In this article the Mundell-Fleming model will be explained, however to begin the article will cover the open economy, as such Mercantilism, Protectionism, and free trade. When you purchase a book online could you say your street traded with the bookstores street, or even your country and theirs? Here, Macroeconomics would answer in that it depends on political considerations, of their span of control over other people. However, in a free market goods move to where they are most valued, you and the bookstore benefit, as trade creates wealth. Macroeconomics is just the collective of these microeconomic actions.
Why do people in America specialise in producing corn or China specialise in producing shoes? The reason is similar to the reason a bank holds foreign currency on demand, it is precisely because they expect demand for their products and it is the cheapest way to acquire other goods that they are not specialised in producing. The further the distance one is able to trade the more wealthy people become, as their opportunity of increased specialisations allow for more products at cheaper prices. Such a prominent example is Silk Road, the ancient network of trade routes.
However, like Silk Road where stopped by increased mercantilism. Firstly, governments restrict trade when they promote the arguments ‘cheap foreign goods, foreign owned companies/land, or immigrants stealing jobs’. Though, that is not the case as trade creates wealth (labour + capital = production). However, governments often pose the argument that trade with other countries can cause a trade deficit and uses this as an excuse for forced nationalism, though firstly countries can’t trade with each other, only individuals can trade. They would have to, therefore, produce everything themselves.
Additionally, it is like the ‘buy local’ argument and would it not also be the case if Donald Has A Trade Deficit With His Grocery Store – Should He Boycott It? If one decided to produce/sell goods but not buy goods (Mercantilism – once being the dominant paradigms), they would soon experience a life like that of Robinson Crusoe. Therefore, if Donald Trump were president America would turn into a remote island with citizens that lived their lives as did Robinson Crusoe. Watch this YouTube review of this here EconPop – The Economics of Castaway.
If we refuse to buy from our neighbours we clearly hurt them, but we also hurt ourselves. There is only one way of being paid for exports and that is by receiving imports in return. So every time we make it harder for imports to come in, we automatically make it harder for our exports to go out. Trade is Australia’s lifeblood, and if we restrict the blood flow we hurt ourselves as well as our neighbours. (Kelly, 1978)
Bert Kelly in talking about the tariff wall against Australia’s Asian neighbours, meaning that for every buyer their must be a seller, likewise for every importer there must be an exporter. It does not necessarily need to be consumer goods it could also be investment in capital goods. Frederic Bastiat’s ‘Candle Makers Petition‘ used this as a metaphor to show that even if foreign competitors were banned, it would only benefit the local producers in the very short-run. And draws more people into the local candlemaking industry, negating any benefit to the candlemakers. For society overall, resources would be wasted in candlemaking that could have been used productively elsewhere.
Protectionist policies are very popular with economical uninformed voters. Producers have more lobbying powers, exporters invoke more sympathy. As such people favour Keynesian thinking, and its ability to achieve mercantile ideals, using currency debasement, see my article Money Pumping – What Malinvestments? Central bank action to devalue currency can be a form of mercantilism as (i) it makes exports cheaper in terms of foreign currency and imports more expensive (ii) it punishes importers and consumers, appearing to entice exporters, however their money could not purchase anything more, (iii) gains a short-term advantage for domestic exporters with overall disadvantage to everybody. People who are helped and people who are hurt now push for such action as producers will always lobby more than consumers, exporters and domestic manufacturers invoke more sympathy than consumers and importers. Other ways to pursue Mercantilism with protectionism policies are tariffs, quotas, subsidies, and/or outright bans.
“Through the gold standard, the world’s economies maintained a system of fixed exchange rates.” (Mankiw, 2010) Whereas, under the Bretton Woods system the US Dollar is the world reserve currency. “We use the term “reserve currency” when referring to the common use of the dollar by other countries when settling their international trade accounts.” (Barron, 2013) Therefore, the dollar deviated from its original agreement and having gone off the gold standard, was able to be inflated by the Fed, decreasing its value against commodities (purchasing power), and because it is the reverse currency it is not subject to competition. If the reserve currency were abolished or changed to another currency then US Dollars would come back to the US. “[Therefore, a fixed exchange rate can be supported by a] currency board [which] is an arrangement by which the central bank holds enough foreign currency to back each unit of domestic currency.” (Mankiw, 2010) The only drawback from dollarisation is that of seigniorage revenues that the government has to give up. Even though, it is tempting to resort to this view, and inflate away debt, raise seigniorage revenues, and to stop falling prices through credit expansion, lower rates then it is confused for more real loanable funds.
If a central bank buys bonds in the nations bonds market, it would shift LM* to the right, lowering exchange rates. “[However, under] a system of fixed exchange rates, a central bank stands ready to buy or sell the domestic currency for foreign currencies at a predetermined price.” (Mankiw, 2010) Therefore, arbitrages respond to the failing exchange rate by selling domestic currency to the central bank, and LM* curve returns back to the original place. However, a country could change the level of fixing. “A reduction in the official value of the currency is called a devaluation, and an increase in its official value is called a revaluation.” (Mankiw, 2010) Devaluations shift LM* to the right, acting like an increase in money supply, Y and NX with floating exchange rate, conversely a revaluation shifts the LM* curve to the left, reduces NX and Y. Despite this here is the graphical Mundell-Fleming model representation of how a fixed exchange rate govern the money supply:
The model developed in now is the Mundell-Fleming model. An economic model for the open-economy monetary and fiscal policy. Robert Mundell who created the model was awarded the Nobel Prize for his work on macroeconomics and the open-economy. In contrast to the closed-economy model of the IS-LM model. The Mundell-Fleming model basically builds upon the IS-LM model, as both cover the interaction between the money market and the goods market. Again both artificially fix the price level within the models and depict causes for short-run fluctuations in aggregate income. This can be a shift in the aggregate demand curve. This extends the short-run model of national income, showing the effects from international trade and finance.
The Mundell-Fleming model assumes a small open-economy with perfect capital flexibility. Because this economy is relatively small and its financial markets are free to lend and borrow to their content without affecting the world interest rate that is exogenously fixed. Again in a small open-economy an interest rate is determined by the worldwide interest rate. In mathematics it is written r = r*. “In a small open economy, the domestic interest rate might rise by a little bit for a short time, but as soon as it did, foreigners would see the higher interest rate and start lending to this country (by, for instance, buying this country’s bonds).” (Mankiw, 2010) This is then considered a capital inflow, which lowers the domestic interest rate closer to r*. “Similarly, if any event started to drive the domestic interest rate downward, capital would flow out of the country to earn a higher return abroad, and this capital outflow would drive the domestic interest rate back to r*.” (Mankiw, 2010)
The Impossibility Trinity states that it is impossible for a country to have a stable foreign exchange rate, plus free capital movement (absence of capital controls), and an independent monetary policy at the same time. A nation, therefore, must choose one side of this trinity and give up one corner. Options for (a) A stable exchange rate and free capital flows, will allow both, however, not independent monetary policy, as setting a domestic interest rate that is different from the exchange rate due to appreciation or depreciation pressure on domestic currency. (B) An independent monetary policy and free capital flows, without a stable exchange rate. (C) A stable exchange rate and independent monetary policy, however no free capital flows, as that would require capital controls. There is also an impossible trinity for fiscal policy:
The new impossible trinity in fiscal policy means that a highly indebted government can only choose two of three outcomes: (i) avoiding default on its debt and avoiding massive tax increase, but coming up short in meeting its fiscal commitments including paying future pensions and social welfare benefits; (ii) avoiding defaults on its debts and keeping its fiscal commitments, but at the price of massive tax increase; or (iii) avoiding tax increase and meeting its fiscal commitment, but eventually defaulting on its debts. (Hedrick-Wong, 2016)
The Mundell-Fleming model helps one to describe the market for goods and services, only with the addition of net exports to that of the IS-LM model. Where the goods market would be now represented in mathematical form as Y = C(Y – T) + I(r) + G + NX(e). Y or aggregate income is here made up of C consumption, I investment, G government purchases, and NX net exports. Each depend on a factor, as consumption depends on income after taxes, or disposable income. “Investment depends negatively on the interest rate [and net] exports depend negatively on the exchange rate e.” (Mankiw, 2010) The exchange rate is assigned the letter e. Exchange rates basically represent the amount of foreign currency per unit of domestic currency.
“Indeed, the model was first developed in large part to understand how alternative exchange-rate regimes work and how the choice of exchange-rate regimes impinges on monetary and fiscal policy.” (Mankiw, 2010) To make it easy the first step is to assume a floating exchange rate. A floating exchange rate is when the central bank allows exchange rates to fluctuate in response to economic conditions. Secondly, to contrast this a fixed exchange rate is used to analyse the economy. Then the analysis should tell us what exchange rate is best. There is also a real exchange rate (relative price of goods domestically and internationally) and a nominal exchange rate (relative price of domestic and foreign currencies). “If e is the nominal exchange rate, then the real exchange rate [equals] eP/P*, where P is the domestic price level and P* is the foreign price level.” (Mankiw, 2010) However, it is assumed within this model that the price level domestic and international are fixed. Making the real exchange rate proportional to the nominal exchange rate. In the long-run when price level falls LM* curve shifts to the right, equilibrium rises:
These two rates, the exchange rate and the interest rate are two variables that affect expenditure on goods and services or the goods-market equilibrium condition. Alternatively, it is called the IS* curve: Y = C(Y – T) + I(r) + G + NX(e). The IS curve is drawn for the given value of r*, where the vertical axis is now the exchange rate not the interest rate, e can represent the nominal exchange rate or the foreign currency per unit of domestic currency. To develop it in the IS curve to show the relationship between the exchange rate and income, as the e is down the NX is up and Y is up. This shows that there is a negative relationship between P and Y shown in the aggregate demand curve:
The short-run (K) where there is a fixed price-level, with low demand for goods/services and the long-run (C) equilibrium, in which the price-level falls to adjust raising real money balances, and shifting LM* to the right. Real exchange rate falls and NX rise. “The speed of transition between the short-run and long-run equilibria depends on how quickly the price level adjusts to restore the economy to the natural level of output.” (Mankiw, 2010)
The Mundell-Fleming model rests on the mercantile views that currency depreciation makes us richer, and supposedly represents the money market in which the equation is familiar to the IS-LM model: M / P = L(r, Y). Where, the supply of real money balances is M / P and this equals the demand L(r, Y). Here, the demand for real money balances is negatively dependent upon the interest rate r and positively on income Y. “The money supply M is an exogenous variable controlled by the central bank, and because the Mundell-Fleming model is designed to analyze short-run fluctuations, the price level P is also assumed to be exogenously fixed.” (Mankiw, 2010) Again the domestic interest rate equals the world interest rate, r = r*: M / P = L(r*, Y). Represented as the LM* equation, where the LM* curve is vertical as the exchange rate does not enter the LM* equation. “Given the world interest rate, the LM* equation determines aggregate income, regardless of the exchange rate.” (Mankiw, 2010) It is vertical because there is only one value of Y that equates money demand with supply, regardless of e.
Equilibrium condition in the model. “The goods-market equilibrium condition above has two financial variables affecting expenditure on goods and services (the interest rate and the exchange rate), but the situation can be simplified using the assumption of perfect capital mobility, so r = r.” (Mankiw, 2010) To sum up the Mundell-Fleming model can be represented by the two equations below, where the first describes the equilibrium in the goods market, the second describes the equilibrium in the money market. “The exogenous variables can are fiscal policy G and T, monetary policy M, the price level P, and the world interest rate r [while the] endogenous variables are income Y and the exchange rate e.” (Mankiw, 2010)
Y = C (Y – T) + I (r*) + G + NX (e) => IS*
M / P = L (r*, Y) => LM*
Such artificial things that can affect the market forces, are monetary policy, fiscal policy and trade policy. In a system of floating exchange rates, e is allowed to fluctuate in response to changing economic conditions. Alternatively, a fixed exchange rate, is when the central bank trades domestic currency for foreign currency at a predetermined price. For fiscal policy under a floating exchange rate, at any given value of e, a fiscal expansion increases Y, shifting IS* to the right, a change in e > 0 means a change in Y = 0. This assumes the Keynesian view in which government spending has a multiplier effect no matter what money buys. Expansionary fiscal policy that is increases in government purchases or decreases in taxes, can increase planned expenditure, shifting the IS* curve to the right. Appreciating the exchange rate while income remains the same. “[Whereas,] in the closed-economy IS-LM model, a fiscal expansion raises income, […]” (Mankiw, 2010). This is because here the LM* curve is vertical, unlike when it is upward sloping LM in the closed economy. In the closed economy the interest rate rises along with rises in income, increasing the demand for money, however, in the open economy as interest rates rise above the world interest rate r*, capital flows in from abroad, and therefore, pushes r back to r*. “[Because] foreign investors need to buy the domestic currency to invest in the domestic economy, the capital inflow increases the demand for the domestic currency [bidding up its value]” (Mankiw, 2010). Domestic goods are now expensive compared to foreign goods, reducing net exports, which offset expansionary fiscal policy effects on income.
In a small open economy with perfect capital mobility, fiscal policy would not affect real GDP, however crowds out net exports by causing the exchange rate to appreciate. In a closed economy, fiscal policy crowds out investment by causing the interest rate to rise. Following on from the above graph, now an increase in M would shift the LM* right because Y needs to rise to restore equilibrium in the money market. Here, a change in e < 0, and a change in Y > 0.
Monetary policy affects output by affecting the components of aggregate demand. As such in a closed economy M ^ , r v , I ^ , Y ^ . Whereas, in a small open economy M ^ , e v , NX ^ , Y ^ . Here, expansionary monetary policy does not increase the world aggregate demand, as it just shifts demand from foreign to domestic products. This increase in domestic income and employment then could be at the expense of international losses. Therefore, as tariffs fail central banks pursue mercantilism. At any value of e a tariff or quota reduces imports and increases NX shifting IS* to the right. Where, a change in e > 0 and a change in Y = 0. If a tariff reduces imported goods, because net exports equal exports minus imports, this means there will be an increase in net exports, shifting net-export schedule to the right. “This shift in the net-exports schedule increases planned expenditure and [therefore] moves the IS* curve to the right.” (Mankiw, 2010) Similar to expansionary fiscal policy affects. The increase in net-exports increases Y, money demand, and r. “Foreign capital quickly responds by flowing into the domestic economy, pushing the interest rate back to the world interest rate r* and causing the domestic currency to appreciate in value.” (Mankiw, 2010) Now, domestic goods are more expensive again, decreasing NX and Y. To restrict trade when NX (e) = Y – C (Y – T) – I (r) – G, a trade restriction should not affect income, consumption, investment, or government purchases. However, it is common sense that any trade restriction decreases income, consumption, investment, or government purchases, as everyone is that much poorer from limited trade. And it is excused as to keep a fixed exchange rate that the money supply (to increase aggregate income) must be increased to shift LM also to the right, using this equation to explain the increase in net exports under a fixed exchange rate: NX = S – I. “When income rises, savings also rises, and this implies an increase in net exports.” (Mankiw, 2010)
However, import restrictions could not reduce a trade deficit, even if NX remains unchanged there is now less trade and therefore, any trade gains as from the restrictions which reduces imports, e also increases and reduces exports too. Import restrictions could save jobs in protected domestic industries, however destroy jobs and direct workers away from export or producing industries. Creating sectoral shifts as these import restrictions cause frictional unemployment. To fix an exchange rate in the short-run the central bank waits to buy or sell domestic currency for foreign currency at a predetermined rate, or nominal exchange rate e which is fixed from the central bank shifting the LM* curve when required. However, in the long-run prices are flexible and the real exchange rate varies from the nominal.
Fiscal policy is ineffective at changing output under a floating exchange rate, while, fixed rates make fiscal policy force M to increase to maintain the fix. “[Because] the central bank stands ready to trade foreign and domestic currency at the fixed exchange rate, arbitrageurs quickly respond to the rising exchange rate by selling foreign currency to the central bank, lending to an automatic monetary expansion.” (Mankiw, 2010) A change in e = 0 and a change in Y > 0. The below graph also represents the same as trade policy under fixed exchange rates, import restrictions increase Y and NX. While, under floating rates, import restrictions do not affect Y or NX. Any gain is at the expense of other countries or the shift in demand from foreign to domestic goods.
In contrast, monetary policy under a floating exchange rate is effective at changing output, while under a fixed exchange rate is not effected as it can only be used to maintain the fix. A change in e = 0 and a change in Y = 0. When a central bank increases the money supply indirectly through expansionary monetary policy, LM* shifts to the right, raising income and lowering the exchange rate. In a closed economy this increases in spending/investment from the lower r. In a small open economy the r is fixed r*. “As soon as an increase in the money supply starts putting downward pressure on the domestic interest rate, capital flows out of the economy, as investors seek a higher return elsewhere.” (Mankiw, 2010) This prevents the domestic r from depreciating below r*. “[Because] investing abroad requires converting domestic currency into foreign currency, the capital outflow increases the supply of domestic currency in the market for foreign currency exchange, causing the domestic currency to depreciate in value.” (Mankiw, 2010) Making domestic goods cheap compared to foreign goods, increasing net exports and income.
Summary, under a floating exchange rate only monetary policy can affect income, under a fixed exchange rate only fiscal policy can affect income:
Arguments for and against either favour the floating or fixed exchange rates: floating allows policy makers free to pursue other stabling employment and prices, floating uncertainty make trade difficult, and fixed prevents monetary mis-management. “When deciding on an exchange-rate regime, policymakers are constrained by the fact that it is impossible for a nation to have free capital flows, a fixed exchange rate, and independent monetary policy.” (Mankiw, 2010)
r can differ from r* (world interest rate): (1) because of country risk when borrowers may default on their loan repayments either from political or economic reasons, higher interest rate compensates for higher risk (2) because of expectations surrounding the country’s exchange rate may fall, as borrowers now pay higher interest rate to compensate lenders for expected currency depreciation. For more on uncertainty and risk see my post on Regime & Policy Uncertainty. “Thus, because of both a country risk and expectations of future exchange-rate changes, the interest rate of a small open economy can differ from interest rates in other economies around the world.” (Mankiw, 2010) To include this variation in the Mundell-Fleming model, the interest rate is assumed in a small open economy to be determined by r* plus an exogenous risk premium 0. r = r* + 0, where 0 is a risk premium (exogenous).”The risk premium is determined by the perceived political risk of making loans in a country and the expected change in the real exchange rate.” (Mankiw, 2010) You now substitute r* + 0 into the IS* and LM* equations: Y = C (Y – T) + I (r* + 0) + G + NX (e). And M / P = L (r* + 0, Y). “For any given fiscal policy, monetary policy, price level, and risk premium, these two equations determine the level of income and exchange rate that equilibrate the goods market and the money market.” (Mankiw, 2010)
A fall in e results from country risk or expected depreciation which make holding a country’s currency less appealing, therefore the increase in Y occurs as the boost in NX that results from the depreciation, greater than the fall in I from the rise in r. However, a central bank may try to prevent depreciation in reducing the supply of money, as it could boost the price of imports to increase the price level, and consumers might respond to the increased risk and hold more money, each shifting the LM* curve left. If 0 increase, IS* shifts left as ^ 0 , ^ r , v I . LM* shifts right as ^ 0 , ^ r , v (M / P)d, so Y must rise to restore money market equilibrium. The result is a change in e < 0 and a change in Y > 0.
In conclusion, the article has covered the small open economy and how it works in the short-run when prices are sticky. Explaining the Mundell-Fleming model and how it describes the small open-economy showing fluctuations in income and the exchange rate. Additionally, the use of monetary, fiscal, and trade policy influence income and the exchange rate. Over-viewing both floating and fixed exchange rates. “In a closed economy, a monetary contraction raises the interest rate, lowers investment, and thus lowers aggregate income.” (Mankiw, 2010) Where, the interest rate is unaltered as the interest rate is determined by the world financial markets. “In a small open economy with a floating exchange rate, a monetary contraction raises the exchange rate, lowers net exports, and thus lowers aggregate income.” (Mankiw, 2010) We also covered the risk premium and exchange rate uncertainty. And how the pros and cons are weighed up using the Impossible Trinity. Finally, we drew upon the two terms (1) devaluation – the official value of the currency and (2) revaluation – an increase in its official value.
Mankiw, G. (2010). Macroeconomics. (International 3rd ed.). New York, United States of America: Worth Publishers.
Bert Kelly, One More Nail (Adelaide: Brolga Books, 1978), ch. 1, “Writing on the Wall,” pp. 1-5, Retrieved [31/05/2016] from <http://economics.org.au/2012/01/tariffs-high-prices-world-war/>.
Barron, P. (2013). How much longer will the dollar be the reserve currency?. Alabama; The Mises Institute. Retrieved [31/05/16] from <https://mises.org/library/how-much-longer-will-dollar-be-reserve-currency>.
Hedrick-Wong, Y. (2016). The truth about the global economic turmoil. Forbes. Retrieved [31/05/2016] from <http://www.forbes.com/sites/yuwahedrickwong/2016/05/02/missing-the-biggest-elephant-in-the-room-the-new-impossible-trinity-and-global-economic-turmoil/#47a632023ee3>.
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Copyright © 2016 Zoë-Marie Beesley
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