(19) Et [E [Èt+1] | Èt+1]
Following the derivation used for the past data we can use the
same procedure to derive the current expectation of the future
data. This would give;
If we were to graph the expected values of E[Ã] and E[Ù] over
time we would get a normal distribution with the mean ì and
standard deviation ó. The value of the ì is the equation (17). So
we get:
(21) ì = Et[ E [ Èt] | Èt ]
In addition, it is important to note the distribution is normal and
symmetrical. Therefore, the agents weigh equally the curren
expectation of the past data and the current expectation of the
future data. From this, we can get the equation for the formation
of å.
So if the system is stabile and there are no shocks
to the CM curve; it
will not move. That is the agents will ask for the same interest
rate in any future time period as they are getting now.
The next issue that comes up is why does the CM curve move. If
the world is static, there are no changes in the expectations, that
is if the expectations are always correct the distribution will be
normal, everything in the world would be predicted and there
would be no need to increase or decrease the imposed interest
rate. However, if there is some shock to the distribution the ex-
pectations do now turn out to be correct; the agent will have to
readjust. This readjustment will cause in effect the CM curve to
move up or down.
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Following this logic, we can write the equation for the CM curve in
the following way
(23) CM
t+1
= CM
t
+ Äå
Notice that this equation is fundamentally different from the equation
(12). The main difference is that the future CM curve is based on the
present curve plus the changes in the expectations.
Since the natural equilibrium of the system is for the
CM=CMt+1 , that is if there are no shocks to the system the
changes in the expectations will not exist and Äå=0. Any ad-
justment in the expectations will serve the purpose to equalize
the CM curve for the next period shifting it up or down depend-
ing on the expectation change, thus neutralizing the changes in
expectations.
The indicator of the frequency and the impact of shocks and the
changes in the CM curve is the variable ë. If ë is close to 1, this
would imply that the data coming from distant past or about the
distant future is not discounted by much and the agents are very
forward looking. This implies that the system is very stabile and
agents are very forward looking. On the other hand if ë is close
to one this implies that the data coming from the past or about
the distant future is very heavily discounted and neglected. Ë
very small would imply the system is very unstable. Such insta-
bility would make the system much more susceptible to the
shocks and the agents would have to adjust much more often
and in much larger size them if ë was close to zero.
As we can see, the suceptability to shocks comes directly from
the variable ë. This is the main reason why some countries have
so little capital mobility and other have so much. The size of the
capital flow will indicate how stabile the country is. To this ef-
fect the ë is the variance of the capital mobility or we can even
call it the security of investment into the foreign country.
3.2.2 Conclusion about the expectations
Although this section was a slight digression from the rest of the pa-
per I have included it into the paper so that I would clarify to the
reader what I meant under the term “expectations”. As I have pre-
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NEVEN VIDAKOVIÆ: Application of the Mundell-Fleming on Small Open Economy
EKONOMIJA / ECONOMICS, 11 (3) str. 392 - 423 (2003)
www.rifin.com
sented in the previous section; expectations are formed in the same
way for all agents equally weighting both the past and the future. The
interesting thing is that the CM curve will move only if there are some
changes in those expectations due to the information flow and the
changes to the future or the past data. This passage is still incomplete
and it will be the matter of my future research.
3.3 MONETARY POLICY
The monetary policy in a small open economy is significantly differ-
ent from the one in large open and closed economy. The differences
are mostly advantages in suppressing inflation and the main disad-
vantage is the fact that the economy in corpore is very open to both
cost-push and demand-pull inflation.
The main purpose of monetary policy in a small open economy (like
Croatia) is to keep depreciating real exchange rate in a long run to
stimulate the exports and depress the imports; to keep the inflation at
a acceptable rate and naturally to provide leadership, guidance and
maintenance of the monetary and banking system with in the econ-
omy.
Let us first examine first the prediction of standard IS-LM model
when we have a shift in the LM curve. The shift in the LM curve will
decrease the interest rates thus causing the increase in the level of in-
vestments. This will in turn stimulate aggregate demand, shift the AD
curve to the right and produce higher level of output. However, in the
case of IS-LM-CM this is not the case.
Like in the standard IS-LM model in the case of Mundell-Fleming
model with an expansionary monetary policy the LM curve will shift
to the right and the interest rates will decrease because of the increase
of the amount of currency in circulation. However, this shift will
cause disequilibrium between the IS-CM curves on one side and the
LM curve on the other side. The direct result of this will be the fact
that because the domestic interest rate is smaller than the one that the
“world’ is imposing upon a country there will be a capital outflow,
causing increase in r and the LM curve will shift back. In one sen-
tence: In a small open economy with high capital mobility, monetary
policy will be ineffective.
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NEVEN VIDAKOVIÆ: Application of the Mundell-Fleming on Small Open Economy
EKONOMIJA / ECONOMICS, 11 (3) str. 392 - 423 (2005)
www.rifin.com
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