LECTURE 3:

THE MUNDELL-FLEMING MODEL - MONETARY & FISCAL POLICY, AND ADJUSTMENT

Question 1: What are the implications of monetary & fiscal policy for income & the balance of payments, at a given exchange rate?

Question 2: Mechanisms of adjustment. How does a country adjust to BoP imbalance? What further implications for the economy?

Key parameter: κ , degree of capital mobility

Key results

: • κ raises effect of G on Y under fixed E (but lowers it under floating).

• κ lowers effect of M on Y under fixed E (but raises it under floating).

Recap slopes down slopes up An increase in spending, e.g., fiscal expansion, shifts IS right, by the multiplier, 1/(s+m).

LM′ slopes up Monetary expansion shifts LM right.

slope = m/κ API-120 - Prof. J.Frankel, Harvard

A

   0

m

/    •   0  

m

/   0 •   0 •

m

/   0 API-120 - Prof. J.Frankel, Harvard

(

M

/

P

)    0

m

/      0  

m

/   0   0 • • API-120 - Prof. J.Frankel, Harvard •

m

/   0

Monetary & fiscal policy in the Mundell-Fleming model with a fixed exchange rate -- Summary • • •

Fiscal expansion

shifts out IS curve. – Result: Y ↑ , –

A

 though by less than simple Keynesian multiplier because i ↑ => crowding out.

Monetary expansion shifts out LM curve.

– Result i ↓ => Y

↑.

(

M

Magnitudes of ∆Y do not depend on degree of capital mobility, κ.

/

P

)

Result for external balance

i) Y

↑ => TB ↓

ii) With an open KA: • Fiscal expansion => i ↑ => KA ↑  · • Monetary expansion => i ↓ => KA ↓ Effect on overall BP (=CA+KA) depends on degree of capital mobility.

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Automatic mechanisms of adjustment

 Reserve flows R -- as under the MABP.

 Price level P -- we assume for the moment that price adjustment is very slow.

 Indebtedness -- rising debt will eventually force a reduction in spending. We omit this factor from the analysis for now.

 Exchange rate E -- if flexible .

MABP (The Monetary Approach to the Balance of Payments)



Defining assumption: Reserve flows are not sterilized.

 Another assumption sometimes associated with MABP: PPP .

Insulated.

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MABP

Without sterilizing reserve flows and i rises over time , until in the long run we are back where we started .

(

M

/

P

)    0   0   0 • • • • • • This offset to the increase in MB happens more quickly, the higher is κ .

API-120 - Prof. J.Frankel, Harvard

A country at point B - as were many developing countries in 1990-96, 2003-08, or 2010-13 - has a BoP surplus.

• The authorities must choose among several options for managing inflows.

(Each option has its own drawback).

Alternative ways to manage inflows (with disadvantages) A. Allow money to flow in. (Can be inflationary) B. Sterilize intervention. (Artificially prolongs disequilibrium) C. Allow currency to appreciate. (Lose competitiveness) D. Reimpose capital controls. (Lose financial integration gains) API-120 - Prof. J.Frankel, Harvard

Examples of attempts to sterilize capital inflows, to dampen real appreciation • In the early 1990s, Colombia, Korea, Indonesia and others sterilized for a year or two and then gave it up.

• More recently, China successfully sterilized for five years … until 2007-08, 2010-11 .

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Example of sterilization of money inflows: China, 2003-2012

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China’s Balance of Payments ≡ rate of change of foreign exchange reserves (largely $), rose rapidly from 2004 on, due to all 3 components: trade balance, Foreign Direct Investment, & portfolio inflows

Reserves

Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008 API-120 - Prof. J.Frankel, Harvard 12

FX reserves of the PBoC climbed higher than any central bank in history http://qz.com/171645/the-invisible-man-managing-chinas-3-8-trillion-in-reserves-just-stepped-down

In 2003 04, forex inflows accelerated rapidly.

(Both TB & KA >> 0.) Initially, the PBoC had no trouble sterilizing the inflows.

=> The MB growth rate was kept down to the growth rate of the

In 2007-08 China had more trouble sterilizing the reserve inflow (as predicted) • PBoC began to have to pay higher domestic interest rates – and to receive lower interest rate on US T bills – => “quasi-fiscal deficit” or “negative carry.” • Inflation became a serious problem in 2007-08.

• Also a “bubble” in the Shanghai stock market.

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Sterilization faltered in 2007 & 2008

Growth of China ’ s monetary base & its components:

Money growth accelerated sharply, 2007-08

Source: HKMA,

Half-Yearly Monetary & Financial Stability Report

, June 2008 API-120 - Prof. J.Frankel, Harvard

China

’

s CPI accelerated in 2007-08

Inflation 1999 to 2008 Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008 API-120 - Prof. J.Frankel, Harvard

Further tools: The PBoC raised reserve ratios required of banks, thus sterilizing in the broad sense of slowing M1.

It also raised lending rates while continuing to underpay depositors:

“financial repression” { Source: HKMA,

Half-Yearly Monetary & Financial Stability Report

, June 2008

Chinese inflation fell in 2008-09,

and again in 2011-14 API-120 - Prof. J.Frankel, Harvard

Appendix: More on China’s sterilization

ΔReserves↑ While increases in reserves (NFA) were large, changes in net domestic assets (NDA) were negative, limiting rises in the monetary base.

The People’s Bank of China sold sterilization bills Data: CEIC Source: Zhang, 2011, Fig.4, p.45.

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Sterilization of foreign reserves:

The decreases in PBoC’s net domestic assets offset increases in foreign assets API-120 - Prof. J.Frankel, Harvard Source: Zhang, 2011, Fig.7, p.47.

Further, the PBoC raised banks’ required reserve ratios, thus sterilizing in the broad sense of slowing M1, even if M Base grew rapidly Source: Zhang, 2011 , Fig.6, p.46.

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China’s inflation broke sharply in 2009,

(<= big one-year loss of China’s exports due to global recession).

But took off again in 2010-11.

Inflation 2001 to 2011 API-120 - Prof. J.Frankel, Harvard

After the interruption of mid-2008 to mid-2009 overheating resumed: rapid rise of land prices in 2010 Real Beijing land prices API-120 - Prof. J.Frankel, Harvard

When house prices rise relative even to rents, it suggests a bubble or easy money API-120 - Prof. J.Frankel, Harvard Scott Reeve blog

China in 2010 resumed attempts to sterilize money inflows by raising banks’ reserve requirements -- to slow M1 growth even while MB is growing rapidly .

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China’s tightened control of the money supply to help head off rising inflation in 2004, 08, and again in 2011.

API-120 - Prof. J.Frankel, Harvard Fxtimes.com

Chinese inflation, once again, began to ease off after mid-2011

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