Chapter 3 Mundell-Fleming Model Asst. Prof. Dr. Mete Feridun

1. Chapter 3 Mundell-Fleming Model Asst. Prof. Dr. Mete Feridun

2. The Mundell-Fleming Model • The Mundell-Fleming Model is an extension of the IS/LM model to include joint determination of net exports and the value of the currency. • Inflation and inflationary expectations are still assumed to be stable. • The overall result of this model shows that fiscal stimulus is likely to have little effect on the value of the currency but reduce net exports, while monetary stimulus is likely to have little effect on net exports but reduce the value of the currency.

3. Mundell-Fleming Model • The model thus suggests that a combination of fiscal expansion and monetary contraction would boost the value of the currency and reduce net exports. • Conversely, fiscal contraction and monetary expansion would boost net exports and reduce the value of the currency. • The problem with this model is it does not take expectations into account. • In particular, if fiscal contraction is accomplished by tax increases, the dollar would rise far less than if it were accomplished by reduced government spending.

4. How the Model Works • To understand the M-F model, return to the I = S identity, which can be written as: • Domestic Saving – Investment = Current Account Balance (which is the negative of net foreign saving) • If foreign saving rises – i.e., if the current account deficit rises – then investment can rise, consumers can spend more, or the government can run a bigger deficit. • To turn it around, if the government deficit increases, investment declines, domestic saving rises, or foreign investors pick up the tab -- if they are willing.

5. Fiscal Expansion • With that in mind, consider an increase in the budget deficit. • Assume for the moment that inflationary expectations are unchanged. • As shown in the IS/LM diagram, two things happen. First, income rises, which reduces net exports. • Second, interest rates rise, which attracts more foreign capital and boosts the value of the domestic currency (for example dollar). • But that gain may be offset by the reduction in net exports. Hence the value of the currency probably will not change very much.

6. Monetary Easing • Now consider monetary easing. Interest rates decline, which reduces the value of the dollar • Real income increases, which boosts imports, which also reduces the value of the dollar. • The lower value of the dollar raises exports and offsets some of the gain in imports, so net exports may not change very much.

7. The Mundell-Fleming Model • Small open economy.- domestic real interest rate is equal to the worldwide real interest rate r=r*. • Net exports are inversely related to the nominal exchange rate NX(e), where e is amount of foreign currency per a unit of domestic currency. • Since prices are fixed in the short run, it is equivalent to assuming that net exports depend on real exchange rate.

8. e LM* IS* Y Equilibrium in the Mundell-Fleming model equilibrium exchange rate equilibrium level of income

9. Impact of Policy Changes • Three scenarios: • Fiscal Expansion • Monetary Expansion • Trade Restriction • Interest rate differential is a key to the adjustment. • Whenever there is a pressure for domestic interest rate to rise, there are capital inflows appreciating exchange rate. • Whenever there is a pressure for domestic interest rate to fall, there are capital outflows depreciating exchange rate.

10. Floating & fixed exchange rates In a system of floating exchange rates, e is allowed to fluctuate in response to changing economic conditions. In contrast, under fixed exchange rates, the central bank trades domestic for foreign currency at a predetermined price. Next, policy analysis – first, in a floating exchange rate system then, in a fixed exchange rate system 10

11. Floating vs. fixed exchange rates Argument for floating rates: allows monetary policy to be used to pursue other goals (stable growth, low inflation). Arguments for fixed rates: avoids uncertainty and volatility, making international transactions easier. disciplines monetary policy to prevent excessive money growth & hyperinflation. 11

12. At any given value of e, a fiscal expansion increases Y,shifting IS* to the right.G↑; Y↑; L(r*,Y)↑; pressure on r*↑; e↑; NX↓; Y↓ e e2 e1 Y Fiscal policy under floating exchange rates Results: e > 0, Y = 0 Y1

13. Lessons: • “Crowding out” • closed economy: Fiscal policy crowds out investment by causing the interest rate to rise. • small open economy: Fiscal policy crowds out net exports by causing the exchange rate to appreciate. • In a small open economy with perfect capital mobility, fiscal policy cannot affect real GDP.

14. An increase in Mshifts LM* right because Y must rise to restore equilibrium in the money market.M↑; pressure on r*↓; e↓; NX↑; Y↑ e e1 e2 Y Y1 Monetary policy under floating exchange rates Results: e < 0, Y > 0 Y2

15. Lessons: • Monetary policy affects output by affecting the components of aggregate demand: • closed economy: M  r IY • small open economy: M  e NX Y • Expansionary monetary policy does not raise world aggregate demand, it merely shifts demand from foreign to domestic products. • So, the increases in domestic income and employment are at the expense of losses abroad.

16. At any given value of e, a tariff or quota reduces imports, increases NX, and shifts IS* to the right.NX↑; Y↑; L(r*,Y)↑; pressure on r*↑; e↑; NX↓; Y↓ e e2 e1 Y Y1 Trade policy under floating exchange rates Results: e > 0, Y = 0

17. Lessons • Import restrictions cannot reduce a trade deficit. • Even though NXis unchanged, there is less trade: • the trade restriction reduces imports. • the exchange rate appreciation reduces exports. • Less trade means fewer “gains from trade.”

18. Lessons, cont. • Import restrictions on specific products save jobs in the domestic industries that produce those products, but destroy jobs in export-producing sectors. • Hence, import restrictions fail to increase total employment. • Also, import restrictions create “sectoral shifts,” which cause frictional unemployment.

19. Fixed exchange rates Under fixed exchange rates, the central bank stands ready to buy or sell the domestic currency for foreign currency at a predetermined rate. In the Mundell-Fleming model, the central bank shifts the LM* curve as required to keep e at its preannounced rate. This system fixes the nominal exchange rate. In the long run, when prices are flexible, the real exchange rate can move even if the nominal rate is fixed. 19

20. Under floating rates, a fiscal expansion would raise e. e e1 Y Fiscal policy under fixed exchange rates Under floating rates, fiscal policy is ineffectiveat changing output. Under fixed rates,fiscal policy is effective at changing output. To keep e from rising, the central bank must sell domestic currency, which increases M and shifts LM* right. Results: e = 0, Y > 0 Y1 Y2

21. An increase in M would shift LM* right and reduce e. e e1 Y Y1 Monetary policy under fixed exchange rates Under floating rates, monetary policy is effective at changing output. Under fixed rates,monetary policy cannot be used to affect output. To prevent the fall in e, the central bank must buy domestic currency, which reduces M and shifts LM* back left. Results: e = 0, Y = 0

22. A restriction on imports puts upward pressure on e. e e1 Y Y1 Trade policy under fixed exchange rates Under floating rates, import restrictions do not affect Y or NX. Under fixed rates,import restrictions increase Y and NX. But, these gains come at the expense of other countries: the policy merely shifts demand from foreign to domestic goods. To keep e from rising, the central bank must sell domestic currency, which increases Mand shifts LM* right. Results: e = 0, Y > 0 Y2

23. Summary of policy effects in the Mundell-Fleming model

24. Interest-rate Differentials (θ) • Domestic interest rate may differ from the world rate r* for many reasons. In particular, it may reflect: • country risk: The risk that the country’s borrowers will default on their loan repayments because of political or economic turmoil. Lenders would require a higher interest rate to compensate them for this risk. • expected exchange rate changes: If a country’s exchange rate is expected to fall, then its borrowers must pay a higher interest rate to compensate lenders for the expected currency depreciation.

25. Differentials in the M-F model • Modify equations: r = r* + θ • Y= C(Y – T) + G + I(r* + θ) + NX(e) • M/P = L(r* + θ, Y) • Increase in θ shifts IS to the left and LM to the right. Let’s see why:

26. e e1 e2 Y Y1 The effects of an increase in  IS* shifts left, because   r I LM* shifts right, because   r(M/P)d, so Y must rise to restore money market equilibrium. ; e↓; NX↑; Y↑ Results: e < 0, Y > 0 Y2

27. Caveats (warnings) • Self-fulfilling depreciation: it happens because people thought it would happen. • An increase in output is caused by exchange rate depreciation. • That does not happen necessarily: • The central bank may try to prevent the depreciation by reducing the money supply. • The depreciation might boost the price of imports enough to increase the price level (which would reduce the real money supply). • Consumers might respond to the increased risk by holding more money. • These factors shift LM to the left.

28. Case Study:The M-F Model Under Reagan and Clinton • According to M-F model, the combination of fiscal ease and monetary tightness in the early 1980s under Reagan would have resulted in a sharply higher dollar and a big decline in net exports. That is precisely what happened. • However, the fiscal contraction and monetary ease during the Clinton era would have resulted in a lower dollar and an increase in net exports, which is not what happened. • Instead, the opposite happened: the dollar strengthened and net exports declined, the same as in the early 1980s. Let’s see why:

29. This is where expectations play a major role. • Under Reagan, business and investor optimism increased because it was expected that the tax cut would stimulate economic growth, which indeed turned out to happen. • Under Clinton, business and investor optimism increased after 1994, when the Republicans gained control of Congress, because of expectations that the reductions in government spending would stimulate economic growth, which was also the case. • Note that the dollar declined during the first two years of the Clinton Administration, as the initial tax increases did not boost confidence. • So, expectations matter a lot!

30. Economic Impact of a Change in Net Exports • A rise in net exports does not necessarily boost GDP. Four cases are considered under which net exports would rise. 1. Foreign growth rises 2. Domestic growth shrinks 3. Lower inflation 4. Weaker currency

31. Economic Impact of Devaluation • If wages and prices rise by the same amount as the currency is devalued, the standard of living is unchanged. • However, foreign saving falls, investment is decreased, and the standard of living rises less rapidly. • If wages and prices rise by less than the drop in the currency, the standard of living declines. • In the long run, devaluation never has a positive impact – unless the currency had been overvalued and is returning to equilibrium. • At best, it serves as a wake-up call for the country to get its domestic affairs in order

32. Just as there is “no free lunch”, in the long run, countries cannot boost growth by devaluing the currency any more than they can boost growth by increasing government spending or printing more money. • Indeed, by reducing foreign capital inflows, devaluations invariably reduce capital formation and the overall growth rate.

33. The Impossible Trinity A nation cannot have free capital flows, independent monetary policy, and a fixed exchange rate simultaneously. A nation must choose one side of this triangle and give up the opposite corner. Free capital flows Fixed exchange rate Independent monetary policy Option 2(Hong Kong) Option 1(U.S.) Option 3(China) 33

34. CASE STUDY:The Chinese Currency Controversy 1995-2005: China fixed its exchange rate at 8.28 yuan per dollar, and restricted capital flows. Many observers believed that the yuan was significantly undervalued, as China was accumulating large dollar reserves. U.S. producers complained that China’s cheap yuan gave Chinese producers an unfair advantage. President Bush asked China to let its currency float 34

35. CASE STUDY:The Chinese Currency Controversy A nation cannot have free capital flows, independent monetary policy, and a fixed exchange rate simultaneously. China obviously wishes to have independent monetary policy. So it must choose one side of the triangle and choose either free capital flows or a fixed exchange If China lets the yuan float, it may indeed appreciate. But if it also allows greater capital mobility, then Chinese citizens may start moving their savings abroad. Such capital outflows could cause the yuan to depreciate rather than appreciate. So it is a tough decision ! 35

36. Chapter Summary Mundell-Fleming model the IS-LM model for a small open economy. takes P as given. can show how policies and shocks affect income and the exchange rate. Fiscal policy affects income under fixed exchange rates, but not under floating exchange rates.

37. Monetary policy affects income under floating exchange rates. under fixed exchange rates, monetary policy is not available to affect output. Interest rate differentials exist if investors require a risk premium to hold a country’s assets. An increase in this risk premium raises domestic interest rates and causes the country’s exchange rate to depreciate.

38. Fixed vs. floating exchange rates Under floating rates, monetary policy is available for purposes other than maintaining exchange rate stability. Fixed exchange rates reduce some of the uncertainty in international transactions.

39. Capital Mobility • Perfect Capital Mobility means that a practically unlimited amount of international capital flows in response to the slightest change in one country’s interest rates. • Absent political and macroeconomic risks, a successful fixed exchange rate regime should make perfect capital mobility more likely. (Exchange rate risk is zero.) • For a small country, perfect capital mobility implies that the country’s interest rate must be equal to the world interest rate.

40. Capital Mobility and Monetary Policy • Under fixed exchange rates and perfect capital mobility, international capital flows dictate the country’s money supply. • International conditions dominate domestic policy. • If a country tries to reduce its money supply to raise its interest rates for domestic policy reasons, • A slightly higher interest rate attracts a nearly unlimited capital inflow. • The exchange rate must be defended by selling domestic currency, thereby expanding the money supply. • It is impossible to sterilize in the face of such large capital flows. • The expanding money supply lowers the domestic interest rate.

41. Capital Mobility and Fiscal Policy • Under fixed exchange rates, perfect capital mobility enhances domestic fiscal policy. • Because interest rates cannot rise, there is no possibility for “crowding out”. • If the government increases spending without raising taxes, it incurs deficits. • The deficits can easily be financed by in the enormous capital inflows.

42. Trade-off? • Improved fiscal policy effectiveness is not a good substitute for monetary policy. • Fiscal policy is cumbersome—slow to enact, not so responsive as monetary policy. • Fiscal policy is very much influenced by short-run political interests. • Not helpful for handling long-run inflationary issues.

43. Monetary Policy Without FE i i LM1 LM1 LM0 LM0 i1 i1 i0 i0 IS IS Y Y Y0 Y1 Y0 ? Again ignoring international complications, if investment is not sensitive to interest rate changes, a reduction in the money supply raises interest rates a lot, but this has little effect on output. Under normal conditions, ignoring international complications, a reduction in the money supply raises interest rates, making investment more expensive, slowing output.

44. Monetary Policy Under fixed exchange rates and perfect capital mobility In this case, any change in the domestic money supply causes a change in the interest rate, leading to the movement of enormous international capital flows. These capital flows happen almost instantly, and continue until the interest rates are restored to their original level—the same level as the world interest rate. Thus, effectively, the interest rate is fixed at the world rate, and domestic monetary policy cannot change the interest rate, and therefore cannot affect the domestic economy. i FE i0 LM IS Y Y0

45. Fiscal Policy without FE LM i i IS1 IS0 i1 LM0 i0 IS1 i0 IS0 Y Y Y0 Y0,1 Y1 Under normal conditions, ignoring international complications, if money demand is very unresponsive to interest rates, then fiscal policy simply raises interest rates, and rendered weak as a result of “crowding out”. Again ignoring international complications, if money demand is sensitive to interest rate changes, fiscal stimulus is powerful. Small changes in interest rates have a large impact on the money supply-demand equilibrium. There is no crowding out.

46. Fiscal Policy Under fixed exchange rates and perfect capital mobility A stimulative fiscal policy shifts IS to the right. Any tiny increase in the interest rate generates enormous changes in the domestic money supply-demand equilibrium as a result of the enormous capital inflow. FE and LM are both anchored at the world interest rate. Thus there is no possibility of crowding out, and fiscal policy is powerful. i FE i0 LM IS Y Y0 Y1

47. Policy Effectiveness • Under perfect capital mobility and fixed exchange rates, • Monetary policy is limited to defending the fixed exchange rate, and • Fiscal policy can be powerful.

48. Internal Shocks • A domestic monetary shock alters the equilibrium relationship between money supply and demand because: • The money supply changes, or • People alter their personal systems of determining how much money to hold (demand) perhaps as a result of innovations or changes in the payments system. • A domestic spending shock alters domestic real expenditure by a change in one of its components (C,I,G). An example is a fiscal policy change.

49. External Shocks • An international capital-flow shock is an unexpected shift of international funds in response to political upheaval or fears of a international policy change. Examples are: • Fear of war • Rumors of the imposition of capital controls • Growing evidence of a likely currency devaluation • A form of capital flight

50. Adverse Int’l Capital-Flow Shock • FE shifts to higher interest rates. • Official settlements balance is in deficit at point E. Central bank must defend the fixed rate. • If the central bank does not sterilize its intervention, LM shifts upward to left, and external balance is restored. • Internal imbalance is created by falling output and rising unemployment. LM1 FE1 i LM0 T FE0 E IS Y1 Y0 Y