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The Mundell - Flemming model

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The Mundell - Flemming model

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Intermediate Economics 2

(201ECN)

Revision 03 on Macroeconomics

(w/c 6th February 2017)

Exercise 3.1

Define the following terms:

Exercise 3.2

Consider the IFM line.

b. Use a diagram to illustrate the IFM line and explain the slope of the IFM line.

Exercise 3.3

Considering the money market equilibrium, explain the so-called Mundell-Fleming trilemma, which

states that ”the free flow of capital, monetary autonomy and a fixed exchange rate are incompatible”.

Exercise 3.4

Characterise the equilibrium of the Mundell-Fleming model under fixed exchange rates and illustrate

it using a diagram.

Consider a country that operates a fixed exchange rate system. Using the Mundell-Fleming model,

discuss the effect of a stock market crash (that decreases Tobin’s q) on output and the interest rate.

Provide diagrams to support your discussion and compare your results with a scenario in which the

central bank of the country follows a Taylor rule.

Consider a country that operates a fixed exchange rate system. Using the Mundell-Fleming model,

discuss the effect of expansionary fiscal policy on output and the interest rate. Provide diagrams to

support your discussion and compare your results with a scenario in which the central bank of the

country follows a Taylor rule.

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Second Semester 2016/17 Coventry University

Consider a country that operates a fixed exchange rate system. Using the Mundell-Fleming model,

discuss the effect of a decrease in the foreign interest rate on output and the interest rate. Provide

diagrams to support your discussion and compare your results with a scenario in which the central

bank of the country follows a Taylor rule.

Consider a country that operates a fixed exchange rate system and assume that the central bank has

decided to devaluate the domestic currency. Using the Mundell-Fleming model, discuss the effect of

the devaluation on output and the interest rate. Provide diagrams to support your discussion.

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Second Semester 2016/17 Coventry University

Exercise 3.1.a

The nominal exchange rate is the (conversion) rate at which foreign currency is traded for domestic

currency (or vice versa).

Exercise 3.1.b

The real exchange rate is the (conversion) rate at which foreign goods are traded for domestic goods

(or vice versa). Formally, the real exchange rate σ is defined as:

SP

σ= P∗ ,

where S denotes the nominal exchange rate (in British terms, i.e. in terms of foreign currency per unit

of domestic currency), P denotes the domestic price level, and P∗ denotes the foreign price level. That

is:

• The numerator reflects the price level of domestic goods in foreign currency.

• The denominator reflects the price level of foreign goods in foreign currency.

Exercise 3.1.c

Under a fixed exchange rate regime, the value of the domestic currency in terms of foreign currency is

maintained by the central bank.

Exercise 3.1.d

Under a flexible exchange rate regime, the value of the domestic currency in terms of foreign currency

floats freely.

Exercise 3.2.a

The IFM line reflects all combinations of the level of output Y and the interest rate i, for which the

interest rate parity condition holds:

1 + i = (1 + ī) SSe t . (1)

t+1

Notation

i Domestic interest rate St Current exchange rate (in $/£)

ī Foreign interest rate e

St+1 Future exchange rate (in $/£)

Exercise 3.2.b

Diagram The IFM line is illustrated in Figure 1.

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Second Semester 2016/17 Coventry University

Interest

Rate i

1 i St 1 B

IFM 0

Ste1 A

Output Y

Slope To explain the slope of the IFM line illustrated in Figure 1, we consider Equation (1) and start

from a Point A on the IFM line, at which the domestic return on investment is equal to the foreign

return on investment. If, for example, output Y increases (see the red arrow in the diagram), Equation

(1) suggests that:

,→ Neither the domestic nor the foreign return on investment will change.

,→ The interest rate i does not need to change to maintain equality of domestic and foreign return

(Point B).

Equilibrium in the Money Market The equilibrium condition in the money market reads:

M

P = k( i )Y . (2)

−

Notation

i Interest rate P Price level Y Output

k Liquidity preference M Money

Benchmark Scenario without Capital Mobility If capital is not mobile, the interest rate i is flexible.

In case of an disequilibrium in the money market, i will adjust until an equilibrium is reached:

• If there is excess supply, the interest rate i will decrease.

• If there is excess demand, the interest rate i will increase.

Therefore, we can conclude from (2):

• Any central bank’s choice of M determines i (LM curve).

• Any central bank’s choice of i determines M (TR curve).

Scenario with Capital Mobility and a Fixed Exchange Rate If capital is mobile and the exchange

rate is fixed, the interest rate parity condition:

1 + i = (1 + ī) SSe t

t+1

must hold, i.e. the interest rate is no longer flexible. Therefore, in case of a disequilibrium in the money

market, the central bank will be forced to adjust the quantity of money (i.e. its money supply):

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Second Semester 2016/17 Coventry University

• If excess supply:

,→ downward pressure on exchange rate St ,

,→ central bank must intervene by decreasing quantity M.

• If excess demand:

,→ upward pressure on exchange rate St ,

,→ central bank must intervene by increasing quantity M.

Therefore, we can conclude that the central bank can neither choose the quantity M of money nor the

interest rate i. Put differently, the central bank faces the so-called Mundell-Fleming trilemma, which

states that ”the free flow of capital, monetary autonomy and a fixed exchange rate are incompatible”.

Notation

i Domestic interest rate St Current exchange rate (in $/£)

ī Foreign interest rate e

St+1 Future exchange rate (in $/£)

Characterisation of the Equilibrium The Mundell-Fleming model under fixed exchange rates is in

equilibrium at the intersection of the IS curve and the IFM line. At this point, the goods and money

market are in equilibrium under fixed exchange rates.

Diagram

Interest

Rate i

i0* IFM 0

IS 0

Y0* Output Y

We proceed in three steps:

• First, we discuss the effect of a stock market crash (that decreases Tobin’s q) on output and the

interest rate using the Mundell-Fleming model.

• Then, we discuss the effect of a stock market crash (that decreases Tobin’s q) on output and the

interest rate using the IS-TR framework.

• Finally, we compare the results.

∗

Instead of providing a ”complete” essay, the following answer gives you guidance about a rough line of argument you

could use in your essay to discuss the respective topics in a meaningful way.

5

Second Semester 2016/17 Coventry University

STEP 1: The Effects of a Decrease in Tobin’s q under a Fixed Exchange Rate System (Mundell-

Fleming Model)

Initial Scenario

Mathematical Representation of the Mundell-Fleming Model with Fixed Exchange Rates The

Mundell-Fleming model with fixed exchange rates can be described by the following two equations:

+ + + − + − + +

i = ī, (4)

• the first equation reflects the equilibrium on the goods market (IS curve), and

• the second equation reflects the interest parity condition under fixed exchange rates (IFM line).

Notation

a Parameter G Government spending T Taxes π Inflation

A Domestic absorption (C + I + G) I Investment X Exports π̄ Inflation target

A∗ Foreign absorption (C∗ + I ∗ + G∗ ) i Interest rate Y Output σ Real exchange rate

b Parameter ī Foreign interest rate Ȳ Output target Ω Wealth

C Consumption q Tobin’s q Z Imports

Graphical Illustration of the Initial Scenario The initial scenario, represented by the curves IS0

and IFM0 , is illustrated Figure 2.

Interest

Rate i

i0* IFM 0

A

IS 0

Y * Output Y

0

Slope of the IS Curve To explain the slope of the IS curve illustrated in Figure 2, we consider

Equation (3) and start from a Point A on the IS curve, at which the supply of goods is equal to the

demand for goods. If, for example, the interest rate i increases (see the red arrow in the diagram),

Equation (3) suggests that:

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Second Semester 2016/17 Coventry University

,→ Output Y must decrease (see the green arrow in the diagram) to re-obtain an equilibrium in the

goods market (Point B).

Slope of the IFM Line Please see Exercise 3.2 for details.

Shifts of the IS Curve and the IFM Line It follows from (3) and (4) that:

• An decrease in Tobin’s q will affect the location of the IS curve (i.e. q is a shift parameter of the

IS curve). If Tobin’s q decreases, then:

,→ Excess supply,

,→ Output Y must decrease to re-obtain an equilibrium in the goods market.

Thus, the IS curve will shift to the left (IS0 → IS1 ), see Figure 3.

• An decrease in Tobin’s q will leave the location of the IFM line unaffected (i.e. q is not a shift

parameter of the IFM line). Thus, the IFM line will not shift (IFM0 = IFM1 ), see Figure 3.

Interest

Rate i

* A

i01

IFM 01

B

IS1 IS 0

Y *

Y * Output Y

1 0

Final Result From the diagram shown in Figure 3, we can conclude that:

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Second Semester 2016/17 Coventry University

• IS curve (Point A ⇒ Point B):

q ↓ ⇒ I ↓ ⇒ Excess supply ⇒ Y ↓,

STEP 2: The Effects of a Decrease in Tobin’s q under a Taylor Rule (IS-TR Model)

Initial Scenario

Mathematical Representation of the IS-TR Framework The IS-TR framework can be described

by the following two equations:

+ + + − + − + +

i = ī + a (π − π̄) + b Y −

Ȳ

Ȳ

, (6)

where:

• the first equation reflects the equilibrium on the goods market (IS curve), and

Notation

a Parameter G Government spending T Taxes π Inflation

A Domestic absorption (C + I + G) I Investment X Exports π̄ Inflation target

A∗ Foreign absorption (C∗ + I ∗ + G∗ ) i Interest rate Y Output σ Real exchange rate

b Parameter ī Neutral interest rate Ȳ Output target Ω Wealth

C Consumption q Tobin’s q Z Imports

Graphical Illustration of the Initial Scenario The initial scenario, represented by the curves IS0

and T R0 , is illustrated Figure 4.

Interest

Rate i

TR0

B

i0* IFM 0

A

IS 0

Y * Output Y

0

8

Second Semester 2016/17 Coventry University

Slope of the TR Curve To explain the slope of the TR curve illustrated in Figure 4, we consider

Equation (6) and start from a Point A on the TR curve, at which the interest rate set by the central bank

is consistent with the Taylor rule. If, for example, the level of output Y increases (see the blue arrow in

the diagram), Equation (6) suggests that:

Y −Ȳ

,→ The output gap Ȳ

will increase.

,→ The actual interest rate i set by central bank must increase (see the orange arrow in the diagram)

to re-align the actual interest rate with the optimal interest rate implied by the Taylor rule (Point

B).

Shifts of the IS Curve and the TR Curve It follows from (5) and (6) that:

• A decrease in Tobin’s q will, as discussed above, affect the location of the IS curve (i.e. q is a

shift parameter of the IS curve). The IS curve will shift to the left (IS0 → IS1 ), see Figure 5.

• A decrease in Tobin’s q will leave the location of the TR curve unaffected (i.e. q is not a shift

parameter of the TR curve). Thus, the TR curve will not shift (T R0 = T R1 ), see Figure 5.

Interest

Rate i

TR01

A

i0 IFM 01

B

i1 C

IS1 IS 0

Y *

Y* Output Y

1 0

Final Result From the diagram shown in Figure 5, we can conclude that:

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Second Semester 2016/17 Coventry University

• IS curve (Point A ⇒ Point B):

q ↓ ⇒ I ↓ ⇒ Excess supply ⇒ Y ↓,

Y −Ȳ

Y ↓ ⇒ Ȳ

↓ ⇒ Optimal interest rate ↓ ⇒ i ↓

⇒ I ↑ ⇒ Excess demand ⇒ Y ↑ ⇒ ......

A comparison of the results suggests that the effect of the decrease of Tobin’s q on:

• output Y is stronger under fixed exchange rates,

• interest rate i is weaker under fixed exchange rates.

This is because the fixed exchange rate prevents the central bank from adjusting the interest rate in

response to the decrease of Tobin’s q.

We proceed in three steps:

• First, we discuss the effect of expansionary fiscal policy (an increase in government spending G)

on output and the interest rate using the Mundell-Fleming model.

• Then, we discuss the effect of expansionary fiscal policy (an increase in government spending

G) on output and the interest rate using the IS-TR framework.

• Finally, we compare the results.

STEP 1: The Effects of an Increase in Government Spending G under a Fixed Exchange Rate

System (Mundell-Fleming Model)

Initial Scenario

Mathematical Representation of the Mundell-Fleming Model with Fixed Exchange Rates The

Mundell-Fleming model with fixed exchange rates can be described by the following two equations:

Y = C(Ω,Y − T ) + I(q , i ) + G + X(A∗ , σ ) − Z(A, σ ), (7)

+ + + − + − + +

i = ī, (8)

where + and − indicate the respective partial derivatives, and:

• the first equation reflects the equilibrium on the goods market (IS curve), and

• the second equation reflects the interest parity condition under fixed exchange rates (IFM line).

Notation

a Parameter G Government spending T Taxes π Inflation

A Domestic absorption (C + I + G) I Investment X Exports π̄ Inflation target

A∗ Foreign absorption (C∗ + I ∗ + G∗ ) i Interest rate Y Output σ Real exchange rate

b Parameter ī Foreign interest rate Ȳ Output target Ω Wealth

C Consumption q Tobin’s q Z Imports

†

Instead of providing a ”complete” essay, the following answer gives you guidance about a rough line of argument you

could use in your essay to discuss the respective topics in a meaningful way.

10

Second Semester 2016/17 Coventry University

Graphical Illustration of the Initial Scenario The initial scenario, represented by the curves IS0

and IFM0 , is illustrated Figure 6.

Interest

Rate i

i0* IFM 0

IS 0

Y0* Output Y

Slope of the IFM Line Please see Exercise 3.2 for details.

Shifts of the IS Curve and the IFM Line It follows from (7) and (8) that:

• An increase in government spending G will affect the location of the IS curve (i.e. G is a shift

parameter of the IS curve). If government spending G increases, then:

,→ Excess demand,

,→ Output Y must increase to re-obtain an equilibrium in the goods market.

Thus, the IS curve will shift to the right (IS0 → IS1 ), see Figure 7.

• An increase in government spending G will leave the location of the IFM line unaffected (i.e. G

is not a shift parameter of the IFM line). Thus, the IFM line will not shift (IFM0 = IFM1 ), see

Figure 7.

Final Result From the diagram shown in Figure 7, we can conclude that:

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Second Semester 2016/17 Coventry University

Interest

Rate i

* A

i01

IFM 01

B

IS1

IS 0

Y *

Y* Output Y

0 1

G ↑ ⇒ Excess demand ⇒ Y ↑,

STEP 2: The Effects of an Increase in Government Spending under a Taylor Rule (IS-TR Model)

Initial Scenario

Mathematical Representation of the IS-TR Framework The IS-TR framework can be described

by the following two equations:

+ + + − + − + +

i = ī + a (π − π̄) + b Y −

Ȳ

Ȳ

, (10)

where:

• the first equation reflects the equilibrium on the goods market (IS curve), and

Notation

a Parameter G Government spending T Taxes π Inflation

A Domestic absorption (C + I + G) I Investment X Exports π̄ Inflation target

A∗ Foreign absorption (C∗ + I ∗ + G∗ ) i Interest rate Y Output σ Real exchange rate

b Parameter ī Neutral interest rate Ȳ Output target Ω Wealth

C Consumption q Tobin’s q Z Imports

Graphical Illustration of the Initial Scenario The initial scenario, represented by the curves IS0

and T R0 , is illustrated Figure 8.

12

Second Semester 2016/17 Coventry University

Interest

Rate i

TR0

i0* IFM 0

IS 0

Y0* Output Y

Shifts of the IS Curve and the TR Curve It follows from (9) and (10) that:

• An increase in government spending G will, as discussed above, affect the location of the IS

curve (i.e. G is a shift parameter of the IS curve). The IS curve will shift to the right (IS0 → IS1 ),

see Figure 9.

• A increase in government spending G will leave the location of the TR curve unaffected (i.e. G

is not a shift parameter of the TR curve). Thus, the TR curve will not shift (T R0 = T R1 ), see

Figure 9.

Interest

Rate i

TR01

i1 C

A

i0 IFM 01

B

IS1

IS 0

Y *

Y* Output Y

0 1

13

Second Semester 2016/17 Coventry University

Final Result From the diagram shown in Figure 9, we can conclude that:

• Output has increased,

• IS curve (Point A ⇒ Point B):

G ↑ ⇒ Excess demand ⇒ Y ↑,

Y −Ȳ

Y ↑ ⇒ Ȳ

↑ ⇒ Optimal interest rate ↑ ⇒ i ↑

⇒ I ↓ ⇒ Excess supply ⇒ Y ↓ ⇒ ......

A comparison of the results suggests that the effect of the increase in government spending G on:

• output Y is stronger under fixed exchange rates,

This is because the fixed exchange rate prevents the central bank from adjusting the interest rate in

response to the expansionary fiscal policy.

We proceed in three steps:

• First, we discuss the effect of a decrease in the foreign interest rate on output and the interest rate

using the Mundell-Fleming model.

• Then, we discuss the effect of a decrease in the foreign interest rate on output and the interest

rate using the IS-TR framework.

STEP 1: The Effects of a Decrease in the Foreign Interest Rate under a Fixed Exchange Rate

System (Mundell-Fleming Model)

Initial Scenario

Mathematical Representation of the Mundell-Fleming Model with Fixed Exchange Rates The

Mundell-Fleming model with fixed exchange rates can be described by the following two equations:

+ + + − + − + +

i = ī, (12)

‡

Instead of providing a ”complete” essay, the following answer gives you guidance about a rough line of argument you

could use in your essay to discuss the respective topics in a meaningful way.

14

Second Semester 2016/17 Coventry University

• the first equation reflects the equilibrium on the goods market (IS curve), and

• the second equation reflects the interest parity condition under fixed exchange rates (IFM line).

Notation

a Parameter G Government spending T Taxes π Inflation

A Domestic absorption (C + I + G) I Investment X Exports π̄ Inflation target

A∗ Foreign absorption (C∗ + I ∗ + G∗ ) i Interest rate Y Output σ Real exchange rate

b Parameter ī Foreign interest rate Ȳ Output target Ω Wealth

C Consumption q Tobin’s q Z Imports

Graphical Illustration of the Initial Scenario The initial scenario, represented by the curves IS0

and IFM0 , is illustrated Figure 10.

Interest

Rate i

i0* IFM 0

IS 0

Y * Output Y

0

Slope of the IFM Line Please see Exercise 3.2 for details.

Shifts of the IS Curve and the IFM Line It follows from (11) and (12) that:

• A decrease in the foreign interest rate ī will leave the location of the IS curve unaffected (i.e. ī

is not a shift parameter of the IS curve). Thus, the IS curve will not shift (IS0 = IS1 ), see Figure

11.

• A decrease in the foreign interest rate ī will affect the location of the IFM line (i.e. ī is a shift

parameter of the IFM line). If the foreign interest rate ī decreases, then:

,→ Investors will buy domestic assets (capital inflows),

,→ Prices of domestic assets will increase,

,→ The domestic interest rate will decrease until the interest rate parity is reinstated.

Thus, the IFM line will shift downward (IFM0 → IFM1 ), see Figure 11.

15

Second Semester 2016/17 Coventry University

Interest

Rate i

A

i0* IFM 0

i1* IFM 1

B C

IS01

Y *

Y * Output Y

0 1

Final Result From the diagram shown in Figure 11, we can conclude that:

i ↓ ⇒ I ↑ ⇒ Excess demand ⇒ Y ↑

STEP 2: The Effects of a Decrease in the Foreign Interest Rate under a Taylor Rule (IS-TR

Model)

Initial Scenario

Mathematical Representation of the IS-TR Framework The IS-TR framework can be described

by the following two equations:

+ + + − + − + +

i = ī + a (π − π̄) + b Y −

Ȳ

Ȳ

, (14)

where:

• the first equation reflects the equilibrium on the goods market (IS curve), and

Notation

a Parameter G Government spending T Taxes π Inflation

A Domestic absorption (C + I + G) I Investment X Exports π̄ Inflation target

A∗ Foreign absorption (C∗ + I ∗ + G∗ ) i Interest rate Y Output σ Real exchange rate

b Parameter ī Neutral interest rate Ȳ Output target Ω Wealth

C Consumption q Tobin’s q Z Imports

16

Second Semester 2016/17 Coventry University

Interest

Rate i

TR0

i0* IFM 0

IS 0

Y0* Output Y

Graphical Illustration of the Initial Scenario The initial scenario, represented by the curves IS0

and T R0 , is illustrated Figure 8.

Shifts of the IS Curve and the TR Curve It follows from (13) and (14) that:

• A decrease in the foreign interest rate will, as discussed above, leave the location of the IS curve

unaffected (i.e. the foreign interest rate is not a shift parameter of the IS curve). Thus, the IS

curve will not shift (IS0 = IS1 ), see Figure 13.

• A decrease in the foreign interest rate will leave the location of the TR curve unaffected (i.e. the

foreign interest rate is not a shift parameter of the TR curve). Thus, the TR curve will not shift

(T R0 = T R1 ), see Figure 13.

Final Result From the diagram shown in Figure 13, we can conclude that:

• Output has not changed,

• Interest rate has not changed.

A comparison of the results suggests that the effect of the decrease in the foreign interest rate on:

• output Y is stronger under fixed exchange rates,

• interest rate i is stronger under fixed exchange rates.

This is because the fixed exchange rate forces central bank to ”import” the international financial shock

by adjusting the interest rate while the Taylor rule allows the central bank to ignore the shock.

17

Second Semester 2016/17 Coventry University

Interest

Rate i

TR01

*

i01

IFM 0

IFM 1

IS01

Y0* 1 Output Y

Note that a devaluation of the domestic currency is associated with a decrease in the nominal exchange

rate S (in British terms, i.e. in terms of foreign currency per unit of domestic currency) and the expected

future exchange rate. Accordingly, since the domestic price level P and the foreign price level P∗ is

given, a devaluation of the domestic currency is associated with a decrease in the real exchange rate:

SP

σ= P∗ .

Initial Scenario

Mathematical Representation of the Mundell-Fleming Model with Fixed Exchange Rates The

Mundell-Fleming model with fixed exchange rates can be described by the following two equations:

+ + + − + − + +

i = ī, (16)

• the first equation reflects the equilibrium on the goods market (IS curve), and

• the second equation reflects the interest parity condition under fixed exchange rates (IFM line).

a Parameter G Government spending T Taxes π Inflation

A Domestic absorption (C + I + G) I Investment X Exports π̄ Inflation target

A∗ Foreign absorption (C∗ + I ∗ + G∗ ) i Interest rate Y Output σ Real exchange rate

b Parameter ī Foreign interest rate Ȳ Output target Ω Wealth

C Consumption q Tobin’s q Z Imports

Graphical Illustration of the Initial Scenario The initial scenario, represented by the curves IS0

and IFM0 , is illustrated Figure 14.

§

Instead of providing a ”complete” essay, the following answer gives you guidance about a rough line of argument you

could use in your essay to discuss the respective topics in a meaningful way.

18

Second Semester 2016/17 Coventry University

Interest

Rate i

i0* IFM 0

IS 0

Y * Output Y

0

Slope of the IFM Line Please see Exercise 3.2 for details.

Shifts of the IS Curve and the IFM Line It follows from (15) and (16) that:

• A decrease in the real exchange rate σ will affect the location of the IS curve (i.e. σ is a shift

parameter of the IS curve). If the real exchange rate σ increases, then:

,→ Exports X will increase and imports Z will decrease,

,→ Excess demand,

,→ Output Y must increase to re-obtain an equilibrium in the goods market.

Thus, the IS curve will shift to the right (IS0 → IS1 ), see Figure 15.

• An increase in the real exchange rate σ will leave the location of the IFM line unaffected (i.e. σ

is not a shift parameter of the IFM line). Thus, the IFM line will not shift (IFM0 = IFM1 ), see

Figure 15.

Final Result From the diagram shown in Figure 15, we can conclude that:

• Output has increased,

• Interest rate has not changed.

• IS curve (Point A ⇒ Point B):

σ ↑ ⇒ X ↑, Z ↓ ⇒ Excess demand ⇒ Y ↑,

M D ↑ ⇒ Excess demand ⇒ upward pressure on exchange rate St ⇒ M S ↑

19

Second Semester 2016/17 Coventry University

Interest

Rate i

* A

i01

IFM 01

B

IS1

IS 0

Y0* Y * Output Y

1

20

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