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by: Ms. Ari Lesch


Marketplace > Iowa State University > Economcs > ECON 302 > INTERMED MACROECON
Ms. Ari Lesch
GPA 3.53


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This 38 page Class Notes was uploaded by Ms. Ari Lesch on Saturday September 26, 2015. The Class Notes belongs to ECON 302 at Iowa State University taught by Staff in Fall. Since its upload, it has received 7 views. For similar materials see /class/214444/econ-302-iowa-state-university in Economcs at Iowa State University.




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Date Created: 09/26/15
k quot quot 7 1 5 Vhw 4 k f 3910 LVIHIJ I39m 9 Bun CHI 1 u qu 3amp4 W um 2M Nth 6 39 Poul F V bquotuquot b 3f 3914 GM cquot W Lu Bf 2a 0 oksw wkd 144quot f 0 MM rm nun NH Acgto a 6L 5 dhrrlu39LlI o w k new arua HJu w have I b p CAIV39M G 0 TL 4n hit M 52 9 g39tirarf lte H 5 quot 99 g Mtg obtrup L 77 r r r T 7Trj 7TAM wz gw Per ect capital mobisltimy implies that there is only one interest rate 39 balance of payments wiiil balance 7 lt9 iif At any other interest rate capitali pws are so large that the balance of payments cannot be zero We show this in Figureyby the line i if V V 6942 Lpewa o 86 v 1 o c arpvewate Sn A SfNAW 0 P Q ru I 39 quot7 7 V o I i caro gt Laf d iu 0 rv 77 quot 77 391 4 z c WWW 4 39 WW 7va W2 1 C 5 squot V VQ l h fIsn39 W m t m sk39gh m T a pg 444 r e f 23 c414 34 7 r W 39 Jagtune Ara2hr quot 39 eruu A M J s44 re o harm2 5 my Dw w Wquot U 0 k J f 7 5 bill 3294 but CLI Iu39t39 A Alba MR 6 14 MW 3 hau a king Um gawk quot 35 As Domestic interest rate T ksfka iaau CAPITAL MOBILITY One of the striking facts about the international economy is the high degree of integra tion or linkage among nancial or capital marketsthe markets in which bonds and stocks are traded In most industrial countries today there are no restrictions on holding assets abroad US residents or residents in Germany or the United Kingdom can hold their wealth either at home or abroad They therefore search around the world for the highest return adjusted for risk thereby linking yields in capital markets in different countries For example if rates in New York rose relative to those in Canada investors would turn to lending in New York while borrowers would turn to Toronto 39 With lending up in New York and borrowing up in Toronto yields would quickly fall into line In the simplest world in which exchange rates are fixed forever taxes are the same everywhere and foreign asset holders never face political risks nationalization restrictions on transfer of assets default y foreign governments we would expect all asset holders to pick the asset that has the highest return That would force asset returns into strict equality everywhere in the world capital markets because no country could borrow for less E4 E3 Surplus Surplus unemployment overemployment r BP 0 k E1 E3 Deficit Deficit unemployment ovorempioymcnt Yquot Y Domestic income output a schedule is therefore the vertical line at Y Along BP 0 the balance of payments is ill equilibrium Points above the BP schedule correspond to surpluses and points below to deficits in the balance of payments With perfect capital mobility the balance of payments can be in equilibrium only when home interest rates equal those abroad Thus BP 0 is flat at the level of world interest rates quotclue L aquot 39039quot a New Erines 3 as ea W w gr 3 r I ivy W W 39 i rg 7 o 1quot150 4 55 VivWhat wwwwl 393 quotWIJC J39cuv C e 11 cu L f 1 b3 393 quot SJ 7 739 E Jo t of w iq yfgm o SLNCurvu 14 4 sv39 hlfeht uagf 9L wc a L ckh Q lat39nug Yey ex hmuC Laban B0 a ct 711 447 a And 55 c 0e can an 5 g 6 a39fv 39x 39 139 Q o if L D Cotex K 7 r Quaen s 2 e and 5 c 21 7quot 4 09quot 1quot yquot e gag az T T 4 I t 5 THE MUNDELLFLm quot UNDER FIXED EXW We are now ready to extend the analysis of n eterrnination to the open economy with perfect capital mobility In this section we assume the exchan e rate is xed In the next section we consider output determination with ICXI e exchange rates The analysis extending themonomy under perfect capital mobility has a special name the MnndellFleming model Robert Mun dell now a pro essor at Columbia University and the late Marcus Fleming who was a researcher at the International Monetary Fund developed this analysis in the 19605 welll be ore exible exchange rates came into operation10 Although la er research has re ned their analysis the initial Mundell Fleming formulation shown here remains essentially intact as a way of understanding how policies work under high capital mobility Under perfect capital mobility the slightest interest differential provokes unite ca ital mobilit central banks cannot c gluct e rates To see why suppose a conntry wishes to raise interest rates It tightens monetary policy and interest rates rise Immediately portfolio holders worldwide shilit their wealth to take advantage of the new rate As a result of the huge capital in ow the balance of payments shows a gigantic surplus foreigners try to buy domestic assets tending to cause the exchange rate to appreciate and forcing the cenmrall bank to intervene to hold the exchange rate constant It buys the foreign money in exchange for domestic money This intervention causes the home money shock to increase As a result the initial monetary contraction is reversed The process comes to an end when home interest rates have been pushed back down to the initial level The conclusion is Under xed exchange rates and perfect capital mobility a country cannot pursue an independent monetary policy Interest rates cannot move out of line with those prevailing in the world market Any attempt at independent monetary policy leads to capital ows and a need to intervene until interest rolls are back in line with those in the world market 39 Table shows the steps in the argument The commitment to a xed rate involves step 5 With the exchange rate tending to appreciate because foreigners are trying to buy the domestic currency the central bank has to provide the domestic currency Just as in an open market operation the central bank buys and sells bonds for money so in intervention in the foreign exchange market the monetary authority buys and sells oreisgn money yen EM or Canadian dollars for domestic money Thus the money supply is linked to the balance of payments Surp luses imply automatic monetary expansion de cits imply monetary contraction TABLE 39 PAYMENTS IMBALANCES INTERVENTION AND THE MONEY SUPPLY WITH FIXED EXCHANGE RATES AND PERFECT CAPITAL MOBILITY A Tightening of money Increased interest rates Capital inflow payments surplus Pressure for currency appreciation Intervention by selling home money and buying foreign money Monetary expansion clue Iu intervention lowers interest rate Back to initial interest rates money stock and payments balance Spl ni WNr CH 4 z e 39 3 SGUW39M F L BMW IcLZLft thT o 39 Avquot UN39FU u PMW S 3 frd xn for 639L 131 5 all wx39IL 3 MN ftLQLa rLfe it l qu 0an h Loin n9 o u urdu be MUHu u Law thug run at E H F dml Raidw Mud 1 ng 2M4Lquotj L G a 5 RN MN Naif chitau tL Mawquot quot4 J may 3 3k MMJquot W 26 blquot aakJ dM MM vbv In C a 3939J 4quot 3 3 g 94 SM gg ng s r 1 E6 5 e Q56 VIWM V l rlf hyj z g P quota N4quot b ML 1 quot a 3 GILL Hl39c C9quotvw fuch GavHA MQLJV quot 63 C fund Ha WJM I M Maude of lewr wwl39 mukm m NFJ39 01 Islnacp raJg v Q y is by contrast t e 139 i1quot elbutwedo not draw the diagram leav39 that or one of the end ofChmpter problems With the money surly inntiwlly unchanged at rsch expansion moves the IS curve up and to the right tending to increase both the interest rate and the level of output higher interest rate sets o f a capital in ow that would lead the exchange rate to appreciate To maintain ln exchan e rate the central bank has to expand the money suggly thus increasing income untlher EquililbmgWy supply has increased anth to diFLVC e interest rate back to its original level i if In this case with an endogenous money supply the interest rate is effectively xed and the simple Keynesian multiplier of Chapter applies for a scal expansion Col l39 by a a In eDOOOOQOOOOIOO 00000 1311 L 39 I I I c 3 Itit39Icl quotklNH rsth M I w 4 I 920 It i worthwhile looking at this point in terms of the open econom model In Figurems we show the IS and LM schedules as well as the BP 0 scheule which now because of perfect capital mobility is a horizontal line Only at a level of interest rates equal t0 abroad t if can the 00mm y have payments balance At any other interest rate capital ows are so massiNe that the balance of payments cannot be in equilibrium and the central bank has to intervene to maintain the exchange rate This intervention shifts the LM Consider speci cally a monetary expansion that starts from point E The LM schedule shifts down and to the right and the economy moves to point E But at E there is a large payments de cit and hence pressure for the exchange rate to depreciate The central bank must intervene selling foreign money and receiving domestic money in exchange The supply of domestic money therefore declines As a result the LM schedule shifts back up and to the left The process continues until the iminiail equilibrium at E is restored Indeed with perfect capital mobility the economy never even gets to point E39 l H 1 The response of capital ows is so large and rapid that the central bank is orcod to reverse the initial expansion of the money stock as soon as it mnemmis it Conversely any attempt to contract the money stock would immediately lead to vast neserve ms forcing an expansion of the money stock and a return to the initial equilihnium amp INTERNATIONAL LINKAGES i 33 orquot a a 39 LIV o dud 6 r 4 4 not FIGURE t quot PITAL MONETARY EXPANSION UNDER FlXED RATES AND PERFECT CA MOBlLlTY Under perfect capital mobility the balance of payments J 3 can bet in equilibrium only at the interest rate i i At even slightly higher rates there are massive capital inflows at lower rates there I 4 J a are capital out ows A monetary expansion that cuts interest rates 3 to point E39 causes downward pressure on the exchange rate The 39 monetary authorities must intervene selling foreign exchange and 39 7 a buying domestic money until the LM schedule has shifted backto its initial position 39 lief tibial 39 ate 61312164 Oeu 16 i so 1 39 p com to maintain a re exc ange mite In squotthe money sto k endogenous because the central bank has to provide the oreign exchange or domestic money dam is demanded at the xed exchange rate This even when capital mobility is less than perfect the central bank has only limited atiilrity to change the money supply without having to worry about maintaining the exchange rate a we ma a tl4 Mania17 39 flan fe39jfld efc rein Insw 204132 7vue Monica MK Hyu xcquot lxc 4 34 W twa 5yuy iiua39LWrc39nm cnsx cxskwamp L mag Mgw FM 839 398 far 5 H JCV J A If MawA J 49 v v 5 1 V r h i a nk Luprahz glam mguw L puuahc aloe 5 ink at mue I LxIH gt 930 Ax lb r233 4 b r 325 of a a mhs nr ewi n Varar k my nfgf fw art 03 0 1 I Fvnvxro has rgmm E F L m M a i 3 Wm a a g a a mei L L w 11Ki 1 D A vra oanmxko a 036156 W er 1 mmemnmimm Lm U 25 THE EFFECTS OF MONETARY AND FlSCAIL POLICY UNDER PERFECT CAPITAL MOBlLITY xed miles MONETARY EXPANSION No output change reserve losses equal to money increase FISCAL EXPANSION Output expansion trade balance worsems flexible rates X Output expansion trade balance improves exchange depreciation No output change reduced net exports exchange appreciation CQXJL A 143 rd 39 H Jug 3345 Ave has by 39 Way themy 6L maaiu ni Q g z n prciu w flu Cf 1AA ram 0 v gt 99 52 9 mM 1amp7 Pml39gtf k 39 can mania O kwl39c W w U fuu wt aurm mkuurd o vafuh ui ow i Ikem 139 f b39eu Id Mae o fluvqu v39u rhyt NJ Meiem ul t o M t hn 9 Qt wv a u 1mm IL PL 0 H1 emu 393 It g 39XL KKOJQ rL o 53 2W FNAS 0 o A 45 M161 4 10 LA MM QKQM veg ee f v wi tswlv l 6 e i wvrr wx 0 E HP 2 0 E 3 E 0 Y Y Output FIGURE 7 CI 3941 AND FUR exeoeg s A rise in 3 e I ll la exc antae rate and interest rate at point E creates an excess demand for goods The IS schedule shifts out to 1339 and the new goods and money market equilibrium is at point P But at 5 our interest rate exceeds that abroad Capital will tend to flow into our country in response to the increased interest rate and the resulting balance of payments surplus leads to currency appreciation The appreciation means that we become less competitive The IS schedule starts shifting back as a result of the appreciation and the process continues until the initial equilibrium at E is reached In the end increased exports or a scal expansion do not change output They simply lead to Currency appreciation and thereby to an offsetting change in net exports flu 9 y Wt 36941551 duhde f mm brute en de all 3 ahamed quot Fiex vk g F b equot 239 EiaeglgRolicy f W We can extend the usefulness of this analysis by recognizing that it is valid for disturbances other than an increase in exports The same analysis applies to a fiscal expansion A tax cut or an increase in government spending would lead to an expansion H in demand in the same way as increased exports Again the tendency for interest rates k to rise leads to appreciation and thene ore to a fall in exports and increased imports r g There is accordingly complete crowding out here The crowding out takes place not as in Chapter because higher immenest rates reduce investment but because the L t exchange appreciation reduces met exports u no 39 real disturbances to demand do not aaf ect e eu sou he is eluic39mmmo 7 Aruex39le39rMes wi e ec 39 Ca139th ni lt1 lt W can dlfiiiquot 39 llsoii i i y caring a is expansin V I i quot With the results we derived for the xed rate case In the previous section we showed that With a xed exchange rate scal expansion under comdihiaons of capital mobility is highly e ecttive in raising equilibrium output For texilbtl39e rates by contrast a scal expansion does not change equilibrium output Instead it produces an o fsetting exchange rate apprecia tion and a shift in the composition of domestic demand toward foreign goods and away from domestic goods This analysis helps in understanding developments in the US economy in the early 1980s when a scal expansion was accompanied by a current account de cit L I P I 80quot6 4quot 13 as S anv39 ACT 4 i w 391 f mt quotw 497 3 2 quot t rq g h in but no 3 gawk I wczae AC 1 u o 0 4 MM he 4L5 SUN aux 391 VVi 1 idi wrwhN m gt J Mustmnt 23 gnome in the Money Stock P e V Rubs 55 was We turn next to analysis of a c ge in the money stock and show that it lends under exible exchange rates to an increase in income and a depreciation of the exchange rate The analysis uses We start from an initial position at point E and consider an increaSe the nominal quantity of money 1W Since prices are given we 39 have an increase in the real money stock M P At E there will be an excess supply of real balances To restore equilibrium intenest rates would have to be lower or income would have to be larger Accordingly the LM schedule shifts down and to the right to LM We ask once again Whether the economy is in equilibrium at point E At E goods and money markets are in equilibrium at the initial exchange rate but interest rates have fallen below the world levels Capital out ows there ore put pressure on the exchange rate leading to a depreciation The exohange depreciation caused by the and it communes doing so until exchange depreciation has raised demand and output to the level indicated by point F Only at Equot do we have goods and money market 1 CHAPTER 939 i E Mama rat 5 m I D H y Y gt PM fsE m THE MONEY STOCK A moneta gynfggzcmon o x EFFECTS OFQN quotmute to LM39 At point 539 the WMLM shim W taggers our interest rate is below rm of payments 0 markets 0 I quottat will tend to ow out the ban The 4 c gt Them03 and the exchange Vale depfmams39 goes m m mm Net exports tion means that we beco f e more m levitate night Wot deprecm f re the Swm shifts out a ch95 E west rise 132 rgrgcess comm we until m wdwrreci ln has 19 W shown Wuam39cepe 391 rates are again at the Wm a 14lth WO3913 7 mi39 Eli Lug higher level of income new gt w t lg 44M gm 24 3393 eHrultm ot A 0A In 9 AZ 1 M cwltle7 KZMMCvu 3A CZc39fg 06c galz N v a MIL 7 e 0 9 MawAu Ila30 Aru a 454 24144 0 kc 6 lc 4 e391 o wa Mme7 27quot JrnKx AAA l MM 9 I KHZ 145 ffIQ39AM W4 Ava om r 7 39 fe4 401793 1 tn 4w u in 39 9 i1 339 s mum r206 399 quotGibn L nu mm 4Y1 4 P 11 7quot CT OR oron lx tlg ls F 773 4 x I quot 0514va 77 ca39wt l J14 4wpf Yon ce 739r4 guy 0 u 39 39 A I r T01quot Mfrsnu 7m gt1 n quot4 H39 s W I 3 A twwm a o yz b ir o 39 9 pquot4 M H ttU39tby r 39can I 154 14 V 1 7W ok o 3 vJL V g I 5 V quot5 21 olty60 VQ 0 C av wvnrz g f6 LrJJ w 9 gt E Tlk L A H vyin bf lz li E 3 19 yoga WW t9 6 TWA i c4quotq gquot aq 0 arm Q98 f Helng 3 N I 111 fm Q9 032503 102303 AM Netscape WywnEcomngl A lcz 1 Ins Imc mannavuv m smsmhMQmamdsinm gt y wmon adaywlj95 9 1 i Cc Ac Are A Ctdsvcev C 39cg A Cud JKKEV a e am Au gukvl Gig S 3 75cc ak g 4 m m7 le 4 C4Av39ut o A I AJo ua CJA zfz Illa I gz Al 39 QWga f I L 7 Jtux 39 gov 754ml a has 7 7o 19 Utah 1 Mud yup 39F quotmam it T 0 quot 39h39 10 yaw quot 7 quot1357047quot 2quot VII 6 r9 W M J 50 cooLmvka v WMka 2 th OQLJ hi o A Jc faAhi br 8quot 4 Adan Ava 03939Ql I MK fa Com 839 1 Cu uksm o fund 6 yj c39JIL fayapuaid AmQ onth3997 um t IA Aref r4 5U Q 0 Gay 4 MM 3M0 t J 4 x37 4 2 c Ca39 J 7 gal a J d 39w 39 lt amp4 JfJvn pg lo C 39r c A 0 lax aw r 4 A 421 A 2A u 6 Calk ZMKA392 29 6 L ALk MZWA 6 WA w h U quotcLA fo QJ 4 15 2 L4 rr39 ev oq C 436 A6 67 A CUM4 fpf 7a4 N i 3939 2412 39vx 2 3 lt u wrfm 7 044XZ1 4w 44 quotQWHJ 95 A4mz aw 1L 7 NW OFAQJLX j KWC KC93w gA A 0 CU c cltul za ygM C Avac cl J uaJ gar gWm figa4 25 Z 2 a quot in ea AZ Ck ew 26c fec 4 4 Q til 1 6 Y H Ilsa yi39Kg c V 1 k 7 Cu 7 L 1 fay guyemu v 0 W111 yUbl O x Q a f an 6amp4 I w uf alum o e y C Q Vlad Ch tt39 0 I la cu In 4 ANV 3959 0 m w o 06v OVf A 0 4 ul gt uk 394 If alt N 4 e 39 Q 1 1quot 39 f g d dio yc tl lc Q39J39 quot3977quot y w Hut guLnrtF 19 mw s Xi fmsml NullMat f m1 But we Gu hl 5 43 ohi 2 f 9 I i w ohmnu 9 mm 4 54 buy f a b iS rm inns H u m sngqm ka Cn vd e u thw PQAW39I39N C v mph 3 3 a 82 3 nut gmkuy Mk Ht WM sway tel lyi La ye v f egg 6 ya ism ULS Fc 44 f khc u Azf m N Jv Eda gitIMP at 38 O k a39js Fad 11331 Cum K vn 1416 ght 39139 Vr nw 0Q5fci i W J M f h awv A Inf447 w rm 4 a 1 6520 5 ml w T 3 Mr W 4 gto 399 at E 0 CAI0 4 2 1 f U ANMltlt 5 n Ra LM quot9 M uk exh 1 been u R K39c u 44M vl le r an xdcglI 39 3141 r JJaaoe 39 I Ah fquotquot 4 39 eri uHI M 4444 cc C barNye 2 45 Jw v 300 Me 0 a a w gm bof b cb m39l hs CALgt0 URN MWW kw Felmka hu lulu Hm emu my W One of the striking facts about the intemationalr economy is the highdegree of integra tion or linkage wrong or wankers the whens in Wabath bonds and stocks are traded In most countries there are no restrainmittens onholdhmg assets US residents or residents in Germany or the Minimal Kingdoms can hold their wealth either as home or abroad 39Iney theretoue semen MW the 39 for the highest return adjusted for risk thereby linking yields in capital Was in different countries For example if rates in New York rose ne iatiime to these ma Canada investors would turn to lending in New York while owens would rum to fforonto 39 With lending up in New York and borrowing up in Toronto yields would quickly fall into line In the simplest world in which exchange rates are lmed oneuer taxes arethe same everywhere and foreign asset holders never face politicail rsiiSks inatnonalizauon restrictions on transfer of assets default risk by foreign govemmenmsm we lid expect all asset holders to pick the asset that has the highest seamen That weulld force asset returns into strict equality everywhere in the world capital markets because no country could borrow for less awash I ui E4 E 3 3 Surplus uquiluls g unemployment ouekaayment 6 S 2 E E 1 L BIP a 39 2 VD a E E1 E3 Q Deficit Melt unemploymnnc ommnnlwvyumluim o rquot 39 r Domestic income cum 0 39 t 3 A AND RB WM J mum 239 g g 391 em oyment IS 0 arm t nou u e e m schedule is therefore the vertical line at Y Along BP 2 0 the I balance of payments is in equilibrium Points above the 8P schedule a g correspond to surpluses and points below to deficits in the balance 39 I m g 9 of payments With perfect capital mobility the balance of payments can be in equilibrium only when home interest rates equal those abroad Thus 8P O is flat at the level of world interest rates Eritrea 3 but n it beans lass th M f Flaw f n u o 1quotuubi Inn 0 arzflu wc a wwl tquot Fm J39cuv Po w m bl bum r n o Ab 4 7 4 is aJ 3quotg7 in LIQM 0 Model 5Lquot Curvy 14 A E 39s bll ehhauagy 9L wm 9 f quotcth09 twain Yry u h qu Lula new A


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