The Mundell-Fleming model From IS-LM to Mundell-Fleming Policy in an open economy.

The Mundell-Fleming model

From IS-LM to Mundell-FlemingPolicy in an open economy

The Mundell-Fleming model

Last week we introduced the basic elements required to analyse an open economyThe current account: imports and

exportsThe capital account: saving/investment

flowsThe balance of payments equilibrium as

a combination of the twoThe role of exchange rates

The Mundell-Fleming model

This week we integrate these elements into the Mundell-Fleming model, which is an IS-LM model extended to account for imports and exports Although this will not be covered, in theory this

can be used in turn to modify the AS-AD model to account for international trade with inflation

As we saw last week, the price level can be included through the analysis of real exchange rates

The Mundell-Fleming model

From IS-LM to the Mundell-Fleming model

Effectiveness of policy

From IS-LM to Mundell-Fleming

Model developed by Robert Mundell and Marcus Fleming It extends the IS-LM model to an open economy

Aggregate demand now contains the current account : i.e. the difference between exports and imports. X(Y*,e) : Exports are a function of the income of

the rest of the world (exogenous) and the exchange rate

M(Y,e) : Importations are a function of national income and the exchange rate

*, ,X YY C Y T I i G e M Y e

From IS-LM to Mundell-Fleming

Determinants of the current account: If e falls (depreciation): exportations are more

competitive and imports more expensive. The net balance of the current account increases.

If Y increases: imports increase and the net balance of the current account falls.

Y* is exogenous, and Y is already determined in IS-LM. There is an extra variable to account for: the exchange rate e.

We need to add another equation (market) in order to be able to solve the system: we use the equilibrium condition on the balance of payments

* *, , , ,CA Y Y e X Y e M Y e

The equilibrium exchange rate is achieved when BP is equal to zero, in other words when the deficits and surpluses of the two accounts compensate exactly.

From IS-LM to Mundell-Fleming

One can see that this equilibrium condition can be expressed in the (Y,i) space of IS-LM.

We still need to relate the exchange rate e to these variables

Reminder: the balance of payments is the sum of the current account and the capital account:

eiKAeYYCAeiYYBP ,,,,,, **

eYYCAeiKA ,,, *

From IS-LM to Mundell-Fleming

The capital account (KA) Is in surplus if the inflows of

capital are larger than the outflows.

Is in deficit in the other case. What determines these

capital flows ?

Intuitive answer: the earnings on savings If savings earn a higher return in Europe compared to

the USA, one would expect American capital to flow towards Europe.

From IS-LM to Mundell-Fleming

Investors choose between assets that pay different interest rates in different currencies.

What is the expected return for each of the possible investment? Their decision needs to account for the interest

rate differentials… …But also for the evolution of the exchange

rates between currencies.

This arbitrage mechanism produces what is called the uncovered interest rate parity (UIRP) This gives us a relation between interest rate

differentials and changes in the exchange rate

From IS-LM to Mundell-Fleming

You are a European investor with capital K (in €) looking for a 1-year investment.You can invest in €-denominated bonds,

and after a year you earn:

Or you can buy $-denominated US bonds: Step 1: you first convert your capital into dollars:

Step 2: after a year, you’ve earned (in dollars):

€1 iK

€/$eK

$€/$ 1 ieK

From IS-LM to Mundell-Fleming

But you need to bring you investment back home ! In other words you need to convert your

capital in $ back into €. In the mean time the $/€ exchange rate may

have changedStep 3: you convert your investment into €

You are indifferent if the 2 returns are equal

$/ € $

$/ €

1E

K e i

e

From IS-LM to Mundell-Fleming

You’re indifferent between $ and € assets if:

Rearranging gives:

If the exchange rate is not too volatile, this can be expressed as:

$/ € $€

$/ €

11

E

K e iK i

e

$/ €€ $

$/ €

1 1E

ei i

e $/ €€

$ $/ €

1

1 E

ei

i e

$/ € $/ €€ $

$/ €

Ee ei i

e

From IS-LM to Mundell-Fleming

Let’s summarise: Capital flows ensure an equalisation of interest rates expressed in the same currency

If the home interest rate is higher than world interest rate, zero net capital flows between countries requires investors to be expecting a depreciation of the home currency. If this is not the case, then capital will flow into the

home country, appreciating e until depreciation expectations occur

Only if the home rate equals the foreign rate will depreciation/appreciation expectations be zero (equilibrium)

Home interest rate

World interest rate

Expected exchange rate depreciation

$/ € $/ €€ $

$/ €

Ee ei i

e

From IS-LM to Mundell-Fleming

On BP the balance of payments is in equilibrium

BP

i

Y

BP is upward-sloping An increase in Y leads to

a BoP deficit (CA deficit) Returning to equilibrium

requires a KA surplus, and hence a higher i

The slope depends on the international mobility of capital The lower capital

mobility, the larger the slope of BP.

BoP surplusAppreciation of e

BoP deficitDepreciation of e

CA deficit

KA surplus

From IS-LM to Mundell-Fleming

The MF model was developed in the 60’s, when capital mobility was low (Bretton Woods)

i

Y

As a simplification, nowadays we assume perfect capital mobility

However, this remains a simplification! For certain cases (like

the case of trade with China), The concept of imperfect capital mobility remains relevant.

BPi*

Perfect capital mobility

i=i*

BoP DeficitDepreciation of e

BoP SurplusAppreciation of e

From IS-LM to Mundell-Fleming

BP

i

Y

i*

We now have 3 curves, IS-LM-BP :

IS

LM

The Mundell-Fleming model

From IS-LM to the Mundell-Fleming model

Effectiveness of policy

The effectiveness of policy

We now move to assessing the effectiveness of policy under the possible exchange rate settings:

Fixed exchange

rate

Flexible exchange

rate

Fiscal Policy ?? ??

Monetary Policy ?? ??

The effectiveness of policy

BP

i

Y

LM shifts to the right The increase in the money

supply lowers the rate of interest, leading to depreciation pressures on e

i*

Monetary policy with fixed exchange rate:

IS

LM

Such a policy cannot be carried out in practice

In order to guarantee the fixed exchange rate the CB must immediately increase i to i=i* by reducing money supply

The effectiveness of policy

BP

i

Y

IS shifts to the right: The crowding out effect

increases the rate of interest, creating appreciation pressures on e

i*

Fiscal policy with fixed exchange rate:

IS

LM

Policy is effective in increasing Y

In order to guarantee the fixed exchange rate the CB must immediately reduce i to i=i* by increasing money supply

The effectiveness of policy

BP

i

Y

LM shifts to the right The interest rate falls, which

leads to a depreciation of the exchange rate e

i*

Monetary policy with flexible exchange rate:

IS

LM

Policy is effective

The depreciation of the exchange rate stimulates exports and penalises imports As a resut IS shifts to the

right

The effectiveness of policy

BP

i

Y

IS shifts to the right The Central Bank doesn’t

have to react: The interest rate increases and the exchange rate appreciates

i*

Fiscal policy with flexible exchange rate:

IS

LM

Policy is ineffective

The appreciation of the exchange rate penalises exports and stimulates imports IS shifts left

The effectiveness of policy

Even with this simple example (assumption of perfect capital mobility), one can see that the effectiveness of policy depends on international conditions!

Fixed exchange

rate

Flexible exchange

rate

Fiscal Policy Effective Ineffective

Monetary Policy Impossible Effective

Summarising all this:

The effectiveness of policy

IncompatibilityTriangle

(Mundell)

FinancialAutarky

MonetaryUnion

FlexibleExchange rate

Autonomous monetary policy

Fixe

d ex

chan

ge rat

e Capital m

obility