The Mundell-Fleming model 2013 General short run macroeconomic - - PowerPoint PPT Presentation

The Mundell-Fleming model

2013

General short run macroeconomic equilibrium

Goods Market Money Market

Interest rates affect aggregate demand Income influences demand for money

…in the open the economy Goods Market Money Market

International capital markets

Real exchange rates affect aggregate demand Interest rates influence the exchange rate Interest rates affect aggregate demand Income influences demand for money

Outline

1.

The assumptions of the Mundell-Fleming model

1.

Interest rate parity 2.

Defining the general equilibrium

1.

Equilibrium under flexible exchange rates

2.

Equilibrium under fixed exchange rates 3.

The Impossible Trinity

4.

Case study: China

5.

Conclusion

Overview

The Mundell-Fleming model

 Extension of the IS-TR model for the open economy with

internationally integrated financial markets

 Key variable: exchange rate

 Assumptions

 Sticky prices  Small open economy

 Small: influenced by changes in the rest of the world, but no impact on

the rest of the world

 Open: free international trade & financial openness

• 1. The Mundell-Fleming model

Robert Mundell Nobel prize 1999

Openness and economic size, 2004

Share of Trade world GDP (%)

• penness

(% of GDP) Total assets (% of GDP) Total liabilities (% of GDP) Denmark 0.6 40.9 55.4 47.4 Poland 0.6 40.0 31.6 84.9 Sweden 0.8 42.3 213.5 223.0 Belgium 0.9 82.3 425.2 394.3 Switzerland 0.9 40.6 570.7 439.9 Netherlands 1.4 62.7 402.5 408.3 Brazil 1.5 15.7 28.3 77.6 Korea, Rep. 1.6 41.9 52.6 56.6 China 4.7 32.7 195.3 207.8 UK 5.1 26.4 357.4 370.6 Germany 6.6 35.5 167.1 159.1 Japan 11.2 11.0 89.0 51.0 Euro countries 23.0 10.8 US 28.4 11.8 84.0 106.7 Financial openness

• 1. The Mundell-Fleming model

International capital flows

 interest rate parity condition

 If international capital markets are perfectly integrated, the

rate of return (in the same currency) on assets sharing the same risk profile should be identical. i=i*

 i = domestic interest rate  i* = international rate of return

 If i≠i* : Investors would be able to make profits by

borrowing in one market and lending in the other.

 Arbitrageurs (international investors) guarantee that when capital

markets are fully integrated i=i* 1.1. The Mundell-Fleming model

IFM schedule

 Equilibrium on the international financial markets (IFM)

i*

Interest rate Output i > i*, capital flows in i < i*, capital flows out

When i ≠i*, capital will flow towards the country with the higher returns until returns are equalized.

Financial integration line (IFM)

1.1. The Mundell-Fleming model

Long term interest rates, 1970 - 2011

1.1. The Mundell-Fleming model

The Mundell Fleming model

 Capital controls and exchange rates

 Impossible Trinity

 Fixed exchange rate  Independent monetary policy  Free capital movements

  assumed to be the case here

 Lessons of Mundell Flemming model:

 The behavior of the economy change when internationally

integrated

 The behavior of the economy depends on its choice of exchange rate

regime

• Should we adapt a fixed or a flexible exchange rate?

1.1. The Mundell-Fleming model

Exchange rate regimes

 Fixed exchange rate

 CB stands ready to buy and sell their currencies at a fixed price  CB intervenes when there is an excess supply or demand of the

currency at the fixed exchange rate

 Ex: Denmark  Euro, China  US Dollar

 Flexible exchange rate

 Central banks allow the exchange rate to adjust to equate the supply

and demand for foreign currency

 The British pound floats freely against both the US dollar and the

Euro

 The fluctuations can be very large

 Reminder: increase in the exchange rate = appreciation  my goods

become more expensive 1.1. The Mundell-Fleming model

General Equilibrium

 The goods market  The money market  The international financial markets

We need to combine all three markets to describe what will happen in general equilibrium, i.e. when all the three markets clear.

• 2. Defining the Macroeconomic equilibrium

Equilibrium in the goods market

 IS-curve

 graphs all combinations of i and Y that result in goods

market equilibrium

 Total demand = total supply of goods

Interest rate IS Output

Changes in output will occur when we are not on the IS curve (as response to shortage to the left of IS and surplus to the right).

 

 

 

*

, , , , Y C Y T I q i G PCA Y Y       

• 2. Defining the Macroeconomic equilibrium

Equilibrium in the goods market

 Shifts of the IS curve in an open economy:

 Real exchange rate: σ = (S P) / P*  P* and P are fixed  σ is proportional to S

 When S decreases: real exchange rate depreciation

• σ  = decrease of relative price of my goods  exports 

and imports

• Net exports increase  shift of IS to the right
• 2. Defining the Macroeconomic equilibrium

Equilibrium in the money market

 TR curve

 represents the equilibrium in the money market

 i.e. the combinations of the interest rate i and the income level Y where

money demand equals money supply  CB follows

 inflation targeting (Taylor rule)  On the TR curve: for different i

different levels of M/P  Always on the TR curve

Interest rate

TR

Output

Y Y Y b i i   

• 2. Defining the Macroeconomic equilibrium

Find the mistake!

Real money supply Output

A A F H

Nominal nterest rate Nominal nterest rate

B

M

Si F B

TR

i

TR´

H C C

IS IS´ D´ D

Y

i

i*

Financial integration line

General equilibrium

Interest rate

TR IS A

Output

• 2. Defining the Macroeconomic equilibrium

Flexible exchange rate

 Flexible exchange rates and perfect capital mobility

• i = i*

 If i > i*  capital inflow

 σ   IS shifts left

 If i < i*  capital outflow

 σ  IS shifts right

 What happens if… ?

1.Demand disturbances (Fiscal policy) 2.Change in monetary policy 3.International financial disturbances (increase in i*) 2.1. Defining the Macroeconomic equilibrium –flexible exchange rates

Demand disturbances

 Starting from equilibrium, real demand increases (government

expenditures increase) Interest rate

A IS´ IS B

Output

However, the resulting increase in S will reduce the demand for goods.

i*

IFM

TR

2.1. Defining the Macroeconomic equilibrium –flexible exchange rates

Demand disturbances

 …i>i* will attract capital inflows, so S appreciates

i*

Interest rate

IS A B IS´

However, the resulting increase in S will reduce the demand for goods.

Output IFM

TR

Fiscal policy is ineffective 2.1. Defining the Macroeconomic equilibrium –flexible exchange rates

Real demand disturbances

 Why is a shift in IS inefficient?

 IS shifts following an increase in the demand for domestic

goods  IS shifts right

 Raise in income has increased money demand and i  Higher i leads to exchange rate appreciation (capital inflow)  Appreciation of S continues as long as i > i*  Appreciation decreases demand for our exports  higher G

is compensated by lower PCA  IS shifts back

 We end up at the initial equilibrium

 Chapter 10: higher i crowded investment (partly) out  Here: exchange rate appreciation reduces exports 2.1. Defining the Macroeconomic equilibrium –flexible exchange rates

Expansionary monetary policy

24

i*

IFM Interest rate TR IS A IS´ C TR´ B

Capital outflow leads to a depreciation of the exchange rate  net exports increase

Output

Monetary policy is effective 2.1. Defining the Macroeconomic equilibrium –flexible exchange rates

Expansionary monetary policy: TR curve

 Monetary policy under flexible exchange rates, TR curve

D(Y)

i* i*

IFM

IS´ IS

D´´(Y‘‘)

Real money stock Output

A A B B C

Interest rate Interest rate

C D´(Y‘)

2.1. Defining the Macroeconomic equilibrium –flexible exchange rates

A‘ A‘ i‘

Y Y‘‘

Expansionary monetary policy

 CB sets i’ < i*  TR shifts to the right

 i <i*  capital outflow  decrease in demand for my

currency

 Decrease in exchange rate  my goods become relatively

cheaper  Net exports increase

 Increase in exports leads to an increase in Y  IS shifts right  Higher Y  higher money demand  move up on the TR

curve

 Depreciation continues until i = i*

 IS, TR and IFM back in equilibrium: same i but higher Y

2.1. Defining the Macroeconomic equilibrium –flexible exchange rates

Beggar-Thy-Neighbor policy

 Country A: Monetary expansion leads to a depreciation of

the exchange rate and an increase in net exports to country B

  Increase in GDP of country A

 Country B sees its net exports to country A decreasing

  Decrease in GDP of country B

Monetary expansion only shifts demand from one country

to another, doesn’t increase the total demand for goods.

2.1. Defining the Macroeconomic equilibrium –flexible exchange rates

i*

International financial disturbances

 Increase in rate of return on foreign assets, i* 

Interest rate

TR

IS A i*´

Output

C

2.1. Defining the Macroeconomic equilibrium –flexible exchange rates

International financial disturbances

29

i*´

IFM´ IFM

TR

i*

Interest rate IS

A

A depreciation in the exchange rate raises net exports

Output IS´

C

2.1. Defining the Macroeconomic equilibrium –flexible exchange rates

International financial disturbances

 Why does an increase in the foreign rate of return leads to

a higher output?

 If i* IFM schedule shifts up

 Then i <i*  capital outflow exchange rate    Net exports   Increase in demand for our goods  IS shifts right  Y  money demand   i 

 We end at the new equilibrium at C, where i = i*

2.1. Defining the Macroeconomic equilibrium –flexible exchange rates

Fixed exchange rate regime

 Fixed exchange rate regime: central bank commits to

maintain a fixed relative price for the domestic currency vis a vis a foreign one.

 For example:

 EU members which have not (yet) adopted the euro are part

• f the exchange rate mechanism, which fixes the value of

their currency vis a vis the euro.

 Denmark, Lithuania, Bosnia-Herzegovina, Bulgaria have a currency

board with the euro.

 Main difference: monetary policy is ineffective, fiscal

policy is effective

2.2. Defining the Macroeconomic equilibrium –fixed exchange rates

i*

Financial integration line

Monetary policy

 Starting from general equilibrium, there is an unanticipated

increase in the supply of money Interest rate TR

IS A

TR´ Output

2.2. Defining the Macroeconomic equilibrium –fixed exchange rates

i*

Financial integration line

Monetary policy

 The central bank has to decrease money supply again to keep

the exchange rate fixed. Interest rate TR

IS A

TR´

Monetary policy is ineffective.

Output

2.2. Defining the Macroeconomic equilibrium –fixed exchange rates

Summary

 Why is monetary policy under fixed exchange rates

ineffective?

 Money supply   TR shifts right  Capital outflow and depreciation of domestic currency would

be the consequence with flexible exchange rate

 To prevent the depreciation CB sells foreign currency to buy

domestic money  by buying domestic money, CB takes the money out of circulation

  Money supply decreases  TR shifts back to the left  S

constant

 We end up at the initial equilibrium  The monetary expansion was ineffective

2.2. Defining the Macroeconomic equilibrium –fixed exchange rates

i*

Financial integration line

Demand disturbances

Interest rate

TR IS A

Figure 10.13

Output

2.2. Defining the Macroeconomic equilibrium –fixed exchange rates

i*

Financial integration line

Demand disturbances

Interest rate TR

IS A IS´

Output

C

2.2. Defining the Macroeconomic equilibrium –fixed exchange rates

TR´

i*

Financial integration line

Demand disturbances

Interest rate TR

IS A IS´

Output

C

2.2. Defining the Macroeconomic equilibrium –fixed exchange rates

Demand disturbances (fixed exchange rate)

 G   IS shifts right

 Higher demand  higher income  Interest rate remains fix  Money supply has to increase in

• rder to keep S constant  TR shifts right

 New equilibrium at higher Y but same i Fixed exchange rate regime: an increase in government

expenditure is effective in increasing output.

 Monetary policy has to accommodate the fiscal expansion in

this case.

This policy is actually more effective in an open economy with fixed

exchange rates than in a closed economy (because of higher i in closed economy) 2.2. Defining the Macroeconomic equilibrium –fixed exchange rates

Source: Mankiw 7th edition

The Impossible Trinity

A nation cannot have simultaneously:

• 1. free capital flows,
• 2. independent monetary

policy, and

• 3. a fixed exchange rate

A nation must choose

• ne side of this

triangle and give up the

• pposite

corner.

Free capital flows Independent monetary policy Fixed exchange rate Option 1 (U.S.) Option 3 (China) Option 2 (Hong Kong)

• 3. The Impossible Trinity

Q: Where lies the Euro zone?

CASE STUDY

 The Chinese Currency Controversy

 1995-2005: China fixed S=8.28 yuan per US$, and

restricted capital flows.

 Many believed that the yuan was significantly

undervalued, because China was accumulating large dollar reserves.

 U.S. producers complained that China’s cheap

yuan gave Chinese producers an unfair advantage.

 America’s government asked China to let its currency

float; Others in the U.S. wanted tariffs on Chinese goods.

• 4. Case study: China

CASE STUDY

 If China lets the yuan float, it may indeed appreciate.  However, if China 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.

 Find an interesting article on this issue:

 http://www.economist.com/node/14921327

• 4. Case study: China

The Mundell-Fleming model: Summary

Exogenous change Fixed exchange rates Flexible exchange rates Expansionary demand disturbance Increase No effect Expansionary monetary disturbance No effect Increase Increase in foreign interest rates Decrease Increase Effect on real GDP Fixed exchange rates Flexible exchange rates Exogenous monetary instrument Exchange rate Money supply Endogenous monetary instrument Money supply Exchange rate

• 5. Conclusion