Chapter 13 - The Mundell-Fleming model

Question 1

What are the key assumptions of the model?

Answer 1

Small open economy with perfect capital mobility i.e. r = r*

Implies that if e.g. domestic savings decline and interest rate increases, foreigners would immediately start to lend to this country and the capital inflow would drive interest rate back to world interest rate

The model assumes the price levels at home and abroad are fixed, thus the real exchange rate is proportional to the nominal exchange rate

Question 2

What is the IS* equation/curve?

Answer 2

Relates to the goods market

NX depends negatively on e – the amount of foreign currency per unit of domestic currency

The IS* equation: Y = C(Y – T) + I(r*) + G + NX(e

The IS* slopes downward because a higher exchange rate reduces net exports which in turn lowers aggregate income

Question 3

What is the LM* equation/curve?

Answer 3

Relates to the money market

M exogenous and controlled by world bank, P is fixed exogenously

M/P = L(r, Y) – the LM equation

The LM* curve is vertical because the exchange rate does not enter the equation

Given the world interest rate, the equation determines aggregate income, regardless of the exchange rate

Question 4

What is the Mundell-Fleming model?

Answer 4

According to the Mundell–Fleming model, a small open economy with perfect capital mobility can be described by two equations IS* and LM*

The first equation describes equilibrium in the goods market, and the second equation describes equilibrium in the money market.

The exogenous variables are fiscal policy G and T, monetary policy M , the price level P and the world
interest rate r*.

The endogenous variables are income Y and the exchange rate e.

The equilibrium for the economy is found where the IS* curve and the LM * curve intersect. This intersection shows the exchange rate and the level of income at which the goods market and the money market are in equilibrium. With this diagram, we can use the Mundell–Fleming model to show how aggregate income Y and the exchange
rate e respond to changes in policy.

Question 5

What is a system of floating exchange rates?

Answer 5

Under a system of floating exchange rates, the exchange rate is set by market forces and is allowed to fluctuate in response to changing economic conditions

The exchange rate adjusts to achieve simultaneous equilibrium in the goods market and the money market

Question 6

What happens in the Mundell-Fleming model if the government increases purchases or cuts taxes (floating exchange rates)?

Answer 6

As planned expenditure increases, IS* shifts to the right

The exchange rate appreciates, the level of income remains the same

The income is at the same level as: as soon as the interest rate starts to rise above the world interest rate, capital flows in from abroad to take advantage. Pushes interest rate back to world interest rate and the demand for domestic currency in the market for foreign currency exchange increases (because foreign investors need to buy domestic currency to invest in domestic economy. Thus, value of domestic currency increases, domestic goods more expensive relative to foreign, reduction in net exports. The fall in NX offsets the effects of the expansionary fiscal policy on income.

Why is the fall in NX so great that it renders fiscal policy powerless to influence income?

M fixed by central bank, P fixed by sticky prices, i.e. M/P fixed

r is fixed at r* so only one level of income can satisfy M/P = L(r*, Y)

Question 7

What happens in the Mundell-Fleming model if the money supply is increased by the central bank (floating exchange rates)?

Answer 7

P is fixed, hence increase in M/P

LM* shifts right, increase in income, lower exchange rate

As interest rate is fixed by the world interest rate, the monetary transmission mechanism is different from a closed economy

As soon as increase in M puts downward pressure on interest rate, capital flows out of the economy (seeking higher returns) – prevent domestic interest rate from falling below world interest rate

Another effect – as investing abroad requires foreign currency, supply of domestic currency in foreign-currency exchange market increases, domestic currency depreciates, which stimulates NX

Question 8

What happens in the Mundell-Fleming model if the government imposes a tariff or quota on imports (floating exchange rates)?

Answer 8

Increase in NX, shifts to the right

Increases planned expenditure, IS* shifts to the right

As the LM* curve is vertical, exchange rate increases but does not affect income

Explanation: increase in NX puts pressure on income Y, which increases money demand and puts upward pressure on the interest rate. Foreign capital flows into the economy pushing interest rate down and causing the domestic currency to appreciate – makes domestic goods more expensive relative to foreign which decreases NX and returns Y to initial level

Hence, trade balance is not affected – the overall effect is less trade

Question 9

Under floating exchange rates, what is the only type of policy that can affect income (Mundell-Fleming)?

Answer 9

Monetary policy – the usual expansionary impact of fiscal policy is offset by a rise in the value of the currency and a decrease in NX

Question 10

What is the difference between how fiscal policy affects a closed vs. a small open economy (floating exchange rates)?

Answer 10

Closed – fiscal policy crowds out investment by causing the interest rate to rise. Open – fiscal policy crowds out NX by causing the exchange rate to appreciate

Question 11

What is a fixed-exchange rate system?

Answer 11

Central bank announces value for the exchange rate and stands ready to buy and sell the domestic currency to keep exchange rate at announced level

Fixes nominal exchange rate

Whether real exchange rate is fixed depends on time horizon, in the long run where prices are flexible, real exchange rate can still change

Hence, in the long run no real variables would be influenced, only M and P

But in the short run, a fixed nominal exchange rate implies fixed real exchange rate as well

Question 12

How does a fixed-exchange rate system work?

Answer 12

Dedicates a country’s monetary policy to the single goal of keeping the exchange rate at the announced level

Central bank allows the money supply to adjust to whatever level will ensure that the equilibrium exchange rate in the market for foreign-currency exchange equals the announced exchange rate

Question 13

What happens in the Mundell-Fleming model if the government pursues an expansionary fiscal policy (fixed exchange rates)?

Answer 13

IS* curve shifts right, putting upward pressure on the market exchange rate

As the central bank stands ready to trade foreign and domestic currency at fixed exchange rate, arbitrageurs quickly respond to rising exchange rate by selling foreign currency to the central bank – automatic monetary expansion – LM* shift to the right

Hence, increase in aggregate income

Question 14

What happens in the Mundell-Fleming model if the central bank increases money supply (fixed exchange rates)?

Answer 14

Initial impact – LM* shifts right, lowering the exchange rate

However, as CB is committed to trading foreign and domestic currency at fixed exchange rate, arbitrageurs quickly respond to the falling exchange rate by selling domestic currency to the CB, causing M and LM* to return to original positions

Hence, monetary policy ineffectual under fixed exchange rate

However, can decide the level at which the exchange rate is fixed

Devaluation – a reduction in the official value of the currency, opposite of revaluation

Devaluation shifts LM* curve to the right – acts like an increase in M under floating exchange rate – hence expands NX and raises aggregate income

Question 15

What happens in the Mundell-Fleming model if the government imposes a tariff or quota on imports (fixed exchange rates)?

Answer 15

NX shifts right, thus IS* shifts right, which tends to raise the exchange rate

To keep exchange rate fixed, M must rise, shifting the LM* curve to the right

A trade restriction under a fixed exchange rate induces monetary expansion rather than an appreciation of the exchange rate, the monetary expansion raises aggregate income

When income rises, savings rise – implies increase in NX

Question 16

Under fixed exchange rates, what is the only type of policy that can affect income (Mundell-Fleming)?

Answer 16

Only fiscal policy – the normal potency of monetary policy is lost because M is dedicated to maintaining the exchange rate at the announced level

Question 17

Why does the law of one price, in relation to exchange rate, not apply i.e. why do interest rates differ across countries?

Answer 17

(1) country risk – when investors buy bonds issued buy European government or make loans to European corporations – fairly confident of repayment. Borrowers in countries where investors are not so sure of repayment may have to pay higher interest rates
(2) expected changes in exchange rate, if currency in a country is expected to fall, the interest rate will be higher to compensate

Question 18

How do we incorporate interest-rate differentials in the Mundell-Fleming model?

Answer 18

r = r* + θ

The risk premium is determined by the perceived political risk of making loans in a country and the expected change in the real exchange rate

Take risk premium as exogenous

Y = C(Y – T) + I(r* + θ) + G + NX(e)

M/P = L(r*+ θ, Y)

Holding the risk premium constant, the tools of monetary, fiscal and trade policy works as before

Question 19

What happens if the risk premium increases (Mundell-Fleming) ?

Answer 19

Most direct effect, domestic interest rate r rises

First, IS* shifts to the left as the higher interest reduces investment

Second, LM* shifts right as higher interest reduces the demand for money and thus allows a higher level of income for any given money supply

Income rises and currency depreciates

Expectations about the exchange rate are partially self-fulfilling

Question 20

In theory, an increase in country risk will cause economy’s income to increase (because of rightward shift of LM* - although higher interest rates depress investment, the depreciation of the currency stimulates NX by more). Why does such a boom not occur in practice?

Answer 20

(1) CB might want to avoid the large depreciation of the domestic currency and thus may respond by decreasing M
(2) The depreciation of the domestic currency may suddenly increase the price of imported goods, causing an increase in P
(3) When some event increases a country’s risk premium, the residents might respond to the same event by increasing their demand for money because money is often the safest asset available

All of the above would tend to shift LM* left, which mitigates the fall in the exchange rate but also tends to depress income

In addition, as higher interest reduces investment, the long-run implication is reduced capital accumulation and lower economic growth

Question 21

What are the pros and cons of floating exchange rates?

Answer 21

Pro - allows monetary policy to be used for other purposes e.g. stabilising employment or prices

Con – exchange-rate uncertainty makes international trade more difficult

Question 22

What are the pros and cons of fixed exchange rates?

Answer 22

Pro – one way to discipline a nation’s monetary authority and prevent excessive growth in the money supply

Pro – simpler to implement than other policy rules the CB can commit to. Simpler as M adjusts automatically

Con – might lead to greater volatility in income and employment

Question 23

Why does the law of one price, in relation to exchange rate, not apply i.e. why do interest rates differ across countries?

Answer 23

(1) country risk – when investors buy bonds issued buy European government or make loans to European corporations – fairly confident of repayment. Borrowers in countries where investors are not so sure of repayment may have to pay higher interest rates
(2) expected changes in exchange rate, if currency in a country is expected to fall, the interest rate will be higher to compensate

Question 24

How do we incorporate interest-rate differentials in the Mundell-Fleming model?

Answer 24

r = r* + θ

The risk premium is determined by the perceived political risk of making loans in a country and the expected change in the real exchange rate

Take risk premium as exogenous

Y = C(Y – T) + I(r* + θ) + G + NX(e)

M/P = L(r*+ θ, Y)

Holding the risk premium constant, the tools of monetary, fiscal and trade policy works as before

Question 25

What happens if the risk premium increases (Mundell-Fleming) ?

Answer 25

Most direct effect, domestic interest rate r rises

First, IS* shifts to the left as the higher interest reduces investment

Second, LM* shifts right as higher interest reduces the demand for money and thus allows a higher level of income for any given money supply

Income rises and currency depreciates

Expectations about the exchange rate are partially self-fulfilling

Question 26

Why does the law of one price, in relation to exchange rate, not apply i.e. why do interest rates differ across countries?

How do we incorporate interest-rate differentials in the Mundell-Fleming model?

What happens if the risk premium increases (Mundell-Fleming) ?

In theory, an increase in country risk will cause economy’s income to increase (because of rightward shift of LM* - although higher interest rates depress investment, the depreciation of the currency stimulates NX by more). Why does such a boom not occur in practice?

Answer 26

(1) CB might want to avoid the large depreciation of the domestic currency and thus may respond by decreasing M
(2) The depreciation of the domestic currency may suddenly increase the price of imported goods, causing an increase in P
(3) When some event increases a country’s risk premium, the residents might respond to the same event by increasing their demand for money because money is often the safest asset available

All of the above would tend to shift LM* left, which mitigates the fall in the exchange rate but also tends to depress income

In addition, as higher interest reduces investment, the long-run implication is reduced capital accumulation and lower economic growth

Question 27

What are the pros and cons of floating exchange rates?

Answer 27

Pro - allows monetary policy to be used for other purposes e.g. stabilising employment or prices

Con – exchange-rate uncertainty makes international trade more difficult

Question 28

What are the pros and cons of fixed exchange rates?

Answer 28

Pro – one way to discipline a nation’s monetary authority and prevent excessive growth in the money supply & hyperinflation

Pro – simpler to implement than other policy rules the CB can commit to. Simpler as M adjusts automatically. if credible, avoids uncertainty and volatility, making international transactions easier

Con – might lead to greater volatility in income and employment

Question 29

What is a speculative attack?

Answer 29

A change in investors’ perceptions that makes the fixed exchange rate untenable

E.g. if there is a rumour CB will abandon exchange rate, people will respond by rushing to the CB to convert before loss of value, CB’s reserves would be drained and could force CB to abandon exchange rate

Currency is sold short on foreign exchange markets: Short selling: Speculators borrow “overvalued” currency, sell it on foreign exchange markets, and intend to buy it back later when currency weakens. - Short selling puts downward pressure on the overvalued currency

Question 30

What is the impossible trinity?

Answer 30

Impossible for a nation to have free capital flows, a fixed exchange rate and independent monetary policy

A nation must choose one side of this triangle, giving up the institutional feature at the opposite corner

Option 1 – allow free flows of capital and conduct independent monetary policy. Giving up fixed exchange rate e.g. Sweden, as a group EA

Option 2 – free capital flows and fixed exchange rate, giving up independent monetary policy e.g. Hong Kong, within the group EA

Option 3 – independent monetary policy and fixed exchange rate, giving up free capital flows, e.g. China. Here, the interest rate is no longer fixed by world interest rates, but is determined by domestic forces, much as is the case in a completely closed economy. Thus, it is possible to both fix the exchange rate and conduct an independent monetary policy.

Every nation must ask itself the following question: Does it want to live with exchange-rate volatility (option 1), give up the use of monetary policy for purposes of domestic stabilization (option 2), or restrict its citizens from participating in world financial markets (option 3)?

Question 31

What happens when the price level falls in the Mundell-Fleming model with a changing price level?

Answer 31

Lower price level raises M/P, LM* shifts right

ε depreciates and the equilibrium level of income increases

The aggregate demand curve summarizes this negative relationship between the price level and the level of income

The Mundell-Fleming model explains the aggregate demand curve for a small open economy

In both cases, the aggregate demand curve shows the set of equilibria in the goods and money markets that arise as the price level varies. And in both cases, anything that changes equilibrium income, other than a change in the price level, shifts the aggregate demand curve.

Policies and events that raise income for a given price level shift the aggregate demand curve to the right; policies and events that lower income for a given price level shift the aggregate demand curve to the left.