MACROECONOMICS: THE OPEN ECONOMY (I); THE MUNDELL-FLEMING MODEL

COMPETITIVENESS In international trade, one can measure

‘competitiveness’ by the following index: Q = EP*/P = [(Nominal Ex. Rate).(Price of good in

foreign currency)] ÷ (Price of good in domestic currency)

The Nominal exchange rate (E) can be defined as the number of units of home currency needed to purchase 1 unit of foreign currency.

E.g., £0.9 needed to purchase €1; E = 0.9/1 A DEPRECIATION of the home currency occurs

when E RISES. i.e., when it takes MORE units of domestic currency to purchase 1 unit of foreign currency.

An APPRECIATION is the opposite – when E FALLS. i.e., when it takes LESS units of domestic currency to buy 2 unit of foreign currency.

OPENING UP THE IS/LM MODEL Assumptions: Modelling a ‘small’ economy, such that it

has no influence over World Prices. Perfect Capital Markets and perfect asset

substitutability. Prices and wages are fixed. Thus,

expected inflation is zero and hence the nominal and real rates of interest are equal.

Y = C + I + G + (X-M) X = Exports = f(y* [FIXED], Q) = Function

of (fixed) foreign output, competitiveness. M = Imports = g(y, Q) = Function of

domestic income, competitiveness.

BALANCE OF PAYMENTS (BOP) Balance of Payments consists of the CAPITAL account

and the CURRENT account. The Current account consists of the trade

balance primarily (Exports – Imports) and interest and profit receipts.

The Capital account consists of capital inflows less capital outflows.

The current account will be in balance when X = M The capital account will be in balance when r = r*

(domestic interest rates = World interest rates). In the modern World (and with the assumption of

perfect capital mobility + asset substitution) the Capital account is FAR greater than the current account.

UNCOVERED INTEREST PARITY Uncovered Interest Parity (UIP) is a position where,

despite interest rate discrepancies between two areas, speculators feel no incentive to trade.

Normally, if one zone had an interest rate higher than another, then speculators would buy bonds in the former zone as it has a higher rate of return.

In turn, this increases the demand of the former zone’s currency and thus appreciates it’s exchange rate.

UIP occurs when the interest rate differential is equal to speculator’s predictions that the currency will depreciate by the same percentage over the time period.

i.e., if London had a 2.5% higher interest rate than New York, but the £ sterling was expected to depreciate by 2.5% over the period that the interest rate differential will be in existence, any gain from buying London Bonds would be offset by the falling value of the £.

Mathematically: (i – i*) = (eE

t+1 – et ) / (et) [UIP]

THE MUNDELL FLEMING MODEL The diagram shows the

augmented IS/LM model. The IS curve has been updated to

include exports and imports. The horizontal line i=i*, shows

where the capital account will be balanced.

BELOW the line, there will be MASSIVE capital outflows as investors seek a higher rate of return.

ABOVE the line, there will be MASSIVE capital inflows as investors buy domestic assets.

The vertical line YBT shows the level of income where there is balance in the current account.

To the LEFT of the line there is a current account SURPLUS.

To the RIGHT of the line there is a current account DEFICIT.

However, as Capital Account >> Current account, we are primarily concerned with the horizontal line.

ISXM

LM

i=i*

YBT

Y

i

i*

MUNDELL FLEMING MODEL: FIXED EXCHANGE RATE TOP: FISCAL EXPANSION BOTTOM: MONETARY

EXPANSION In a fiscal expansion under a

fixed ex. Rate, the ISXM curve shifts out, moving us from A to B.

There is now a massive INFLOW of foreign capital, as the i > i*

The Central Bank must therefore expand the money supply and shift the LM curve to maintain the interest rate (and therefore ex. Rate). Hence, B to C.

In a Monetary expansion under a fixed ex. Rate, the LM curve shifts to LM’, moving us from A to B.

However, there is now a net OUTFLOW of foreign capital as i< i*, so the Central Bank must contract the money supply (thus shifting the Lm back) to maintain the interest rate (and therefore ex. Rate).

Thus, we shift BACK to A.

ISXM

LM

i=i*

Y

i

i*

ISXM

LM

i=i*

Y

i

i*

ISXM’

LM’

A

B

C

LM’

A

B

MUNDELL FLEMING MODEL: FLEXIBLE EXCHANGE RATE TOP: FISCAL EXPANSION BOTTOM: MONETARY

EXPANSION In a fiscal expansion under fully

flexible ex. Rates, the ISXM curve would shift out to ISXM’ and we move from A to B.

However, we now have massive capital inflows which appreciates the currency and thus, there is a loss of competitiveness.

Hence, Exports fall, Imports rise and we move back to A.

In a Monetary expansion under fully flexible ex. Rates, we move from LM to Lm’ and hence from A to B.

There are massive capital inflows and the currency depreciates, thus improving competitiveness.

Hence, Exports Rise, Imports Fall, ISXM moves to ISXM’ and we move from B to C.

ISXM

LM

i=i*

i

i*

LM’

A

B

ISXM

LM

i=i*

i

i*A

B

ISXM’

C

ISXM’

MUNDELL FLEMING MODEL: SUMMARY

Expansionary Policy Exchange Rate Regime

Flexible Fixed

Fiscal No long-run effect on output

SUPEREFFECTIVE

Monetary SUPEREFFECTIVE No long-run effect on output