Chapter 3 MundellFleming Model Asst. Prof. Dr. Mete Feridun. The MundellFleming Model. The MundellFleming Model is an extension of the IS/LM model to include joint determination of net exports and the value of the currency.
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LM*
IS*
Y
Equilibrium in the MundellFleming modelequilibrium
exchange
rate
equilibrium
level of
income
In a system of floating exchange rates, e is allowed to fluctuate in response to changing economic conditions.
In contrast, under fixed exchange rates, the central bank trades domestic for foreign currency at a predetermined price.
Next, policy analysis –
first, in a floating exchange rate system
then, in a fixed exchange rate system
10
Argument for floating rates:
allows monetary policy to be used to pursue other goals (stable growth, low inflation).
Arguments for fixed rates:
avoids uncertainty and volatility, making international transactions easier.
disciplines monetary policy to prevent excessive money growth & hyperinflation.
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At any given value of e, a fiscal expansion increases Y,shifting IS* to the right.G↑; Y↑; L(r*,Y)↑; pressure on r*↑; e↑; NX↓; Y↓
e
e2
e1
Y
Fiscal policy under floating exchange ratesResults:
e > 0, Y = 0
Y1
An increase in Mshifts LM* right because Y must rise to restore equilibrium in the money market.M↑; pressure on r*↓; e↓; NX↑; Y↑
e
e1
e2
Y
Y1
Monetary policy under floating exchange ratesResults:
e < 0, Y > 0
Y2
At any given value of e, a tariff or quota reduces imports, increases NX, and shifts IS* to the right.NX↑; Y↑; L(r*,Y)↑; pressure on r*↑; e↑; NX↓; Y↓
e
e2
e1
Y
Y1
Trade policy under floating exchange ratesResults:
e > 0, Y = 0
Under fixed exchange rates, the central bank stands ready to buy or sell the domestic currency for foreign currency at a predetermined rate.
In the MundellFleming model, the central bank shifts the LM* curve as required to keep e at its preannounced rate.
This system fixes the nominal exchange rate. In the long run, when prices are flexible, the real exchange rate can move even if the nominal rate is fixed.
19
Under floating rates, a fiscal expansion would raise e.
e
e1
Y
Fiscal policy under fixed exchange ratesUnder floating rates, fiscal policy is ineffectiveat changing output.
Under fixed rates,fiscal policy is effective at changing output.
To keep e from rising, the central bank must sell domestic currency, which increases M and shifts LM* right.
Results:
e = 0, Y > 0
Y1
Y2
An increase in M would shift LM* right and reduce e.
e
e1
Y
Y1
Monetary policy under fixed exchange ratesUnder floating rates, monetary policy is effective at changing output.
Under fixed rates,monetary policy cannot be used to affect output.
To prevent the fall in e, the central bank must buy domestic currency, which reduces M and shifts LM* back left.
Results:
e = 0, Y = 0
A restriction on imports puts upward pressure on e.
e
e1
Y
Y1
Trade policy under fixed exchange ratesUnder floating rates, import restrictions do not affect Y or NX.
Under fixed rates,import restrictions increase Y and NX.
But, these gains come at the expense of other countries: the policy merely shifts demand from foreign to domestic goods.
To keep e from rising, the central bank must sell domestic currency, which increases Mand shifts LM* right.
Results:
e = 0, Y > 0
Y2
e1
e2
Y
Y1
The effects of an increase in IS* shifts left, because
r I
LM* shifts right, because
r(M/P)d,
so Y must rise to restore money market equilibrium.
; e↓; NX↑; Y↑
Results: e < 0, Y > 0
Y2
1. Foreign growth rises
2. Domestic growth shrinks
3. Lower inflation
4. Weaker currency
A nation cannot have free capital flows, independent monetary policy, and a fixed exchange rate simultaneously.
A nation must choose one side of this triangle and give up the opposite corner.
Free capital flows
Fixed exchange rate
Independent monetary policy
Option 2(Hong Kong)
Option 1(U.S.)
Option 3(China)
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19952005: 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 was accumulating large dollar reserves.
U.S. producers complained that China’s cheap yuan gave Chinese producers an unfair advantage.
President Bush asked China to let its currency float
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A nation cannot have free capital flows, independent monetary policy, and a fixed exchange rate simultaneously.
China obviously wishes to have independent monetary policy. So it must choose one side of the triangle and choose either free capital flows or a fixed exchange
If China lets the yuan float, it may indeed appreciate. But if it also allows greater capital mobility, then Chinese citizens may start moving their savings abroad.
Such capital outflows could cause the yuan to depreciate rather than appreciate.
So it is a tough decision !
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MundellFleming model
the ISLM model for a small open economy.
takes P as given.
can show how policies and shocks affect income and the exchange rate.
Fiscal policy
affects income under fixed exchange rates, but not under floating exchange rates.
Monetary policy countries cannot boost growth by devaluing the currency any more than they can boost growth by increasing government spending or printing more money.
affects income under floating exchange rates.
under fixed exchange rates, monetary policy is not available to affect output.
Interest rate differentials
exist if investors require a risk premium to hold a country’s assets.
An increase in this risk premium raises domestic interest rates and causes the country’s exchange rate to depreciate.
Fixed vs. floating exchange rates countries cannot boost growth by devaluing the currency any more than they can boost growth by increasing government spending or printing more money.
Under floating rates, monetary policy is available for purposes other than maintaining exchange rate stability.
Fixed exchange rates reduce some of the uncertainty in international transactions.
i
i
LM1
LM1
LM0
LM0
i1
i1
i0
i0
IS
IS
Y
Y
Y0
Y1
Y0
?
Again ignoring international complications, if investment is not sensitive to interest rate changes, a reduction in the money supply raises interest rates a lot, but this has little effect on output.
Under normal conditions, ignoring international complications, a reduction in the money supply raises interest rates, making investment more expensive, slowing output.
Under fixed exchange rates and perfect capital mobility
In this case, any change in the domestic money supply causes a change in the interest rate, leading to the movement of enormous international capital flows. These capital flows happen almost instantly, and continue until the interest rates are restored to their original level—the same level as the world interest rate.
Thus, effectively, the interest rate is fixed at the world rate, and domestic monetary policy cannot change the interest rate, and therefore cannot affect the domestic economy.
i
FE
i0
LM
IS
Y
Y0
LM
i
i
IS1
IS0
i1
LM0
i0
IS1
i0
IS0
Y
Y
Y0
Y0,1
Y1
Under normal conditions, ignoring international complications, if money demand is very unresponsive to interest rates, then fiscal policy simply raises interest rates, and rendered weak as a result of “crowding out”.
Again ignoring international complications, if money demand is sensitive to interest rate changes, fiscal stimulus is powerful. Small changes in interest rates have a large impact on the money supplydemand equilibrium. There is no crowding out.
Under fixed exchange rates and perfect capital mobility
A stimulative fiscal policy shifts IS to the right. Any tiny increase in the interest rate generates enormous changes in the domestic money supplydemand equilibrium as a result of the enormous capital inflow. FE and LM are both anchored at the world interest rate. Thus there is no possibility of crowding out, and fiscal policy is powerful.
i
FE
i0
LM
IS
Y
Y0
Y1
LM1
FE1
i
LM0
T
FE0
E
IS
Y1
Y0
Y
State of the Domestic Economy
State of
Balance of
Payments
In the situations marked by “??”, aggregate demand policy cannot deal effectively with both the internal and external situations simultaneously.
State of the Domestic Economy
State of
Balance of
Payments
Consider a devaluation of the dollar, where the CA balance is measure in pounds per year:
CA balance = P£X • X  P£m • M
Quantity
of Imports
Quantity
of Exports
£ price of Exports
£ price of Imports
No change or down
No change or down
No change or up
No change or down
Effect =
•
•

Net change in trade balance
+
0
Months since devaluation

18 months
Capital flows out
Current account balance improves
Money supply increases
Interest rate drops
Our currency depreciates
GDP rises more
Current account balance worsens
Spending and output increase
Price level rises
LM0
FE0
Following expansionary monetary policy, the currency depreciates to correct the deficit payments balance—FE moves to the right. IS moves to the right as the current account improves.
i
LM1
E0
FE1
E1
T1
IS1
IS0
Y0
Y1
Y
Interest rate rises
Capital flows in
Our currency may appreciate at first, but probably depreciates eventually
GDP falls, then rises more
Gov’t spending increases
Current account balance worsens
Spending and output increase
Price level rises