correlation between S and I**• In a world of high capital mobility, saving will flow to the country with highest return to investment. • In an open economy, I = S + (T – G) + (Z – X). • Countries should have large deviations of saving from investment with current account deficits or surpluses. • However, data 1965-86: Countries with high ratio of saving to income, i.e. Japan, Norway, also have high ratios of investment to income and countries with low ratio of saving to income, i.e. U.K., U.S., also have low ratios of investment to income. • Question: real world imperfect capital mobility? The Feldstein-Horioka Saving Investment Puzzle**Mid-1980s: the world capital market is 2/3 or ¾ towards**perfect capital mobility. Is the degree of capital mobility high enough to assume perfect capital mobility? • Some countries may have capital controls that limit movements while some engages in a near perfect capital mobility with neighboring countries. • Perfect mobility: Monetary policy is completely ineffective in fixed regime, fiscal policy is completely ineffective in flexi regime. Conclusion