(II) THE MUNDELL-FLEMING MODEL LECTURE 3: THE MODEL WITH A FIXED EXCHANGE RATE Keynesian Model of the trade balance TB & income Y. . Key.
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Transcript (II) THE MUNDELL-FLEMING MODEL LECTURE 3: THE MODEL WITH A FIXED EXCHANGE RATE Keynesian Model of the trade balance TB & income Y. . Key.
(II) THE MUNDELL-FLEMING MODEL
LECTURE 3:
THE MODEL WITH A FIXED EXCHANGE RATE
Keynesian Model of the trade balance TB & income Y.
.
Key assumption: P fixed => Y β π.
Mundell-Fleming model
Key additional assumption:
international capital flows KA respond to interest rates i.
Questions:
Effect of fiscal expansion or other Ξπ΄ .
Effect of monetary expansion.
Recall the Keynesian model of the trade balance
TB is a function of the exchange rate & income:
TB = π πΈ - mY.
We now embody E effects (whether via exports or imports) in π;
and we assume the Marshall-Lerner condition holds:
ππ
ππΈ
> 0.
Determination of income
Trade Balance: TB = π(E) β mY.
Aggregate output = domestic Aggregate Demand + net foreign demand:
Y
=
A(i, Y)
where
ππ΄
ππ
<0 and
+
ππ΄
ππ
TB(E, Y),
> 0.
More specifically, let A(i, Y) = Δ - b(i) + cY ,
where the function -b( ) captures the negative effect of the
interest rate i on investment spending, consumerdurables, etc.
Combining equations,
Y =
A(i, Y) + TB(E, Y )
= Δ - b(i) + cY + π πΈ - mY.
Now solve to get the IS curve:
Y =
Δ β b(i) + π
πΈ
π +π
where s οΊ 1βc is the marginal propensity to save.
IS curve: An inverse relationship between i and Y
consistent with supply = demand in the goods market.
IS: Y =
i
IS
π΄ β ππ + π
π +π
IS'
Ξπ΄/(π + π)
Y
An increase in spending, Δ, e.g., a fiscal expansion,
shifts IS to the right by the multiplier 1/(s+m).
The LM curve: Money supply = money demand.
π1
=
π
i
L(i, Y)
where
LM
β
ππΏ
ππ
< 0,
ππΏ
ππ
>0.
LM´
A monetary
expansion
(M1β) shifts
the LM curve
to the right.
Y
β’ Do central banks actually set the money supply?
β’ Supposedly in the 1980s heyday of monetarism they set M1.
β’ Also the monetary base made a comeback after 2008: Quantitative Easing.
Y
The Mundell-Fleming equations with a fixed exchange rate
IS: Y =
π΄ β ππ + π
π +π
LM:
IS
π1
=
π
L(i, Y)
LM
i
Y
Prof.J.Frankel
Monetary expansion in the Mundell-Fleming model: M1β
IS: Y =
π΄ β ππ + π
π +π
LM:
IS
π1
π
= L(i, Y)
LM
i
LM'
Or think of the
central bank
setting i directly.
Y
Prof.J.Frankel
Spending expansion in the Mundell-Fleming model: π΄β
IS: Y =
IS
π΄ β ππ + π
π +π
IS'
LM:
π1
π
= L(i, Y)
Taylor
rule
i
LM
Or the central bank may
follow a Taylor Rule:
setting i systematically
in response to Y & inflation.
Y
Prof.J.Frankel
The Mundell-Fleming model introduces capital flows
IS
LM
BP=0
i
Y
BP β‘ TB + KA
TB = π β mY
BP=0:
New addition: capital flows
respond to interest rate differential
KA = πΎπ΄ + ΞΊ (πβπ β)
where ΞΊ οΊ
π(πΎπ΄)
, capital mobility.
π(πβπβ)
π β mY + πΎπ΄ + ΞΊ πβπ β = 0
We want to graph BP = 0.
Solve for interest differential:
(i-i*) =
Prof.J.Frankel
1
ΞΊ
[(βπΎπ΄βπ] +
π
( )Y.
ΞΊ
BP=0:
(i-i*) =
1
ΞΊ
[(βπΎπ΄ β πβπ ]
+
π
( )Y
ΞΊ
.
The slope is (m/πΏ).
ΞΊ=0
i
πΏ>0
i
BP=0
πΏ >> 0
i
BP=0
Surplus
BP=0
Deficit
Y
Y
Y
Capital mobility gives some slope to the BP=0 line:.
A rise in income and the trade deficit is consistent with BP=0 β¦
if higher interest rates attract a big enough capital inflow.
Prof.J.Frankel
Application: Why did many developing countries find
themselves with BoP surpluses during 2003-08 & 2010-13?
β’ Strong economic performance (especially Asia)
-- IS shifts right.
β’ Easy monetary policy in US and other
major industrialized countries (low i*)
-- BP shifts down.
β’ Boom in mineral & agricultural commodities
(esp. Africa & Latin America)
-- BP shifts right.
Causes of BoP Surpluses in Developing Countries
I.
1990-1997,
2003-08 &
2010-13
βPullβ Factors (internal causes)
1. Monetary stabilization
=> LM shifts up
2. Removal of capital controls => ΞΊ rises
3. Spending boom
=> IS shifts out/up
II.
βPushβ Factors (external causes)
1.
Low interest rates in rich countries
=> i* down =>
2.
Boom in export markets =>
β’
}
BP
shifts
out/
down