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GeorgeAlogoskoufis,Interna'onalMacroeconomics,2016
TheMundell-FlemingModelandtheDornbuschModel
ProfessorGeorgeAlogoskoufisAthensUniversityofEconomicsandBusiness
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GeorgeAlogoskoufis,Interna'onalMacroeconomics,2016
TheMundellFlemingModel
• This model has been the basis on which a large part of the short-term analysis of international macroeconomic phenomena has rested for several decades.
• It is an extension of the basic Keynesian model IS-LM, in an open economy with free capital mobility.
• The reference point of the model is that there is price rigidity in goods and services markets but that financial market prices adjust quickly in order to achieve equilibrium.
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GeorgeAlogoskoufis,Interna'onalMacroeconomics,2016
TheStaFcFormoftheMundellFlemingModel
• We assume a small open economy, which takes international developments as exogenous, because of its small size.
• The demand for domestic goods and services depends on three factors: domestic income (positive), the domestic interest rate (negative) and the real exchange rate.
• The latter is defined as the relative price of international goods and services, expressed in domestic currency, and has a positive effect on domestic demand.
• These factors, together with fiscal policy, determine aggregate demand, which of course will be equal to total output.
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GeorgeAlogoskoufis,Interna'onalMacroeconomics,2016
EquilibriumintheMarketforGoodsandServices
yisthelogarithmofdomesFcoutput,sthelogarithmofthenominalinterestrate(unitsofdomesFccurrencyperunitofforeigncurrency),p*thelogarithmoftheforeignpricelevel(inforeigncurrencyunits),pthelogarithmofthedomesFcpricelevel,ithedomesFcnominalinterestrate(whichbecauseofpricerigidityisequaltotherealinterestrater),andganindexoftheimpactoffiscalpolicyonaggregatedemand.Theparametersδ,γandσareposiFve,with0<γ<1.
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y = δ (s + p*− p)+ γ y −σ i + g
GeorgeAlogoskoufis,Interna'onalMacroeconomics,2016
EquilibriumintheDomesFcMoneyMarket
misthelogarithmofthemoneysupply,φtheelasFcityofmoneydemandwithrespecttorealoutput,andλthesemi-elasFcityofmoneydemandwithrespecttothenominalinterestrate.
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m − p = φy − λi
GeorgeAlogoskoufis,Interna'onalMacroeconomics,2016
EquilibriuminInternaFonalFinancialMarkets
WeassumethatthereisfreeinternaFonalcapitalmobility,andthatequilibriumintheinternaFonalfinancialmarketsimpliesuncoveredinterestparity.Withsta'cexpecta'onsaboutthefutureevoluFonoftheexchangerate,thismeansthatdomesFcinterestratesareequaltointernaFonalinterestrates.
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i = i*
GeorgeAlogoskoufis,Interna'onalMacroeconomics,2016
ShortRunMacroeconomicEquilibriumintheMundellFlemingModel
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GeorgeAlogoskoufis,Interna'onalMacroeconomics,2016
ARegimeofFixedExchangeRates
SubsFtuFnguncoveredinterestparityintheequilibriumcondiFonforthemarketsofgoodsandservicesandmoney,andtakingthetotaldifferenFalofthesystemofequaFonsobtained,weget,
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dm = φδ1− γ
ds − λ + φσ1− γ
⎛⎝⎜
⎞⎠⎟di*+ φ
1− γdg
dy = δ1− γ
ds − σ1− γ
di*+ 11− γ
dg
GeorgeAlogoskoufis,Interna'onalMacroeconomics,2016
IneffecFvenessofMonetaryPolicyinaRegimeofFixedExchangeRates
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GeorgeAlogoskoufis,Interna'onalMacroeconomics,2016
IneffecFvenessofMonetaryPolicyinaRegimeofFixedExchangeRates• AdomesFccreditexpansionhasnoeffectonthemoneysupply,ifthereisnochangeintheexchangerate,internaFonalinterestratesorfiscalpolicy.DomesFccreditexpansionwouldcauseforeignreserveouZlows,asdomesFcinterestratescannotfallbelowinternaFonalrates,andthecentralbankwillhavetointervenetosupportthefixedexchangerate.
• TheseouZlows,willbeequivalenttotheiniFalincreaseindomesFccredit,andtherewillbenoeffectonthedomesFcmoneysupply.
• TheMundellFlemingmodelpredictsthatdomesFcmonetarypolicyhasnoabilitytoinfluencetheeconomyunderaregimeoffixedexchangerates.
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GeorgeAlogoskoufis,Interna'onalMacroeconomics,2016
EffectsofaDevaluaFon
AdevaluaFoncausesanincreaseinbothdomesFcincome,andthemoneysupply.Thisisduetotheshi]indemandinfavorofdomesFcproducts,theincreaseinnetexportsandtheconsequentaccumulaFonofforeignreservesthatincreasethemoneysupply.
Thus,adevaluaFoncausesbothanincreaseindomesFcincomeandanimprovementinthecurrentaccountinthismodel.
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GeorgeAlogoskoufis,Interna'onalMacroeconomics,2016
EffectsofaFiscalExpansionunderFixedExchangeRates
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GeorgeAlogoskoufis,Interna'onalMacroeconomics,2016
EffectsofaFiscalExpansionunderFixedExchangeRates
AfiscalexpansionincreasesbothdomesFcincomeandthedomesFcmoneysupply.ThisisbecauseitincreasesthedemandfordomesFcproducts,thisleadstoanincreaseinmoneydemand,which,withgivendomesFccredit,resultsininflowsofforeignexchangereserves,whichincreasethemoneysupply.
AlternaFvelyonecansaythatafiscalexpansioncausesupwardpressureondomesFcinterestrates,whichcauseforeigncapitalinflowstoequilibratethemoneymarket,asdomesFcinterestratesmaynotdifferfrominternaFonalrates.
WhereasadevaluaFonincreasesdomesFcincomebutcausesanimprovementinthecurrentaccount,iftheMarshallLernercondiFonissaFsfied,afiscalexpansioncausesadeterioraFoninthecurrentaccount.
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GeorgeAlogoskoufis,Interna'onalMacroeconomics,2016
EffectsofanIncreaseinInternaFonalInterestRatesunderFixedExchangeRates
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GeorgeAlogoskoufis,Interna'onalMacroeconomics,2016
EffectsofanIncreaseinInternaFonalInterestRatesunderFixedExchangeRates
Finally,anincreaseininternaFonalinterestratesleadstoadecreaseinbothdomesFcincome,andthemoneysupply.
TheincreaseininternaFonalinterestratescausecapitalouZlows,whichduetotheintervenFonsofthecentralbanktosupporttheexchangerate,reduceforeignexchangereservesandthemoneysupplyandincreasedomesFcinterestrates.
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GeorgeAlogoskoufis,Interna'onalMacroeconomics,2016
DifferencebetweenFixedandFloaFngExchangeRates
WhenthemonetaryauthoriFesdonotinterveneintheforeignexchangemarket,ashappensunderfloaFngexchangerates,theendogenousvariablesaredomesFcincomeandtheexchangerate.Themoneysupply(anddomesFcinterestrates)canbeusedasapolicytool.
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GeorgeAlogoskoufis,Interna'onalMacroeconomics,2016
FloaFngExchangeRates
SubsFtuFnguncoveredinterestparityintheequilibriumcondiFonsforthemarketsforgoodsandservicesandmoney,andtakingthetotaldifferenFalofthesystemofequaFonsobtained,weget,
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ds = 1− γφδ
dm + λ(1− γ )+φσφδ
⎛⎝⎜
⎞⎠⎟di*− 1
δdg
dy = 1φdm + λ
φdi*
GeorgeAlogoskoufis,Interna'onalMacroeconomics,2016
EffectsofanIncreaseintheMoneySupplyunderFloaFngExchangeRates
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GeorgeAlogoskoufis,Interna'onalMacroeconomics,2016
EffectsofanIncreaseintheMoneySupplyunderFloaFngExchangeRates
AnincreaseinthemoneysupplythroughadomesFccreditexpansionleadstoadepreciaFonofthecurrency.ThedepreciaFoncausesanincreaseindomesFcdemandandhasaposiFveimpactondomesFcoutputandthecurrentaccount.
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GeorgeAlogoskoufis,Interna'onalMacroeconomics,2016
EffectsofaFiscalExpansionunderFloaFngExchangeRates
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GeorgeAlogoskoufis,Interna'onalMacroeconomics,2016
EffectsofaFiscalExpansionunderFloaFngExchangeRates
AfiscalexpansionputsupwardpressureondomesFcinterestrates,andcausesanappreciaFonoftheexchangerate.TheappreciaFonoftherealexchangeratereducesaggregatedomesFcdemandandcounteractsthedemandeffectsofthefiscalexpansion.Accordingly,afiscalexpansionisnotaccompaniedbymonetaryexpansion,hasnoimpactondomesFcoutputinafloaFngexchangerateregime.ItsonlyeffectistocauseanappreciaFonoftheexchangerateandadeterioraFoninthecurrentaccount.
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GeorgeAlogoskoufis,Interna'onalMacroeconomics,2016
EffectsofanIncreaseinInternaFonalInterestRatesunderFloaFngExchangeRates
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GeorgeAlogoskoufis,Interna'onalMacroeconomics,2016
EffectsofanIncreaseinInternaFonalInterestRatesunderFloaFngExchangeRates
AnincreaseininternaFonalinterestratesleadstoadepreciaFonofthedomesFccurrency.ThisleadstoanincreaseindomesFcdemand,astherestricFveeffectofrisinginterestratesisoutweighedbytheexpansionaryimpactofthedepreciaFonoftheexchangerate.TotheextentthatthedomesFcmoneysupplyisconstant,thedecreaseinmoneydemandcausedbytheincreaseininterestratesisoffsetbyanincreaseinmoneydemandduetoincreaseddomesFcoutputandincome.
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GeorgeAlogoskoufis,Interna'onalMacroeconomics,2016
WeaknessesoftheMundellFlemingModel
• First,itignores,likeallshort-termmodelsofthistype,thedisFncFonbetweenstocks(suchasforeigndebt)andflows(suchasthecurrentaccount).
• Second,itassumescompletepricesFckiness,soitcannotsayanythingaboutpricechangesandinflaFonanditseffectsoninternalandexternalbalance.
• Third,itassumesstaFcexpectaFons.
• Finally,itsmicroeconomicfoundaFonsarenotbasedonopFmisingbehaviouronthepartofhouseholdsandfirms.
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GeorgeAlogoskoufis,Interna'onalMacroeconomics,2016
TheDornbuschModelTheDornbuschmodelisasignificantimprovementoftheMundellFlemingmodel,inatleasttwodirecFons:
First,ithasalessextremeapproachtotheadjustmentofthepricelevel.Insteadofassumingconstantpricesitassumesthatthepricelevelgraduallyadjuststoequilibratethemarketforgoodsandservicesatfullemployment.
Second,insteadofstaFcexpectaFons,itassumesraFonalexpectaFonsaboutthefutureevoluFonoftheexchangerate,whichisassumedtobefloaFng.
Inthisway,themodelcanexplaintheovershooFngofnominalexchangeratestomonetarychanges,butalsotodescribetheadjustmentoftheeconomytowardslong-termequilibriumwithfullemployment.
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GeorgeAlogoskoufis,Interna'onalMacroeconomics,2016
AssumpFonsoftheDornbuschModel
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m − p = φy − λi
yd = δ (s − p)+ γ y −σ i + g
p•= π (yd − y)
i = i*+ se•
= i*+ s•
GeorgeAlogoskoufis,Interna'onalMacroeconomics,2016
SoluFonoftheDornbuschModel
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s•= − 1
λ(m − p −φy + λi*) = − 1
λ(m − p −φy)− i*
p•= π δ (s − p)+ σ
λ(m − p)+ g − (1− γ )+ σφ
λ⎛⎝⎜
⎞⎠⎟ y
⎡⎣⎢
⎤⎦⎥
GeorgeAlogoskoufis,Interna'onalMacroeconomics,2016
LongRunEquilibriumintheDornbuschModelandtheAdjustmentPath
• First,thelong-runequilibriumcharacterizedbymonetaryneutrality.ApermanentchangeinthemoneysupplyhasnorealeffectbutmerelycausesachangeinthesameproporFontothepricelevelandtheexchangerate.
• Second,achangeinthemoneysupplyhasshort-termrealeffects,asthepricelevelcannotadjustimmediately,butonlygradually.Onlythenominalratecanchangeimmediately.
• Third,theeconomyconvergestoitslong-runequilibrium,fromanyiniFalstate.Thelongrunequilibriumisasaddlepoint,sincethetwofirstorderdifferenFalequaFonsofthemodelhaveoneposiFveandonenegaFveroot.Thereisauniquepaththatleadstothislong-termequilibrium.Thepathisuniquebecausethepricelevelisapredeterminedvariableandtheexchangerateisanonpredeterminedvariable.
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GeorgeAlogoskoufis,Interna'onalMacroeconomics,2016
AnIncreaseintheMoneySupplyandExchangeRateOvershooFng
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GeorgeAlogoskoufis,Interna'onalMacroeconomics,2016
TheInter-temporalEvoluFonoftheExchangeRate,PricesandInterestRates,FollowingaMonetaryExpansion
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Χρόνος t
Χρόνος t
Χρόνος t
s
i
sE
sE'
s0
p
pE
pE'
i*
i0
t0
t0
t0
GeorgeAlogoskoufis,Interna'onalMacroeconomics,2016
TheInter-temporalEvoluFonoftheNominalandRealExchangeRate,FollowingaMonetaryExpansion
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Χρόνος t
Χρόνος t
s
sE
sE'
s0
s+p*-p
t0
t00
GeorgeAlogoskoufis,Interna'onalMacroeconomics,2016
AnIncreaseinInternaFonalInterestRatesintheDornbuschModel
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GeorgeAlogoskoufis,Interna'onalMacroeconomics,2016
ConclusionabouttheDornbuschModel
• TheDornbuschmodel,likemostmodelsbasedonthegradualadjustmentofthepricelevel,combineslong-runclassicalneutrality,withshort-runKeynesianfeatures.TheovershooFngofexchangeratechangeswouldnotoccurifthepriceleveldidnotadjustgradually,as,ifpricesalsoadjustedimmediately,theeconomywouldimmediatelyjumptoitslongrunequilibrium.
• TheDornbuschmodelexplainshowthecombinaFonofgradualadjustmentofthepricelevelandtheimmediateadjustmentofexchangeratesresultsinhighvolaFlityofbothnominalandrealexchangerates,asaresultofbothmonetary,andrealshocks.
• However,muchliketheMundellFlemingmodel,uponwhichitisanimprovement,theDornbuschmodellackssaFsfactorymicroeconomicfoundaFons.
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