Exchange rates and the Mundell-Fleming model Imports, exports, exchange rates From IS-LM to Mundell-Fleming Policy in an open economy.

Exchange rates and the Mundell-Fleming model

Imports, exports, exchange rates

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

Balance of payments and exchange rate

Up until now, we have worked only in the case of closed economies No trade considerations were present

However, we know that in fact trade is important in understanding macroeconomics, particularly so with globalisation. As for previous models, this means we have to

introduce corrections to the model to obtain a better understanding of what trade does to the economy

Exchange rates and Mundell-Fleming

Imports, exports and exchange rates

Current account, capital account and balance of payments

From IS-LM to Mundell-Fleming

Effectiveness of policy


The first element to take into account in an open economy is the presence of imports M and exports X in aggregate demand

These represent another possible leakage from the circular flow of income In particular, agents will have a propensity

to import which will have to be taken into account when calculating multipliers

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


Second problem: in terms of national accounting, exports / imports are not measured in the same units: We need to convert imports paid in foreign

currency into national currency Exports towards other countries are also

affected by the value of the currency This is where the exchange rate comes in



The exchange rate (e) is the price of one currency in terms of another currency

Note of caution ! There are 2 ways of working it out: The amount of $ you can buy with 1€ :

1€ = 1.35$ The amount of € required to buy 1$ :

1$ = 0.75€

These two measures are equivalent, but be careful, the second one (often used in models) is not intuitive : If e falls, less € are needed to purchase 1$, so the euro

has appreciated (it is worth more in $ terms) If e increases, more € are needed to purchase 1$, so the

euro has depreciated (it is worth less in $ terms)


e=price of the currency (dollars/euro)

Quantity

Equilibrium exchange rate e*

Supply of euros

Purchase of dollar-denominated assets, imports

Purchase of euro-denominated assets, exports

Demand for euros

The exchange rate is a price


The exchange rate is in nominal terms It is possible to define a real exchange rate

which accounts for the price levels in the two currency areas

The real exchange rate gives a relative price It expresses the relative value of a

representative basket in the euro zone to the same basket in the USA.

$

€€/$€/$ P

Peereal


This allows us to define the purchasing power parity (PPP) exchange rate. The PPP exchange rate is the nominal exchange rate

that occurs when the real exchange rate is 1.

The PPP exchange rate is often considered to be the long run equilibrium exchange rate It is also used to compare economic variables across

countries, particularly measures related to standards of living or welfare

$

€€/$€/$ P

Peereal

€

$€/$ P

PePPP






Current account and capital account

The current account is not the only element of international trade.

The balance of payments composed of:The current account CA:

Tracks outflows minus inflows of goods and services It corresponds to the Exports – Imports component.

The capital account KA: Tracks inflows minus outflows of capital of a country Either as direct investment (building factories, etc) Or purchases/sales of assets


The current account was explained in the previous section as the ‘net exports’ added to C + I + G. What role does the capital account play ?

To understand their relation, let’s derive the savings/investment balance for an open economy

Setting Z = Y :

MTSCY

XGICZ

XGIMTS


This gives us the equilibrium condition in terms of investment and savings:

XI T MS G Simplifying assumption: the government budget is in

equilibrium (G-T = 0) If there is a CA deficit (X-M < 0), there are not enough

savings (agents are spending too much). Some of the financing of investment (I) must come from abroad.

If there is a CA surplus (X-M > 0), there is excess savings (agents are not spending enough). The excess saving are used to fund foreign investment.

The adjustment to the current account balance occurs through an inflow or outflow of savings: This is the capital account.


The BoP is in equilibrium when CA+KA = 0 The current account

and capital imbalances add to 0

As seen in the previous slide, this is equivalent to saying that S = I in an open economy


Source: BIS,2007 World Report


The USA have been net importers and net borrowers since the 1980’s. The US current account deficit in 2006 was 6,6% of its GDP.

Europe has recently seen positive balances on its current account, which reflects a relatively low level of growth.

Japan has traditionally been a net exporter and a net lender.

The current accounts surpluses of emerging Asian countries (particularly China) have grown during the 1990’s

XI T MS G


The amount of savings required to finance the current account deficit of the USA has tripled since 1997.

On the other had, the emerging economies have become net providers of savings flows.

Europe and Asia (including Japan) has covered 2/3 of the funding needs of the USA in 2002.

XI T MS G







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) : Imports are a function of national income and the exchange rate



Determinants of the current account: If e increases (depreciation): exports 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

eYMeYXeYYCA ,,,, **

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.


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 ,,, *


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.


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


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


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

ae

ieK

€/$

$€/$ 1


You’re indifferent between $ and € assets if:

Rearranging gives:

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

ae

ieKiK

€/$

$€/$€

11

$€/$

€/$€ 11 ie

ei

a ae

e

i

i

€/$

€/$

$

€

1

1

€/$

€/$€/$$€ e

eeii

a


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€/$

€/$€/$$€ e

eeii

a


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 internationa 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


The MF model was developped 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


BP

i

Y

i*

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

IS

LM






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 ?? ??


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


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


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


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


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:


IncompatibilityTriangle

(Mundell)

FinancialAutarky

MonetaryUnion

FlexibleExchange rate

Autonomous monetary policy

Fixe

d ex

chan

ge rat

e Capital m

obility

Exchange rates and the Mundell-Fleming model Imports, exports, exchange rates From IS-LM to Mundell-Fleming Policy in an open economy.

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