MF Model_Session 15 and 16

8/7/2019 MF Model_Session 15 and 16

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Prepared by:

Amarendu Nandy

Session 15 & 16


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Organization

The Mundell-Fleming model(IS-LM for the small open economy)

causes and effects of interest rate

differentials

arguments for fixed vs. floatingexchange rates


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IS Curve

IS Curve is derived from the Goods MarketClearing condition:Supply of goods: Yequals toDemands of Goods coming from:Consumption demand: C;Investment demand: I;

Government Expenditure: G

IS relation: Y C Y T I Y i G( ) ( , )


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IS Curve

IS Curve captures the effect of nominal interestrate i on output Y, for given values of T and G.

(tax and government purchase).

Investment demand depends negative on interestrate. Hence, when iincrease, the investment andthen the total demand will fall. So will the total

output Y.

Therefore, IS curve is downward sloping.

IS relation: Y C Y T I Y i G( ) ( , )


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Open-Economy Short-RunMacro Model Thecurrent account balance is the

difference between exports andimports.

The private capital account balance isthe difference between private capitalinflows and outflows.

The balance of payments is inequilibrium when the current accountand private capital account balances

sum to zero.


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Private Balance of PaymentsDeficit

If the private balance of payments is in deficit,

current account + private capital account < 0

supply of currency>demand for currency

With a flexible exchange rate, the currencydepreciates until

current account + private capital account = 0

demand for currency = supply of currency With a fixed exchange rate, the country must

buy up the excess supply of its currency.


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Private Balance of PaymentsSurplus

If the private balance of payments is in surplus,

demand for currency>supply of currency

current account + private capital account > 0

With a flexible exchange rate, the currencyappreciates until

demand for currency = supply of currency

current account + private capital account = 0

With a fixed exchange rate, the country must sellits currency to eliminate the excess demand.


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The Mundell-Fleming model

Key assumption:Small open economy with perfect capital mobility.

r = r*

Goods market equilibrium the IS* curve:

( ) ( ) ( )*Y C Y T I r G NX e

wheree = nominal exchange rate

= foreign currency per unit domestic currency


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The IS*curve: Goods market eqm

The IS*curve is drawn for a

given value of r*.

Intuition for the slope:

Y

e

IS*

( ) ( ) ( )*

Y C Y T I r G NX e

e NX Y

We could derive this using theKeynesian cross.

Remember, the IS curveincorporates the multiplier effect.


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The LM*curve: Money market eqm

The LM*curve

is drawn for a given

value of r*. is vertical because:

given r*, there is

only one value of Y

that equates money

demand with supply,

regardless of e.

Y

e LM*

( , )*

M P L r Y


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Equilibrium in the Mundell-Fleming model

Y

e LM*( , )*M P L r Y

IS*

( ) ( ) ( )*Y C Y T I r G NX e

equilibriumexchange

rate

equilibriumlevel ofincome


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Floating & fixed exchange rates

In a system of floating exchange rates,e is allowed to fluctuate in response tochanging economic conditions.

In contrast, under fixed exchange rates,the central bank trades domestic for foreigncurrency at a predetermined price.

Next, policy analysis first, in a floating exchange rate system

then, in a fixed exchange rate system


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Fiscal policy under floating exchange rates

Y

e( , )*M P L r Y

( ) ( ) ( )*Y C Y T I r G NX e

Y1

e1

1

*LM

1

*IS

2

*IS

e2At any given value of e,

a fiscal expansion

increases Y,

shifting IS*to the right.

Results:

e> 0, Y= 0


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Lessons about fiscal policy

In a small open economy with perfectcapital mobility, fiscal policy cannotaffect real GDP.

Crowding out closed economy:

Fiscal policy crowds out investment bycausing the interest rate to rise.

small open economy:Fiscal policy crowds out net exports bycausing the exchange rate to appreciate.


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Monetary policy under floating exchange

rates

Y

e

e1

Y1

1

*LM

1

*IS

Y2

2

*LM

e2

An increase in M

shifts LM* right

because Y must rise

to restore eqm in

the money market.

Results:

e< 0, Y > 0

( , )*M P L r Y

( ) ( ) ( )*Y C Y T I r G NX e


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Lessons about monetary policy

Monetary policy affects output by affectingthe components of aggregate demand:

closed economy: M r I Y

small open economy: M e NX Y

Expansionary mon. policy does not raise worldagg. demand, it merely shifts demand fromforeign to domestic products.

So, the increases in domestic income andemployment are at the expense of losses abroad.


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Trade policy under floating exchange rates

Y

e

e1

Y1

1

*LM

1

*IS

2

*IS

e2

At any given value of e,

a tariff or quota reducesimports, increases NX,

and shifts IS* to the right.

Results:

e> 0, Y= 0

( , )*M P L r Y

( ) ( ) ( )*Y C Y T I r G NX e

NXdoes not change! Why?


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Lessons about trade policy

Import restrictions cannot reduce a tradedeficit.

Even though NX is unchanged, there is

less trade: the trade restriction reduces imports.

the exchange rate appreciation reduces

exports. Less trade means fewer gains from

trade.


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Lessons about trade policy, cont.

Import restrictions on specific productssave jobs in the domestic industries thatproduce those products, but destroy

jobs in export-producing sectors. Hence, import restrictions fail to

increase total employment.

Also, import restrictions create sectoralshifts, which cause frictional

unemployment.


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Fiscal policy under fixed exchange rates

Y

e

Y1

e1

1

*LM

1

*IS

2

*IS

Under floating rates,

a fiscal expansion

would raise e.

Results:

e= 0, Y > 0Y2

2

*LM

To keep efrom rising,the central bank must

sell domestic currency,

which increases M

and shifts LM*right.


fiscal policy is ineffective

at changing output.

Under fixed rates,

fiscal policy is very

effective at changing

output.


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Monetary policy under fixed exchange rates

2

*LM

An increase in M would

shift LM* right and reduce e.

Y

e

Y1

1

*LM

1

*IS

e1

To prevent the fall in e,

the central bank mustbuy domestic currency,

which reduces M and

shifts LM* back left.

Results:

e= 0, Y = 0


monetary policy is

very effective at

changing output.Under fixed rates,

monetary policy cannot

be used to affect output.

2

*LM


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Trade policy under fixed exchange rates

Y

e

Y1

e1

1

*LM

1

*IS

2

*IS

A restriction on imports puts

upward pressure on e.

Results:

e= 0, Y > 0 Y2

2

*LM

To keep efrom rising,

the central bank mustsell domestic currency,

which increases M

and shifts LM*right.

Under floating rates,import restrictions

do not affect Y or NX.

Under fixed rates,

import restrictions

increase Y and NX.


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CASE STUDY:

The Chinese Currency Controversy

1995-2005: China fixed its exchange rate at 8.28

yuan per dollar, and restricted capital flows.

Many observers believed that the yuan was

significantly undervalued, as China wasaccumulating large dollar reserves.

U.S. producers complained that Chinas cheap

yuan gave Chinese producers an unfair advantage.

President Bush asked China to let its currencyfloat; Others in the U.S. wanted tariffs on Chinesegoods.


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CASE STUDY:

The Chinese Currency Controversy

If China lets the yuan float, it may indeed

appreciate.

However, if China also allows greater capital

mobility, then Chinese citizens may start movingtheir savings abroad.

Such capital outflows could cause the yuan todepreciate rather than appreciate.


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Summary

1. Mundell-Fleming model

the IS-LM model for a small open economy.

takes Pas given.

can show how policies and shocks affect incomeand the exchange rate.

2. Fiscal policy

affects income under fixed exchange rates, but not

under floating exchange rates.


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Summary

3. Monetary policy

affects income under floating exchange rates.

under fixed exchange rates, monetary policy is notavailable to affect output.

4. Interest rate differentials

exist if investors require a risk premium to hold acountrys assets.


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Summary

5. Fixed vs. floating exchange rates

Under floating rates, monetary policy is available forcan purposes other than maintaining exchange ratestability.

Fixed exchange rates reduce some of theuncertainty in international transactions.


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Policy Effectiveness in the Mundell-Fleming Model

Fixed Exchange Rate Flexible Exchange Rate

Monetary Ineffective in changing Effective in changingPolicy income by itself; offset income; causes net

by capital inflows or exports to change tooutflows. Effective validate monetary

when coordinated policy.with fiscal policy.

Fiscal Effective in changing Ineffective in changingPolicy income because it income by itself; net

forces an accommo- exports will change todative monetary offset it. Effectivepolicy. When coordinated with

accomodativemonetary policy.


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International OrganizationsInternational Finance Organizations

International Helps coordinate internationalMonetary Fund (IMF) financial flows[www.imf.org]

World Bank Helps developing countries

[www.worldbank.org] obtain low interest loans

International Trade Organizations

World Trade Works toward free trade ingoods Organization and services and mediates trade(WTO) disputes among members[www.wto.org]

R i l d S i l I O i ti


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Regional and Special Issue OrganizationsGroup of 7 A group of 7 countries (Britain, Canada, France, Germany, Italy, Japan,

and the U.S.) that promotes trade negotiations andcoordinates economic policies among its membersOrganization A group of 13 major oil exporting countries in the Middle East,

of Petroleum Africa, and South America established to create greater cooperationandExporting coordination among member countries to help prevent the price of oilCountries from falling too low(OPEC)Organization A group of countries from Europe and North America plusfor Economic Japan, New Zealand, Mexico, the Czech Republic, Korea,Cooperation & Hungary, and Poland that promotes economic cooperationDevelopment among its members(OECD)North Established to eliminate trade barriers among Mexico,American Free the United States, and CanadaTrade Agree-

ment (NAFTA)European Union Seeks to integrate members by eliminating trade barriers and

establishing a common currency. Members are Belgium, Italy,Germany, France, Luxembourg, the Netherlands, Denmark,Ireland, the United Kingdom, Greece, Spain, Protugal, Austria,Finland, and Sweden.


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Advantages of a CommonCurrency Reduction in exchange rate risk Eliminates the risk of exchange rate variability,

which increases capital market stability

Reduction in transactions costs There is no exchange of currencies among

members, so transaction costs are reduced

Economies of scale

Along with the dollar, the euro may serve as areserve currency, so the EU gets interest freeloans


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Disadvantages of a CommonCurrency Loss of independent monetary

policy

With a common currency monetarypolicy is the same in all countriesbecause there is one money supply andone central bank

Loss of nationalism Losing a national currency may be a

loss of national identity or heritage


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Optimal Currency Areas An optimal currency area is a group of

countries suitable to adopt a commoncurrency without significantlyjeopardizing domestic policy goals.

Criteria for optimal currency areas

Similar industries

Significant labor mobility

Broad range of industries

Diverse demand shocks

Documents

MF Model_Session 15 and 16