Elasticity Approach 2

8/12/2019 Elasticity Approach 2

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Lecture 6

Elasticity Approach to the Balance of Payment

Mundell-Fleming Model


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Which are the eects of a depreciation/devaluation

on the current account?

we assume the prices of goods and services are

xed so that changes in the nominal exchange

rate imply corresponding changes in the real ex-

change rate;

(i.e. we assume that the supply elasticities for the

domestic export good and foreign import good

are perfectly elastic so that changes in demand

volumes have no eect on their price).

Current account:

CA =PX eP M

where P (P) is the domestic (foreign) price level; e

is the nominal exchange rate; X is the volume of do-

mestic exports; Mis the volume of domestic imports.


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We have that X depends positively on the ex-

change rate: dXde > 0: When the exchange rate

depreciates foreign residents nd domestic goods

cheaper.

We have that M depends negatively on the ex-

change rate: dMde < 0: When the exchange rate

depreciates domestic residents nd foreign goods

more expensive.

We dene the price elasticity of demand for ex-

ports as the percentage change in exports over

the percentage change in prices (here the nomi-

nal exchange rate): x=dXX=

dee

Similarly for imports: m=dMM=

dee


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Now we want to examine the eect of a change in the

nominal exchange rate on the current account.

dCA

de =

dX

de e

dM

de M

Suppose that we are initially in a balanced current

accountX= eM. Divide both side by M:

dCA

de

1

M =dX

de

e

M e

dM

de

1

M 1

So thatdCA

de

1

M = x+ m 1

Marshall-Lerner condition says that, starting from a

position of equilibrium in the current account, a de-

preciation will improve the current account only if thesum of the of the two elasticities is greater than unity.


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Two eects:

1) Price eect contributes to a worsening of the cur-

rent account because imports become more expensive:

for a given Mwe have that eM";

2) Volume eect contributes to improving the current

account because exports become cheaper from a for-

eign country's perspective: "Xand#M.

J-curve: in the short-run the Marshall-Lerner condi-

tion might not hold. In the short-run exports and

imports volume do not change that much, so that

the price eect dominates leading to a worsening of

the current account following a depreciation of the

exchange rate. The evolution of the current account

following a depreciation is illustrated by a J-curve.


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The J-Curve

Current

Account

Surplus

Time

Deficit


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Mundell-Fleming model: keynesian tradition in the

sense that aggregate economic activity is determinedby aggregate demand.

Building blocks:

Aggregate supply is at:

it implies that prices are xed.

Balance of Payment:

the current account is determined independently

of the capital account;

PPP does not hold and the size of the current

account surplus depends positively on the real ex-change rate and negatively on the real income:

CA=CA

Y;eP

P

!=CA

Y; e

+

!


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-note that we have assumed that the Marshall-

Lerner condition holds;

-shift to tastes and foreign income are exogenous

factor that can be incorporated into the CA equa-tion;

exchange rate expectations are static;

Capital Account: we distinguish two situations:

a) Perfect capital mobility: if capital if perfectly

mobile then UIP condition always hold and sincewe assume that expectations are static it has to

be

r=r

b) Imperfect capital mobility: nite ows of capi-

tal depends only on interest rate dierential acrosscountries

K=K

r r

+

!


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Balance of Payment: equilibrium when the ow

of capital nance the current account surplus or

decit

BP = CA

Y; e

+

!+K

r r

+

!= 0

IS curve in open economy:

From the national income accounting identity we have

that:

Y =C+ I+CA+G

where C is our keynesian consumption function in

which consumption depends on disposable income:

C=C(Y T) ; 0

Elasticity Approach 2

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