The Mundell-Fleming model

Transcription

1 The Mundell-Fleming model 2013

2 General short run macroeconomic equilibrium Income influences demand for money Goods Market Money Market Interest rates affect aggregate demand

3 in the open the economy Income influences demand for money Goods Market Money Market Interest rates affect aggregate demand Real exchange rates affect aggregate demand International capital markets Interest rates influence the exchange rate

4 Overview Outline 1. The assumptions of the Mundell-Fleming model 1. Interest rate parity 2. Defining the general equilibrium 1. Equilibrium under flexible exchange rates 2. Equilibrium under fixed exchange rates 3. The Impossible Trinity 4. Case study: China 5. Conclusion

5 1. The Mundell-Fleming model The Mundell-Fleming model Extension of the IS-TR model for the open economy with internationally integrated financial markets Key variable: exchange rate Assumptions Sticky prices Small open economy Robert Mundell Nobel prize 1999 Small: influenced by changes in the rest of the world, but no impact on the rest of the world Open: free international trade & financial openness

6 1. The Mundell-Fleming model Openness and economic size, 2004 Share of world GDP (%) Trade openness (% of GDP) Financial openness Total assets (% of GDP) Total liabilities (% of GDP) Denmark Poland Sweden Belgium Switzerland Netherlands Brazil Korea, Rep China UK Germany Japan Euro countries US

7 1.1. The Mundell-Fleming model International capital flows interest rate parity condition If international capital markets are perfectly integrated, the rate of return (in the same currency) on assets sharing the same risk profile should be identical. i = domestic interest rate i* = international rate of return i=i* If i i* : Investors would be able to make profits by borrowing in one market and lending in the other. Arbitrageurs (international investors) guarantee that when capital markets are fully integrated i=i*

8 Interest rate 1.1. The Mundell-Fleming model IFM schedule Equilibrium on the international financial markets (IFM) When i i*, capital will flow towards the country with the higher returns until returns are equalized. i* i > i*, capital flows in i < i*, capital flows out Financial integration line (IFM) Output

9 1.1. The Mundell-Fleming model Long term interest rates,

10 1.1. The Mundell-Fleming model The Mundell Fleming model Capital controls and exchange rates Impossible Trinity Fixed exchange rate Independent monetary policy Free capital movements assumed to be the case here Lessons of Mundell Flemming model: The behavior of the economy change when internationally integrated The behavior of the economy depends on its choice of exchange rate regime Should we adapt a fixed or a flexible exchange rate?

11 1.1. The Mundell-Fleming model Exchange rate regimes Fixed exchange rate CB stands ready to buy and sell their currencies at a fixed price CB intervenes when there is an excess supply or demand of the currency at the fixed exchange rate Ex: Denmark Euro, China US Dollar Flexible exchange rate Central banks allow the exchange rate to adjust to equate the supply and demand for foreign currency The British pound floats freely against both the US dollar and the Euro The fluctuations can be very large Reminder: increase in the exchange rate = appreciation my goods become more expensive

12 2. Defining the Macroeconomic equilibrium General Equilibrium The goods market The money market The international financial markets We need to combine all three markets to describe what will happen in general equilibrium, i.e. when all the three markets clear.

13 Interest rate 2. Defining the Macroeconomic equilibrium Equilibrium in the goods market IS-curve graphs all combinations of i and Y that result in goods market equilibrium Total demand = total supply of goods *,,,, Y C Y T I q i G PCA Y Y Changes in output will occur when we are not on the IS curve (as response to shortage to the left of IS and surplus to the right). IS Output

14 2. Defining the Macroeconomic equilibrium Equilibrium in the goods market Shifts of the IS curve in an open economy: Real exchange rate: σ = (S P) / P* P* and P are fixed σ is proportional to S When S decreases: real exchange rate depreciation σ = decrease of relative price of my goods exports and imports Net exports increase shift of IS to the right

15 Interest rate 2. Defining the Macroeconomic equilibrium Equilibrium in the money market TR curve represents the equilibrium in the money market i.e. the combinations of the interest rate i and the income level Y where money demand equals money supply i CB follows Y Y b Y inflation targeting (Taylor rule) On the TR curve: for different i different levels of M/P i TR Always on the TR curve Output

16 Nominal nterest rate Nominal nterest rate Find the mistake! i A M H B F D C S i D i A H C B F TR TR IS IS Real money supply Y Output

17 Interest rate 2. Defining the Macroeconomic equilibrium General equilibrium TR i* A Financial integration line IS Output

18 2.1. Defining the Macroeconomic equilibrium flexible exchange rates Flexible exchange rate Flexible exchange rates and perfect capital mobility i = i* If i > i* capital inflow σ IS shifts left If i < i* capital outflow σ IS shifts right What happens if? 1.Demand disturbances (Fiscal policy) 2.Change in monetary policy 3.International financial disturbances (increase in i*)

19 Interest rate 2.1. Defining the Macroeconomic equilibrium flexible exchange rates Demand disturbances Starting from equilibrium, real demand increases (government expenditures increase) A B TR i* IFM However, the resulting increase in S will reduce the demand for goods. IS IS Output

20 Interest rate 2.1. Defining the Macroeconomic equilibrium flexible exchange rates Demand disturbances i>i* will attract capital inflows, so S appreciates i* A B TR However, the resulting increase in S will reduce the demand for goods. IFM IS IS Fiscal policy is ineffective Output

21 2.1. Defining the Macroeconomic equilibrium flexible exchange rates Real demand disturbances Why is a shift in IS inefficient? IS shifts following an increase in the demand for domestic goods IS shifts right Raise in income has increased money demand and i Higher i leads to exchange rate appreciation (capital inflow) Appreciation of S continues as long as i > i* Appreciation decreases demand for our exports higher G is compensated by lower PCA IS shifts back We end up at the initial equilibrium Chapter 10: higher i crowded investment (partly) out Here: exchange rate appreciation reduces exports

22 Interest rate 2.1. Defining the Macroeconomic equilibrium flexible exchange rates Expansionary monetary policy TR TR Capital outflow leads to a depreciation of the exchange rate net exports increase i* A B C IS IS IFM Monetary policy is effective Output 24

23 Interest rate Interest rate 2.1. Defining the Macroeconomic equilibrium flexible exchange rates Expansionary monetary policy: TR curve Monetary policy under flexible exchange rates, TR curve D (Y ) D(Y) D (Y ) i* i* IFM i A A C B Real money stock A A Y C B IS Y IS Output

24 2.1. Defining the Macroeconomic equilibrium flexible exchange rates Expansionary monetary policy CB sets i < i* TR shifts to the right i <i* capital outflow decrease in demand for my currency Decrease in exchange rate my goods become relatively cheaper Net exports increase Increase in exports leads to an increase in Y IS shifts right Higher Y higher money demand move up on the TR curve Depreciation continues until i = i* IS, TR and IFM back in equilibrium: same i but higher Y

25 2.1. Defining the Macroeconomic equilibrium flexible exchange rates Beggar-Thy-Neighbor policy Country A: Monetary expansion leads to a depreciation of the exchange rate and an increase in net exports to country B Increase in GDP of country A Country B sees its net exports to country A decreasing Decrease in GDP of country B Monetary expansion only shifts demand from one country to another, doesn t increase the total demand for goods.

26 2.1. Defining the Macroeconomic equilibrium flexible exchange rates Interest rate International financial disturbances Increase in rate of return on foreign assets, i* TR i* i* A C IS Output

27 Interest rate 2.1. Defining the Macroeconomic equilibrium flexible exchange rates International financial disturbances TR i* C IFM i* A depreciation in the exchange rate raises net exports A IS IFM IS Output 29

28 2.1. Defining the Macroeconomic equilibrium flexible exchange rates International financial disturbances Why does an increase in the foreign rate of return leads to a higher output? If i* IFM schedule shifts up Then i <i* capital outflow exchange rate Net exports Increase in demand for our goods IS shifts right Y money demand i We end at the new equilibrium at C, where i = i*

29 2.2. Defining the Macroeconomic equilibrium fixed exchange rates Fixed exchange rate regime Fixed exchange rate regime: central bank commits to maintain a fixed relative price for the domestic currency vis a vis a foreign one. For example: EU members which have not (yet) adopted the euro are part of the exchange rate mechanism, which fixes the value of their currency vis a vis the euro. Denmark, Lithuania, Bosnia-Herzegovina, Bulgaria have a currency board with the euro. Main difference: monetary policy is ineffective, fiscal policy is effective

30 Interest rate 2.2. Defining the Macroeconomic equilibrium fixed exchange rates Monetary policy Starting from general equilibrium, there is an unanticipated increase in the supply of money TR TR i* A Financial integration line IS Output

31 Interest rate 2.2. Defining the Macroeconomic equilibrium fixed exchange rates Monetary policy The central bank has to decrease money supply again to keep the exchange rate fixed. TR TR i* A Financial integration line IS Monetary policy is ineffective. Output

32 2.2. Defining the Macroeconomic equilibrium fixed exchange rates Summary Why is monetary policy under fixed exchange rates ineffective? Money supply TR shifts right Capital outflow and depreciation of domestic currency would be the consequence with flexible exchange rate To prevent the depreciation CB sells foreign currency to buy domestic money by buying domestic money, CB takes the money out of circulation Money supply decreases TR shifts back to the left S constant We end up at the initial equilibrium The monetary expansion was ineffective

33 2.2. Defining the Macroeconomic equilibrium fixed exchange rates Interest rate Figure Demand disturbances TR i* A Financial integration line IS Output

34 2.2. Defining the Macroeconomic equilibrium fixed exchange rates Interest rate Demand disturbances TR i* A C Financial integration line IS IS Output

35 2.2. Defining the Macroeconomic equilibrium fixed exchange rates Interest rate Demand disturbances TR TR i* A C Financial integration line IS IS Output

36 2.2. Defining the Macroeconomic equilibrium fixed exchange rates Demand disturbances (fixed exchange rate) G IS shifts right Higher demand higher income Interest rate remains fix Money supply has to increase in order to keep S constant TR shifts right New equilibrium at higher Y but same i Fixed exchange rate regime: an increase in government expenditure is effective in increasing output. Monetary policy has to accommodate the fiscal expansion in this case. This policy is actually more effective in an open economy with fixed exchange rates than in a closed economy (because of higher i in closed economy)

37 3. The Impossible Trinity The Impossible Trinity A nation cannot have simultaneously: 1. free capital flows, 2. independent monetary policy, and 3. a fixed exchange rate Q: Where lies the Euro zone? Option 1 (U.S.) Free capital flows Option 2 (Hong Kong) A nation must choose one side of this Independent triangle and monetary give up the policy opposite corner. Option 3 (China) Fixed exchange rate Source: Mankiw 7 th edition

38 4. Case study: China CASE STUDY The Chinese Currency Controversy : China fixed S=8.28 yuan per US$, and restricted capital flows. Many believed that the yuan was significantly undervalued, because China was accumulating large dollar reserves. U.S. producers complained that China s cheap yuan gave Chinese producers an unfair advantage. America s government asked China to let its currency float; Others in the U.S. wanted tariffs on Chinese goods.

39 4. Case study: China CASE STUDY If China lets the yuan float, it may indeed appreciate. However, if China 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. Find an interesting article on this issue:

40 5. Conclusion The Mundell-Fleming model: Summary Effect on real GDP Exogenous change Fixed exchange rates Flexible exchange rates Expansionary demand disturbance Increase No effect Expansionary monetary disturbance No effect Increase Increase in foreign interest rates Decrease Increase Fixed exchange rates Flexible exchange rates Exogenous monetary instrument Exchange rate Money supply Endogenous monetary instrument Money supply Exchange rate