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The Mundell-Fleming model. From IS-LM to Mundell-Fleming Policy in an open economy. The Mundell-Fleming model. Last week we introduced the basic elements required to analyse an open economy The current account: imports and exports The capital account: saving/investment flows

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## The Mundell-Fleming model

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**The Mundell-Fleming model**From IS-LM to Mundell-Fleming Policy in an open economy**The Mundell-Fleming model**• Last week we introduced the basic elements required to analyse an open economy • The current account: imports and exports • The capital account: saving/investment flows • The balance of payments equilibrium as a combination of the two • The 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**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**From IS-LM to Mundell-Fleming**• Reminder: the balance of payments is the sum of the current account and the capital account: • 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**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):**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 changed • Step 3: you convert your investment into € • You are indifferent if the 2 returns are equal**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:**Expected exchange rate depreciation**Home interest rate World interest rate 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)**From IS-LM to Mundell-Fleming**• On BP the balance of payments is in equilibrium i BoP surplus Appreciation of e • 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 BP KA surplus • The slope depends on the international mobility of capital • The lower capital mobility, the larger the slope of BP. CA deficit BoP deficit Depreciation of e Y**BP**From IS-LM to Mundell-Fleming • The MF model was developed in the 60’s, when capital mobility was low (Bretton Woods) Perfect capital mobility i=i* i BoP Surplus Appreciation of e • As a simplification, nowadays we assume perfect capital mobility i* • However, this remains a simplification! • For certain cases (like the case of trade with China), The concept of imperfect capital mobility remains relevant. BoP Deficit Depreciation of e Y**From IS-LM to Mundell-Fleming**• We now have 3 curves, IS-LM-BP : i LM BP i* IS Y**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:**The effectiveness of policy**• Monetary policy with fixed exchange rate: i • LM shifts to the right • The increase in the money supply lowers the rate of interest, leading to depreciation pressures on e LM BP • In order to guarantee the fixed exchange rate the CB must immediately increase i to i=i* by reducing money supply i* IS • Such a policy cannot be carried out in practice Y**The effectiveness of policy**• Fiscal policy with fixed exchange rate: i • IS shifts to the right: • The crowding out effect increases the rate of interest, creating appreciation pressures on e LM BP • In order to guarantee the fixed exchange rate the CB must immediately reduce i to i=i* by increasing money supply i* IS • Policy is effective in increasing Y Y**The effectiveness of policy**• Monetary policy with flexible exchange rate: i • LM shifts to the right • The interest rate falls, which leads to a depreciation of the exchange rate e LM • The depreciation of the exchange rate stimulates exports and penalises imports • As a resut IS shifts to the right BP i* IS • Policy is effective Y**The effectiveness of policy**• Fiscal policy with flexible exchange rate: i • IS shifts to the right • The Central Bank doesn’t have to react: The interest rate increases and the exchange rate appreciates LM BP • The appreciation of the exchange rate penalises exports and stimulates imports • IS shifts left i* IS • Policy is ineffective Y**The effectiveness of policy**• Summarising all this: • Even with this simple example (assumption of perfect capital mobility), one can see that the effectiveness of policy depends on international conditions!**The effectiveness of policy**Monetary Union Incompatibility Triangle (Mundell) Capital mobility Fixed exchange rate Flexible Exchange rate Financial Autarky Autonomous monetary policy

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