
- •About the author
- •Brief Contents
- •Contents
- •Preface
- •This Book’s Approach
- •What’s New in the Seventh Edition?
- •The Arrangement of Topics
- •Part One, Introduction
- •Part Two, Classical Theory: The Economy in the Long Run
- •Part Three, Growth Theory: The Economy in the Very Long Run
- •Part Four, Business Cycle Theory: The Economy in the Short Run
- •Part Five, Macroeconomic Policy Debates
- •Part Six, More on the Microeconomics Behind Macroeconomics
- •Epilogue
- •Alternative Routes Through the Text
- •Learning Tools
- •Case Studies
- •FYI Boxes
- •Graphs
- •Mathematical Notes
- •Chapter Summaries
- •Key Concepts
- •Questions for Review
- •Problems and Applications
- •Chapter Appendices
- •Glossary
- •Translations
- •Acknowledgments
- •Supplements and Media
- •For Instructors
- •Instructor’s Resources
- •Solutions Manual
- •Test Bank
- •PowerPoint Slides
- •For Students
- •Student Guide and Workbook
- •Online Offerings
- •EconPortal, Available Spring 2010
- •eBook
- •WebCT
- •BlackBoard
- •Additional Offerings
- •i-clicker
- •The Wall Street Journal Edition
- •Financial Times Edition
- •Dismal Scientist
- •1-1: What Macroeconomists Study
- •1-2: How Economists Think
- •Theory as Model Building
- •The Use of Multiple Models
- •Prices: Flexible Versus Sticky
- •Microeconomic Thinking and Macroeconomic Models
- •1-3: How This Book Proceeds
- •Income, Expenditure, and the Circular Flow
- •Rules for Computing GDP
- •Real GDP Versus Nominal GDP
- •The GDP Deflator
- •Chain-Weighted Measures of Real GDP
- •The Components of Expenditure
- •Other Measures of Income
- •Seasonal Adjustment
- •The Price of a Basket of Goods
- •The CPI Versus the GDP Deflator
- •The Household Survey
- •The Establishment Survey
- •The Factors of Production
- •The Production Function
- •The Supply of Goods and Services
- •3-2: How Is National Income Distributed to the Factors of Production?
- •Factor Prices
- •The Decisions Facing the Competitive Firm
- •The Firm’s Demand for Factors
- •The Division of National Income
- •The Cobb–Douglas Production Function
- •Consumption
- •Investment
- •Government Purchases
- •Changes in Saving: The Effects of Fiscal Policy
- •Changes in Investment Demand
- •3-5: Conclusion
- •4-1: What Is Money?
- •The Functions of Money
- •The Types of Money
- •The Development of Fiat Money
- •How the Quantity of Money Is Controlled
- •How the Quantity of Money Is Measured
- •4-2: The Quantity Theory of Money
- •Transactions and the Quantity Equation
- •From Transactions to Income
- •The Assumption of Constant Velocity
- •Money, Prices, and Inflation
- •4-4: Inflation and Interest Rates
- •Two Interest Rates: Real and Nominal
- •The Fisher Effect
- •Two Real Interest Rates: Ex Ante and Ex Post
- •The Cost of Holding Money
- •Future Money and Current Prices
- •4-6: The Social Costs of Inflation
- •The Layman’s View and the Classical Response
- •The Costs of Expected Inflation
- •The Costs of Unexpected Inflation
- •One Benefit of Inflation
- •4-7: Hyperinflation
- •The Costs of Hyperinflation
- •The Causes of Hyperinflation
- •4-8: Conclusion: The Classical Dichotomy
- •The Role of Net Exports
- •International Capital Flows and the Trade Balance
- •International Flows of Goods and Capital: An Example
- •Capital Mobility and the World Interest Rate
- •Why Assume a Small Open Economy?
- •The Model
- •How Policies Influence the Trade Balance
- •Evaluating Economic Policy
- •Nominal and Real Exchange Rates
- •The Real Exchange Rate and the Trade Balance
- •The Determinants of the Real Exchange Rate
- •How Policies Influence the Real Exchange Rate
- •The Effects of Trade Policies
- •The Special Case of Purchasing-Power Parity
- •Net Capital Outflow
- •The Model
- •Policies in the Large Open Economy
- •Conclusion
- •Causes of Frictional Unemployment
- •Public Policy and Frictional Unemployment
- •Minimum-Wage Laws
- •Unions and Collective Bargaining
- •Efficiency Wages
- •The Duration of Unemployment
- •Trends in Unemployment
- •Transitions Into and Out of the Labor Force
- •6-5: Labor-Market Experience: Europe
- •The Rise in European Unemployment
- •Unemployment Variation Within Europe
- •The Rise of European Leisure
- •6-6: Conclusion
- •7-1: The Accumulation of Capital
- •The Supply and Demand for Goods
- •Growth in the Capital Stock and the Steady State
- •Approaching the Steady State: A Numerical Example
- •How Saving Affects Growth
- •7-2: The Golden Rule Level of Capital
- •Comparing Steady States
- •The Transition to the Golden Rule Steady State
- •7-3: Population Growth
- •The Steady State With Population Growth
- •The Effects of Population Growth
- •Alternative Perspectives on Population Growth
- •7-4: Conclusion
- •The Efficiency of Labor
- •The Steady State With Technological Progress
- •The Effects of Technological Progress
- •Balanced Growth
- •Convergence
- •Factor Accumulation Versus Production Efficiency
- •8-3: Policies to Promote Growth
- •Evaluating the Rate of Saving
- •Changing the Rate of Saving
- •Allocating the Economy’s Investment
- •Establishing the Right Institutions
- •Encouraging Technological Progress
- •The Basic Model
- •A Two-Sector Model
- •The Microeconomics of Research and Development
- •The Process of Creative Destruction
- •8-5: Conclusion
- •Increases in the Factors of Production
- •Technological Progress
- •The Sources of Growth in the United States
- •The Solow Residual in the Short Run
- •9-1: The Facts About the Business Cycle
- •GDP and Its Components
- •Unemployment and Okun’s Law
- •Leading Economic Indicators
- •9-2: Time Horizons in Macroeconomics
- •How the Short Run and Long Run Differ
- •9-3: Aggregate Demand
- •The Quantity Equation as Aggregate Demand
- •Why the Aggregate Demand Curve Slopes Downward
- •Shifts in the Aggregate Demand Curve
- •9-4: Aggregate Supply
- •The Long Run: The Vertical Aggregate Supply Curve
- •From the Short Run to the Long Run
- •9-5: Stabilization Policy
- •Shocks to Aggregate Demand
- •Shocks to Aggregate Supply
- •10-1: The Goods Market and the IS Curve
- •The Keynesian Cross
- •The Interest Rate, Investment, and the IS Curve
- •How Fiscal Policy Shifts the IS Curve
- •10-2: The Money Market and the LM Curve
- •The Theory of Liquidity Preference
- •Income, Money Demand, and the LM Curve
- •How Monetary Policy Shifts the LM Curve
- •Shocks in the IS–LM Model
- •From the IS–LM Model to the Aggregate Demand Curve
- •The IS–LM Model in the Short Run and Long Run
- •11-3: The Great Depression
- •The Spending Hypothesis: Shocks to the IS Curve
- •The Money Hypothesis: A Shock to the LM Curve
- •Could the Depression Happen Again?
- •11-4: Conclusion
- •12-1: The Mundell–Fleming Model
- •The Goods Market and the IS* Curve
- •The Money Market and the LM* Curve
- •Putting the Pieces Together
- •Fiscal Policy
- •Monetary Policy
- •Trade Policy
- •How a Fixed-Exchange-Rate System Works
- •Fiscal Policy
- •Monetary Policy
- •Trade Policy
- •Policy in the Mundell–Fleming Model: A Summary
- •12-4: Interest Rate Differentials
- •Country Risk and Exchange-Rate Expectations
- •Differentials in the Mundell–Fleming Model
- •Pros and Cons of Different Exchange-Rate Systems
- •The Impossible Trinity
- •12-6: From the Short Run to the Long Run: The Mundell–Fleming Model With a Changing Price Level
- •12-7: A Concluding Reminder
- •Fiscal Policy
- •Monetary Policy
- •A Rule of Thumb
- •The Sticky-Price Model
- •Implications
- •Adaptive Expectations and Inflation Inertia
- •Two Causes of Rising and Falling Inflation
- •Disinflation and the Sacrifice Ratio
- •13-3: Conclusion
- •14-1: Elements of the Model
- •Output: The Demand for Goods and Services
- •The Real Interest Rate: The Fisher Equation
- •Inflation: The Phillips Curve
- •Expected Inflation: Adaptive Expectations
- •The Nominal Interest Rate: The Monetary-Policy Rule
- •14-2: Solving the Model
- •The Long-Run Equilibrium
- •The Dynamic Aggregate Supply Curve
- •The Dynamic Aggregate Demand Curve
- •The Short-Run Equilibrium
- •14-3: Using the Model
- •Long-Run Growth
- •A Shock to Aggregate Supply
- •A Shock to Aggregate Demand
- •A Shift in Monetary Policy
- •The Taylor Principle
- •14-5: Conclusion: Toward DSGE Models
- •15-1: Should Policy Be Active or Passive?
- •Lags in the Implementation and Effects of Policies
- •The Difficult Job of Economic Forecasting
- •Ignorance, Expectations, and the Lucas Critique
- •The Historical Record
- •Distrust of Policymakers and the Political Process
- •The Time Inconsistency of Discretionary Policy
- •Rules for Monetary Policy
- •16-1: The Size of the Government Debt
- •16-2: Problems in Measurement
- •Measurement Problem 1: Inflation
- •Measurement Problem 2: Capital Assets
- •Measurement Problem 3: Uncounted Liabilities
- •Measurement Problem 4: The Business Cycle
- •Summing Up
- •The Basic Logic of Ricardian Equivalence
- •Consumers and Future Taxes
- •Making a Choice
- •16-5: Other Perspectives on Government Debt
- •Balanced Budgets Versus Optimal Fiscal Policy
- •Fiscal Effects on Monetary Policy
- •Debt and the Political Process
- •International Dimensions
- •16-6: Conclusion
- •Keynes’s Conjectures
- •The Early Empirical Successes
- •The Intertemporal Budget Constraint
- •Consumer Preferences
- •Optimization
- •How Changes in Income Affect Consumption
- •Constraints on Borrowing
- •The Hypothesis
- •Implications
- •The Hypothesis
- •Implications
- •The Hypothesis
- •Implications
- •17-7: Conclusion
- •18-1: Business Fixed Investment
- •The Rental Price of Capital
- •The Cost of Capital
- •The Determinants of Investment
- •Taxes and Investment
- •The Stock Market and Tobin’s q
- •Financing Constraints
- •Banking Crises and Credit Crunches
- •18-2: Residential Investment
- •The Stock Equilibrium and the Flow Supply
- •Changes in Housing Demand
- •18-3: Inventory Investment
- •Reasons for Holding Inventories
- •18-4: Conclusion
- •19-1: Money Supply
- •100-Percent-Reserve Banking
- •Fractional-Reserve Banking
- •A Model of the Money Supply
- •The Three Instruments of Monetary Policy
- •Bank Capital, Leverage, and Capital Requirements
- •19-2: Money Demand
- •Portfolio Theories of Money Demand
- •Transactions Theories of Money Demand
- •The Baumol–Tobin Model of Cash Management
- •19-3 Conclusion
- •Lesson 2: In the short run, aggregate demand influences the amount of goods and services that a country produces.
- •Question 1: How should policymakers try to promote growth in the economy’s natural level of output?
- •Question 2: Should policymakers try to stabilize the economy?
- •Question 3: How costly is inflation, and how costly is reducing inflation?
- •Question 4: How big a problem are government budget deficits?
- •Conclusion
- •Glossary
- •Index

340 | P A R T I V Business Cycle Theory: The Economy in the Short Run
Mundell–Fleming model assumes an open economy. The Mundell–Fleming model extends the short-run model of national income from Chapters 10 and 11 by including the effects of international trade and finance discussed in Chapter 5.
The Mundell–Fleming model makes one important and extreme assumption: it assumes that the economy being studied is a small open economy with perfect capital mobility. That is, the economy can borrow or lend as much as it wants in world financial markets and, as a result, the economy’s interest rate is determined by the world interest rate. Here is how Mundell himself, in his original 1963 article, explained why he made this assumption:
In order to present my conclusions in the simplest possible way and to bring the implications for policy into sharpest relief, I assume the extreme degree of mobility that prevails when a country cannot maintain an interest rate different from the general level prevailing abroad. This assumption will overstate the case but it has the merit of posing a stereotype towards which international financial relations seem to be heading. At the same time it might be argued that the assumption is not far from the truth in those financial centers, of which Zurich, Amsterdam, and Brussels may be taken as examples, where the authorities already recognize their lessening ability to dominate money market conditions and insulate them from foreign influences. It should also have a high degree of relevance to a country like Canada whose financial markets are dominated to a great degree by the vast New York market.
As we will see, Mundell’s assumption of a small open economy with perfect capital mobility will prove useful in developing a tractable and illuminating model.2 One lesson from the Mundell–Fleming model is that the behavior of an economy depends on the exchange-rate system it has adopted. Indeed, the model was first developed in large part to understand how alternative exchange-rate regimes work and how the choice of exchange-rate regime impinges on monetary and fiscal policy. We begin by assuming that the economy operates with a floating exchange rate. That is, we assume that the central bank allows the exchange rate to adjust to changing economic conditions. We then examine how the economy operates under a fixed exchange rate. After developing the model, we will be in a position to address
an important policy question: what exchange-rate system should a nation adopt?
12-1 The Mundell–Fleming Model
In this section we construct the Mundell–Fleming model, and in the following sections we use the model to examine the impact of various policies. As you will see, the Mundell–Fleming model is built from components we have used in previous chapters. But these pieces are put together in a new way to address a new set of questions.
2 This assumption—and thus the Mundell–Fleming model—does not apply exactly to a large open economy such as that of the United States. In the conclusion to this chapter (and more fully in the appendix), we consider what happens in the more complex case in which international capital mobility is less than perfect or a nation is so large that it can influence world financial markets.
C H A P T E R 1 2 The Open Economy Revisited: The Mundell-Fleming Model and the Exchange-Rate Regime | 341
The Key Assumption: Small Open Economy
With Perfect Capital Mobility
Let’s begin with the assumption of a small open economy with perfect capital mobility. As we saw in Chapter 5, this assumption means that the interest rate in this economy r is determined by the world interest rate r*. Mathematically, we can write this assumption as
r = r *.
This world interest rate is assumed to be exogenously fixed because the economy is sufficiently small relative to the world economy that it can borrow or lend as much as it wants in world financial markets without affecting the world interest rate.
Although the idea of perfect capital mobility is expressed with a simple equation, it is important not to lose sight of the sophisticated process that this equation represents. Imagine that some event occurred that would normally raise the interest rate (such as a decline in domestic saving). In a small open economy, the domestic interest rate might rise by a little bit for a short time, but as soon as it did, foreigners would see the higher interest rate and start lending to this country (by, for instance, buying this country’s bonds). The capital inflow would drive the domestic interest rate back toward r*. Similarly, if any event started to drive the domestic interest rate downward, capital would flow out of the country to earn a higher return abroad, and this capital outflow would drive the domestic interest rate back up to r*. Hence, the r = r* equation represents the assumption that the international flow of capital is rapid enough to keep the domestic interest rate equal to the world interest rate.
The Goods Market and the IS* Curve
The Mundell–Fleming model describes the market for goods and services much as the IS–LM model does, but it adds a new term for net exports. In particular, the goods market is represented with the following equation:
Y = C(Y – T ) + I(r) + G + NX(e).
This equation states that aggregate income Y is the sum of consumption C, investment I, government purchases G, and net exports NX. Consumption depends positively on disposable income Y − T. Investment depends negatively on the interest rate. Net exports depend negatively on the exchange rate e. As before, we define the exchange rate e as the amount of foreign currency per unit of domestic currency—for example, e might be 100 yen per dollar.
You may recall that in Chapter 5 we related net exports to the real exchange rate (the relative price of goods at home and abroad) rather than the nominal exchange rate (the relative price of domestic and foreign currencies). If e is the nominal exchange rate, then the real exchange rate e equals eP/P*, where P is the domestic price level and P* is the foreign price level. The Mundell–Fleming model, however, assumes that the price levels at home and abroad are fixed, so the real exchange rate is proportional to the nominal exchange rate. That is, when the domestic currency appreciates (and the nominal exchange rate rises from, say, 100 to 120 yen per dollar), foreign goods

342 | P A R T I V Business Cycle Theory: The Economy in the Short Run
become cheaper compared to domestic goods, and this causes exports to fall and imports to rise.
The goods-market equilibrium condition above has two financial variables affecting expenditure on goods and services (the interest rate and the exchange rate), but the situation can be simplified using the assumption of perfect capital mobility, so r = r*. We obtain
Y = C(Y − T ) + I(r *) + G + NX(e).
Let’s call this the IS* equation. (The asterisk reminds us that the equation holds the interest rate constant at the world interest rate r*.) We can illustrate this equation on a graph in which income is on the horizontal axis and the exchange rate is on the vertical axis. This curve is shown in panel (c) of Figure 12-1.
FIGURE 12-1
The IS* Curve The IS* curve is derived from the net-exports schedule and the Keynesian cross. Panel
(a) shows the net-exports schedule: an increase in the exchange rate from e1 to e2 lowers net exports from NX(e1) to NX(e2). Panel (b) shows the Keynesian cross: a decrease in net exports from NX(e1) to NX(e2) shifts the planned-expenditure schedule downward and reduces income from Y1 to Y2. Panel (c) shows the IS* curve summarizing this relationship between the exchange rate and income: the higher the exchange rate, the lower the level of income.
Exchange rate, e
1. An |
e2 |
increase in |
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the exchange |
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rate ... |
e1 |
2. ... lowers
net exports, ...
(a) The Net-Exports Schedule
NX
NX(e2) NX(e1) Net exports,
NX
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(b) The Keynesian Cross |
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Expenditure |
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Actual |
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3. ... which |
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expenditure |
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shifts planned |
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expenditure |
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downward ... |
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NX |
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Planned |
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expenditure |
4. ... and |
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lowers |
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income. |
45° |
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Y2 |
Y1 |
Income, |
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output, Y |
Exchange rate, e
e2
e1
(c)The IS* Curve
5.The IS* curve summarizes these changes in the goodsmarket equilibrium.
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IS* |
Y2 |
Y1 |
Income, |
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output, Y |
C H A P T E R 1 2 The Open Economy Revisited: The Mundell-Fleming Model and the Exchange-Rate Regime | 343
The IS* curve slopes downward because a higher exchange rate reduces net exports, which in turn lowers aggregate income. To show how this works, the other panels of Figure 12-1 combine the net-exports schedule and the Keynesian cross to derive the IS* curve. In panel (a), an increase in the exchange rate from e1 to e2 lowers net exports from NX(e1) to NX(e2). In panel (b), the reduction in net exports shifts the planned-expenditure schedule downward and thus lowers income from Y1 to Y2. The IS* curve summarizes this relationship between the exchange rate e and income Y.
The Money Market and the LM* Curve
The Mundell–Fleming model represents the money market with an equation that should be familiar from the IS–LM model:
M/P = L(r, Y ).
This equation states that the supply of real money balances M/P equals the demand L(r, Y ). The demand for real balances depends negatively on the interest rate and positively on income Y. The money supply M is an exogenous variable controlled by the central bank, and because the Mundell–Fleming model is designed to analyze short-run fluctuations, the price level P is also assumed to be exogenously fixed.
Once again, we add the assumption that the domestic interest rate equals the world interest rate, so r = r*:
M/P = L(r*, Y ).
Let’s call this the LM* equation. We can represent it graphically with a vertical line, as in panel (b) of Figure 12-2. The LM* curve is vertical because the exchange rate does not enter into the LM* equation. Given the world interest rate, the LM* equation determines aggregate income, regardless of the exchange rate. Figure 12-2 shows how the LM* curve arises from the world interest rate and the LM curve, which relates the interest rate and income.
Putting the Pieces Together
According to the Mundell–Fleming model, a small open economy with perfect capital mobility can be described by two equations:
Y = C(Y − T ) + I(r*) + G + NX(e) |
IS*, |
M/P = L(r*, Y ) |
LM*. |
The first equation describes equilibrium in the goods market; the second describes equilibrium in the money market. The exogenous variables are

344 | P A R T I V Business Cycle Theory: The Economy in the Short Run
FIGURE 12-2
(a) The LM Curve
Interest rate, r
LM
1. The money market equilibrium condition ...
r r*
2. ... and the world
interest rate ...
The LM* Curve Panel (a) shows the standard LM curve [which graphs the equation M/P = L(r, Y)] together with a horizontal line representing the world interest rate r *. The intersection of these two curves determines the level of income, regardless of the exchange rate. Therefore, as panel (b) shows, the LM* curve is vertical.
Income, output, Y
(b) The LM* Curve
Exchange rate, e
LM*
3. ... determine the level of income.
Income, output, Y
fiscal policy G and T, monetary policy M, the price level P, and the world interest rate r*. The endogenous variables are income Y and the exchange rate e.
Figure 12-3 illustrates these two relationships. The equilibrium for the economy is found where the IS* curve and the LM * curve intersect. This intersection shows the exchange rate and the level of income at which the goods market and the money market are both in equilibrium. With this diagram, we can use the Mundell–Fleming model to show how aggregate income Y and the exchange rate e respond to changes in policy.