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Balance of Payments II: Output, Exchange Rates, and Macroeconomic Policies in the Short Run
This chapter develops the open-economy IS-LM model. It then compares the short-run effects of stabilization policies under fixed and flexible exchange rate regimes.
If demand shifts from the products of country B to the products of country A, a depreciation by country B or an appreciation by country A would correct the external imbalance and also relieve unemployment in country B and restrain inflation in country A. This is the most favorable case for flexible exchange rates based on national currencies.
Robert Mundell, 1961
It is easy to understand the dislike…for a [fixed exchange rate] system which dictated that a slump must be aggravated by monetary reactions, although, doubtless, [people] had forgotten that the same system served to enhance booms.
Alec Ford, 1962
1. Example: disparate reactions of central bankers to exchange rate movements after the 2008 crisis
2. Chapters 13 through 15 took output as exogenous. This chapter studies the interaction of the exchange rate and output in the short run.
3. The model is an open-economy version of IS/LM. Its key assumption is that prices are sticky in the short run. It will explain the relationships between all macroeconomic variables in the short run.
4. It will yield important insights about the effect of monetary and fiscal policies under fixed and flexible rates.
In the wake of the 2008 Global Financial Crisis, exchange rates have been fluctuating a great deal, and not surprisingly they have once again risen to global prominence in economic, financial, and political debates. In late 2010, the Brazilian finance minister Guido Mantega seemed to invoke the ghosts of the 1930s when he spoke of a new “currency war” as the Brazilian real appreciated; in early 2013, the head of the Deutsche Bundesbank Jens Weidmann used the same term as the euro gained strength. Over the same postcrisis period, however, other central bankers, such as the Chairman of the Federal Reserve Ben Bernanke and the Governor of the Bank of England Mervyn King, managed to display much less anxiety about their currency movements, as the values of the dollar and the pound slipped. Why were the Brazilian and the German economists so fretful? Why were their American and British counterparts so relaxed? Their attitudes reflect the idea that the exchange rate matters for the economy as a whole.
Thus far our study of exchange rates has been largely disconnected from real activity and the rest of the economy. Chapters 2 through 4 developed a theory of exchange rates, in which the economy’s level of output was taken as given. To gain a more complete understanding of how an open economy works, we now extend our theory and explore what happens when exchange rates and output fluctuate in the short run. To do this, we build on the accounting framework we learned in the balance of payments chapter to understand how macroeconomic aggregates (including output, income, consumption, investment, and the trade balance) move together and in response to shocks in an open economy.
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Call it the Mundell-Fleming model.
The model we study is an open-economy variant of the well-known IS-LM model that is widely used in the study of closed-economy macroeconomics. The key assumption of this type of Keynesian model is that prices are “sticky” in the short run so that output is determined by shifts in demand in the goods market. When we are finished, we will have a model that explains the relationships among all the major macroeconomic variables in an open economy in the short run.
Such a model can shed light on many policy issues. We can see how monetary and fiscal policies affect the economy, and discuss how they can be used to stabilize the economy and maintain full employment. One key lesson we learn in this chapter is that the feasibility and effectiveness of macroeconomic policies depend crucially on the type of exchange rate regime in operation.