Download The Mundell-Fleming (Open Economy IS-LM)

Business Cycles in the Open Economy
Mundell‐Fleming with Fixed Exchange Rates
Andrew Rose, Global Macroeconomics 10
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Three Important Assumptions
Three Important Assumptions
• Prices are Sticky
Prices are Sticky
– Business Cycle Model, Short Run
• Capital
Capital is Internationally Mobile
is Internationally Mobile – No No
Substantial Barriers to Private Capital Flows
– Rich countries, some emerging markets (but only Ri h
i
i
k (b
l
recently)
• Nominal Exchange Rates fixed
N i lE h
R
fi d by Central Bank
b C
lB k
– Some economies, though more have fixed in past
Andrew Rose, Global Macroeconomics 10
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Add Net Exports to Real Economy (IS)
Add Net Exports to Real Economy (IS)
• Recall that net exports (NX≡X‐M; current account) Recall that net exports (NX≡X M; current account)
determined by:
1. Domestic output Y, raises imports (M)
2 Foreign output Y* (assumed to be exogenous, since 2.
Foreign output Y* (assumed to be exogenous since
foreign), raises exports (X)
3. Real exchange rate  (eP/P*), “competitiveness” affects both X and M
Andrew Rose, Global Macroeconomics 10
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Add Net Exports to Real Economy (IS)
Add Net Exports to Real Economy (IS)
• Thus
Thus IS now: Y IS now: Y = A(G,i,Y) + NX(,Y,Y
A(G,i,Y) + NX(,Y,Y*))
– A is domestic absorption
Andrew Rose, Global Macroeconomics 10
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Financial Equilibrium (LM):
What is a Fixed Exchange Rate?
h
d
h
?
• Nominal
N i l exchange rate fixed, so real exchange h
t fi d
l
h
rate (=eP/P*)
(
/ ) fixed in short run
• Fixed Exchange Rate Regime  authorities take either side of FX transaction in unlimited quantity
Andrew Rose, Global Macroeconomics 10
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Fixed Exchange Rate Regime
Fixed Exchange Rate Regime
• The
Th “Authorities”: Government
“A th iti ” G
t chooses
h
t fi
to fix exchange rate (or not); Central Bank enacts policy
– Fix: Authorities promise to use international reserves to take either side of any FX transaction in any size at k
h
d f
fixed exchange rate (or within bands)
– Hence fix may affect IR, HPM, thus money supply
Andrew Rose, Global Macroeconomics 10
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Financial Equilibrium
Financial Equilibrium
• LM looks same but not under complete control of Central Bank
– Recall M=μ*HPM; HPM=(IR+CBC); IR used to fix exchange rate
Andrew Rose, Global Macroeconomics 10
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Balance of Payments (BoP)
Balance of Payments (BoP)
• Recall: c/acc + k/acc + ORS = 0
R ll /
k/
ORS 0
– Current Account given by net exports (NX)
Current Account given by net exports (NX)
– Capital Account – private capital flows
– ORS – authorities must keep exchange rate fixed
• “Credible Fix” is expected to remain fixed
“Credible Fi ” is e pected to remain fi ed
• Can loosen assumption, allow “imperfect credibility”
Andrew Rose, Global Macroeconomics 10
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Capital Mobility 1
Capital Mobility 1
• Assume capital can flow freely without (serious) ssu e cap ta ca o
ee y t out (se ous)
restrictions between the small open (home) economy and large (“center” or “anchor”) neighbor(US/EMU)
hb ( /
)
• Assume domestic & foreign bonds “perfect substitutes,” identical in liquidity, maturity, taxes, b tit t ” id ti l i li idit
t it t
risk…
– Can also easily add country risk premium
Can also easily add country risk premium
• Also assume nominal exchange rate is fixed and p
yf
(
)
expected to stay fixed (“credible fix”)
Andrew Rose, Global Macroeconomics 10
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Capital Mobility 2
Capital Mobility 2
• Conclude:
Conclude: perfect capital mobility implies supply and perfect capital mobility implies supply and
demand curves infinitely elastic at i=i*
– If i>i* capital flows in quickly and massively p
q
y
y
(capital account surplus since we sell bonds to foreigners)
Andrew Rose, Global Macroeconomics 10
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Summary: Mundell‐Fleming
Summary: Mundell
Fleming Model
Model
• Real economy (IS)
Real economy (IS)
– Looks same as before, but NX added (foreign income and real exchange rate fixed)
• Financial markets (LM)
– Looks same as before, though now money is endogenous (international reserves used to defend exchange rate, affect money supply) • Balance of Payments (BoP)
B l
fP
(B P)
– New: horizontal because of capital mobility: i=i*
Andrew Rose, Global Macroeconomics 10
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Formally
• IS: Y = A(G,i,Y) + NX(,Y,Y*) IS Y A(G i Y) + NX( YY*)
where A= {1/(1 ‐ c(1‐t))}*[C0 + cTr + I0 – bi + G0],
and ,Y* exogenous
• LM: Ms/P = L(i, Y)
where M
where
Ms = HPM = (IR + CBC)
=  HPM =  (IR + CBC)
• BoP: c/acc + k/acc + ORS = 0
Andrew Rose, Global Macroeconomics 10
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Graphically
i
LM
i*
BoP
A
IS
Y*
Andrew Rose, Global Macroeconomics 10
Y
13
Monetary Policy (LM) Shock
Monetary Policy (LM) Shock
• Expansionary Open Market Opera on (CBC↑)
• Leads to i↓, capital ou
d
↓
l
llows, interven on
i
LM
LM'
A
i*
BoP
B
IS
Andrew Rose, Global Macroeconomics 10
Y
14
Enduring Effect
Enduring Effect
• Note that central bank can only change N t th t
t lb k
l h
composition
p
of high‐powered money since it g p
y
defends fixed exchange rate (IR↓) to offset capital outflow (HPM and Ms unchanged)
Andrew Rose, Global Macroeconomics 10
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Key Concept: Mundell’s Incompatible/Holy Trinity
bl / l
• The
The following are individually desirable but following are individually desirable but
mutually incompatible:
1 Independent
1.
Independent national monetary policy national monetary policy
(“Monetary Sovereignty”)
2 Perfect capital mobility
2.
Perfect capital mobility
3. Fixed/stable exchange rates
• Different
Different countries make different countries make different “sacrifices”
sacrifices and choices also change over time
Andrew Rose, Global Macroeconomics 10
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Fiscal Policy
Fiscal Policy
•
G↑ (debt‐financed) leads to capital inflows, IR↑, HPM↑, Ms↑ and Y↑
IS'
i
B
LM
IS
LM'
A
i*
BoP
C
Y
Andrew Rose, Global Macroeconomics 10
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Enduring Effect
Enduring Effect
• Highly potent (no “crowding out” since Hi hl
t t( “
di
t” i
interest rates given from abroad)
g
)
• Changes composi on of output (G↑, NX↓)
– Can explain “twin deficits” of government, c/acc
Andrew Rose, Global Macroeconomics 10
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Foreign (Interest Rate) Shock
Foreign (Interest Rate) Shock
• Foreign (large country) interest rate rise (i
Foreign (large country) interest rate rise (i*↑)
↑)
– BoP schedule shifts up
LM’
LM
LM
B
A
IS
Andrew Rose, Global Macroeconomics 10
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Foreign Shocks, Continued
Foreign Shocks, Continued
• Role in crises/regime switch
Role in crises/regime switch
– Mexico 1994, EMS 1992
– Decline in Northern rates 2001, 2007
Decline in Northern rates 2001, 2007‐8
8
• Sterilization of reserve flows: offsetting change in international reserves with equal and opposite
international reserves with equal and opposite change in central bank credit
– As
As IR falls, CBC rises 1:1
IR falls, CBC rises 1:1
– HPM unchanged
– Only possible temporarily
yp
p
y
Andrew Rose, Global Macroeconomics 10
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Notes
• Can
Can generalize (im
generalize (im‐)) potency of potency of
monetary/fiscal shocks to all financial/real shocks
• Can allow for imperfect capital mobility with upwards sloping BoP (must raise interest rates upwards sloping BoP
(must raise interest rates
above foreign to attract inflows)
– One way to model a “large” country
O
t
d l “l
”
t
Andrew Rose, Global Macroeconomics 10
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Key Takeaways
Key Takeaways
• Credible
Credible fixes constrain monetary policy
fixes constrain monetary policy
• Real shocks have large effects during fixes
• Mundell’s
d ll’ Trilemma: tradeoffs between open il
d ff b
capital markets, stable exchange rates, and monetary sovereignty
i
Andrew Rose, Global Macroeconomics 10
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