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## Exchange rate determination and the Mundell-Fleming model## Introduction## The open economySo 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 countryMost of the open economy models treat the rest of the world as one country. Focus in these models is on Therefore, there are only two currencies (the foreign and the domestic) and a single exchange rate.the foreign currency. ## Exchange rate systemsFor 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 • With a Also remember the following notation:
## The classical model of exchange rate determinationThe 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 priceThe classical model for exchange rate determination is based on 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 The law of one price need not apply exactly due to the following reasons. • • • Government intervention. The government may, for example, by subsidizing electricity for firms, create a market with two different prices for the same good. For |

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