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Chapter Twelve
Introducing
This model is a close relative of the IS-LM model; both stress the interaction between the goods market and the money market. Price levels are fixed, and both show short-run fluctuations in aggregate income. The Mundell-Fleming Model assumes an open economy in which trade and finance are added; the IS-LM assumes a closed economy.
e LM*
IS*
Income, output, Y
3
This model, often described as the dominant policy paradigm for studying open-economy monetary and fiscal policy, makes one important and extreme assumption: the economy being studied is a small open economy and there is perfect capital mobility, meaning that it can borrow or lend as much as it wants in world financial markets, and therefore, the economys interest rate is controlled by the world interest rate, mathematically denoted as r = r*. One key lesson about this model is that the behavior of an economy depends on the exchange rate regime it adoptsfloating or fixed. This model will help answer the question of which exchange rate regime should a nation adopt?
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Under a system of floating exchange rates, the exchange rate is set by market forces and is allowed to fluctuate in response to changing economic conditions.
The exchange rate e, adjusts to achieve simultaneous equilibrium in the goods market and the money market. When something changes that equilibrium, the exchange rate is allowed to adjust to a new rate.
Chapter Twelve
The Small Open Economy Under Floating Exchange Rates Lets start with two equations (notice the asterisk next to IS and LM to remind us that the equations hold the interest rate constant):
Assumption 1: The domestic interest rate is equal to the world interest rate (r = r*). Assumption 2: The price level is exogenously fixed since the model is used to analyze the short run (P). This implies that the nominal exchange rate is proportional to the real exchange rate. Assumption 3: The money supply is also set exogenously by the central bank (M). Assumption 4: Our LM* curve will be vertical because the exchange rate does not enter Chapter Twelve 6 into our LM* equation.
The IS* curve slopes downward because a higher exchange rate reduces net exports (since a currency appreciation makes domestic goods more expensive to foreigners), which in turn, lowers aggregate income. (e goes down, NX goes up, Y goes up) Exchange rate, e
IS*
Chapter Twelve
Income, output, Y
An increase in the exchange rate, lowers net exports, which shifts planned expenditure downward and lowers income. The IS* curve summarizes these changes in the goods market equilibrium. (a) Exchange rate, e,
Expenditure, E
(b)
NX(e)
Chapter Twelve
Net exports, NX
Interest rate, r
LM r = r*
The LM curve and the world interest rate together determine the level of income. The LM* curve is vertical because the exchange rate does not enter into the LM* equation. Recall the LM* equation is: M/P = Chapter Twelve L (r*,Y)
Income, output, Y
LM*
e
+DG, or DT +De, no DY
When the increase in the money supply puts downward pressure on the domestic interest rate, capital flows out as investors seek a higher return elsewhere. The capital outflow prevents the interest rate from falling. The outflow also causes the exchange rate to depreciate, making domestic goods less expensive relative to foreign goods, and stimulates NX. Hence, monetary 10 policy influences the e rather than r.
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. Chapter Twelve 12
M P L (r *,Y )
At any given value of e, a tariff or quota reduces imports, increases NX, and shifts IS* to the right.
Results:
e e2 e1
LM 1*
IS 2* IS 1*
De > 0, DY = 0
Chapter Twelve
Y1
Y
13
LM* LM*'
LM 1*LM 2*
which increases M But, these gains come atandexpenseLM* right. the shifts of other countries:
the policy merely shifts demand Results: from foreign to domestic goods.
De = 0, DY > 0
Y1 Y2
Y
17
Chapter Twelve
impact on:
Policy fiscal expansion Y 0 e NX Y e 0 NX 0
mon. expansion
import restriction
Chapter Twelve
0
0
18
The Mundell-Fleming model shows that fiscal policy does not influence aggregate income under floating exchange rates. A fiscal expansion causes the currency to appreciate, reducing net exports and offsetting the usual expansionary impact on aggregate demand. The Mundell-Fleming model shows that monetary policy does not influence aggregate income under fixed exchange rates. Any attempt to expand the money supply is futile, because the money supply Chapter Twelve must adjust to ensure that the exchange rate stays at its announced19 level.
Chapter Twelve
20
A country with fixed exchange rates can, however, conduct a type of monetary policy by deciding to change the level at which the exchange rate is fixed. A reduction in the official value of the currency is called a devaluation, and an increase in the value is called a revaluation.
Chapter Twelve
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What if the domestic interest rate were above the world interest rate?
The higher return will attract funds from the rest of the world, driving the domestic interest rate back down. And, if the domestic interest rate were below the world interest rate, r*, domestic residents would lend abroad to earn a higher return, driving the domestic interest rate back up. In the end, the domestic interest rate would equal the world interest rate.
Chapter Twelve 22
Why doesnt this logic always apply? There are two reasons why interest rates differ across countries:
1) Country Risk: when investors buy U.S. government bonds, or make loans to U.S. corporations, they are fairly confident that they will be repaid with interest. By contrast, in some less developed countries, it is plausible to fear that political upheaval may lead to a default on loan repayments. Borrowers in such countries often have to pay higher interest rates to compensate lenders for this risk.
2) Exchange Rate Expectations: suppose that people expect the French franc to fall in value relative to the U.S. dollar. Then loans made in francs will be repaid in a less valuable currency than loans made in dollars. To compensate for the expected fall in the French currency, the interest rate in FranceTwelve be higher than the interest rate in the United States. 23 Chapter will
Now suppose that political turmoil causes the countrys risk premium q to rise. The most direct effect is that the domestic interest rate r rises. The higher interest rate has two effects: 1) IS* curve shifts to the left, because the higher interest rate reduces investment. 2) LM* shifts to the right, because the higher interest rate reduces the demand for money, and this allows a higher level of income for any given money supply. These two shifts cause income to rise and thus push down the equilibrium exchange rate on world markets. The important implication: expectations of the exchange rate are partially self-fulfilling. For example, suppose that people come to believe that the French franc will not be valuable in the future. Investors will place a larger risk premium on French assets: q will rise in France. This expectation will drive up French interest rates and will drive down the value of the French franc. Thus, the expectation that a currency will lose value in the future causes it to lose value today. The next slide will Chapter Twelve 25 demonstrate the mechanics.
An increase in the risk premium associated with a country drives up its interest rate. Because the higher interest rate reduces investment, the IS* curve shifts to the left. Because it also reduces money demand, the LM* curve shifts to the right. Income rises, and the exchange rate depreciates.
Chapter Twelve 26
There are three reasons why, in practice, such a boom in income does not occur. First, the central bank might want to avoid the large depreciation of the domestic currency and therefore, may respond by decreasing the money supply M. Second, the depreciation of the domestic currency may suddenly increase the price of domestic goods, causing an increase in the overall price level P. Third, when some event increase the country risk premium q, residents of the country might respond to the same event by increasing their demand for money (for any given income and interest rate), because money is often the safest asset available. All three of these changes would tend to shift the LM* curve toward the left, which mitigates the fall in the exchange rate but also tends to depress income.
Chapter Twelve
27
1) Allows monetary policy to be used for other purposes such as stabilizing employment or prices.
1) avoids uncertainty and volatility, making international transactions easier. 2) disciplines monetary policy to prevent excessive money growth & hyperinflation.
1) Monetary policy is committed to the single goal of maintaining the announced level. 2) May lead to greater volatility in income and employment.
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Chapter Twelve
Interest-rate differentials
Two reasons why r may differ from r*
country risk: The risk that the countrys borrowers will default on their loan repayments because of political or economic turmoil. Lenders require a higher interest rate to compensate them for this risk. expected exchange rate changes: If a countrys exchange rate is expected to fall, then its borrowers must pay a higher interest rate to compensate lenders for the expected currency depreciation.
Chapter Twelve 29
where q (Greek letter theta) is a risk premium, assumed exogenous. Substitute the expression for r into the IS* and LM* equations:
Y C (Y T ) I (r * q ) G NX (e )
M P L (r * q ,Y )
Chapter Twelve 30
q r I
LM* shifts right, because q r (M/P)d, so Y must rise to restore money market eqm. Results: De < 0, DY > 0
Chapter Twelve
e e1 e2
LM 1*LM 2*
Y1 Y2
IS 1* IS 2* Y
31
CASE STUDY:
30
25
20
15
10 7/10/94
Chapter Twelve
8/29/94
10/18/94
12/7/94
1/26/95
3/17/95
5/6/95
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CASE STUDY:
30
25
20
15
10 7/10/94
Chapter Twelve
8/29/94
10/18/94
12/7/94
1/26/95
3/17/95
5/6/95
35
Another factor: The Federal Reserve raised U.S. interest rates several times during 1994 to prevent U.S. inflation. (Dr* > 0) Chapter Twelve 37
Chapter Twelve
38
December 1, 1994
December 15, 1994
$ 9 billion
$ 7 billion
During 1994, Mexicos central bank hid the fact that its reserves were being depleted.
Chapter Twelve 39
the disaster
Dec. 20: Mexico devalues the peso by 13%
(fixes e at 25 cents instead of 29 cents)
Investors are SHOCKED! they had no idea Mexico was running out of reserves. q, investors dump their Mexican assets and pull their capital out of Mexico. Dec. 22: central banks reserves nearly gone. It abandons the fixed rate and lets e float. In a week, e falls another 30%.
Chapter Twelve 40
A speculative attack is a case where a change in investors perceptions makes a fixed rate untenable.
To avoid these kinds of attacks, some economists suggest the use of a currency board, an arrangement by which the central bank holds enough foreign currency to back each unit of the domestic currency. The next for a nation is to consider dollarization, a plan in which the domestic currency is abandoned and the U.S. dollar is used instead.
Chapter Twelve 41
It is impossible for a nation to have free capital flows, a fixed exchange rate, and independent monetary policy.
Option 3: China
CASE STUDY:
CASE STUDY:
Chapter Twelve
45
Y C (Y T ) I (r *) G NX ( )
(LM* )
M P L (r *,Y )
LM*(P2) LM*(P1)
P (M/P)
LM shifts left
2 1
IS* Y2 Y1
P
P2 P1
NX
Y
AD Y2 Y1
Y
47
Chapter Twelve
LM*(P1) LM*(P2)
1 2
IS*
P
P1 P2
Y1
Y LRAS
Y
SRAS1 SRAS2 AD
NX Y
Chapter Twelve
Y1
Y
48
Recall the two equations of the Mundell-Fleming model: IS*: Y=C(Y-T) + I(r*) + G + NX(e) e LM*: M/P=L (r*,Y)
LM* LM*'
When the price level falls, the LM* curve shifts to the right. The equilibrium level of income rises. The second graph displays the negative relationship between P and Y, which is summarized by the aggregate demand curve.
AD
Chapter Twelve
Income, output,Y
50
Point K in both panels shows the equilibrium under the Keynesian assumption that prices are fixed at P1. Point C in both diagrams shows the equilibrium under the classical assumption that the price level adjusts to maintain income at its natural level Y.
Chapter Twelve
LM* LM*'
K C
e2
P K C
P1 P2
SRAS1 SRAS2 AD
51
Income, output,Y
1. Mundell-Fleming model
Chapter Summary
the IS-LM model for a small open economy. takes P as given. can show how policies and shocks affect income and
2. Fiscal policy
affects income under fixed exchange rates, but not
3. Monetary policy
Chapter Summary
affects income under floating exchange rates. under fixed exchange rates, monetary policy is not
countrys assets. An increase in this risk premium raises domestic interest rates and causes the countrys exchange rate to depreciate.
Chapter Summary
for purposes other than maintaining exchange rate stability. Fixed exchange rates reduce some of the uncertainty in international transactions.
Mundell-Fleming Model Floating exchange rates Fixed exchange rates Devaluation Revaluation
Chapter Twelve
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