Mundel

l-Fle

min

gM

odel

ofa

Sm

all

Open

Eco

nom

y

Dudle

yCook

e

Trinity

Colleg

eD

ublin

Dudle

yCooke

(Trinity

Colleg

eD

ublin)

Mundel

l-Fle

min

gM

odel

1/

50

Rea

ding

Man

kiw

and

Tay

lor,

Chap

ter

12.

Also

see

Cop

elan

d,Chap

ters

4an

d6.

Dudle

yCooke

(Trinity

Colleg

eD

ublin)

Mundel

l-Fle

min

gM

odel

2/

50

Pla

n Open

Eco

nom

yIS

and

LM

equat

ions

Bal

ance

ofPay

men

tsan

dCap

ital

Mob

ility

Fisca

l/m

onet

ary

pol

icy

under

Fix

edan

dFlo

atin

gExc

han

geRat

es.

Dudle

yCooke

(Trinity

Colleg

eD

ublin)

Mundel

l-Fle

min

gM

odel

3/

50

Sup

erQ

uick

Histo

rica

lB

ackg

roun

d

Pre

-War

Per

iod

cove

rs18

80-1

914

(using

the

Cla

ssic

Gol

dSta

ndar

d)

wher

eco

untr

ies

peg

ged

thei

rex

chan

gera

teto

the

valu

eof

gold

.

Inte

r-W

arPer

iod

isro

ugh

lyuntil19

31.

Cou

ntr

ies

use

dU

SD

olla

rs,

Pou

nds

Ste

rlin

gor

Gol

dto

peg

thei

rex

chan

gera

te-

this

stop

ped

when

the

UK

dep

arte

dfrom

gold

inth

efa

ceof

larg

eca

pital

outfl

ows.

Bre

tton

Woods

Per

iod

cove

rs19

46-1

971.

Cou

ntr

ies

peg

ged

thei

rex

chan

gera

teto

the

US

Dol

lar.

This

stop

ped

when

Nix

onsu

spen

ded

conve

rtib

ility

.

Flo

ating

Per

iod

-bas

ical

lyuntilnow

.H

owev

er,th

isdoes

not

acco

unt

for

the

launch

ofth

eEuro

in19

99an

dot

her

curr

ent

issu

esin

Asia.

Dudle

yCooke

(Trinity

Colleg

eD

ublin)

Mundel

l-Fle

min

gM

odel

4/

50

The

Bas

elin

eO

pen

Eco

nom

yM

ode

l

We

study

anec

onom

ysim

ilar

toth

atuse

dfo

rth

ecl

osed

econ

omy.

ISan

dLM

conditio

ns

asbef

ore,

but

also

inco

rpor

ate:

1in

tern

atio

nal

trad

e/cu

rren

tac

count

2ca

pital

acco

unt

(bal

ance

ofpay

men

ts)

and

capital

contr

ols

3Rea

l(a

nd

nom

inal

)ex

chan

gera

te

Dudle

yCooke

(Trinity

Colleg

eD

ublin)

Mundel

l-Fle

min

gM

odel

5/

50

The

Open

Eco

nom

yIS

Cur

ve

We

now

wan

tto

inco

rpor

ate

the

curr

ent

acco

unt/

real

exch

ange

rate

resp

onse

into

the

IS.

The

nat

ional

inco

me

iden

tity

is:

Y=

C(Y

−T

)+Ip

(r)+

G︸

︷︷︸

close

dec

onom

y

+X−

M︸︷︷

︸net

expor

ts

Cden

otes

the

Key

nes

ian

consu

mption

funct

ion

and

Iis

inve

stm

ent

dem

and.

The

IScu

rve

still

give

sco

mbin

atio

ns

ofre

alou

tput

and

the

inte

rest

rate

such

that

pla

nned

and

act

ualex

pen

diture

sar

eeq

ual.

How

ever

,we

now

know

itis

pos

sible

tobor

row

from

orle

nd

toth

ere

stof

the

wor

ldvi

ath

ecu

rren

tac

count.

Dudle

yCooke

(Trinity

Colleg

eD

ublin)

Mundel

l-Fle

min

gM

odel

6/

50

Cur

rent

Acc

ount

and

Exc

hang

eRat

e

We

assu

me

that

the

curr

ent

acco

unt

isdet

erm

ined

indep

enden

tly

ofth

eca

pital

acco

unt.

PPP

does

not

hol

d,ev

enin

the

long-

run,an

dth

esize

ofth

ecu

rren

tacc

ount

surp

lus

dep

ends

positive

lyon

the

(rea

l)ex

change

rate

:

CA

=CA

(Q,.

..)

IfQ

rise

s,ou

rgo

ods

bec

ome

more

com

pet

itiv

eab

road

.For

eign

ers

switch

from

buyi

ng

thei

rgo

ods

toou

rgo

ods.

This

prov

ides

aboos

tto

inco

me.

The

proce

ssis

calle

dex

pen

diture

switch

ing.

Itis

ake

ym

echan

ism

inth

eop

enec

onom

y.

Dudle

yCooke

(Trinity

Colleg

eD

ublin)

Mundel

l-Fle

min

gM

odel

7/

50

PPP P

,Price

Level

S,Exchange

Rate

S0

P0

Q0

=1

Sw

itch

toD

om

estic

Goods

Sw

itch

toFore

ign

Goods

Dudle

yCooke

(Trinity

Colleg

eD

ublin)

Mundel

l-Fle

min

gM

odel

8/

50

Exc

hang

eRat

ean

dN

etExp

orts

1/S,1/Exchange

Rate

X−

M,Net

Export

sN

X0

=X

0−

M0

1/S0

NX

Dudle

yCooke

(Trinity

Colleg

eD

ublin)

Mundel

l-Fle

min

gM

odel

9/

50

Com

men

ts

Dia

gram

1:W

eim

plic

itly

assu

me

that

we

cannot

be

onth

e“Q

=1

line”

;i.e.

PPP

does

not

hol

d.

Inre

ality,

this

could

hap

pen

for

any

num

ber

ofre

ason

s.H

ere

we

will

assu

me

this

bec

ause

the

ISLM

-cum

-Mundel

l-Fle

min

gm

odel

isa

shor

t-ru

nm

odel

.

Dia

gram

2:In

Man

kiw

and

Tay

lor,

“S”

appea

rson

the

vert

ical

axis.

Not

eth

atwe

hav

edefi

ned

the

exch

ange

rate

diff

eren

tly.

That

is,

bec

ause

the

exch

ange

rate

isa

rela

tive

pric

e,we

hav

etw

opos

sible

way

sto

write

it(s

omet

imes

be

very

confu

sing)

.

Rem

ember

:an

incr

ease

inS

isa:

wea

ker

dom

estic

curr

ency

/dep

reci

atio

nin

the

dom

estic

curr

ency

Dudle

yCooke

(Trinity

Colleg

eD

ublin)

Mundel

l-Fle

min

gM

odel

10

/50

Cur

rent

Acc

ount

We

also

ass

um

eth

at

the

CA

dep

ends

on

GD

P(inco

me

leve

ls).

The

mor

ein

com

eth

em

ore

impor

tswe

buy:

CA

=CA

(Y,.

..)

Rec

allth

atP

isfixe

dan

dnot

eP∗

isex

ogen

ous

from

the

poi

nt

ofth

evi

ewof

the

dom

estic

econ

omy.

We

re-w

rite

the

over

allex

pres

sion

for

the

curr

ent

acco

unt

inth

efo

llow

ing

way

:

CA

(Q,Y

)=

CA

( S +,Y −

)A

gain

:due

tost

icky

pric

esth

ere

alan

dnom

inal

exch

ange

rate

sm

ove

inth

esa

me

direc

tion

.

Dudle

yCooke

(Trinity

Colleg

eD

ublin)

Mundel

l-Fle

min

gM

odel

11

/50

The

ISan

dExc

hang

eRat

e

Open

econ

ISlo

oks

like

clos

edec

onIS

,but

is,

Y=

C(Y

−T

)+Ip

(r)+

G︸

︷︷︸

close

dec

onom

y

+CA

( S +,Y −

) .i,

Interest

Rate

Y,O

utput

Y0

i 1 i 0

IS(S0)

IS(S1)

Dudle

yCooke

(Trinity

Colleg

eD

ublin)

Mundel

l-Fle

min

gM

odel

12

/50

Open

Eco

nom

yLM

Cur

ve

The

clos

edan

dop

enec

onom

yLM

curv

ear

eth

esa

me.

LM

≡M

s

P=

Md

P=

L(Y +

,i −)

i,In

tere

st

Rate

Y,O

utput

Y0

i 0

LM

Dudle

yCooke

(Trinity

Colleg

eD

ublin)

Mundel

l-Fle

min

gM

odel

13

/50

Dom

estic

and

For

eign

Bon

ds

Althou

ghth

eLM

isunch

ange

d,th

eex

chan

gera

tedoes

mat

terfo

rth

eas

set

mar

ket

bec

ause

ther

ear

edom

estic

and

fore

ign

bonds.

The

exch

ange

rate

det

erm

ines

equili

briu

min

the

fore

ign

exch

ange

mar

ket;

i.e.

the

dom

estic

and

fore

ign

bon

dm

arke

ts.

Ifwe

assu

me

that

expec

tation

sar

est

atic

,under

per

fect

capital

mobili

ty:

i=

i∗

Wher

ei∗

isex

ogen

ous

for

the

smal

lop

enec

onom

y,e.

g.i∗

isth

eU

Sin

tere

stra

te.

Dudle

yCooke

(Trinity

Colleg

eD

ublin)

Mundel

l-Fle

min

gM

odel

14

/50

Cap

ital

Acc

ount

and

Cap

ital

Mob

ility

Ifth

ere

isim

per

fect

capital

mob

ility

UIP

may

fail

tohol

d:

i�=

i∗

Flo

ws

ofca

pital

dep

end

onin

tere

stra

tediff

eren

tial

sbet

wee

nco

untr

ies:

KA

=K

A(i−

i∗);

∆K

A/

∆(i−

i∗)

>0

Ifi>

i∗th

ere

isa

capital

inflow

,i.e.

fore

ign

residen

tswan

tto

buy

hom

eas

sets

.

Ifi<

i∗th

ere

isa

capital

outfl

ow.

Dudle

yCooke

(Trinity

Colleg

eD

ublin)

Mundel

l-Fle

min

gM

odel

15

/50

Bal

ance

ofPay

men

ts

The

bal

ance

ofpay

men

tsco

nditio

nis:

CA

(Q,Y

)+K

A(i−

i∗)−

∆R

=B

P

Her

e,we

den

ote

fore

ign

exch

ange

rese

rves

,R

.1

Equili

briu

mob

tain

sw

hen

the

flow

ofca

pital

finan

ces

the

curr

ent

acco

unt

defi

cit

orab

sorb

sth

esu

rplu

s,i.e.

BP

=0.

As

inco

me

rise

s,gi

ven

Q,th

eCA

det

erio

rate

sas

impor

tdem

and

grow

s.To

pres

erve

BP

=0,

the

KA

must

impr

ove.

This

net

capital

inflow

can

only

be

achie

ved

byan

incr

ease

inth

edom

estic

inte

rest

rate

.

1W

edon’t

nee

dto

wor

ryab

out

this

untilwe

consider

afixe

dex

chan

ge

rate

so,fo

rnow

,R

=0,an

dCA

=−K

A.

Dudle

yCooke

(Trinity

Colleg

eD

ublin)

Mundel

l-Fle

min

gM

odel

16

/50

BP

Cur

vew

ith

Imper

fect

Cap

ital

Mob

ility

When

ther

eis

per

fect

capital

mob

ility

the

BP

curv

eis

hor

izon

talin

(i,Y

)-sp

ace

-it

does

not

dep

end

onth

eex

chan

gera

tean

dis

give

nby

,i=

i∗

i,In

terest

Rate

Y,O

utput

Y0

i 0

BP(S0)

BP(S1)

i 1

Dudle

yCooke

(Trinity

Colleg

eD

ublin)

Mundel

l-Fle

min

gM

odel

17

/50

Oth

erCom

men

ts

‘Inte

rnal

equili

briu

m’occ

urs

when

IS=

LM

,i.e.

the

mar

kets

for

goods

and

for

mon

eyar

ein

equili

briu

m.

‘Ext

ernal

equili

briu

m’occ

urs

when

BP

=0,

i.e.

the

flow

ofca

pital

issu

ffici

ent

tofinan

ceCA

≶0.

We

wou

ldal

soex

pec

tan

inte

rest

rate

diff

eren

tial

topr

oduce

only

afinite

chan

gein

capital

flow

s-

i.e.

ther

eis

som

eca

pital

imm

obili

ty.

Per

fect

capital

mar

kets

isa

ben

chm

ark

situ

atio

n.

Dudle

yCooke

(Trinity

Colleg

eD

ublin)

Mundel

l-Fle

min

gM

odel

18

/50

IS-L

M-B

PEqu

ilibr

ium

The

mor

ere

strict

edar

eca

pital

flow

s,th

ela

rger

the

rise

inth

ein

tere

stra

te,fo

ra

give

nch

ange

inou

tput.

The

BP

isth

enst

eeper

in(i

,Y)-

spac

e.

i,In

tere

st

Rate

Y,O

utp

ut

Y0

i 0

LM

BP

-no

capitalflow

s

BP

-fu

llm

obility

BP

-lim

ited

mobility

IS

Dudle

yCooke

(Trinity

Colleg

eD

ublin)

Mundel

l-Fle

min

gM

odel

19

/50

Fun

ctio

nalFor

ms

and

Rec

ap

So

far

we

hav

ebee

nge

ner

al.

We

can

also

adop

tso

me

funct

ional

form

s.

As

inth

ecl

osed

econ

omy

(sam

enot

atio

n):

L(i

,Y),

Ip(r

)an

dC

(Y−

T).

We

also

hav

eCA

(Q,Y

).W

esu

ppos

eth

at,in

linea

rte

rms,

CA

(q,y

)=

λq−

βy.

Then

,IS

and

LM

are:

y=

a+

δ(y

−t )

︸︷︷

︸co

nsn

funct

ion

+

inve

st’t

d’d

︷︸︸︷

(h0−

γi )

+λq−

βy

︸ ︷︷︸

CA

+FP ︷︸︸︷ g

ms ︸︷︷︸ MP−

exog. ︷︸︸︷ p=

ky−

�i

The

form

ofth

eB

Pdep

ends

onw

hat

we

assu

me

rega

rdin

gca

pital

mob

ility

.W

ewon

’tbe

explic

itab

out

the

form

ofK

A(i−

i∗).

Dudle

yCooke

(Trinity

Colleg

eD

ublin)

Mundel

l-Fle

min

gM

odel

20

/50

Rep

rese

ntat

ions

ofIS

-LM

-BP

with

Per

fect

Cap

ital

Mob

ility

Under

per

fect

capital

mob

ility

the

BP

curv

eis

hor

izon

talin

(i,y

)-sp

ace.

We

can

then

dra

wth

eIS

and

LM

conditio

ns

aswe

did

inth

ecl

osed

econ

omy.

Copel

and

use

sth

isappro

ach

.

Mankiw

take

sa

diff

eren

tappro

ach

:H

euse

sth

eB

Peq

uat

ion

inth

eIS

and

LM

equat

ions

and

dra

ws

ISan

dLM

curv

esin

(q,y

)-sp

ace.

Thes

ear

eto

tally

equiv

ale

nt.

We

will

follo

wth

efirs

tas

ital

low

sus

tolo

okat

Imper

fect

CapitalM

obili

ty(i.e

.a

non-h

orizo

nta

lB

P)

more

easily

.

Dudle

yCooke

(Trinity

Colleg

eD

ublin)

Mundel

l-Fle

min

gM

odel

21

/50

Man

kiw

’sAlter

native

MF

Mode

l

i=

i∗,Interest

Rate

y,O

utput

q,Exchange

Rate

y,O

utput

q0

i0

LM

IS

LM ISBP

y0

y0

Dudle

yCooke

(Trinity

Colleg

eD

ublin)

Mundel

l-Fle

min

gM

odel

22

/50

Fix

edan

dFlo

atin

gExc

hang

eRat

eReg

imes

Flo

ating

exch

ange

rate

:th

enom

inal

exch

ange

rate

,s,

adju

sts

inor

der

tom

ainta

ineq

uili

briu

m(C

A=

−KA

).E.g

.U

Know

.

Fix

edex

change

rate

:th

enom

inal

exch

ange

rate

,s,

isfixe

d,so

the

centr

alban

khas

toin

terv

ene

info

reig

nex

chan

gem

arke

tsin

order

tom

ainta

inth

epar

ity.

E.g

.U

Kin

1990

(ERM

).

Obvi

ously,

Irel

and

is“fi

xed”

agai

nst

,sa

y,G

erm

any,

and

floa

ting

agai

nst

the

US.

We

can

also

vary

the

deg

ree

ofca

pital

mob

ility

.E.g

.Irel

and

has

no

real

rest

rict

ions,

Chin

ahas

capital

contr

ols

(i.e

.im

mob

ile).

Dudle

yCooke

(Trinity

Colleg

eD

ublin)

Mundel

l-Fle

min

gM

odel

23

/50

Exo

geno

us/E

ndog

enou

sVar

iabl

esRev

isited

The

exch

ange

rate

(qor

s)an

dre

serv

es(R

)ar

eth

eex

tra

variab

les

vs.

the

clos

edec

onom

y.

Again

:

1th

eex

chan

gera

tem

ayfloa

t(b

een

dog

enou

s),w

ith

Mex

ogen

ous,

and

R=

0

2or

be

fixe

d,using

R,w

ith

Men

dog

enou

s(m

ore

onth

atla

ter)

The

dom

estic

inte

rest

rate

isex

ogen

ous

ifth

ere

isper

fect

capital

mob

ility

(i=

i∗)

but

may

mov

eif

capital

isim

mob

ile(i�=

i∗).

Dudle

yCooke

(Trinity

Colleg

eD

ublin)

Mundel

l-Fle

min

gM

odel

24

/50

Wha

tEx-

Rat

eReg

imes

doCou

ntries

Ado

pt?

Dudle

yCooke

(Trinity

Colleg

eD

ublin)

Mundel

l-Fle

min

gM

odel

25

/50

Who

uses

Cap

ital

Con

trol

san

dW

hy?

Som

ere

cent

exam

ple

sof

capital

contr

ols:

Chile

an“e

nca

je”

tost

opex

cess

ive

inflow

sof

capital

-re

quired

inflow

sto

be

dep

osited

atth

ece

ntr

alban

kfo

ra

give

nper

iod

oftim

e.M

alay

sian

contr

ols

impos

edin

Sep

tem

ber

1998

afte

rth

eA

sian

crisis

hit

in19

97-9

8.

Cap

ital

contr

ols

are

ofte

nse

enas

‘bad

’as

they

are

like

adisto

rtin

gta

xon

savi

ngs

dec

isio

ns.

Ver

yre

cently

the

IMF,an

dev

enth

eEco

nom

ist,

hav

ebee

nsu

gges

ting

that

capital

contr

ols

are

use

fulin

som

esitu

atio

ns.

We

care

about

this

bec

ause

contr

ols

on

capitalca

naffec

tth

epolic

yco

ncl

usions.

Dudle

yCooke

(Trinity

Colleg

eD

ublin)

Mundel

l-Fle

min

gM

odel

26

/50

Effec

tsof

Gov

ernm

ent

Pol

icy

inth

eM

FM

ode

l

First

we’

lltr

yan

ddev

elop

som

ein

tuitio

nfo

rth

eway

the

MF

model

wor

ks.

Bas

icst

rate

gy:

1fo

ra

give

npol

icy,

we

call

what

wou

ldhap

pen

inth

ecl

osed

econ

omy

the

tem

por

ary

equili

briu

m

2from

this

we

will

then

mov

eto

the

per

man

ent

(new

)eq

uili

briu

m

For

sim

plic

ity,

we

will

alway

sst

art

from

the

pos

itio

nin

whic

hth

ecu

rren

tac

count

and

bal

ance

ofpay

men

tsar

ein

equili

briu

m.

That

is,

CA

=K

A=

0.

Dudle

yCooke

(Trinity

Colleg

eD

ublin)

Mundel

l-Fle

min

gM

odel

27

/50

Flo

atin

gExc

hang

eRat

es-

Mon

etar

yPol

icy

-Im

per

fect

Cap

ital

Mob

ility

Con

sider

↑ms.

Price

sar

efixe

d,so

real

bal

ance

srise

.T

he

LM

shifts

right,

outp

ut

rise

s,an

dth

ein

tere

stra

tefa

lls.

This

equili

brium

iste

mpora

ry.

As

the

inte

rest

rate

falls

ther

eis

aca

pital

outfl

ow(K

A<

0).

The

exch

ange

rate

rise

s(d

omes

tic

curr

ency

dep

reci

ates

),boos

ting

expor

ts,an

dim

prov

ing

the

curr

ent

acco

unt

(CA

>0)

.

Outp

ut

rise

sca

using

adet

erio

ration

inth

ecu

rren

tac

count

(CA

<0)

.

But,

BP

=CA

+K

A=

0fo

req

uili

briu

m.

Dudle

yCooke

(Trinity

Colleg

eD

ublin)

Mundel

l-Fle

min

gM

odel

28

/50

Mov

ing

toth

ePer

man

ent

Equ

ilibr

ium

The

chan

gein

the

exch

ange

rate

cause

sth

eIS

tosh

ift,

this

raises

the

inte

rest

rate

alit

tle

and

stop

sso

me

ofth

eca

pital

outfl

ow.

The

BP

also

shifts

.

All

this

stop

sw

hen

the

∆K

Aco

vers

the

∆CA

,w

hic

his

pos

itiv

e.

Ove

rall:

1W

est

art

at:

CA

=K

A=

BP

=0.

2W

een

dat

:CA

>0,

KA

<0,

and

BP

=0.

Dudle

yCooke

(Trinity

Colleg

eD

ublin)

Mundel

l-Fle

min

gM

odel

29

/50

Flo

atin

g-

MP

-Im

per

fect

Mob

ility

i,In

tere

st

Rate

y,O

utput

y0

i 0

LM

(m

0)

LM

(m

1)

IS(s1)

BP(s0)

BP(s1)

IS(s0)

y′ 0

y1

i 1 i′ 0

Dudle

yCooke

(Trinity

Colleg

eD

ublin)

Mundel

l-Fle

min

gM

odel

30

/50

Sam

eSitua

tion

BU

Tw

ith

Per

fect

Cap

ital

Mob

ility

We

now

consider

per

fect

capital

mob

ility

.T

his

isth

esa

me

aske

epin

gi

fixe

d,as

we

hav

ei=

i∗.

Now

we

can

also

get

som

ecl

ear

analy

tica

lso

lutions.

Fro

mth

eLM

equat

ion

we

can

see

imm

edia

tely

that

:

∆m

s−

∆p

=k

∆y−

�∆i∗

⇒∆

y

∆m

s=

1 k>

0

We

don’t

nee

dto

use

the

ISto

get

this.

Why?

Inth

ecl

osed

econ

omy,

∆m

s⇒

∆i.

This

influen

ces

the

ISvi

ain

vest

men

t.Sin

ce∆

i∗=

∆i=

0we

don

’tnee

dto

wor

ryab

out

that

inth

isca

se.

Dudle

yCooke

(Trinity

Colleg

eD

ublin)

Mundel

l-Fle

min

gM

odel

31

/50

The

Exc

hang

eRat

e

We

also

nee

dal

soto

expla

inw

hat

hap

pen

sto

the

exch

ange

rate

.

For

this

we

nee

dth

eIS

equat

ion

asq

appea

rsth

ere.

Use

the

ISan

dLM

toel

imin

ate

outp

ut.

This

implie

s:

λq

=[m

s−

p+

�i∗ ]

1 k(1

−δ )

−[..

. ]

⇒∆

q

∆m

s=

1−

δ

kλ

>0

∆q

>0

isa

real

dep

reci

atio

n.

I.e.

dom

estic

goods

are

mor

eco

mpet

itiv

e.

This

isth

ere

aso

nw

hy

∆y

/∆

ms>

0.

Ther

eis

‘exp

enditure

switch

ing’

with

stic

kypr

ices

(as

oppos

edto

aliq

uid

ity

effec

t).

Dudle

yCooke

(Trinity

Colleg

eD

ublin)

Mundel

l-Fle

min

gM

odel

32

/50

Flo

atin

g-

Mon

etar

yExp

ansion

-Cap

ital

Mob

ility

i,In

terest

Rate

y,O

utput

y0

i 0

IS(s0)

IS(s1)

i′ 0

LM

(m

0)

LM

(m

1)

y′ 0

y1

�

Expenditure

Sw

itchin

g

Dudle

yCooke

(Trinity

Colleg

eD

ublin)

Mundel

l-Fle

min

gM

odel

33

/50

Sum

mar

y:M

onet

ary

Exp

ansion

Und

erFlo

atin

gExc

hang

eRat

es Dep

reci

atio

nof

the

nom

inal

(and

real

)va

lue

ofdom

estic

curr

ency

(↑q).

Incr

ease

inth

ele

velof

inco

me

(↑y)

and

fall

inth

ein

tere

stra

te(o

nly

ifca

pital

isnot

per

fect

lym

obile

).

As

CA

=CA

(q,y

)we

see

a↑C

Aev

enth

ough

the

chan

gein

outp

ut

and

the

exch

ange

rate

are

offse

ttin

g.

No

chan

gein

the

bal

ance

ofpay

men

ts(in

const

ant

equili

briu

mw

hen

the

ex-r

ate

floa

ts),

so↓K

A(i.e

.ou

tflow

s).

Dudle

yCooke

(Trinity

Colleg

eD

ublin)

Mundel

l-Fle

min

gM

odel

34

/50

Flo

atin

gExc

hang

eRat

es-

Fisca

lPol

icy

-Per

fect

Cap

ital

Mob

ility

Rec

allth

ecl

osed

econ

omy.

Ther

e,↑g

⇒↑y

but

ther

eis

also

↑i⇒

↓I,w

hic

hlo

wer

sou

tput.

The

full

change

ingove

rnm

ent

spen

din

gis

not

pass

edth

rough

tooutp

ut

due

to‘c

row

din

gout’.

Ther

eis

asim

ilar

effec

tunder

floa

ting

exch

ange

rate

s.H

owev

er:

1it

invo

lves

ach

ange

inth

eex

chan

gera

te

2th

eeff

ect

isst

ronge

r.

Dudle

yCooke

(Trinity

Colleg

eD

ublin)

Mundel

l-Fle

min

gM

odel

35

/50

Det

erm

inin

gth

eCha

nge

inO

utpu

tdu

eto

aFisca

lExp

ansion

Gov

ernm

ent

spen

din

gen

ters

the

IScu

rve

so:

y=

a+

δ(y

−t )

+h

0−

γi∗

+λq−

βy

+g

⇒(1

−δ+

β)∆

y=

∆g

+λ

∆q

Now

we

have

toagain

figure

out

what

happen

sto

the

exch

ange

rate

.Fol

low

ing

the

sam

elo

gic

asbef

ore

(i.e

.el

imin

ate

outp

ut

inIS

byth

eLM

),

λq

=[m

s−

p+

�i∗ ]

1 k(1

−δ )

−[..

. ]

⇒∆

q

∆g

=−

1 λ<

0

Now

the

valu

eof

our

curr

ency

falls

(an

appr

ecia

tion

ofth

eex

chan

gera

tedue

togo

vt.

purc

has

es).

Dudle

yCooke

(Trinity

Colleg

eD

ublin)

Mundel

l-Fle

min

gM

odel

36

/50

Open

Eco

nom

yM

echa

nism

for

Fisca

lPol

icy

The

ISca

non

lym

ove

tem

por

arily

.W

hy?

The

BP

and

LM

are

unaff

ecte

dby

the

chan

gein

g(a

nd

subse

quen

tch

ange

ins)

.

Ess

ential

ly,th

e∆

gis

entire

lyfu

nded

byov

erse

asbor

row

ing

asa

$1

∆g

iseq

ual

to$1

∆K

A>

0,w

hic

heq

uili

briu

mre

quires

tobe

offse

tby

the

chan

gein

net

expor

tsan

dex

chan

gera

te.

Ove

rall,

ther

eis

acu

rren

tac

count

defi

cit

(equiv

.ca

pital

acco

unt

surp

lus)

.

Dudle

yCooke

(Trinity

Colleg

eD

ublin)

Mundel

l-Fle

min

gM

odel

37

/50

Flo

atin

g-

Fisca

lExp

ansion

-Cap

ital

Mob

ility

r,In

terest

Rate

y,O

utput

y0

=y1

i 0

LM

IS(g0,s0)=

IS(g1,s1)

IS(g1,s0)

y′ 0

i′ 0

��

Com

ple

te

Crow

din

gO

ut

Dudle

yCooke

(Trinity

Colleg

eD

ublin)

Mundel

l-Fle

min

gM

odel

38

/50

Sum

mar

y:Fisca

lExp

ansion

Und

erFlo

atin

gExc

hang

eRat

es Arise

inth

ere

alex

chan

gera

tean

dth

ein

tere

stra

te(ifca

pital

isnot

per

fect

lym

obile

-as

consider

edab

ove)

.

Arise

inin

com

e(ifca

pital

isnot

per

fect

lym

obile

)an

da

det

erio

ration

inth

ecu

rren

tac

count

(↓CA)

asth

ein

com

ean

dex

chan

gera

teeff

ects

are

rein

forc

ing.

No

chan

gein

the

bal

ance

ofpay

men

ts(in

const

ant

eqm

when

the

ex-r

ate

floa

ts),

so↑K

A(i.e

.ca

pital

inflow

sto

cove

rCA

<0)

.

Dudle

yCooke

(Trinity

Colleg

eD

ublin)

Mundel

l-Fle

min

gM

odel

39

/50

Fix

edExc

hang

eRat

es:

How

isth

eExc

hang

eRat

eFix

ed?

Rec

all:

BP

=CA

+K

A−

∆R

.W

ith

afloat

we

said

R=

0.

How

ever

,th

eex

chan

gera

teca

nbe

fixe

d(s

=s)

byth

ece

ntr

alban

kin

terv

enin

gin

the

fore

ign

exch

ange

mar

ket.

Under

afixe

dex

chan

gera

tere

gim

e,th

ece

ntr

alban

kbuys

and

sells

dom

estic

curr

ency

.T

he

mon

eysu

pply

is,

Ms≡

R+

D

Her

e,D

isdom

estic

cred

it,an

dis

contr

olle

dby

the

centr

alban

k,an

dR

are

fore

ign

curr

ency

rese

rves

,hel

dby

the

centr

alban

k.

Dudle

yCooke

(Trinity

Colleg

eD

ublin)

Mundel

l-Fle

min

gM

odel

40

/50

The

Bal

ance

ofPay

men

tsan

dRes

erve

s

Under

afloating

exch

ange

rate

,th

ece

ntr

alban

kdoes

not

use

fore

ign

rese

rves

toin

terv

ene

incu

rren

cym

arke

ts,so

say

the

dom

estic

curr

ency

appr

ecia

tes

(S↓)

,

∆M

s=

∆D

⇒∆

R=

0

Under

afixe

dex

change

rate

,th

eap

prec

iation

ofth

edom

estic

curr

ency

can,fo

rex

ample

,be

prev

ente

dif

the

centr

alban

kse

llsso

me

dom

estic

curr

ency

using

its

fore

ign

rese

rves

,

∆M

s=

∆D

+∆

R⇒

∆R

>0

Import

ant:

∆D

captu

res

Monet

ary

Polic

yand

∆M

sis

endogen

ous.

Dudle

yCooke

(Trinity

Colleg

eD

ublin)

Mundel

l-Fle

min

gM

odel

41

/50

AB

alan

ce-o

f-Pay

men

tsSur

plus

,D

efici

tan

dCrisis

IfB

P=

0how

can

ther

ebe

a‘b

alan

ce-o

f-pay

men

tssu

rplu

s’or

‘defi

cit’

?

Bas

ical

ly,th

iste

rmin

olog

yre

fers

toth

eCA

vs.

KA

pos

itio

n,w

hic

hnee

dnot

equal

zero

when

the

exch

ange

rate

isfixe

d.

CA

(Q,Y

)+K

A(i−

i∗)

=∆

R

Exa

mple

:If

the

CA

defi

cit

>K

Asu

rplu

s⇒

a‘B

-o-P

defi

cit’

wher

ewe

nee

dto

sell

rese

rves

(∆R

<0)

toke

eps

=s.

A‘B

-o-P

crisis’ca

nocc

ur

when

∆R

<0

isve

ryla

rge.

How

ever

,ou

rB

Pw

illal

way

sen

dup

atB

P=

0.

Dudle

yCooke

(Trinity

Colleg

eD

ublin)

Mundel

l-Fle

min

gM

odel

42

/50

Dur

atio

nof

Fix

edEx-

Rat

eReg

imes

Dudle

yCooke

(Trinity

Colleg

eD

ublin)

Mundel

l-Fle

min

gM

odel

43

/50

IS-L

M-B

Pw

ith

Fix

edExc

hang

eRat

es

Now

q=

q,so

the

ISan

dLM

conditio

ns

are:

y=

a+

δ(y

−t )

+h

0−

γi∗

+g

+λq−

βy

R+

D︸︷︷

︸=

ms

−p

=ky

−�i

∗

Note

:any

move

men

tin

the

bala

nce

-of-pay

men

tsis

reflec

ted

inth

ech

ange

inre

serv

es.

So:

CA

(Q,Y

)+K

A(i−

i∗)

=∆

R=

B-o

-P

and,

CA�=

−KA

but,

BP

=0

Dudle

yCooke

(Trinity

Colleg

eD

ublin)

Mundel

l-Fle

min

gM

odel

44

/50

Pre

view

:Fix

edExc

hang

eRat

esan

dPer

fect

Cap

ital

Mob

ility

Mon

etar

yPol

icy:

Ina

fix

∆y

/∆

D=

0.T

his

isa

resu

ltof

the

trile

mm

apr

oble

m.

But

we

will

hav

ele

ssre

serv

es.

Sin

cere

serv

esar

efinite

this

pol

icy

could

cause

the

fixe

dre

gim

eto

be

aban

don

ed(e

ventu

ally

).

Fisca

lPol

icy:

Now

∆y

/∆

g>

0,w

her

eas

with

floa

ting

exch

ange

rate

snot

much

hap

pen

ed.

This

produce

sa

CA

defi

cit

finan

ced

byca

pital

inflow

s.

Con

sider

the

‘mor

ein

tere

stin

g’ca

seof

imper

fect

lym

obile

capital

.

Dudle

yCooke

(Trinity

Colleg

eD

ublin)

Mundel

l-Fle

min

gM

odel

45

/50

Fix

edExc

hang

eRat

es-

Mon

etar

yExp

ansion

-Im

per

fect

Cap

ital

Mob

ility

Inth

esh

ort-

run,if

capital

isnot

com

ple

tely

mob

ile,th

ein

tere

stra

tedec

rease

s,in

com

ein

crea

ses,

and

soth

eca

pitalan

dcu

rren

tac

counts

det

erio

rate

(CA

,KA

<0)

.T

he

LM

shifts

left

.

As↓r

,fo

reig

ner

swan

tto

buy

dom

estic

curr

ency

,w

hic

hputs

dow

nwar

dpre

ssure

on

the

exch

ange

rate

.

The

centr

alban

kin

terv

enes

and

sells

rese

rves

tost

opth

is(∆

R<

0)an

dco

ntinues

untilou

tput

and

the

inte

rest

rate

are

bac

kto

thei

rpr

evio

us

leve

l.LM

shifts

back

.

Inth

enew

equili

briu

m,th

eon

lydiff

eren

ceis

inth

eco

mpos

itio

nof

the

mon

eyst

ock

(i.e

.le

ssre

serv

es,

∆R

<0,

mor

edom

estic

cred

it,

∆D

>0,

and

∆M

s=

0)

Dudle

yCooke

(Trinity

Colleg

eD

ublin)

Mundel

l-Fle

min

gM

odel

46

/50

Fix

edExc

hang

eRat

es-

Mon

etar

yExp

ansion

-Im

per

fect

Cap

ital

Mob

ility

i,In

tere

stRate

y,O

utp

ut

y0

i 0

IS

BP(s)

LM

(D

0,R

0)=

LM

(D

1,R

1)

LM

(D

1,R

0)

y′ 0

i′ 0

Dudle

yCooke

(Trinity

Colleg

eD

ublin)

Mundel

l-Fle

min

gM

odel

47

/50

Fix

edExc

hang

eRat

es-

Fisca

lExp

ansion

-Im

per

fect

Cap

ital

Mob

ility

As

are

sult

ofpol

icy

(i.e

.,↑g

),th

eIS

shifts

right.

Ther

eis

arise

inr

whic

hpr

oduce

sca

pital

inflow

s(K

A>

0)an

da

rise

iny

whic

hca

use

sa

curr

ent

acco

unt

defi

cit

(CA

<0)

.

As↑r

,fo

reig

ner

sbuy

dom

estic

curr

ency

,w

hic

hputs

upwar

dpre

ssure

on

the

exch

ange

rate

.

The

centr

alban

kin

terv

enes

and

buys

rese

rves

(∆R

>0)

.A

s∆

D=

0,th

en∆

Ms>

0.T

he

LM

shifts

right.

The

inte

rest

rate

falls

alit

tle,

and

som

eca

pital

flow

sou

t.O

utp

ut

rise

s,wor

senin

gth

ecu

rren

tac

count

pos

itio

n.

Dudle

yCooke

(Trinity

Colleg

eD

ublin)

Mundel

l-Fle

min

gM

odel

48

/50

Fix

edExc

hang

eRat

es-

Fisca

lExp

ansion

-Im

per

fect

Cap

ital

Mob

ility

Fisca

lpol

icy

isle

sseff

ective

(vs.

full

capital

mob

ility

)at

chan

ging

outp

ut

asth

edom

estic

inte

rest

rate

has

chan

ged.

Bel

ow;D

1=

D0,

R1

<R

0an

d∆

Ms>

0.i,

Intere

st

Rate

y,O

utput

y0

y′ 0

y1

i 0

IS(g0)

BP(s)

LM

(D

0,R

0)

IS(g1)

LM

(D

0,R

1)

i 1

Dudle

yCooke

(Trinity

Colleg

eD

ublin)

Mundel

l-Fle

min

gM

odel

49

/50

Con

clus

ions

We

hav

est

udie

da

smal

lop

enec

onom

y:

1W

ehav

elo

oked

atth

eeff

ects

ofFisca

lan

dM

onet

ary

Pol

icy

under

Fix

edan

dFlo

atin

gex

chan

gera

tes.

2W

ehav

eco

nsider

edth

ero

leof

capital

contr

ols

(i.e

.im

per

fect

capital

mob

ility

)in

that

conte

xt.

Dudle

yCooke

(Trinity

Colleg

eD

ublin)

Mundel

l-Fle

min

gM

odel

50

/50