Chapter 22 THE MUNDELL-FLEMING MODEL WITH PARTIAL INTERNATIONAL CAPITAL MOBILITY
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1 Chapter 22 THE MUNDELL-FLEMING MODEL WITH PARTIAL INTERNATIONAL CAPITAL MOBILITY This chapter extends the Keynesian model to allow for international trade in assets in the context of fixed exchange rates and partial capital mobility. Assuming that capital flows towards the country offering the higher return, a balance-of-payments equilibrium schedule (BP) is added to the IS-LM diagram. The BP schedule is flatter the lower the marginal propensity to import and, of particular interest here, the greater the responsiveness of capital flows to international interest rate differentials, that is, the higher the degree of capital mobility. A key question is whether the BP schedule is flatter or steeper than the LM curve. Capital mobility is considered "high" if the BP schedule is flatter than the LM curve, and "low" if it is steeper. The distinction matters to the impact of both fiscal and monetary policy. Fiscal expansion produces a balance of payments deficit when capital mobility is low, for example, and a surplus when capital mobility is high. Monetary expansion, on the other hand, produces an external deficit whether capital mobility is high or low, but the size of the deficit increases with the degree of capital mobility, as does the rate at which the loss of reserves undoes the initial expansion. The long-run equilibrium in this model occurs when the three curves (IS, LM, and BP) intersect at the same point. It is important to understand that merely being on the BP schedule does not mean trade is balanced. Capital mobility may allow a country to run a trade deficit or surplus for some time, by running down or building up its stock of foreign assets. In the long run, however, adjustment must take place. A balance of payments deficit, for example, is sustainable only as long as reserves hold out (recall that we are still assuming fixed exchange rates). Finally, the chapter reconsiders the assignment problem, and demonstrates that, as long as capital is mobile, the only stable assignment rule is to use monetary policy to attain external balance and fiscal policy to attain internal balance.
2 SHORT-ANSWER QUESTIONS 1. True or false: An upward-sloping balance of payments curve implies that there is a differential between domestic and foreign interest rates that is not eliminated by arbitrage. 2. Discuss the following statement: Under fixed exchange rates, a country may conduct independent monetary policy only as long as the central bank has sufficient international reserves. 3. True or false: Under fixed exchange rates, the greater the degree of international capital mobility, the greater are the effects of fiscal policy. 4. What is an "accommodating monetary policy"? Does such a policy tend to offset or augment the effects of fiscal policy? Explain. 5. Explain how fiscal expansion under fixed exchange rates can produce either a balance of payments surplus or a balance of payments deficit. 6. Why must the internal balance curve be at least as steep as the external balance curve? If the curves have the same slope, monetary and fiscal policy are no longer independent instruments. Explain why they are not. 7. If a fiscal contraction moves a country from a position of external balance to one of deficit, is capital mobility high or low? 8. If the BP schedule is flatter than the LM schedule, will fiscal contraction produce pressure for a devaluation or revaluation of the currency? 9. True or false: The higher the degree of capital mobility, the more fleeting the impact of monetary policy on income.
3 PROBLEMS 1. Deriving the Balance of Payments Curve: In the Keynesian model, the volume of imports increases with income so that the current account is a decreasing function of income. The current account, CA, is thus drawn with a negative slope in the diagram below. The capital account is a function of the interest rate but is assumed to be independent of the level of income. The capital account deficit, -KA, is drawn as a horizontal line in the top diagram; an increase in the domestic interest rate shifts the -KA curve down to - KA'. Where CA intersects -KA, the balance of payments is equal to zero. The set of all points of "external balance" (CA = -KA) is traced out by the BP locus in the lower diagram. Suppose international investors are unwilling to invest in the country depicted in the diagram so that a large interest rate differential is required to attract foreign capital. What does this imply about the shape of the balance of payments curve? Now suppose international capital flows are highly sensitive to changes in the interest rate. What does the balance of payments curve look like under this assumption?
4 (d) If a devaluation improves the country's trade balance, the current account curve will shift to the right. What happens to the balance of payments curve? Suppose an increase in income leads to a proportional rise in exports and imports. What does this imply about the shape of the CA curve? The balance of payments curve? 2. Combining the IS, LM, and BP Schedules: In previous chapters, the BP schedule would have been vertical had it been drawn. Explain. Does equilibrium in the goods and asset markets mean the economy is on the BP curve? If quotas are imposed on imports, what happens to a country's IS curve? What happens to its BP curve? What happens to the IS and BP curves if foreigners increase their demand for our goods? 3. Fiscal Policy and Capital Mobility: The effects of fiscal policy depend partly on the degree of capital mobility. Explain how, under conditions of high capital mobility, a fiscal expansion can produce a balance of payments surplus. If a fiscal expansion has no net effect on the external balance, what can we infer about the degree of capital mobility? In 1981, increased government spending in France generated downward pressure on the franc vis-a-vis the other EMS currencies. But ten years later, increased government spending in Germany generated upward pressure on the deutschemark vis-a-vis the other EMS currencies. What changed during the intervening years? 4. Monetary Policy and Capital Mobility: Explain why the direction of the change in the balance of payments resulting from a change in monetary policy does not depend on the degree of capital mobility. Explain how the effectiveness of a monetary expansion depends on the degree of capital mobility if (i) the central bank sterilizes reserve flows. (ii) the central bank does not sterilize reserve flows. Based on your answers to, what is the implication of perfect capital mobility (taken up in the next chapter) for the effectiveness of monetary policy?
5 5. Interest Rate Differentials and Capital Controls: Capital controls, taxes on foreign assets, and transaction costs impose a "wedge" between the rates earned on domestic and foreign assets. The size and variability of the differential, or wedge, depend critically on the type of restriction that is imposed on the financial market. In the 1960s, the United States government imposed an Interest Equalization Tax on holdings of foreign assets by American residents. The tax rate was set so that the effective (after-tax) earnings from foreign assets equaled the rate earned on domestic assets. Assuming this law applied to all foreign assets, how will this tax affect capital mobility? Now suppose the government imposes a flat fee on all foreign transactions. What is the effect on capital flows? What is the impact on capital flows if a tax of 10% were charged on all foreign transactions? 6. Adjustment Mechanisms: Starting from a position of external balance, what is the long-run impact of a fiscal expansion on income if the central bank does not sterilize reserve flows and capital mobility is low? capital mobility is high? capital mobility is low and prices are no longer assumed fixed? 7. Internal and External Balance (Figure 22.A.1): (d) How does the degree of capital mobility affect the slope of the BB schedule? Why can the BB schedule never be steeper than the YY schedule? If, where the BB and YY schedules intersect, trade is balanced, what do we know about the interest rate differential? In which of the four zones can we know for certain in which direction to change our policy instruments? Why is it ambiguous in the other zones? 8. Difficulties of Policy-Making: What are some of the problems in implementing successful policies for external and internal balance? Why do some economists argue that such discretionary policy-making be abandoned in favor of a consistent set of rules?
6 9. Capital Flight: Some economists estimate that about half of the loans made to developing countries have been transferred abroad by residents of those countries. Repatriating this capital is a crucial element of solving these countries' economic problems. (d) If you were to advise the government of a debtor country, which exchange rate policy would you recommend to induce capital repatriation? What problems is the government likely to face in following this advice? What trade policy would you recommend? What interest rate policy would you recommend?
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