Mundell-Flemming model

Assumptions

Small open economy

Static model

Fixed Price

Demand for domestic goods equation

Net exports (NX) equation

3 channels Real ER (Q) affects NX

Real exchange rate

• Q increase → QIM rising → NX falls

Output in H

• Depreciation (Q increasing) → X increasing → NX increase

Output in F

• Q increases → M fall (QIM (Y, Q) term) → NX increase

Ambiguous effect as channels are both positive & negative

Marshall-Lerner condition

Depreciation of a currency leads to increasing net exports

• assume condition satisfied

When is Goods market in equilibrium

when Domestic output = Demand for domestic goods

• Y = Z

Demand for domestic goods and net exports - graph

DD =/ ZZ → includes F & H goods

• ZZ - Demand for dom (H) goods only

M an increasing function of Y so slope becomes flatter (DD -> AA) when taking M out and focusing on H goods

Including X shifts curve up as doesnt depend on Y (AA → ZZ)

NX = 0 when DD = ZZ

Goods market equilibrium graphically

Equilibrium can be in trade surplus or deficit

Y = Z in equilibrium

Effect of a real depreciation

Trade initially balanced

Q increases -> NX increase

• ML condition holds at any level of Y

Equilibrium moves from A -> A’

Trade balance improves (now in surplus)

J-curve

When Q increases (depreciation), it takes time for the quantity of imports and exports to adjust

• NX initially declines (Immediate fall in X value and rise in M value)

• Over time, X increases and M falls

• NX eventually exceeds the level before depreciation

  • People realise over time that in relative terms H goods are now cheaper

J-curve grpah

J-curve empirically

Real ER opposite way round in data

-              Appreciation is followed by an initial decrease in trade deficit

-              Followed by a lagged increase in deficit

Opposite for depreciation

Real depreciation equation

Q = SP* / P

• increases