Topic 7: The Mundell-Fleming Model Read: Ch.18.3-18.6. Outline: 1. Introduction. 2. The IS-LM-BP equilibrium. 3. Floating exchange rates 4. Fixed exchange rates. 5. The case of imperfect capital mobility 6. The policy mix. Introduction: The Mundell-Fleming model goes further than the simple Swan diagram in exploring the relationship between fiscal policy, monetary policy and exchange rate policy. It explicitly distinguishes between the two extremes of a fixed exchange rate regime and a fully floating one. In its simplest form it assumes that capital markets are perfect and that domestic interest rates are equal to world interest rates. The Mundell Fleming model also assumes that the economy is in a recession and prices are fixed; the main endogenous variables are the level of GDP and the nominal domestic interest rate (i); under a flexible exchange rate system R is also endogenous, but in a fixed rate system, it is set exogenously and M becomes endogenous.
IS-LM-BP equilibrium: The IS curve is the locus of i Y points at which the domestic goods market is in equilibrium, i.e. Y = A + CA. It is downward sloping, since an increase in i lowers I and this reduces A; thus output should fall in order to maintain equilibrium. This relationship can be derived from the income determination model by assuming that I depends negatively on i and is not exogenous. The LM curve is the locus of i Y points such that the domestic money market is in equilibrium. It is upward sloping since an increase in i reduces the demand for money and thus Y should rise in order to restore money demand (for a fixed money supply). Note that the determinants of money demand are different from those assumed in the monetary approach. Money demand specifically depends on i. However, it is still implicitly assumed that no currency substitution takes place. The BP curve is the locus of i Y points such that the nation s balance of payments is in equilibrium. The shape of this curve depends on whether we are talking of a small economy which faces perfect capital mobility or not. Under perfect capital mobility, the domestic interest rate must always equal the world interest rate i which is exogenous. Thus the BP line is horizontal at i and does not shift for any reason other than a change in i. Under imperfect capital mobility, such as when domestic and foreign assets are imperfect substitutes (this is assumed in the portfolio balance approach which we skipped), OR when the economy is relatively large, the BP line is upwards sloping. This is because i need not always equal i when the economy is large or capital flows are imperfect. Thus, an increase in i above i is possible, but will create an inflow of cap-
ital (move the capital account towards surplus). To offset this, the current account must move towards deficit, which requires an increase in A, some of which spills over into higher Y. The slope of BP depends on how elastic foreign capital flows are. A flat BP implies highly elastic flows: a small increase in i can create a huge capital inflow requiring a large increase in A (and Y ) to restore balance of payments equilibrium. On the i Y diagram, the BP line is drawn for a given value of R and of the world interest rate i. An increase in i will shift the BP line upward since the domestic interest rate will have to catch up with the world interest rate. This is true even if BP is flat. A change in R shifts the BP line (unless it is flat at i ). An increase in R causes the BP line to shift downwards or rightwards. This is because a depreciation causes the trade balance to move towards surplus; this would require a fall in i (at any given Y ) to create a balancing outflow of capital. Conversely, at given i, Y would have to rise in order for the trade balance to move back to where it was. A decrease in R causes the BP line to shift upwards. Equilibrium in all three contexts (goods, money and balance of payments) arises only where IS, LM and BP intersect. What mechanism ensures that this will happen? Flexible Exchange Rates: Under flexible exchange rates, Y, R and, except in the case of perfect capital mobility, i all change to ensure that the three markets are in simultaneous equilibrium. It is best to assume that initially all three are in equilibrium. Expansionary monetary policy: Now suppose that the central bank increases M by buying either domestic bonds D or foreign bonds F. The LM curve shifts right and puts downward pressure on i. In the case of perfect capital mobility, even the slightest downwards pres-
sure on i will cause a large, immediate capital outflow. This will create an excess demand for foreign currency leading to a depreciation (rise in R). The depreciation will cause an increase in the trade balance (which helps cancel out the capital account deficit). This increases the demand for domestic products and causes IS to shift rightwards. Ultimately, IS shifts to the intersection of the new LM with BP. In the new equilibrium, Y has increased and the currency has depreciated. Comparison with monetary model: in that model an increase in M also causes R to go up, but this is accompanied by an increase in P. This is because of the assumption of full employment. Thus, with a flexible rate, monetary policy is very effective in stimulating demand for domestic output. Expansionary fiscal policy: Suppose that, starting again from the government increases G or cuts T. This causes A to rise and IS shifts out. There is upward pressure on i. This small pressure brings in large instantaneous capital flows which increase supply of foreign currency. thus R appreciates (falls). The fall in R leads to a fall in the CA (offsetting the KA surplus). As the CA falls, IS shifts back. Eventually, IS returns to its old level. The increase in G and A have merely crowded out exports, no overall increase in aggregate demand or in Y. This, with a flexible exchange rate, fiscal policy is ineffective in changing aggregate demand for domestic products Fixed Exchange Rates: Expansionary monetary policy: Assume that the CB increases the money supply by buying domestic securities (D goes up in the CB portfolio). The LM curve tends to shift out. This would put downward pressure on the domestic interest rate. A flood of capital leaves the country. This leads to an increase in demand
for foreign currency. With a fixed exchange rate, the CB will have to sell its foreign reserves in order to meet the demand for foreign exchange. Thus F falls. Money supply goes down by the amount R times the fall of F which offsets the initial increase through the increase in D. The LM curve shifts back to original position. The punch-line is that the Central bank is unable to control the money supply exogenously. The level of the money supply is purely determined by the need to buy and sell reserves in meeting imbalances on the foreign exchange market. What if the increase in the money supply was attempted by an increase in F through a purchase of foreign securities? LM would shift out temporarily as before. Downward pressure will happen on domestic i causing an outflow of capital, causing in turn an increase in demand for foreign exchange. Ultimately, the government will have to sell foreign reserves equal in amount to the initial purchase. So no change in either F or M. The LM shifts back. Under fixed exchange rates, monetary policy cannot be used to affect aggregate demand in the domestic economy. Thus it cannot be used for internal balance. Only fiscal policy remains as a tool through which internal balance can be achieved. Expansionary fiscal policy: Suppose G goes up. This directly causes an increase in AD (by the multiplier effect refer to elementary macro if you are interested in further details). The IS curve shifts out, upward pressure on i. Capital flows in instantaneously. Excess supply of foreign currency. Government buys this and F goes up, so does M. LM shifts out to the intersection of new IS and BP. Note that the increase in G will have the full multiplier effect on output.
Under fixed rates, fiscal policy can provide a powerful stimulus to aggregate expenditures on domestic goods. None of the crowding out that happened in the case of floating rate happens in this case. But note that there are some problems with only being able to use fiscal policy for internal balance. government spending has to be approved through a lengthy legislative process and tax revenues depend on tax rates which are even more difficult to change; if the government cuts taxes and people don t expect it to keep taxes at the lower level for a long period of time then domestic consumption spending does not increase very much anyway; the effects of tax and government spending changes take a long time to enter the stream of spending even after they have been enacted; in an economy which can only use fiscal policy for internal balance there is no rapid response measure (note that even monetary policy is not instantaneous and can take months to be implemented and have effect). Imperfect capital mobility: We shall only consider cases where the BP curve is less steep than LM. The case where it is steeper leads to some paradoxical results. Although an upward sloping BP can result either if (i) the economy is large OR (ii) if it is small but domestic and foreign assets are not perfect substitutes, the behaviour of the economy will be different under the two scenarios. We restrict attention to the case of a large economy which can affect world prices and interest rates. Under flexible rates, the location of the LM will be fixed by government monetary policy since the money supply is completely exogenous. Suppose government spending goes up. The IS curve shifts out. This causes the domestic interest rate to go up, capital flows in. This has two effects: (i) a decrease in R; (ii) an increase in i, the world interest rate.
Both factors cause BP to shift up. The decrease in R will cause exports to fall, shifting IS back. But it does not shift all the way back, only till it intersects the LM and the new BP. Thus fiscal policy can cause three effects: (i) R goes down; (ii) i goes up and (iii) Y goes up. Under perfect capital mobility only R goes down. Now suppose government increases M. The LM curve shifts out. Domestic i falls and capital flows out: therefore R rises and i falls. As R rises, both IS and BP shift outwards. BP also shifts out (i.e. down) since i falls. In the new equilibrium, R has fallen and Y has risen. The effect on i is ambiguous since it depends on which of IS or BP shifts out more. Under fixed rates, the location of the IS curve will be fixed by government fiscal policy and the level at which the exchange rate is fixed. An increase in M will also cause LM to shift out and i to fall. The fall in i will induce capital outflows which in turn cause i to fall. The BP shifts out. In the new equilibrium, LM shifts back (since the fall in the world interest rate only partially offsets the capital outflows, sales of foreign reserves are still needed to maintain foreign currency markets in equilibrium). But it only shifts back to the intersection of the IS with the new BP. Thus, i falls and Y goes up. So monetary policy has some effect on internal balance. A large country can retain some use of monetary policy for internal balance but the magnitude of the effects of monetary policy on output and employment might be small. Now suppose that G goes up or T is cut. The IS shifts out and domestic i rises. capital flows in. The inflow of capital means an outflow from other countries: the world interest rises. The BP shifts up. This partially offsets the capital inflow. The government however has to buy foreign reserves anyway so LM shifts out as well.
In the new equilibrium, LM shifts out to the intersection of the new BP with the new IS. Thus, output increases and i rises. For a large economy, government fiscal policy will have smaller than the full multiplier effect on output. The policy mix: The IS-LM-BP analysis directly captures only the effect of monetary and fiscal policy on internal balance. A second approach to studying the joint attainment of Internal Balance (IB) and External Balance (EB) is to use a diagram with G T on one axis and i on the other. The analysis assumes (i) a fixed exchange rate and (ii) that the economy is large enough that changes in G T and M are both capable of affecting both IB and EB. An increase in G T represents expansionary fiscal policy. An increase in i represents contractionary monetary policy. The IB locus is a combination of i and (G T ) such that internal balance is maintained. The economy is neither in recession nor in inflation. This is upward sloping. For a given i, an increase in G T would stimulate the economy and cause inflation. Thus i should rise whenever G T does in order to restore IB. Any point above IB represents recession; any point below represents an inflationary situation. The EB line represents i and G T combinations such that external balance is maintained. This is also upward sloping. For a given i, an increase in G T causes domestic absorption to go up and reduces the current account. Thus i would have to go up in order to induce sufficient capital inflows to restore the balance of payments. Thus whenever G T goes up, EB can be maintained only if i goes up. Any point above EB represents a surplus in balance of payments. Any point
below is a deficit. EB is generally flatter then IB so long as international capital flows are sufficiently elastic to interest rate movements. This is because monetary policy is relatively more effective in attaining EB while fiscal policy is relatively more effective in attaining IB. In other words, for a given increase in G T, all else equal, it takes a much smaller increase in i to restore EB (since a small increase in i can stimulate substantial capital inflow) than it would to restore IB. The IB-EB diagram can be divided into four zones: I: above IB and above EB (recession plus BOP surplus) II: below IP and above EB (inflation plus BOP surplus) III: below IB and below EB (inflation plus BOP deficit) IV: above IB and below EB (recession plus BOP deficit). The principle of effective market classification states that no matter where the economy starts off (assuming it is not already at full balance) monetary policy should be directed towards hitting EB, while fiscal policy should be directed towards hitting IB. Otherwise, the economy can go into a spiral.