exchange rates and the mundell-fleming model imports, exports, exchange rates from is-lm to...
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Exchange rates and the Mundell-Fleming model
Imports, exports, exchange rates
From IS-LM to Mundell-FlemingPolicy in an open economy
Balance of payments and exchange rate
Up until now, we have worked only in the case of closed economies No trade considerations were present
However, we know that in fact trade is important in understanding macroeconomics, particularly so with globalisation. As for previous models, this means we have to
introduce corrections to the model to obtain a better understanding of what trade does to the economy
Exchange rates and Mundell-Fleming
Imports, exports and exchange rates
Current account, capital account and balance of payments
From IS-LM to Mundell-Fleming
Effectiveness of policy
Imports, exports and exchange rates
The first element to take into account in an open economy is the presence of imports M and exports X in aggregate demand
These represent another possible leakage from the circular flow of income In particular, agents will have a propensity
to import which will have to be taken into account when calculating multipliers
*, ,X YY C Y T I i G e M Y e
Imports, exports and exchange rates
Second problem: in terms of national accounting, exports / imports are not measured in the same units: We need to convert imports paid in foreign
currency into national currency Exports towards other countries are also
affected by the value of the currency This is where the exchange rate comes in
*, ,X YY C Y T I i G e M Y e
Imports, exports and exchange rates
The exchange rate (e) is the price of one currency in terms of another currency
Note of caution ! There are 2 ways of working it out: The amount of $ you can buy with 1€ :
1€ = 1.35$ The amount of € required to buy 1$ :
1$ = 0.75€
These two measures are equivalent, but be careful, the second one (often used in models) is not intuitive : If e falls, less € are needed to purchase 1$, so the euro
has appreciated (it is worth more in $ terms) If e increases, more € are needed to purchase 1$, so the
euro has depreciated (it is worth less in $ terms)
Imports, exports and exchange rates
e=price of the currency (dollars/euro)
Quantity
Equilibrium exchange rate e*
Supply of euros
Purchase of dollar-denominated assets, imports
Purchase of euro-denominated assets, exports
Demand for euros
The exchange rate is a price
Imports, exports and exchange rates
The exchange rate is in nominal terms It is possible to define a real exchange rate
which accounts for the price levels in the two currency areas
The real exchange rate gives a relative price It expresses the relative value of a
representative basket in the euro zone to the same basket in the USA.
$
€€/$€/$ P
Peereal
Imports, exports and exchange rates
This allows us to define the purchasing power parity (PPP) exchange rate. The PPP exchange rate is the nominal exchange rate
that occurs when the real exchange rate is 1.
The PPP exchange rate is often considered to be the long run equilibrium exchange rate It is also used to compare economic variables across
countries, particularly measures related to standards of living or welfare
$
€€/$€/$ P
Peereal
€
$€/$ P
PePPP
Exchange rates and Mundell-Fleming
Imports, exports and exchange rates
Current account, capital account and balance of payments
From IS-LM to Mundell-Fleming
Effectiveness of policy
Current account and capital account
The current account is not the only element of international trade.
The balance of payments composed of:The current account CA:
Tracks outflows minus inflows of goods and services It corresponds to the Exports – Imports component.
The capital account KA: Tracks inflows minus outflows of capital of a country Either as direct investment (building factories, etc) Or purchases/sales of assets
Current account and capital account
The current account was explained in the previous section as the ‘net exports’ added to C + I + G. What role does the capital account play ?
To understand their relation, let’s derive the savings/investment balance for an open economy
Setting Z = Y :
MTSCY
XGICZ
XGIMTS
Current account and capital account
This gives us the equilibrium condition in terms of investment and savings:
XI T MS G Simplifying assumption: the government budget is in
equilibrium (G-T = 0) If there is a CA deficit (X-M < 0), there are not enough
savings (agents are spending too much). Some of the financing of investment (I) must come from abroad.
If there is a CA surplus (X-M > 0), there is excess savings (agents are not spending enough). The excess saving are used to fund foreign investment.
The adjustment to the current account balance occurs through an inflow or outflow of savings: This is the capital account.
Current account and capital account
The BoP is in equilibrium when CA+KA = 0 The current account
and capital imbalances add to 0
As seen in the previous slide, this is equivalent to saying that S = I in an open economy
Current account and capital account
Source: BIS,2007 World Report
Current account and capital account
The USA have been net importers and net borrowers since the 1980’s. The US current account deficit in 2006 was 6,6% of its GDP.
Europe has recently seen positive balances on its current account, which reflects a relatively low level of growth.
Japan has traditionally been a net exporter and a net lender.
The current accounts surpluses of emerging Asian countries (particularly China) have grown during the 1990’s
XI T MS G
Current account and capital account
The amount of savings required to finance the current account deficit of the USA has tripled since 1997.
On the other had, the emerging economies have become net providers of savings flows.
Europe and Asia (including Japan) has covered 2/3 of the funding needs of the USA in 2002.
XI T MS G
Exchange rates and Mundell-Fleming
Imports, exports and exchange rates
Current account, capital account and balance of payments
From IS-LM to Mundell-Fleming
Effectiveness of policy
From IS-LM to Mundell-Fleming
Model developed by Robert Mundell and Marcus Fleming It extends the IS-LM model to an open economy
Aggregate demand now contains the current account : i.e. the difference between exports and imports. X(Y*,e) : Exports are a function of the income of
the rest of the world (exogenous) and the exchange rate
M(Y,e) : Imports are a function of national income and the exchange rate
*, ,X YY C Y T I i G e M Y e
From IS-LM to Mundell-Fleming
Determinants of the current account: If e increases (depreciation): exports are more competitive
and imports more expensive. The net balance of the current account increases.
If Y increases: imports increase and the net balance of the current account falls.
Y* is exogenous, and Y is already determined in IS-LM. There is an extra variable to account for: the exchange rate e.
We need to add another equation (market) in order to be able to solve the system: we use the equilibrium condition on the balance of payments
eYMeYXeYYCA ,,,, **
The equilibrium exchange rate is achieved when BP is equal to zero, in other words when the deficits and surpluses of the two accounts compensate exactly.
From IS-LM to Mundell-Fleming
One can see that this equilibrium condition can be expressed in the (Y,i) space of IS-LM.
We still need to relate the exchange rate e to these variables
Reminder: the balance of payments is the sum of the current account and the capital account:
eiKAeYYCAeiYYBP ,,,,,, **
eYYCAeiKA ,,, *
From IS-LM to Mundell-Fleming
The capital account (KA) Is in surplus if the inflows of
capital are larger than the outflows.
Is in deficit in the other case. What determines these
capital flows ?
Intuitive answer: the earnings on savings If savings earn a higher return in Europe compared to
the USA, one would expect American capital to flow towards Europe.
From IS-LM to Mundell-Fleming
Investors choose between assets that pay different interest rates in different currencies.
What is the expected return for each of the possible investment? Their decision needs to account for the interest
rate differentials… …But also for the evolution of the exchange
rates between currencies.
This arbitrage mechanism produces what is called the uncovered interest rate parity (UIRP) This gives us a relation between interest rate
differentials and changes in the exchange rate
From IS-LM to Mundell-Fleming
You are a European investor with capital K (in €) looking for a 1-year investment.You can invest in €-denominated bonds,
and after a year you earn:
Or you can buy $-denominated US bonds: Step 1: you first convert your capital into dollars:
Step 2: after a year, you’ve earned (in dollars):
€1 iK
€/$eK
$€/$ 1 ieK
From IS-LM to Mundell-Fleming
But you need to bring you investment back home ! In other words you need to convert your
capital in $ back into €. In the mean time the $/€ exchange rate may
have changedStep 3: you convert your investment into €
You are indifferent if the 2 returns are equal
ae
ieK
€/$
$€/$ 1
From IS-LM to Mundell-Fleming
You’re indifferent between $ and € assets if:
Rearranging gives:
If the exchange rate is not too volatile, this can be expressed as:
ae
ieKiK
€/$
$€/$€
11
$€/$
€/$€ 11 ie
ei
a ae
e
i
i
€/$
€/$
$
€
1
1
€/$
€/$€/$$€ e
eeii
a
From IS-LM to Mundell-Fleming
Let’s summarise: Capital flows ensure an equalisation of interest rates expressed in the same currency
If the home interest rate is higher than world interest rate, zero net capital flows between countries requires investors to be expecting a depreciation of the home currency. If this is not the case, then capital will flow into the
home country, appreciating e until depreciation expectations occur
Only if the home rate equals the foreign rate will depreciation/appreciation expectations be zero (equilibrium)
Home interest rate
World interest rate
Expected exchange rate depreciation€/$
€/$€/$$€ e
eeii
a
From IS-LM to Mundell-Fleming
On BP the balance of payments is in equilibrium
BP
i
Y
BP is upward-sloping An increase in Y leads to
a BoP deficit (CA deficit) Returning to equilibrium
requires a KA surplus, and hence a higher i
The slope depends on the internationa mobility of capital The lower capital
mobility, the larger the slope of BP.
BoP surplusAppreciation of e
BoP deficitDepreciation of e
CA deficit
KA surplus
From IS-LM to Mundell-Fleming
The MF model was developped in the 60’s, when capital mobility was low (Bretton Woods)
i
Y
As a simplification, nowadays we assume perfect capital mobility
However, this remains a simplification! For certain cases (like
the case of trade with China), The concept of imperfect capital mobility remains relevant.
BPi*
Perfect capital mobility
i=i*
BoP DeficitDepreciation of e
BoP SurplusAppreciation of e
From IS-LM to Mundell-Fleming
BP
i
Y
i*
We now have 3 curves, IS-LM-BP :
IS
LM
Exchange rates and Mundell-Fleming
Imports, exports and exchange rates
Current account, capital account and balance of payments
From IS-LM to Mundell-Fleming
Effectiveness of policy
The effectiveness of policy
We now move to assessing the effectiveness of policy under the possible exchange rate settings:
Fixed exchange
rate
Flexible exchange
rate
Fiscal Policy ?? ??
Monetary Policy ?? ??
The effectiveness of policy
BP
i
Y
LM shifts to the right The increase in the money
supply lowers the rate of interest, leading to depreciation pressures on e
i*
Monetary policy with fixed exchange rate:
IS
LM
Such a policy cannot be carried out in practice
In order to guarantee the fixed exchange rate the CB must immediately increase i to i=i* by reducing money supply
The effectiveness of policy
BP
i
Y
IS shifts to the right: The crowding out effect
increases the rate of interest, creating appreciation pressures on e
i*
Fiscal policy with fixed exchange rate:
IS
LM
Policy is effective in increasing Y
In order to guarantee the fixed exchange rate the CB must immediately reduce i to i=i* by increasing money supply
The effectiveness of policy
BP
i
Y
LM shifts to the right The interest rate falls, which
leads to a depreciation of the exchange rate e
i*
Monetary policy with flexible exchange rate:
IS
LM
Policy is effective
The depreciation of the exchange rate stimulates exports and penalises imports As a resut IS shifts to the
right
The effectiveness of policy
BP
i
Y
IS shifts to the right The Central Bank doesn’t
have to react: The interest rate increases and the exchange rate appreciates
i*
Fiscal policy with flexible exchange rate:
IS
LM
Policy is ineffective
The appreciation of the exchange rate penalises exports and stimulates imports IS shifts left
The effectiveness of policy
Even with this simple example (assumption of perfect capital mobility), one can see that the effectiveness of policy depends on international conditions!
Fixed exchange
rate
Flexible exchange
rate
Fiscal Policy Effective Ineffective
Monetary Policy Impossible Effective
Summarising all this:
The effectiveness of policy
IncompatibilityTriangle
(Mundell)
FinancialAutarky
MonetaryUnion
FlexibleExchange rate
Autonomous monetary policy
Fixe
d ex
chan
ge rat
e Capital m
obility
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