The Mundell-Fleming model 2013 General short run macroeconomic - PowerPoint PPT Presentation

The Mundell-Fleming model 2013

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

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

Overview Outline The assumptions of the Mundell-Fleming model 1. Interest rate parity 1. Defining the general equilibrium 2. Equilibrium under flexible exchange rates 1. Equilibrium under fixed exchange rates 2. The Impossible Trinity 3. Case study: China 4. 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 Robert Mundell Nobel prize 1999  Small open economy  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

1. The Mundell-Fleming model Openness and economic size, 2004 Share of Trade Financial openness world GDP openness Total assets Total liabilities (%) (% of GDP) (% of GDP) (% of GDP) Denmark 0.6 40.9 55.4 47.4 Poland 0.6 40.0 31.6 84.9 Sweden 0.8 42.3 213.5 223.0 Belgium 0.9 82.3 425.2 394.3 Switzerland 0.9 40.6 570.7 439.9 Netherlands 1.4 62.7 402.5 408.3 Brazil 1.5 15.7 28.3 77.6 Korea, Rep. 1.6 41.9 52.6 56.6 China 4.7 32.7 195.3 207.8 UK 5.1 26.4 357.4 370.6 Germany 6.6 35.5 167.1 159.1 Japan 11.2 11.0 89.0 51.0 Euro countries 23.0 10.8 US 28.4 11.8 84.0 106.7

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=i*  i = domestic interest rate  i* = international rate of return  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*

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. Interest rate i > i*, capital flows in Financial integration i* line (IFM) i < i*, capital flows out Output

1.1. The Mundell-Fleming model Long term interest rates, 1970 - 2011

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?

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

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.

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             PCA Y Y  * Y C Y T I q i G , , , , Interest rate Changes in output will occur when we are not on the IS curve (as response to shortage to the left of IS IS and surplus to the right). Output

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

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 TR  Y Y   i i b Interest rate Y  CB follows  inflation targeting (Taylor rule)  On the TR curve: for different i different levels of M/P  Always on the TR curve Output

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

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

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*)

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

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

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

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

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

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

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.

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

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