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Introduction
In an open economy, domestic spending no longer determines domestic output. Instead, spending on domestic goods determines output. A currency depreciation (increases in R) has two distinct effects on this measure: (i) value effects, and (ii) volume effects. A currency depreciation is equivalent to an increase in the relative price of imports to domestic goods. Even if the volume of trade does not change, the measured value of imports unambiguously increases. The volume effects run in the opposite direction. Exports should rise and imports should fall due to the reason imports are now relatively more expensive.
The domestic income is now dependent on both foreign income and the real exchange rate. The IS curve is steeper in an open economy setting due to the marginal propensity to import. The fact that some of our income is spent on imports decreases the amount of induced spending in our economy. For a given reduction in the interest rate, a smaller increase in output and income is required to restore goods market equilibrium.
Capital Mobility
Lets consider a very simplified version of the international economy. Let us assume the following:
(i) exchange rates are fixed forever at a given level,
(ii) taxes are the same everywhere, and
(iii) foreign asset holders face no political risk.
In this setting, capital would chase the highest return. As such, interest rates would have to equate across economies. These assumptions do not hold in reality. Although a very slightly unrealistic assumption, we will assume perfect mobility of capital, in which investors can purchase assets in any country they choose, quickly, in unlimited amounts, and with little transaction cost. With this assumption, differences in interest rates will induce capital flows between economies. These flows put pressure on interest rates until they are once again equated between nations.
Mundell-Fleming Model with a Floating Exchange Rate
In an open economy with external trade and financial transactions, how are the key macrovariables (GDP, inflation, balance of payments, exchange rates, interest rates, etc) determined and interact with each other? What are the effects of fiscal and monetary policies? The Mundell-Fleming model is the standard open macroeconomic model that tries to answer these questions. Theoretically, it is the most popular model. But its applicability to actual policy making is not as high as we would hope (especially for developing and transition countries). In 1963 when he was young, Prof. Robert Mundell was working with Marcus Fleming at the IMF and wrote a paper which gave birth to this model. He has been at Columbia University (New York) for the last 25 years. He has been a strong advocate of stabilization of major currencies and establishment of euro. In 1999, he won the Nobel Prize in economics, partly because of the Mundell-Fleming model.
The Mundell-Fleming model is an open macro application of the standard IS-LM analysis. More precisely, it is an IS-LM analysis with trade and international capital mobility. Consider the following three aspects of the macroeconomy:
(1) Aggregate demand (IS and LM curves, representing goods and money markets)
(2) Aggregate supply (production function and labor market)
(3) Balance of payments (current account and capital account)
The usual textbook exposition (with no trade or capital mobility) combines (1) and (2), with a downward sloping AD (aggregate demand) curve and an upward-sloping AS (aggregate supply) curve. The Mundell-Fleming model combines (1) and (3), namely AD and B (balance of payments) curves. This means that the Mundell-Fleming model (in its simplest version) has no supply side constraint. As in the most elementary Keynesian model, it implicitly assumes that capital and labour are generally underemployed so that any demand stimulus will expand real GDP (rather than cause inflation).
Aggregate Demand - IS curve
Aggregate demand is composed of two parts: absorption (A, namely, domestic demand) and trade balance (T, namely, foreign demand). We ignore service trade, factor income and transfers, so the current account is the same as the trade balance.
Y = A + T (GDP by expenditure decomposition)
where
A=C + I + G (definition of absorption)
= A (Y, i; G) A1 >0, A2 <0, A3 >0; G is an exogenous spending (shift parameter) [A1 means partial derivative of A with respect to first variable, etc.]
and
T = M*- qM (definition of trade balance, measured in domestic currency)
= T (q, Y*, Y) T1 >0, T2 >0, T3 <0; foreign
income Y* is assumed fixed (Y: income C: private consumption I: private investment G: government spending M: imports M*: foreign imports (=our exports), i: interest rate) Note that A and T are defined as real variables (deflated by domestic price P). The real exchange rate q is defined thus:
q = EP*/P (a rise in q means real depreciation of home currency) Please note that T1 >0, namely, partial derivative of trade balance with respect to q is positive. This means that the Marshall-Lerner condition is satisfied, so real depreciation will improve the trade balance (when other variables remain unchanged). From above, we have
Y= A (Y, i; G) + T (q, Y*, Y)
= F (Y, i, q; G) Note: 0 < F1 < 1
Collecting Y to the left-hand side,
Y = f (i, q; G) f1 <0, f2 >0, f3 >0
This is our IS curve. It is downward-sloping in the (i, Y) plane. Moreover, a rise in q (real depreciation) or a rise in G (government spending) shifts the IS curve up and to the right.
Aggregate Demand - LM curve
The LM curve is the same as in the domestic macro version. It shows the condition for money market equilibrium. In particular, we ignore the possibility of "currency substitution," a phenomenon where domestic citizens hold foreign currency (typically US dollar) as well as domestic currency, and change their relative shares as circumstances change. No currency substitution is a reasonable assumption in developed countries, where people hold only domestic currency. But in many developing countries, currency substitution may be a big factor that influences the money demand. Currency substitution is also called "dollarization." But dollarization has two meanings: (1) the situation where people use dollars in addition to domestic currency because they do not trust the latter (in this case, the monetary authority usually tries to prevent the use of dollar); (2) the situation where the government declares that the national currency is the US dollar, abolishes the central bank, and gives up independent monetary policy. Currency substitution is equivalent to the first (traditional) meaning of dollarization.
The LM curve is simply:
Ms/P = LD(i, Y) LD1 <0, LD2 >0
(Ms: money supply P: price level)
As in the domestic version, it is upward-sloping in the (i, Y) plane. A rise in money supply Msshifts the LM curve down and to the right. In this formulation, the price level P is assumed fixed. This may be unrealistic in a small open economy where exchange rate pass-through (E -> P) is significant.
Balance of payments
The balance of payments (B) is the sum of current account (T) and capital account (K). Remember, for simplicity we have assumed away the flows of service, factor income and transfers so that the current account is identical with the trade balance.
B= T + K
= T (q, Y) + K (i - i*) T1 >0, T2 <0; K1 >0
= 0
Assumptions:
The exchange rate is floating (the real exchange rate q is also flexible).
1) The monetary authority does not intervene in the foreign exchange market. This means that there is no change in international reserves, the monetary account is zero, and, therefore, the current account and the capital account must always add up to zero (T + K = 0).
2) Additionally, we assume perfect capital mobility. This means that i = i*, K1 = +∞, and K is indeterminate. In other words, if i > i* there will be a massive capital inflow into the home country and if i < i* there will be a massive outflow, so the only way K can remain finite is when i = i*. When that happens, K can take any value (positive or negative) to offset T, so that T + K = 0 holds.
3) The exchange rate expectation is static. That is to say, people expect that the future exchange rate will be the same as today's (even though the exchange rate is floating). This is a simplifying assumption. If we depict this situation in the (i, Y) plane, we have a horizontal line at i*. The domestic interest rate must be equal to the worldinterest rate. There will be a massive capital inflow above that line and a massive capital outflow below that line.
Equilibrium
Under a freely floating exchange rate and perfect capital mobility, the following
three equations derived above determine the equilibrium position.
Y = f (i, q; G) f1 <0, f2 >0, f3 >0 <IS>
Ms/P = LD(i, Y) LD1 <0, LD2 >0 <LM>
i = i* <BOP>
Recall that foreign income, foreign interest rate and domestic price are all fixed (Y*, i*, P).
The equilibrium can be pictured as follows:
Comparative Statics
Comparative statics means checking how the equilibrium changes if one input variable is changed. More technically, it is a matrix of signs (+ or -) indicating the changes in endogenous variables in response to a change in each exogenous variable.
In this model, we ask two specific questions:
(1) Can we increase Y by an expansionary fiscal policy (an increase in G)?
(2) Can we increase Y by an expansionary monetary policy (an increase in Ms)? G and Ms are the input variables and Y is the output variable in question. (We may add that these questions themselves reflect the rather old-fashioned mentality of macroeconomic fine-tuning. More recently, fiscal and monetary policies are not considered as tools for adjusting real GDP.)
First, consider fiscal expansion,
1. An increase in G shifts the IS curve upward and to the right.
2. This puts an upward pressure on the domestic interest rate (i > i*).
3. But this immediately invites a massive capital inflow.
4. This appreciates the nominal exchange rate E as well as the real exchange rate q.
5. This worsens the trade balance T.
As the model is constructed, no gradual adjustment is allowed; these events are supposed to take place instantaneously. The exchange rate appreciates and the trade balance worsens until the initial increase in G is completely offset. The IS curve is pushed back to the original position and Y cannot increase at all.What happened is that, in Y = A + T, as A is increased by fiscal spending, T is reduced by exactly the same amount. Y is unchanged, and only the relative composition of Y is changed. The conclusion is that under a floating exchange rate and perfect capital mobility, fiscal policy is ineffective. Here, "ineffective" means unable to increase Y.
These conclusions are significantly different from those of the domestic version of the IS-LM model. In the domestic version, fiscal and monetary policies are both effective, and their relative effectiveness depends on various elasticities and slopes. But in this case, one policy is utterly impotent and the other policy is doubly potent. By now, you should clearly see why (by what mechanism and assumptions) these conclusions are generated.
Equilibrium with no Capital Mobility
With a fixed exchange rate and no capital mobility, how does the equilibrium look? Our three equations are as follows:
Y = f (i, q; G). f1 <0, f2 >0, f3 >0 <IS>
Ms/P = LD(i, Y) LD1 <0, LD2 >0. <LM>
T(q, Y) = 0 T1 >0, T2 <0 <BOP>
But since the real exchange rate q is given and unchanged by assumption, we can ignore it for now. q will matter only when the government devalues or revalues the exchange rate.
Since the trade balance must be zero, output Y and the interest rate i are determined by IS and LM as if in a purely domestic macro model. IS is downward sloping and LM is upward sloping in the (i, Y) plane. The economy goes to the intersection of IS and LM. This is the short-run equilibrium.
But this is not the final outcome. This short-run equilibrium may be off the BOP line (T=0). If it is to the right of T=0, there is a trade deficit because Y is too large. To keep the exchange rate fixed, the central bank is obliged to sell dollars, lose IR and reduce H. Gradually, money supply Ms falls and the LM curve shifts up and to the left until the three lines (IS, LM, T=0) intersect at the same point. After that, there is no more movement; we have reached the long-run equilibrium.
As we said before, the government can resist the shift of LM by sterilization. But eventually, it will run out of international reserves. Then the process above must continue.
Equilibrium under Perfect Capital Mobility
With a fixed exchange rate and perfect capital mobility, what is the equilibrium situation? Consider the following set of equations
Y= f (i, q; G). f1 <0, f2 >0, f3 >0. <IS>
Ms/P = LD(i, Y). LD1 <0, LD2 >0. <LM>
i = i*. <BOP>
The only difference from the case of no capital mobility is the BOP condition. Instead of trade balance, we have interest rate equalization.
Let us do comparative statics with this model. Are monetary and fiscal policies effective (can they change Y)? We already said that money is endogenous under a fixed exchange rate and any attempt for sterilization is futile when capital is perfectly mobile. So we know monetary policy can do nothing. To be more precise, consider an attempt at monetary expansion by increasing DC (open market purchase of domestic government bonds). The LM curve wants to shift down and to the right, but this movement is immediately countered by a massive capital outflow and a loss of IR, at the slightest fall of the domestic interest rate. So the total high-powered money H (=DC+IR) remains constant. LM cannot shift. The conclusion is that under a fixed exchange rate and perfect capital mobility, monetary policy is ineffective.
In the previous section with a floating exchange rate, a massive capital outflow prompted currency depreciation and an export boom. Here with a fixed exchange rate, it simply leads to the loss of international reserves.
If government spending G is increased, the IS curve is pushed up and to the right. But this tends to raise i and generate a massive capital inflow. To prevent an appreciation of the domestic currency, the central bank must buy up dollars, which will increase IR and H. Money supply Ms jumps up and the LM curve shifts out as a consequence. Note that this occurs instantaneously. Unlike the case of no capital mobility, there is no distinction between short-run and long-run. Everything takes place at once.
Since both IS and LM shifts to the right, Y is doubly increased. The conclusion is that under a fixed exchange rate and perfect capital mobility, fiscal policy is very effective.
Conclusion
In the previous sections we have seen that with a floating exchange rate, a massive capital outflow prompted currency depreciation and an export boom and with a fixed exchange rate, it simply leads to the loss of international reserves. The conclusion is that under a floating exchange rate and perfect capital mobility, monetary policy is very effective and under a fixed exchange rate and perfect capital mobility, fiscal policy is very effective.
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