Lecture 6

Elasticity Approach to the Balance of Payment

Mundell-Fleming Model

Which are the e®ects of a depreciation/devaluationon the current account?

² we assume the prices of goods and services are¯xed so that changes in the nominal exchangerate imply corresponding changes in the real ex-change rate;

(i.e. we assume that the supply elasticities for thedomestic export good and foreign import goodare perfectly elastic so that changes in demandvolumes have no e®ect on their price).

² Current account:

CA= P £X ¡ eP¤ £M

where P (P¤) is the domestic (foreign) price level; eis the nominal exchange rate; X is the volume of do-mestic exports; M is the volume of domestic imports.

² We have that X depends positively on the ex-change rate: dXde > 0: When the exchange ratedepreciates foreign residents ¯nd domestic goodscheaper.

² We have that M depends negatively on the ex-change rate: dMde < 0: When the exchange ratedepreciates domestic residents ¯nd foreign goodsmore expensive.

² We de¯ne the price elasticity of demand for ex-ports as the percentage change in exports overthe percentage change in prices (here the nomi-nal exchange rate): ´x =

dXX =dee

² Similarly for imports: ´m = ¡dMM =dee

Now we want to examine the e®ect of a change in thenominal exchange rate on the current account.

dCAde

=dXde

¡ edMde

¡M

Suppose that we are initially in a balanced currentaccount X = eM . Divide both side by M :

dCAde

1M

=dXdeeM¡ edMde

1M¡ 1

So thatdCAde

1M

= ´x + ´m¡ 1

Marshall-Lerner condition says that, starting from aposition of equilibrium in the current account, a de-preciation will improve the current account only if thesum of the of the two elasticities is greater than unity.

Two e®ects:

1) Price e®ect contributes to a worsening of the cur-rent account because imports become more expensive:for a given M we have that eM ";

2) Volume e®ect contributes to improving the currentaccount because exports become cheaper from a for-eign country's perspective: " X and #M .

J-curve: in the short-run the Marshall-Lerner condi-tion might not hold. In the short-run exports andimports volume do not change that much, so thatthe price e®ect dominates leading to a worsening ofthe current account following a depreciation of theexchange rate. The evolution of the current accountfollowing a depreciation is illustrated by a J-curve.

The J-Curve Current Account Surplus Time Deficit

Mundell-Fleming model: keynesian tradition in thesense that aggregate economic activity is determinedby aggregate demand.

Building blocks:

Aggregate supply is °at:

² it implies that prices are ¯xed.

Balance of Payment:

² the current account is determined independentlyof the capital account;

² PPP does not hold and the size of the currentaccount surplus depends positively on the real ex-change rate and negatively on the real income:

CA = CAÃY;eP¤

P

!= CA

ÃY¡; e+

!

-note that we have assumed that the Marshall-Lerner condition holds;

-shift to tastes and foreign income are exogenousfactor that can be incorporated into the CA equa-tion;

² exchange rate expectations are static;

² Capital Account: we distinguish two situations:

a) Perfect capital mobility: if capital if perfectlymobile then UIP condition always hold and sincewe assume that expectations are static it has tobe

r = r¤

b) Imperfect capital mobility: ¯nite °ows of capi-tal depends only on interest rate di®erential acrosscountries

K = KÃr ¡ r¤

+

!

Balance of Payment: equilibrium when the °owof capital ¯nance the current account surplus orde¯cit

BP = CAÃY¡; e+

!+K

Ãr ¡ r¤

+

!= 0

IS curve in open economy:

From the national income accounting identity we havethat:

Y = C + I +CA+G

where C is our keynesian consumption function inwhich consumption depends on disposable income:

C = C (Y ¡ T) ; 0 <dCdY< 1

Investment depends negatively on the real interestrate:

I = I (r)dIdr< 0

and

CA = CAÃY¡; e+

!

and G, public expenditure is taken as exogenous.

IS locus describe the combination of income and realinterest rate for which savings are su±cient to coverthe ¯nancing required by investment (domestic andforeign).

LM curve in open economy

-same as in the closed economy case: money marketequilibrium determines the equality between moneysupply and money demand

MP

= LÃY+; r¡

!

-LM locus describes the combination of income andreal interest rate so that the money market is in equi-librium.

BOP Equilibrium Locus under Imperfect Capital Mobility r BP ( ) 0e BP ( ) 1e

Y

Dependence of the IS curve on the nominal exchange rate r IS ( )1e IS ( ) 0e

y

Equilibrium:

In general there are three endogenous variables in thismodel. The interest rate, r, the level of income, Y ,and the third endogenous variable depends on the ex-change rate regime assumed.

a) Floating exchange rate regime: e, the nominal ex-change rate, adjusts in order to keep the zero balanceof payment condition.

b)Fixed exchange rate regime: e is given, and theCentral bank has to conduct o±cial foreign exchangeintervention to maintain the exchange rate ¯xed.

We will analyze monetary and ¯scal policies dependingon the exchange rate regime and on the degree ofcapital mobility. Remember in the following analysis:

a) external equilibrium: BoP is zero.

b) internal equilibrium is given by the goods marketand money market equilibrium (i.e. intersection be-tween LM and IS curve).

Monetary Expansion under a Floating Exchange RateRegime:

E®ects:

² depreciation of the nominal exchange rate;

² an increase in income;

² a fall in the real interest rate as long as capital isimperfectly mobile;

² an improvement in the current account of the bal-ance of payment;

Monetary Expansion under a Floating Exchange Rate Regime

r LM ( ) 0M LM ( ) 1M BP ( )0e 0 BP ( ) 1e 2 1 IS ( ) 1e IS ( ) 0e

Y

Adjustment mechanism:

² Since prices are ¯xed, an increase in money sup-ply requires lower interest rates. This will induce acapital out°ows and decrease demand for domes-tic currency. In order to restore the equilibriumin the balance of payment we need to depreciatethe exchange rate so that the current account im-proves.

Comparison with the monetary model: same qual-itative results in terms of exchange rate changes.

Income increase is the counterpart of price rise inthe monetary model.

With perfect capital mobility, we do not observe anychange in the real interest rate. All the adjustmenttakes place through the nominal exchange rate. Out-put e®ects are bigger the higher is the degree of capitalmobility.

Fiscal Expansion under a Floating Exchange Rate Regime:

E®ects:

² appreciation of the nominal exchange rate;

² an increase in income;

² an increase in the real interest rate as long ascapital is imperfectly mobile;

² a deterioration the current account of the balanceof payment;

Adjustment mechanism:

² An increase in public spending implies higher in-terest rates. This will induce capital in°ows andan increase in the demand for domestic currency.In order to restore the equilibrium in the balanceof payment we need to appreciate the exchangerate so that the current account deteriorates.

With perfect capital mobility, the IS curve can moveonly temporarily. All the adjustment takes place throughthe nominal exchange rate. Change in the exchangerate is such that the expansionary e®ect of publicspending is o®set. Increase in public spending crowdsout external demand. No impact on output.

Comparison with closed economy: output expansionis lower because of crowding out e®ect of exchangerate appreciation on external demand. This e®ect isstronger the higher is the degree of capital mobility.

Monetary Policy under Fixed Exchange Rate Regime:

² in the short-run, provided that capital is not com-pletely mobile, the interest rate falls, income in-creases and the balance of payment deterioratesin the current account and in the capital account.

² in the long run, we observe a fall in foreign re-serves but no change on output, interest rate andthe balance of payment.

Adjustment mechanism: once money supply in-creases, the de¯cit in the balance of payment willinduce a decrease in the demand for domestic cur-rency. The Central bank intervenes to keep theexchange rate ¯xed by selling foreign reserves fordomestic currency. In doing so, it reduces themoney supply. (i.e. ¢FX = ¢DC).

The higher the degree of capital mobility, the lessare the short-run e®ects.

Monetary Expansion under a Fixed Exchange Rate Regime

r LM ( )11 ,FXDC LM ( ) 00 ,FXDC BP 0 LM ( ) 01 ,FXDC 1 IS

Y