THE IS-LM MODEL IN THE OPEN ECONOMY

The model developed in this chapter is an extension of the open economy IS-LM model, known as
the Mundell-Fleming model. (Robert Mundell received the Nobel Prize in 1999, "for his analysis of
monetary and fiscal policy under different exchange rate regimes and his analysis of optimum
currency areas“)
● Key questions:
- What determines the exchange rate?
- How can policy affect output and exchange rates?
OPEN ECONOMY IS

Assume for simplicity that both domestic and foreign prices are given, thus ε and E move together.
• Normalization: P*/P = 1, thus ε = E. and since P is given no inflation so i=r
• This yields:
Interest rate parity
Equilibrium in financial markets: domestic and foreign onds must have the same expected rate of
return
Assume for simplicity
1. the expected depreciation of the exchange rate is given
2. the domestic economy is small, so it takes i* (and Y*) as exogenous – determined in the rest of
the world
 An increase in the domestic interest rate leads to an increase in the exchange rate.
 An increase in the foreign interest rate leads to a decrease in the exchange rate.
 An increase in the expected future exchange rate leads to an increase in the current exchange
rate

• When 𝑖 ↑, then 𝐸 ↑
1. The IRP is upward sloping:

• When 𝑖 ↓, then 𝐸 ↓
When i goes up financial investors want to
invest more on domestic bonds. This leads
demand for domestic currency to increase E.
movement along

The relation is drawn for a given expected future exchange rate, Ee, and a given foreign interest
rate, i*, and is rep- resented by an upward-sloping line. The higher the domestic interest rate, the
higher the exchange rate. Equation (20.5) also implies that, when the domestic interest rate is
equal to the foreign interest rate (i = i*), the exchange rate is equal to the expected future
exchange rate (E = Ee). This implies that the line corresponding to the interest parity condition goes
through point A (where i = i*) in the figure.
 3. When 𝐸𝑒 ↑, then IRP shifts to the 4. When 𝑖∗ ↑, then
right. Everything constant, 𝐸 ↑ IRP shifts to the left.
2. when 𝑖 = 𝑖∗ ⇒ 𝐸 = 𝐸𝑒
𝐸↓
Everything constant,

we don’t expect a future we expect an appreciation of Increase in foreign interest rate

variation in the exchange rate domestic currency of 1+t so a there is an increase in demand
depreciation of foreign currency in the of foreign bonds and this implies
future demand for domestic currency that investors buys foreign
increase currency so demand for
domestic currency decrease E

OPEN ECONOMY LM
Money market equilibrium:
Given output and interest rates: choice between money and bonds is determined in the same way

• As in the closed economy 𝑖 is the policy rate set by the central bank, therefore: 𝑖 = 𝑖_
as in the closed economy.

OPEN-ECONOMY IS-LM-IRP:

(IS) 𝑌 = 𝐶(𝑌 − 𝑇) + 𝐼(𝑖, 𝑌) + 𝐺 + 𝑁𝑋(𝑌∗, 𝑌, 𝐸)

Short-run equilibrium in a small open economy with perfect capital mobility requires:

(LM) 𝑖 = 𝑖_

Together, these three relations determine output, the interest rate and the exchange rate.
Take the IS relation first and consider the effects of an increase in the interest rate on output. An
increase in the interest rate now has two effects:
●The first effect a higher interest rate leads to a decrease in investment, a decrease in the demand
for domestic goods and a decrease in output.
● The second effect, which is present only in the open economy, is the effect through the exchange
rate: an increase in the domestic interest rate leads to an increase in the exchange rate – an
appreciation. The appreciation, which makes domestic goods more expensive relative to foreign
goods, leads to a decrease in net exports and, therefore, to a decrease in the demand for domestic
goods and a decrease in output.
Both effects work in the same direction: an increase in the interest rate decreases demand directly
and indirectly – through the adverse effect of the appreciation on demand.
The IS curve is downward-sloping: an increase in the interest rate leads to lower output.
The LM relation is exactly the same in an open economy as in a closed economy. The LM
curve is upward-sloping. For a given value of the real money stock, M / P, an increase in output
leads to an increase in the demand for money and to an increase in the equilibrium interest rate.
Given the foreign interest rate and the expected future exchange rate, the equilibrium interest rate
of the IS-LM determines the equilibrium exchange rate.
Before analyzing the impact of policy in an open economy, one needs to specify the international
monetary system in which a country operates.
• Floating exchange rates: E is allowed to fluctuate in response to economic conditions, ultimately
the demand and supply of domestic currency vs. foreign currency (e.g. US and Euro-Area countries
nowadays)
• Fixed exchange rate: E is not allowed to fluctuate, and the Central Bank maintains the ongoing
parity buy buying or selling the domestic currency at a predetermined price (e.g. Argentina – US
in the 90s, China – US till 2005: now pegged floating regime)
FISCAL AND MONETARY POLICY WITH FLOATING EXCHANGE RATES
Fiscal policy
Assume an expansionary fiscal policy (G↑ and/or T↓)
the effects of an increase in G (and/or decrease in T) are:
• Y (domestic output) ↑ as domestic demand Z increase
• i (interest rate) is kept constant by the CB by
increasing money supply

• The components of the aggregate demand (𝐶, 𝐼,

• E (exchange rate) is constant as i is kept constant

𝑁𝑋):
C ↑as Y goes up, I ↑as Y ↑ and
NX ↓as Y(imports go up) and E is constant

Monetary policy
Assume an expansionary monetary policy (𝑖↓) the effects of a decrease in i are:
• Y (domestic output) ↑ as I ↑ and NX ↑
(through the decrease in E)
• i (interest rate) ↓and so investors want more foreign
bonds decreasing demand for domestic currency

• The components of the aggregate demand (𝐶, 𝐼,

• E (exchange rate) goes down

𝑁𝑋):
C ↑as Y ↑, I ↑as Y ↑and i ↓and the effect on NX is
ambiguous as E ↓so NX ↑
but Y ↑ so NX↓ through imports
If the increase in G happens in an economy where output is close to potential output, Yn the CBm
worry that by moving the economy above potential output, might push inflation up. It is likely to
respond by raising the interest rate. output will increase by less and the exchange rate will
appreciate, from E to E′′. effect on I is ambiguous C goes up and NX go down.
FISCAL AND MONETARY POLICY WITH FIXED EXCHANGE RATES
A country can decide to fix the exchange rate
- in terms of a given foreign currency (e.g in terms of $)
- in terms of a given basket of foreign currencies
Once decided the target, the CB uses the monetary policy to achieve the target
A fixed exchange rate regime does not imply that E remains always constant (but changes are rare
and determined by a policy intervention!)
- E↓: devaluation
- E↑: revaluation
In a fixed rate regimes devaluation and revaluation of the exchange rates are determined by the CB
(and not by the currency markets)

the central bank sets the exchange rate at a given at a given level 𝐸

form their expectations accordingly, i.e. 𝐸e𝑡+1=E

If financial investors believe that the exchange rate will remain pegged at this value, then they will

This implies that with fixed exchange rates the IRP

Under a fixed exchange rate regime the central bank gives up monetary policy because the
domestic interest rate must always be equal to the foreign interest rate.

(IS) 𝑌 = 𝐶(𝑌 − 𝑇) + 𝐼(𝑖, 𝑌) + 𝐺 + 𝑁𝑋(𝑌∗, 𝑌, 𝐸)

Short-run equilibrium in a small open economy with perfect capital mobility requires:

Under a fixed exchange regime:

• the policy interest rate is entirely determined by the foreign interest rate and monetary policy
can no longer be used.
• the central bank must adjust the domestic interest rate (and money supply) in order to match
movements in the foreign interest rate (at risk of unwanted effects on its own domestic economy).
Monetary Policy
Under a fixed exchange regime, monetary policy cannot be longer used and the central bank must
always adjust the domestic interest rate in order to match the movements of the foreign interest
rate.
Fiscal Policy
Under a fixed exchange rate regime, the effects of the fiscal policy are identical to those we saw for
the case of flexible exchange rate regime. The difference between fixed and flexible exchange is
the ability of the central bank to respond to a given fiscal policy
• Example. fiscal policy aimed to reduce public deficit has a negative effect on Y. In a fixed
exchange regime the CB cannot counteract with a reduction of the interest rate

In an open economy the central bank can modify the monetary base and supply of money not only
through bonds but also through reserves of foreign currency by buying and selling foreign currency
• CB buys foreign currency, then reserves of foreign currency increases and monetary base
increases Ms ↓; at the same time in the currency market the demand for foreign currency ↑ and
consequentely E↓
• CB sells foreign currency then the reserves of foreign currency decreases and monetary base
decreases Ms ↑; at the same time in the currency market the demand fo foreign currency ↓ and
consequentely E↑.
Suppose foreign CB decides to increase the interest rate and we are in a floating exchange rate

The increase in i* (more convenient to buy foreign bonds, higher demand for foreign currency,
depreciation of the exchange rate) is seen in the IRP CURVE that shifts to the left.
We have an appreciation of NX↑ and improvement in the trade balance, higher demand for
domestic goods and so increase in production (the increase in NX↑ causes Y↑ and shifts the IS
curve to the right)

Suppose now foreign CB decides do decrease interest rate but we are in a fixed exchange rate

The increase in i* (more convenient to buy foreign bonds, higher demand for foreign currency,
depreciation of the exchange rate) is seen in the IRP CURVE that shifts to the left. In this case, the
CB doesn’t want a depreciation of the exchange rate so the domestic interest rate goes up to be
equal to the new foreign interest rate. In this way, the exchange rate remains at the same level as it
was before. With the higher interest rate the level of production Y goes down as investments goes
down.

Fiscal policy has a greater effect on output in an economy with fixed exchange rates than in an
economy with flexible exchange rates.
True.
In a fixed exchange rate system, fiscal expansion directly raises demand without triggering currency
appreciation (as the exchange rate is fixed). Under flexible exchange rates, fiscal expansion often
leads to currency appreciation, which reduces net exports, dampening the effect on output.