Keynesian Model of the trade balance TB & income Y.

Key assumption: P fixed => .

Mundell-Fleming model

Key additional assumption: international capital flows KA respond to interest rates i .

LECTURE 2:THE MUNDELL-FLEMING MODEL WITH A FIXED EXCHANGE RATE

YY

M

A

P

Questions: Effect of fiscal expansion or other .

Effect of monetary expansion / .

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.

 

.

If the domestic country is small, Y* is exogenous; drop for simplicity. Rewrite TB = .

0dE

dX

0**

mdY

dX0m

dY

dIM

X

mYEX )(

0dE

dIM

0dE

XdNotationally, we embody all E effects (whether via exports or imports) in ;

And we assume the Marshall-Lerner condition holds: .

Empirical estimates of sensitivity of exports and imports to E & Y

• 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.

log X

)/*log( PEP

Estimated price elasticities (LR)

satisfy the Marshall-Lerner

Condition.Estimated income elasticities are mostly

between 1.0 - 2.0.

Trade Balance = TB = (E) – mY.

Aggregate output = domestic Aggregate Demand + net foreign demand: Y = A(i, Y) + TB(E, Y),

  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.

Solve to get the IS curve:

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

X

msEXibA

Y )()(

where and .0di

dA0c

dY

dA

mYEXcYibA )()(Combining equations,

Y =

msEXibA

Y )()(

IS curve: An inverse relationship between i and Y consistent with the equilibrium that supply = demand in the goods market.

,A

The overall balance of payments is given by

BP = TB + KA ,

 where , the degree of capital mobility > 0.

We want to graph BP = 0. Solve for the interest rate:

*)()( iiKAmYEX

*)( iiddKA

YmKAXii )/())(/1(*)(

The Mundell-Fleming model introduces capital flows

slope = m/

Finally, the LM curve is given by __ __ M / P = L ( i, Y)

  where

0dY

dL0di

dL

→ A monetary

expansion shifts the LM curve to the right .

LM´

Application of the Mundell-Fleming modelto payments surpluses experienced by emerging markets.

Causes of Capital Flows to Emerging Markets

I. “Pull” Factors (internal causes)1. Monetary stabilization => LM shifts up2. Removal of capital controls => κ rises3. Spending boom => IS shifts out/up4. Domestic privatization, => IS or BP shift out

deregulation & liberalization

2. Desire to diversify by global investors => =>

II. “Push” Factors (external causes)1. Low interest rates in rich countries

=> i* down =>

BP shifts down}

Causes of 2003-08 and 2010-11 Capital Flowsto 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.