LECTURE 2:

THE MUNDELL-FLEMING MODEL WITH A FIXED EXCHANGE RATE

Keynesian Model

of the trade balance

TB

& income

Y.

Key assumption:

P

fixed =>

Y



Y .

Mundell-Fleming model

Key additional assumption: international capital flows

KA r

espond to interest rates

i .

Questions:

Effect of fiscal expansion or other 

A

.

Effect of monetary expansion 

M

/

P

.

ALTERNATE APPROACHES TO DETERMINATION OF EXTERNAL BALANCE

 Elasticities Approach to the Trade Balance  Keynesian Approach to the Trade Balance  Mundell-Fleming Model of the Balance of Payments  Monetary Approach to the Balance of Payments  NonTraded Goods or Dependent-Economy Model of the Trade Balance  Intertemporal Approach to the Current Account

KEYNESIAN MODEL

OF THE

TRADE BALANCE

Import demand is a function of the exchange rate & income. The same for exports: =>

TB = X(E,Y*) – IM(E,Y),

where

IM

is here defined to be import spending expressed in domestic terms.

dX dE

 0

dIM

 0

dE

.

dX dY

* 

m

*  0

dIM



m

 0

dY

If the domestic country is small,

Y*

drop for simplicity. Rewrite is exogenous;

TB =

X

(

E

) 

mY

.

Notationally, we embody all

E

effects (whether via exports or imports) in And we assume the Marshall-Lerner condition holds

d X

: .

dE X

;

Empirical estimates of sensitivity of exports and imports to

E

&

Y

log X log(

EP

* /

P

) • For empirical purposes, we estimate by OLS regression – with allowance for lags, giving J-curve; – shown in logs, giving parameters as: • price elasticities, and • income elasticities.

• Illustration: Marquez (2002) finds for most Asian countries: – Marshall-Lerner condition holds, after a couple of years, and – income elasticities are in the 1.0-2.0 range.

Estimated income elasticities are mostly between 1.0

2.0

.

Estimated price elasticities (LR) satisfy the Marshall-Lerner Condition.

Trade Balance Aggregate output = domestic Aggregate Demand + net foreign demand:

Y = A(i, Y) + TB(E, Y),

where

dA

 0

di dA

and .

dY

More specifically, let

A(i, Y) = Ā - b(i) + cY

, where the function -

b( )

captures the negative effect of the interest rate

i

on investment spending, consumer durables, etc.

Combining equations,

Y = A



b

(

i

) 

cY



X

(

E

) 

mY

Solve to get the IS curve:

Y



A



b

(

s i

)  

m X

(

E

) where s  1 – c is the marginal propensity to save.

IS curve: An inverse relationship between

i

and

Y

consistent with the equilibrium that supply = demand in the goods market.

Y



A



b

(

i s

)  

m X

(

E

)

A

,

The Mundell-Fleming model introduces capital flows

The overall balance of payments is given by

BP = TB + KA



X

(

E

) 

mY



KA

  (

i



i

*)

,

where

d

(

dKA i



i

*)   , the degree of capital mobility

> 0

.

We want to graph

BP = 0 .

(

i



i

*)  ( 1 /  )( 

X

 Solve for the interest rate:

KA

)  (

m

/  )

Y

slope =

m

/ 

Finally, the LM curve is given by __ __

M / P = L ( i, Y)

dL

where

di dL

 0

dY

→ LM´ A monetary expansion shifts the LM curve to the right .

Causes of Capital Flows to Emerging Markets Application of the Mundell Fleming model to payments surpluses experienced by emerging markets .

I.

“Pull” Factors (internal causes)

1. Monetary stabilization => LM shifts up 2. Removal of capital controls => κ rises 3. Spending boom => IS shifts out/up 4. Domestic privatization, => IS or BP shift out deregulation & liberalization

II. “Push” Factors (external causes)

1. Low interest rates in rich countries => i* down => 2. Desire to diversify by global investors =>

} BP shifts down =>

Causes of 2003-08 and 2010-11 Capital Flows to Developing Countries

• Strong economic performance (especially China & India)

-- IS shifts right.

• Easy monetary policy in US and other major industrialized countries (low

i*) -- BP shifts down.

• Big boom in mineral & agricultural commodities (esp. Africa & Latin America)

-- BP shifts right.