The Impossible Trinity by Mundell and Fleming

in the Philippine Economy

(2005-2014)

Romcyl Lukas C. Gomeyac

I. Introduction
For us to deeply digest the subject matter, let us take first into account the policy,
acts, and mandates of the previous administration from the year 2005 up to 2014.
2001 to 2010 as the 14th president of the Philippines, Gloria Macapagal Arroyo was
able to increase the economy’s gross domestic product that averages to 4.5% which is
expanding every quarter of her presidency. It is because of the creation of the Ro-Ro
(Roll on- Roll off) system, network of ships and barges that link the highly
fragmented islands of the Philippines. Creation of jobs due to the infusion of fresh
capital in the form of investments. Arroyo has gone on many international trips to
secure the support of various companies and businessmen by making the country
seem palatable and worthy venue for their next business ventures. Conventional
infrastructure, the administration has also ushered in the greater gains in terms of
infrastructure in the country; we have seen the emergence of many domestic and
international airports like the ones in Bacolod and Clark. Road conditions in between
farms and actual markets places were farmers could peddle their goods was answered
by the completion of the Halsema Highway that connects the provinces in the heart of
the cordillera.
In the Aquino administration domestic demand was experiencing a robust growth
that GDP is at 6.2%, investments in the manufacturing sector made growth in their
productivity to 3% and recently Germany, Argentina, Japan and Australia invested
huge amounts of money to be focused on banking, farming and electronic firms and is
to be expected to mature as an additional figure on the country’s gross domestic
product in the next 5 years.
The study aims to provide a comprehensive analysis on the relationship between
foreign exchange rate, capital inflows and money supply on the gross domestic
product by using the impossible trinity model that focuses on the tradeoff between the
three factors (exchange rate, capital inflows and money supply) with respect to the
country’s GDP.

II. Theoretical Discussion

This study refers to the Gross Domestic Product dependent upon the values in the
impact of exchange rates, money supply and capital inflows. The Impossible Trinity
Model states that it is impossible for an economy to achieve sound and effective
exchange rate, free capital movement and an independent monetary policy. According to
the impossible trinity, a central bank can only pursue two of the above-mentioned three
policies simultaneously. Basic assumptions are as follows: 1) spot and forward exchange
rates are identical and existing rates are expected to persist indefinitely. 2) Fixed money
wage rate, unemployed resources and constant returns to scale are assumed. Thus
domestic price level is kept constant, and the supply of domestic output is elastic. 3)
Taxes and savings increase with income. 4) The balance of trade depends only on income
and the exchange rate. 4) Capital mobility is perfect and all securities are perfect
substitutes. Only risk neutral investors are in the system. The demand for money
therefore depends only on income and interest rate, and investment depends on the
 interest rate. 5) The country under consideration is so small that the country cannot affect
foreign incomes or the world level of interest rate.
The Mundell-Fleming model is based on the following equations.

The IS Curve
Y=C+I+G+NX
The LM Curve
M/P=L(i,Y)
*a higher interest rate or a lower income level leads to lower money demand.

The BOP (Balance of Payment)

BoP=CA+KA
*current account surplus and capital account surplus

IS Components
C=C(Y-T(Y),i-E(profit))
*Expected rate of inflation. Higher disposable income or a lower interest rate leads to
higher consumption spending.
I=I(i-E(profit),Y-1)
*Y-1 is the GDP in the previous year. Higher lagged income or a lower real interest rate
leads to higher investment spending.

Balance of Payment Components

CA=NX
KA=z(i-i*)+K
*where i* is the foreign interest rate, k is the exogenous component of financial capital
flows, z is the interest sensitive component of capital flows, and the derivative of the function z
is the degree of capital mobility.
III. Methodology
This study seeks the qualitative and quantitative relationship between interest rate,
foreign exchange and money supply with respect to the changes in the Philippine Gross
Domestic Product. By using multiple regression analysis, the study should test the Mundell-
Fleming model and how the past administration managed to balance and intensify the
independent variables (foreign exchange rate, money supply and capital flows) with respect to
the dependent variable which is the Gross Domestic Product.

a) Econometric Model
Ŷ= β1 + β2X1 + βзX₂ +β4X3+μ

Defined as:
GDP = f (Exchange rate Capital Cash Flow, Money supply)
Y = Gross Domestic Product
β1= Intercept Coefficient
β2, β3 , β4 = Coefficients of the Independent Variables
X1 = Exchange Rate
X₂ = Capital Inflows
X3= Money Supply
μ = Error term

Units of measurement are the same in the paper, and then values are not converted in
some other way to be consistent in the analysis. Data collection is done thru the internet
specifically in official government pages (Philippine Statistics Authority, Banko Sentral ng
Pilipinas)

b) Statement of Hypothesis
Whereby, we are considering the following hypothesis:
Ho1: β₂= 0: Exchange rate is not statistically significantly different from zero; Positive
Relationship with Gross Domestic Product.
Ho2: βз=0: Capital Inflow is not statistically significantly different from zero; Positive
relationship with Gross Domestic Product.
Ho3: β4=0: Money supply is not statistically significantly different from zero; Positive
Relationship with Gross Domestic Product.
There should be a positive a priori assumption in all of the independent variables to prove
the hypothesis of the research is correct. And if the given results follow the assumptions then we
should reject the null hypothesis, accept it when proven otherwise.
IV. Results and Discussion
This is where we study the result of the regression analysis that is accumulated using
Microsoft Excel and SPSS to prove the relationship between exchange rate, capital inflow and
money supply with respect to Gross Domestic Product. Results and computations of the
regression analysis and descriptive statistics are as follows:
A)Descriptive Statistics
TABLE 1

Variables Mean Standard Deviation Minimum Maximum

GDP 87.65991 22.34990441 56.778 122.50412
Exchange Rate 45.9 4.175324339 42 55
Capital Inflows 1.121797 0.411422502 0.486189 1.7150577
Money Supply 3.909 1.419479169 2.19 6.94

Interpretation:
First we interpret the dependent variable which is the Gross Domestic Product, at
a mean of 87.66, 22.34 points are to deviate from that mean and the lowest value is 56.778 and
maximum is valued at 122.50. Independent variables are the next ones to be interpreted;
Exchange rate has a mean of 45.9, 4.18 points from the sample are to deviate from the mean and
has a minimum value of 42 and 55 as its maximum. Capital Inflows are most likely to be 1.12
and .41 points of it will be deviating from the mean minimum values are valued at .49 and 1.72
as its maximum. Money Supply will be stable at 3.909 and 1.42 points from it will likely to be
deviate from the sample mean, 2.19 will be its minimum value and 6.94 will be its maximum
value.

b) Regression Result
TABLE 2

Variables Coefficient Standard Error T-Stat P-Value

Intercept 106.77586
Exchange Rate -1.464290817
Capital Inflows 0.928417336
Money Supply 12.03722297
Adjusted R2 0.941127068
Interpretation are as follows:
33.33120161 3.203480668 0.018518584
0.627077517 -2.335103362 0.058232679
5.289590056 0.175517824 0.866446406
2.090067452 5.759250956 0.001194419

GDP=106.78-1.46X1+.93X2+12.04X3
Gross Domestic Product will have a value of 106.78 trillion Pesos if exchange
rate, capital inflows and money supply will be held as constant. A negative exchange rate is not
economically feasible then it is ONLY omitted in the regression model not in the general
conclusion. 1 trillion Peso increase in capital inflows increases the gross domestic product by .93
trillion pesos and a 1 trillion increase in the money supply increases the gross domestic product
by 12.04 trillion pesos.

c) Adjusted R2
R-squared will determine the goodness of fit. 94.11 percent of the values of
exchange rate, capital inflows and money supply is best explained by the changes in
the gross domestic product.

d) T-Test
For the paper to identify whether the independent variables have a significant
relationship to the dependent variable, the paper will be using the Two-Thumb Rule
as a basis of the level of significance in which if the t-stats respectively are greater
than two (2) then hypothesis testing will tell us whether to reject or accept the stated
hypothesis. If the t-stats are greater than 2 then we should reject the null hypothesis
and accept the null if proven otherwise.
As to the t-stat of exchange rate an absolute value of 2.33 then we should reject
the null hypothesis, and so thus the t-stat of the Gross Domestic Product and Money
supply which has the t-stat of 3.20 and5.76 respectively. Therefore we should reject
the null hypothesis because it is not statistically significant than zero.
Capital inflows has a t-stat of .18 which is less than 2, therefore we should accept
the null hypotheses for it is statistically significant than zero.

e) Standard Error
A sample is a true sample if and only if the sample represents the population.
Standard error shows the paper results in the regression analysis. Gross domestic
product, exchange rate, capital inflows and money supply have the values of 33.33,
.63, 5.29, and 2.09 respectively. Values taken are obviously low therefore as the
values reach 0 the more reliable the samples are. The chances of committing errors in
representation in repeated sampling are low.

f) P-value
The measure to what degree that the paper will have to reject the null hypothesis.
The lesser the p- value the greater the degree of null hypothesis is to be rejected, and if p-
values are great then null hypotheses are not likely to be rejected. P-values of exchange
rate, capital inflows and money supply are .05, .87 and .001 respectively.

g) Issue
It is likely to happen that multi-co linearity will be an issue for r-squared is at
94.11 percent which is already high. T-stats of the respective independent variables are
low therefore we should conclude that the independent variables (exchange rate, capital
inflows and money supply) have direct relationship to Gross domestic product.
V. Conclusion and Policy Implication
The study aims to show the relationship between Gross Domestic Product to capital
inflows, foreign exchange rate and money supply as proposed by the model of Mundell and
Fleming. The model states that in a given economy one cannot attain a good vale of exchange
rate, a robust capital inflow and an expansionary money supply. In the regression analysis the
paper predicted that in the Philippine economy the past two administrations the government
focused on capital inflows as seen thru the robust growth in infrastructure in the Arroyo
administration and an increase on the productivity of the industry sector leading the gross
domestic products of both administration to increase. A stable money supply is empirical during
the two administrations for they actually landed the inflation rate between the expectations of the
government leaving prices stable in the economy. As the regression result states, foreign
exchange rate is not related to gross domestic product because comparing the policies and the
data collected, the government did not have the policy to make the peso currency competitive in
the world trade.
Newspapers and business magazines suggests that the incoming administration should
continue the policies made by the past administrations. It is because before we export goods and
services, the country must create intrinsic value. Domestic demand must first be satisfied by the
domestic supply so that the imports will not be that big enough to lower the country’s gross
domestic product. Starting this year the country start to strengthen domestic supply so that
benefits from exports will be excess income to be invested in the world trade.
 APPENDIX

Year GDP Exchange Rate Capital Inflows Money Supply

2005 56.7780 55 0.91413 2.19
2006 62.7120 51 1.39221 2.38
2007 68.9270 46 1.34408 2.96
2008 77.2090 44 0.59451 3.12
2009 80.2610 47 0.98721 3.57
2010 90.0350 45 0.48619 3.94
2011 97.0630 43 0.87357 4.30
2012 105.6490 42 1.35231 4.61
2013 115.4610 42 1.55872 5.08
2014 122.5041 44 1.71506 6.94

SUMMARY OUTPUT

Regression Statistics
Multiple R 0.980179
R Square 0.960751
Adjusted R Square 0.941127
Standard Error 5.422924
Observations 10

ANOVA
df SS MS F Significance F
Regression 3 4319.215 1439.738 48.9572 0.00013
Residual 6 176.4486 29.4081
Total 9 4495.664

Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
Intercept 106.7759 33.3312 3.203481 0.018519 25.21735 188.3344 25.21735 188.3344
Exchange Rate -1.46429 0.627078 -2.3351 0.058233 -2.99869 0.070113 -2.99869 0.070113
Capital Inflows 0.928417 5.28959 0.175518 0.866446 -12.0147 13.87158 -12.0147 13.87158
Money Supply 12.03722 2.090067 5.759251 0.001194 6.923012 17.15143 6.923012 17.15143
REFERENCES:

 Mundell, Robert A. (1963). "Capital mobility and stabilization policy under fixed and
flexible exchange rates". Canadian Journal of Economic and Political Science 29 (4):
475–485.
 http://psa.gov.ph/
 http://www.bsp.gov.ph/
 Fleming, J. Marcus (1962). "Domestic financial policies under fixed and floating
exchange rates". IMF Staff Papers 9: 369–379.