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International Economics

Unit 3Macroeconomic Policy in an Open

Economy. Mundell-Fleming model

1

Previous conclusion

The ultimate effects of a devaluation are in large part dependent upon theeconomic policies that accompany the devaluation.

Economic objectives

- Internal Balance:- Price stability- Full employment

- External Balance:- Equilibrium in the BP

Economic policies

- Aggregate supply policies- Aggregate demand policies:

- Expenditure changing policies. Aim to influence the level of AD- Expenditure switching policies. Aim to influence the composition ofAD 2

RER

O A

IB

E0

E1

Inflation

Unemployment

RER

O A

EB

E0

E1

Surplus

CA > 0

Deficit

CA < 0

Internal and external equilibrium: the SWAN diagram

3

The Swan diagram

4

Mundell-Fleming model (IS-LM-BP model)

Aim: Analyze the effectiveness of fiscal and monetary policy

Assumptions:- Domestic and foreign prices are constant- Unemployment- International capital mobility

Economic relationships (Equations).

5

Exports and Government expenditure are considered to be autonomous

The goods market

6

Derivation of the IS schedule

7

The money market

Ms= D + R (φ =1)

D = Domestic asset (bond) holdings of the monetary authorities =Domestic creditR = Foreign asset holdings (Foreign exchange and any otherinternationally acceptable assets) of the monetary authorities,valued in domestic currency = International reserves

Mt = Mt(Y) Msp = Msp (r)

Md = Ms

Mt+Msp = Ms 8

Derivation of the LM schedule

9

The foreign sector

X is exogenous

K = K(r)

BP = CA + K = 0

10

Derivation of the BP schedule

11

Figure 4.5 Equilibrium of the model

12

Monetary policy (Example of expansionary MP)

–The Central Bank purchases bonds from the public and injects newly created money. LM to the right–Prices of bonds go up–Interest rates go down–Investment, consumption and income increase–BOP goes into deficit or the domestic currency depreciates

Fiscal policy (Example of expansionary FP)

–G increases (The government pays for this increase by selling bonds) and this increases income. IS to the right–Price of bonds go down–Interest rates go up–Investment, consumption and income decrease–Final result on Y: increases but by less than the increase in G–The CA deteriorates and the K improves: BOP changes? Exchange rates?

As we will see, the exchange rate regime turns out to be crucial to the behaviour of the economy

13

r

YY0O

r0

BP

IS

LM

LM’

Y’

A C

B

+ –r

YY0O

r0

BP

IS

LM

LM’

Y’

A

CB

+ –

IS’

r’

r’

MP FP

No capital mobility and fixed exchange rates

14

r

YY0O

r0

BP

IS

LMLM’

Y’

A=C

B+

–

r’

MP

Imperfect capital mobility and fixed exchanges rates

15

Imperfect capital mobility and fixed exchanges rates

r

YY0O

r0

BP

IS

LM

LM’

Y’

A

B

+–

r’

IS’

C

r

YY0O

r0

BP

IS

LMLM’

Y’

A

C

+–

r’

IS’

B

FP

16

r

YY0O

r0 BP

IS

LM

LM’

Y’

+

–

r

YY0O

BP

IS

LM

LM’

Y’

A C +

–

IS’

A=Cr0

MPFP

Perfect capital mobility and fixed exchange rates

17

Imperfect capital mobility and flexible exchange rates

MP

rBP

IS

LMLM’

A C

B

+ –

IS’

BP’

r

YY0O

BP

IS

LMLM’’

LM’

Y’

A

B

+ –

IS’’

C

BP’’

18

Negligible effect on LM Non-negligible effect on LM

Imperfect capital mobility and flexible exchange rates

FP

IS’’

r

YY0O

BP

IS

LM

A

C

B

IS’+ –

BP’’ r

YO

BP

IS

LM

A

C

B

IS’’

+– IS’

BP’’

19

r

YY0O

BP

IS

LM

Y’

+

–

A=C

IS’

r

YY0O

BP

IS

LM

LM’

Y’

A C +

–

IS’

r = r* r = r*

MP FP

Perfect capital mobility and flexible exchange rates

20

Monetary and fiscal policies: Summary effects

ER regime Degree of K mobility

Monetary Policy Fiscal Policy

SR LR SR LR

Fixed ER NKM E I E I (Crowding out)

IKM E I E E (the more effective the flatter the BP curve)

PKM I (totally) E (totally)

Floating ER IKM ES increases

ES increases

E E

(the more effective the stepper the BP curve)S increases if BP slope>LM slope.S decreases if BP slope<LM slope

PKM E S increases I (totally) S decreases

21

The principle of effective market classification: the assignment problem

MP

O FP

A

IB

CB

DE

Unemp.

Inflation

FPN

MPN

FPR FPE

MPR

MPE

∆MS

∇G ∆G

∇MS

22

The assignment problem

O

A

EB

C

B

Surplus

Deficit

FPN

MPN

FPR FPE

MPR

MPE

∇MS

∆MS

∇G ∆G

MP

FP O

A

EBC

Deficit

MPN

FPR FPE

MPR

MPE∆MS

∇G ∆G

MP

FPPFN

Surplus

B

23

MP

O

EP

EB

FPN

MPN

FPR FPE

MPR

MPE

IB

FP

J

MP

O

EP

EB

FPN

MPN

FPR FPE

MPR

MPE

IB

FP

DeficitInflation

SurplusUnemp. Surplus

Inflation

DeficitUnemp.

D

F

24


MPR

MPE

MP

EP

IB

FPN

MPN

FPR FPE

EB

J

FP

25


Limitations of the Mundell-Fleming model

1. Marshall-Lerner condition2. Interaction of stocks and flows3. Neglect of long run budget constrains4. Aggregate supply curve is horizontal5. Treatment of capital flows6. Monetary and fiscal policies are not that flexible7. Exchange rate expectations

26

LM(P1)

IS(P1, G0)

AD

IS(P1, G1)

IS(P0, G1)

r

YY0O

Y1

A B

P

YY0O Y1

AD’

P0

P1

IS(P0, G0)

LM(P0)

r0r1

AD-AS model in an open economy

27

AD and fixed exchange rates


01

1 0

wwP P

=

LLFEO

LD

wP

LS

YYFEO

ASST’P

0

1

wP

L1

ASST

ASLT

Y1

P1

P0

28

AS and fixed exchange rates


P

Y*O

ASST

P*

AD

E

Y

29

ST equilibrium


30

LT equilibrium


31

Is there an automatic adjustment process?


32

Can we help the adjustment process?


33

Effects of a devaluation: short-term and long-term


34

AD and floating exchange rates


35

Are demand policies effective?


36

LT equilibrium


37

Is there an automatic adjustment process?


38

Can we help the adjustment process?


39

Supply shocks

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