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LECTURE 3: THE MUNDELL-FLEMING MODEL -- MONETARY & FISCAL POLICY, AND ADJUSTMENT

LECTURE 3: THE MUNDELL-FLEMING MODEL -- MONETARY & FISCAL POLICY, AND ADJUSTMENT. Question 1 : What are the implications of monetary & fiscal policy for income & the balance of payments, at a given exchange rate?

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LECTURE 3: THE MUNDELL-FLEMING MODEL -- MONETARY & FISCAL POLICY, AND ADJUSTMENT

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  1. LECTURE 3: THE MUNDELL-FLEMING MODEL --MONETARY & FISCAL POLICY, AND ADJUSTMENT • Question 1: What are the implications of monetary & fiscal policy for income & the balance of payments, at a given exchange rate? • Question 2: Mechanisms of adjustment. How does a country adjust toBoPimbalance? Whatfurther implications for the economy? • Key parameter: κ , degree of capital mobility • Key results: • κ raises effect of G on Y under fixed E(but lowers it under floating). • κ lowers effect of M on Y under fixed E (but raises it under floating).

  2. Recap slopes down An increase in spending, e.g., fiscalexpansion, shifts IS right, by the multiplier, 1/(s+m). slopes up LM′ Monetary expansion shifts LM right. slopes up slope = m/κ API-120 - Prof. J.Frankel, Harvard

  3. • • • API-120 - Prof. J.Frankel, Harvard

  4. • • • API-120 - Prof. J.Frankel, Harvard

  5. Monetary & fiscal policy in the Mundell-Fleming model with a fixed exchange rate -- Summary • Fiscal expansion shifts out IS curve. • Result: Y↑ , • though by less than simple Keynesian multiplier because i↑ => crowding out. • Monetary expansion shifts out LM curve. • Result i ↓ => Y↑. • Magnitudes of ∆Y do not depend on degree of capital mobility, κ. Resultfor externalbalance i)Y↑ => TB ↓ ii) With an open KA: • Fiscal expansion => i ↑ => KA ↑ · • Monetary expansion => i ↓ => KA ↓ Effect on overall BP (=CA+KA) depends on degree of capital mobility. API-120 - Prof. J.Frankel, Harvard

  6. Automatic mechanisms of adjustment • Reserve flows R -- as under the MABP. • Price level P -- we assume for the moment that price adjustment is very slow. • Indebtedness -- rising debt will eventually force a reduction in spending. We omit this factor from the analysis for now. • Exchange rate E -- if flexible . MABP(The Monetary Approach to the Balance of Payments) • Defining assumption:Reserve flows are not sterilized. • Another assumption sometimes associated with MABP: PPP .

  7. Insulated. API-120 - Prof. J.Frankel, Harvard

  8. MABP: If reserve outflow is not sterilized, then MB falls, LM shifts back, and i rises over time, Without sterilizing reserve flows until in the long run we are back where we started. • • • • • • This offset to the increase in MB happens more quickly, the higher is κ . API-120 - Prof. J.Frankel, Harvard

  9. A country at point B-- as were many developing countries in 1990-96,2003-08, or 2010-13 -- has a BoP surplus. • The authorities must choose among several options for managing inflows.(Each option has its own drawback). Alternative ways to manage inflows (with disadvantages) A. Allow money to flow in. (Can be inflationary) B. Sterilize intervention. (Artificially prolongs disequilibrium) C. Allow currency to appreciate. (Lose competitiveness) D. Reimpose capital controls. (Lose financial integration gains) API-120 - Prof. J.Frankel, Harvard

  10. Examples of attempts to sterilize capital inflows, to dampen real appreciation • In the early 1990s, Colombia, Korea, Indonesia and others sterilized for a year or two and then gave it up. • More recently, China successfully sterilized for five years … until 2007-08, 2010-11. API-120 - Prof. J.Frankel, Harvard

  11. Example of sterilization of money inflows: China, 2003-2012 API-120 - Prof. J.Frankel, Harvard

  12. China’s Balance of Payments ≡ rate of change of foreign exchange reserves (largely $), rose rapidly from 2004 on, due to all 3 components: trade balance, Foreign Direct Investment, & portfolio inflows Reserves Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008 12 API-120 - Prof. J.Frankel, Harvard

  13. FX reserves of the PBoC climbed higher than any central bank in history API-120 - Prof. J.Frankel, Harvard http://viableopposition.blogspot.com/2012/03/chinas-holdings-of-us-treasuries-what.html http://qz.com/171645/the-invisible-man-managing-chinas-3-8-trillion-in-reserves-just-stepped-down

  14. In 2003-04, forex inflows accelerated rapidly. (Both TB & KA >> 0.) Initially, the PBoC had no trouble sterilizing the inflows. => The MB growth rate was kept down to the growth rate of thereal economy (≈ 10%/year), so there was little inflationary pressure. API-120 - Prof. J.Frankel, Harvard

  15. In 2007-08 China had more trouble sterilizing the reserve inflow (as predicted) • PBoC began to have to payhigher domestic interest rates • and to receive lower interest rate on US T bills • => “quasi-fiscal deficit” or “negative carry.” • Inflation became a serious problem in 2007-08. • Also a “bubble” in the Shanghai stock market. API-120 - Prof. J.Frankel, Harvard

  16. Sterilization faltered in 2007 & 2008Growth of China’s monetary base & its components: Money growth accelerated sharply, 2007-08 Source: HKMA, Half-Yearly Monetary & Financial Stability Report, June 2008 API-120 - Prof. J.Frankel, Harvard

  17. China’s CPI accelerated in 2007-08 Inflation 1999 to 2008 Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008 API-120 - Prof. J.Frankel, Harvard

  18. Further tools: The PBoC raised reserve ratios required of banks, thus sterilizing in the broad sense of slowing M1. It also raised lending rates while continuing to underpay depositors: { “financial repression” Source: HKMA, Half-Yearly Monetary & Financial Stability Report, June 2008

  19. Chinese inflation fell in 2008-09, and again in 2011-14 API-120 - Prof. J.Frankel, Harvard

  20. Appendix: More on China’s sterilization ΔReserves↑ While increases in reserves (NFA) were large, changes in net domestic assets (NDA) were negative, limiting rises inthe monetary base.

  21. The People’sBank of China sold sterilization bills Data: CEIC Source: Zhang, 2011, Fig.4, p.45. API-120 - Prof. J.Frankel, Harvard

  22. Sterilization of foreign reserves:The decreases in PBoC’s net domestic assetsoffset increases in foreign assets API-120 - Prof. J.Frankel, Harvard Source: Zhang, 2011,Fig.7, p.47.

  23. Further, the PBoC raised banks’ required reserve ratios,thus sterilizing in the broad sense of slowing M1, even if MBase grew rapidly Source: Zhang, 2011, Fig.6, p.46. API-120 - Prof. J.Frankel, Harvard

  24. China’s inflation broke sharply in 2009, (<= big one-year loss of China’s exports due to global recession). But took off again in 2010-11. Inflation 2001 to 2011 API-120 - Prof. J.Frankel, Harvard

  25. After the interruption of mid-2008 to mid-2009 overheating resumed: rapid rise of land prices in 2010 Real Beijing land prices API-120 - Prof. J.Frankel, Harvard

  26. When house prices rise relative even to rents, it suggests a bubble or easy money Scott Reeve blog API-120 - Prof. J.Frankel, Harvard

  27. China in 2010 resumed attempts to sterilize money inflows by raising banks’ reserve requirements-- to slow M1 growth even while MB is growing rapidly. API-120 - Prof. J.Frankel, Harvard

  28. China’s tightened control of the money supply to help head off rising inflation in 2004, 08, and again in 2011. API-120 - Prof. J.Frankel, Harvard Fxtimes.com

  29. Chinese inflation, once again, began to ease off after mid-2011 API-120 - Prof. J.Frankel, Harvard

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