Exchange rate determination and the Mundell-Fleming model


The open economy

So far, our model for exchange rate determination has been very simple. We have assumed that domestic interest rates are unaffected by foreign interest rates. We begin this chapter by looking more carefully at this assumption (the classical model of exchange rate determination). Then, a more realistic model of exchange rate determination is considered. Finally, we will discuss the Mundell-Fleming model (MF-model).

The MF model is a model for an open economy. Such models must consider the determination of the exchange rate and how the exchange rate affects imports and exports. They also typically assume that capital may move freely and that investments will flow to countries where the return is maximized.

The Mundell-Fleming model is probably the simplest among the many macroeconomic models of the open economy. The MF model is basically an extension of the neo-classical synthesis with a model for the exchange rate that allows for free capital flows.

The rest of the world as one country

Most of the open economy models treat the rest of the world as one country. Focus in these models is on aggregate exports and imports and we are less interested in which particular countries we trade with. The same argument applies to capital flows. In these models, the rest of the world will have a single currency that we call the foreign currency. Therefore, there are only two currencies (the foreign and the domestic) and a single exchange rate.

Exchange rate systems

For an open economy, the particular exchange rate system in use becomes important. In Chapter 2 we discussed some possible systems. In simple models, only two systems are considered: a floating or a fixed exchange rate.

• With a floating exchange rate, the exchange rate is determined as any price, that is, by supply and demand. The central bank never intervenes in the market.

• With a fixed exchange rate, the exchange is completely fixed. In reality, most countries with a fixed rate allow the exchange rate to vary within certain limits. These variations are disregarded and the central bank will always intervene to keep the exchange rate at its fixed value.

Also remember the following notation:

Changes in exchange rates.

Fig. 16.1: Changes in exchange rates.

The classical model of exchange rate determination

The classical model of exchange rate determination is the one we have used so far. This section will consider the foundations of this model.

The law of one price

The classical model for exchange rate determination is based on the law of one price. This law claims that there can be only one price for a given product at any given time. Gold, for example, must cost more or less the same wherever you buy it.

If gold was traded for USD 30,000 per kilo in New York and for USD 40,000 per kilo in Chicago, you would be able to make a lot of money by buying gold in New York and selling it in Chicago. There would be opportunities for arbitrage - opportunities to make money with no risk. Gold would be transported from New York to Chicago until the price difference was eliminated.

The law of one price need not apply exactly due to the following reasons.

Transportation costs: If the price difference is less than the cost of transport, the difference may remain.

Ease of access. A soda in a convenience store is often more expensive than in a super market. You pay slightly more for the convenience of the ease of access.

• Government intervention. The government may, for example, by subsidizing electricity for firms, create a market with two different prices for the same good.

For non-transportable goods and services, the price difference may be much larger. Even if the price of a haircut is much higher in Chicago than in Boise, Idaho, there are no strong arbitrage possibilities that will remove the price difference.

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