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Business Cycles in the Open Economy Mundell‐Fleming with Fixed Exchange Rates Andrew Rose, Global Macroeconomics 10 1 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 2 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 3 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 4 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 5 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 6 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 7 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 8 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 9 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 10 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 11 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 12 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 15 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 16 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 17 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 18 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 19 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 20 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 21 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 22