Intermediate Economics - Revision 03

Second Semester 2016/17 Coventry University
Intermediate Economics 2
(201ECN)
Revision 03 on Macroeconomics
(w/c 6th February 2017)
The Mundell-Fleming Model (Part 1)
Exercise 3.1
Define the following terms:
a. Nominal exchange rate,
b. Real exchange rate,
c. Fixed exchange rate regime,
d. Flexible exchange rate regime.
Exercise 3.2
Consider the IFM line.
a. Provide a verbal and a formal definition of 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.
Exercise 3.5 (Essay)

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.

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.
1

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.
2
Answers to Exercise 3.1

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.
3
Interest
Rate i
1  i St  1 B
IFM 0
Ste1 A
Output Y
Figure 1: IFM Line
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):
4
• 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
Answers to Exercise 3.5∗

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
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:
Y = C(Ω,Y − T ) + I(q , i ) + G + X(A∗ , σ ) − Z(A, σ ), (3)

+ + + − + − + +
i = ī, (4)
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
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
Figure 2: Initial Scenario
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:
,→ Investment I will decrease.
,→ Demand for goods will decrease.
6
,→ There will be excess supply.
,→ 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.
Implications of a Decrease in Tobin’s q

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:
,→ Investment I will decrease,

,→ 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
i01
IFM 01
B
IS1 IS 0
Y *
Y * Output Y
1 0
Figure 3: Implications of a Decrease in Tobin’s q
Final Result From the diagram shown in Figure 3, we can conclude that:
• Output has decreased,
• Interest rate has not changed.
7
Economic Dynamics The underlying economics dynamics can be summarised as follows:

• IS curve (Point A ⇒ Point B):
q ↓ ⇒ I ↓ ⇒ Excess supply ⇒ Y ↓,
• Money market / foreign exchange market (Point B ⇒ Point B):
M D ↓ ⇒ Excess supply ⇒ downward pressure on exchange rate St ⇒ M S ↓
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 second equation reflects the Taylor rule (TR curve).
Notation
b Parameter ī Neutral interest rate Ȳ Output target Ω Wealth
and T R0 , is illustrated Figure 4.
Interest
Rate i
TR0
B
i0* IFM 0
A
IS 0
Y * Output Y
0
8
Slope of the IS Curve Please see the discussion above.
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 optimal interest rate 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).
Implications of a Decrease in Tobin’s q

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
TR01
A
i0 IFM 01
B
i1 C
IS1 IS 0
Y *
Y* Output Y
1 0
Figure 5: Implications of a Decrease in Tobin’s q
• Output has decreased,
• Interest rate has decreased.
9

q ↓ ⇒ I ↓ ⇒ Excess supply ⇒ Y ↓,
• TR curve and IS curve (Point B ⇒ Point C):

Y −Ȳ
Y ↓ ⇒ Ȳ
↓ ⇒ Optimal interest rate ↓ ⇒ i ↓
⇒ I ↑ ⇒ Excess demand ⇒ Y ↑ ⇒ ......
STEP 3: Comparison of Results

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.
Answers to Exercise 3.6†

• 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.
STEP 1: The Effects of an Increase in Government Spending G under a Fixed Exchange Rate
System (Mundell-Fleming Model)
Initial Scenario
+ + + − + − + +
i = ī, (8)
Notation
†
10
Interest
Rate i
i0* IFM 0
IS 0
Y0* Output Y
Slope of the IS Curve Please see Exercise 3.5 for details.
Implications of an Increase in Government Spending

• 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.
• Output has increased,
11
Interest
Rate i
* A
i01
IFM 01
B
IS1
IS 0
Y *
Y* Output Y
0 1
Figure 7: Implications of an Increase in Government Spending
G ↑ ⇒ Excess demand ⇒ Y ↑,
M D ↑ ⇒ Excess demand ⇒ upward pressure on exchange rate St ⇒ M S ↑
STEP 2: The Effects of an Increase in Government Spending under a Taylor Rule (IS-TR Model)
Initial Scenario

+ + + − + − + +
i = ī + a (π − π̄) + b Y −
Ȳ
Ȳ
, (10)
where:
Notation
12
Interest
Rate i
TR0
i0* IFM 0
IS 0
Y0* Output Y
Slope of the TR Curve Please see Exercise 3.5 for details.
Implications of an Increase in Government Spending

• 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
TR01
i1 C
A
i0 IFM 01
B
IS1
IS 0
Y *
Y* Output Y
0 1
Figure 9: Implications of an Increase in Government Spending
13
• Interest rate has increased.

G ↑ ⇒ Excess demand ⇒ Y ↑,
• TR curve and IS curve (Point B ⇒ Point C):

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:
• 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 expansionary fiscal policy.
Answers to Exercise 3.7‡

• 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

+ + + − + − + +
i = ī, (12)

‡
14
Notation
Interest
Rate i
i0* IFM 0
IS 0
Y * Output Y
0
Implications of a Decrease in the Foreign Interest Rate

• 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
Interest
Rate i
A
i0* IFM 0
i1* IFM 1
B C
IS01
Y *
Y * Output Y
0 1
Figure 11: Implications of a Decrease in the Foreign Interest Rate
• Interest rate has decreased.
• IFM line (Point A ⇒ Point B):
ī ↓ ⇒ Agents buy domestiv bonds ⇒ Bond prices ↑ ⇒ i ↓
• IS curve (Point B ⇒ Point C):
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

+ + + − + − + +
i = ī + a (π − π̄) + b Y −
Ȳ
Ȳ
, (14)
where:
Notation
16
Interest
Rate i
TR0
i0* IFM 0
IS 0
Y0* Output Y
Slope of the TR Curve Please see Exercise 3.5 for details.
Implications of a Decrease in the Foreign Interest Rate

• 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.
• Output has not changed,

A comparison of the results suggests that the effect of the decrease in the foreign interest rate on:
• 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
Interest
Rate i
TR01
*
i01
IFM 0
IFM 1
IS01
Y0* 1 Output Y
Figure 13: Implications of a Decrease in the Foreign Interest Rate
Answers to Exercise 3.8§

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

+ + + − + − + +
i = ī, (16)
Notation
§
18
Interest
Rate i
i0* IFM 0
IS 0
Y * Output Y
0
Implications of a Decrease in the Real Exchange Rate

• 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.

σ ↑ ⇒ X ↑, Z ↓ ⇒ Excess demand ⇒ Y ↑,

M D ↑ ⇒ Excess demand ⇒ upward pressure on exchange rate St ⇒ M S ↑
19
Interest
Rate i
* A
i01
IFM 01
B
IS1
IS 0
Y0* Y * Output Y
1
Figure 15: Implications of a Decrease in the Real Exchange Rate
20

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Second Semester 2016/17 Coventry University

The Mundell-Fleming Model (Part 1)

a. Nominal exchange rate,

b. Real exchange rate,

c. Fixed exchange rate regime,

d. Flexible exchange rate regime.

a. Provide a verbal and a formal definition of the IFM line.

Exercise 3.5 (Essay)

Exercise 3.6 (Essay)

Exercise 3.7 (Essay)

Exercise 3.8 (Essay)

Answers to Exercise 3.1

Answers to Exercise 3.2

Figure 1: IFM Line

Answers to Exercise 3.3

Answers to Exercise 3.4

Answers to Exercise 3.5∗

Y = C(Ω,Y − T ) + I(q , i ) + G + X(A∗ , σ ) − Z(A, σ ), (3)

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

Figure 2: Initial Scenario

,→ Investment I will decrease.

,→ Demand for goods will decrease.

,→ There will be excess supply.

Implications of a Decrease in Tobin’s q

,→ Investment I will decrease,

Figure 3: Implications of a Decrease in Tobin’s q

• Output has decreased,

• Interest rate has not changed.

Economic Dynamics The underlying economics dynamics can be summarised as follows:

• Money market / foreign exchange market (Point B ⇒ Point B):

M D ↓ ⇒ Excess supply ⇒ downward pressure on exchange rate St ⇒ M S ↓

Y = C(Ω,Y − T ) + I(q , i ) + G + X(A∗ , σ ) − Z(A, σ ), (5)

• the second equation reflects the Taylor rule (TR curve).

Figure 4: Initial Scenario

Slope of the IS Curve Please see the discussion above.

,→ The optimal interest rate will increase.

Implications of a Decrease in Tobin’s q

Figure 5: Implications of a Decrease in Tobin’s q

• Output has decreased,

• Interest rate has decreased.

Economic Dynamics The underlying economics dynamics can be summarised as follows:

• TR curve and IS curve (Point B ⇒ Point C):

STEP 3: Comparison of Results

Answers to Exercise 3.6†

Figure 6: Initial Scenario

Slope of the IS Curve Please see Exercise 3.5 for details.

Implications of an Increase in Government Spending

• Output has increased,

• Interest rate has not changed.

Figure 7: Implications of an Increase in Government Spending

Economic Dynamics The underlying economics dynamics can be summarised as follows:

• IS curve (Point A ⇒ Point B):

• Money market / foreign exchange market (Point B ⇒ Point B):

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

Y = C(Ω,Y − T ) + I(q , i ) + G + X(A∗ , σ ) − Z(A, σ ), (9)

• the second equation reflects the Taylor rule (TR curve).

Figure 8: Initial Scenario

Slope of the IS Curve Please see Exercise 3.5 for details.

Slope of the TR Curve Please see Exercise 3.5 for details.

Implications of an Increase in Government Spending

Figure 9: Implications of an Increase in Government Spending

• Interest rate has increased.

Economic Dynamics The underlying economics dynamics can be summarised as follows:

• TR curve and IS curve (Point B ⇒ Point C):