CHAPTER 4

Aggregate Demand in Open Economy

4.1. Introduction

In previous chapter, we assembled the pieces of the IS–LM model. We saw that the IS curve
represents the equilibrium in the market for goods and services, that the LM curve represents the
equilibrium in the market for real money balances, and that the IS and LM curves together
determine the interest rate and national income. Then we have seen government policies that
affect the interest rate and national income.

When conducting monetary and fiscal policy, policymakers often look beyond their own
country’s borders. Even if domestic prosperity 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 international
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, is an open-
economy version 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 aggregate
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 previous chapter by including the effects of
international trade and finance.

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. One virtue of this assumption is
that it simplifies the analysis: once the interest rate is determined, we can concentrate our
attention on the role of the exchange rate. In addition, for some economies, such as Belgium or
the Netherlands, the assumption of a small open economy with perfect capital mobility is a good
one. Yet this assumption— and thus the Mundell–Fleming model—does not apply exactly to a
large open economy such as the United States.

One lesson from the Mundell–Fleming model is that the behavior of an economy depends on the
exchange-rate system it has adopted. 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, and we discuss whether a floating or fixed exchange rate is better. This
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question has been important in recent years, as many nations around the world have debated
what exchange-rate system to adopt.

4.2. The Mundell–Fleming Model

In this section we build 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 chapter. 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. This
assumption means that the interest rate in the domestic economy r is determined by the world
interest rate r*. Mathematically, we can write this assumption as r = 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 were to occur 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 were ever to start driving 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 upward toward r*.
Hence, the r = r* equation represents the assumption that the international flow of capital is rapid
enough to keep the domestic interest rate equal to the world interest rate.

4.2.1. 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 = C(Y − T) + I(r*) + G + 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 − T. Investment depends negatively on the interest rate, which equals the world
interest rate r*. Net exports depend negatively on the exchange rate e. The exchange rate e as the

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amount of foreign currency per unit of domestic currency—for example, e might be 10 yen per
birr. It is value of one birr in foreign currency.

foreign…currency
e=
domestic ⋯currency
The exchange rate is related to net exports to through 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 r equals
p
e r =e ¿
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 nominal exchange
rate appreciates (say, from 10 to 12 yen per birr), foreign goods become cheaper compared to
domestic goods, and this causes exports to fall and imports to rise.

We can illustrate this equation for goods market equilibrium 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 5-1 and is called the IS* curve. The new label reminds us that the curve is drawn
holding the interest rate constant at the world interest rate r*.

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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 5-1 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* curves summarizes this relationship between the
exchange rate e and income Y.

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4.2.2. 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, with the additional assumption that the domestic interest rate
equals the world interest rate:

This equation states that the demand for real money balances, M/P, equals the demand, L(r,Y).
The demand for real balances depends negatively on the interest rate, which is now set equal to
the world interest rate r*, and positively on income Y.

The money supply M is an exogenous variable 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. We can represent this equation graphically with a vertical
LM* curve, as in panel (b) of Figure 12-2. The LM* curve is vertical because the exchange rate
does not enter into the LM* equation. Given the world interest rate, the LM* equation
determines aggregate income, regardless of the exchange rate. Figure below shows how the LM*
curve arises from the world interest rate and the LM curve, which relates the interest rate and
income.

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4.2.3. Putting the Pieces Together
According to the Mundell–Fleming model, a small open economy with perfect capital mobility
can be described by two equations:

The first equation describes equilibrium in the goods market, and the second equation 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.

Figure below illustrates these two relationships. The equilibrium for the economy is found where
the IS* curve and the LM* curve intersect. This intersection shows the exchange rate and the
level of income at which both the goods market and the money market are 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.

A) 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. We start with the system relevant
for most major economies today: floating exchange rates. Under floating exchange rates, the
exchange rate is allowed to fluctuate in response to changing economic conditions.

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I) 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 below. As a result, the exchange rate appreciates,
whereas 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. Why the difference? 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: as soon as the interest rate tries to rise above the world interest rate r*, capital
flows in from abroad. This capital inflow increases the demand for the domestic currency in the
market for foreign-currency exchange and, thus, bids up the value of the domestic currency. The
appreciation of the exchange rate makes domestic goods expensive relative to foreign goods, and
this reduces net exports. The fall in net exports 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:

In both closed and open economies, the quantity of real money balances supplied M/P is fixed,
and 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) allows equilibrium income to rise

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(which increases the quantity of money demanded). 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 exchange rate and the fall in net exports must be
large enough to offset fully the normal expansionary effect of the policy on income.

II) 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 balances. The
increase in real balances shifts the LM* curve to the right, as in Figure below. Hence, an increase
in the money supply raises income and lowers the exchange rate.

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, the interest rate is fixed by the world interest rate. As soon
as an increase in the money supply puts downward pressure on the domestic interest rate, capital
flows out of the economy as investors seek a higher return elsewhere. This capital outflow
prevents the domestic interest rate from falling. In addition, because the capital outflow increases
the supply of the domestic currency in the market for foreign-currency exchange, the exchange
rate depreciates. The fall in the exchange rate makes domestic goods inexpensive relative to
foreign goods and, thereby, stimulates net exports. Hence, in a small open economy, monetary
policy influences income by altering the exchange rate rather than the interest rate.

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III) Trade Policy:
Suppose that the government reduces the demand for imported goods by imposing an import
quota or a tariff. What happens to aggregate income and the exchange rate?

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 below. 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.

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Often a stated goal of policies to restrict trade is to alter the trade balance NX. Yet, such policies
do not necessarily have that effect. The same conclusion holds in the Mundell–Fleming model
under floating exchange rates. Recall that from open economy equilibrium product market

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.

B) The Small Open Economy under Fixed Exchange Rates

We now turn to the second type of exchange-rate system: fixed exchange rates. In the 1950s and
1960s, most of the world’s major economies, including the United States, operated within the
Bretton Woods system—an international monetary system under which most governments
agreed to fix exchange rates. The world abandoned this system in the early 1970s, and exchange
rates were allowed to float. Some European countries later reinstated a system of fixed exchange
rates among themselves, and some economists have advocated a return to a worldwide system of
fixed exchange rates. 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.

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 that the central
bank announced that it was going to fix the exchange rate at 10 yen per birr. It would then stand
ready to give birr 1 in exchange for 10 yen or to give 10 yen in exchange for birr 1. To carry out
this policy, the central bank would need a reserve of birr (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 equilibrium exchange rate 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 that the central bank announces that it will fix the exchange rate at 10 yen per
birr, but, in the current equilibrium with the current money supply, the exchange rate is 15 yen
per birr. This situation is illustrated in panel (a) of Figure below. Notice that there is a profit
opportunity: an arbitrageur could buy 30 yen in the marketplace for birr 2, and then sell the yen
to the central bank for birr 3, making a birr 1 profit. When the central bank buys these yen from

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the arbitrageur, the birr 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
announced level.

Conversely, suppose that when the central bank announces that it will fix the exchange rate at 10
yen per birr, the equilibrium is 50 yen per birr. Panel (b) of Figure above shows this situation. In
this case, an arbitrageur could make a profit by buying 10 yen from the central bank for birr 1
and then selling the yen in the marketplace for birr 2.When the central bank sells these yen, the
birr 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, 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–Fleming model, prices are fixed, so a fixed nominal
exchange rate implies a fixed real exchange rate as well.

1) 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 below,
putting upward pressure on the exchange rate. But because the central bank stands ready to trade

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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 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.

2) Monetary Policy
Imagine that a central bank operating with a fixed exchange rate were to try 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 below. 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, monetary 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 monetary policy: it can
decide to change the level at which the exchange rate is fixed. A reduction in the value of the
currency is called devaluation, and an increase in its value is called 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.

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 3) 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 below. 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.

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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 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 appreciation of the exchange rate. The monetary expansion, in turn, raises aggregate
income.

Summary of Policy in the Mundell–Fleming Model:

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 floating or fixed. Table below
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. 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.

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4.3. 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 monetary policy to be used
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.

Advocates of fixed exchange rates argue that exchange-rate uncertainty makes international trade
more difficult. After the world abandoned the Bretton Woods system of fixed exchange rates in
the early 1970s, both real and nominal exchange rates became (and remained) much more
volatile than anyone had expected. Some economists attribute this volatility to irrational and
destabilizing speculation by international investors. Business executives often claim that this
volatility is harmful because it increases the uncertainty that accompanies international business
transactions. Yet, despite this exchange-rate volatility, the amount of world trade has continued
to rise under floating exchange rates.

Advocates of fixed exchange rates 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. For instance, 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 the end, the choice between floating and fixed rates is not as stark as it may seem at first.
During periods of fixed exchange rates, countries can change the value of their currency if
maintaining the exchange rate conflicts too severely with other goals. During periods 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 of the central bank’s objectives.

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4.4. The Mundell–Fleming Model with a Changing Price Level
So far we have been using the Mundell–Fleming model to study the small open economy in the
short run when the price level is fixed. To see how this model relates to models we have
examined previously, let’s consider what happens when the price level changes.

To examine price adjustment in an open economy, we must distinguish between the nominal
exchange rate e and the real exchange rateε , which equals eP/P*.We can write the Mundell–
Fleming model as

These equations should be familiar by now. The first equation describes the IS* curve, and the
second equation describes the LM* curve. Note that net exports depend on the real exchange
rate.

Figure below shows what happens when the price level falls. Because a lower domestic price
level raises the level of real money balances, the LM* curve shifts to the right, as in panel (a) of
the Figure. The real exchange rate depreciates, 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) of the Figure.

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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 that arise as the price level
varies. And in both cases, anything that changes the equilibrium for a given price level shifts the
aggregate demand curve. Policies that raise income shift the aggregate demand curve to the right;
policies that lower income shift the aggregate demand curve to the left.

We can use this diagram to show how the short-run model is related to the long-run model.
Figure below 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 equilibrium,
the demand for goods and services is too low to keep the economy producing at its natural rate.
Over time, low demand causes the price level to fall. The fall in the price level raises real money
balances, shifting the LM* curve to the right. The real exchange rate depreciates, so net exports
rise. Eventually, the economy reaches point C, the longrun equilibrium. The speed of transition
between the short-run and long-run equilibria depends on how quickly the price level adjusts to
restore the economy to the natural rate.

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The levels of income at point K and point C are both of interest. Our central concern in this
chapter has been how policy influences point K, the short-run equilibrium. Whenever
policymakers consider any change in policy, they need to consider both the short-run and long-
run effects of their decision.

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