### L2.

```LECTURE 2:
The Mundell-Fleming Model
with a Fixed Exchange Rate
Keynesian Model of the trade balance TB & income Y.
Key assumption: P fixed => Y  Y .
Mundell-Fleming model
international capital flows KA respond to interest rates i.
Questions:
Effect of fiscal expansion or other  A .
Effect of monetary expansion
 M / P.
ALTERNATE APPROACHES TO DETERMINATION OF
EXTERNAL BALANCE
 Elasticities Approach to the Trade Balance
 Keynesian Approach to the Trade Balance
 Mundell-Fleming Model of the Balance of Payments
 Monetary Approach to the Balance of Payments
 Intertemporal Approach to the Current Account
KEYNESIAN MODEL OF THE TRADE BALANCE
Import demand is a function of the exchange rate & income.
The same for exports: => TB = X(E,Y*) – IM(E,Y),
where IM is here defined to be import spending expressed in domestic terms.
dX
0
dE
dX
 m*  0
dY *
dIM
0
dE
.
dIM
m0
dY
If the domestic country is small, Y* is exogenous;
drop it for simplicity.
Rewrite TB = X ( E )  mY.
Notationally, we embody all E effects (whether via exports or imports) in X ;
and we assume the Marshall-Lerner condition holds: d X  0 .
dE
STYLIZED J-CURVES
With instantaneous
pass-through
to import prices
With delayed
pass-through
to import prices
Empirical estimates of sensitivity of exports and
imports to E & Y
log X
log(EP * / P)
• For empirical purposes, we estimate by OLS regression
– with allowance for lags, giving J-curve;
– controlling for income Y & Y* as well as E,
– shown in logs, giving parameters as:
• price elasticities & income elasticities.
• Illustration: Marquez (2002) finds for most Asian countries:
– Marshall-Lerner condition holds, after a couple of years, and
– income elasticities are in the 1.0-2.0 range.
Estimated income
elasticities
are mostly
between 1.0 - 2.0.
Estimated price
elasticities (LR)
satisfy the
Marshall-Lerner
Condition.
An application of the marginal propensity to import:
Why did trade fall so much more sharply than income
in the 2008-09 global recession?
2009
Bussière, Callegari, Ghironi, Sestieri, & N.Yamano, 2013,
Why did trade fall so sharply in the 2008-09 global recession?
Bussière, Callegari, Ghironi, Sestieri, & Yamano, 2013, "Estimating Trade Elasticities: Demand Composition and the Trade Collapse of 2008-09."
The usual explanations involve trade credit,
inventories, and trade in intermediate inputs.
Bussière et al (2013) argue that Investment, which declined
much more in 2009 than the other components of GDP, has
a higher marginal propensity to import than the other components.
Behavior of real components of GDP
in the 2008-09 recession
GDP
for import-intensity
Imports
& Exports
Investment
Bussière, Callegari, Ghironi, Sestieri, & N.Yamano,
Trade Balance = TB = X (E) – mY.
Aggregate output = domestic Aggregate Demand + net foreign demand:
Y
=
A(i, Y)
+ TB(E, Y),
dA
dA
c0 .
where
 0 and
dY
di
More specifically, let A(i, Y) = Ā - b(i) + cY ,
where the function -b( ) captures the negative effect of
the interest rate i on investment spending, consumer durables, etc.
Combining equations,
Y = A  b(i)  cY  X ( E)  mY
Solve to get the IS curve:
A  b(i )  X ( E )
Y
where s  1 – c is the marginal propensity to save.
sm
IS curve: An inverse relationship between i and Y
consistent with the equilibrium that supply = demand in the goods market.
A  b(i )  X ( E )
Y
sm
An increase in spending, Ā,
A,
e.g., a fiscal expansion, shifts IS
to the right by the multiplier 1/(s+m).
The Mundell-Fleming model introduces capital flows:
The overall balance of payments is given by
BP = TB + KA
where
 X ( E)  mY  KA   (i  i*) ,
dKA
 , the degree of capital mobility > 0.
d (i  i*)
We want to graph BP = 0.
Solve for the interest rate:
(i  i*)  (1/  )( X  KA)  (m /  )Y
slope = m/
Finally, the LM curve is given by 1  = L ( i, Y)
dL
dL
where
,
0
 0.
di
→
dY
LM´
A monetary
expansion
shifts
the LM curve
to the right .
• Do central banks actually set M?
• Supposedly they set M1, in the 1980s heyday of monetarism.
• Also the monetary base made a comeback after 2008: Quantitative Easing.
• Normally they think in terms of setting i.
• Still, the role of the LM equation can be taken by a Taylor Rule,
• which describes central banks as setting i in response to Y & inflation.
Appendix: Causes of Developing Country BoP Surpluses
2003-08 & 2010-13
• Strong economic performance (especially China & India)
-- IS shifts right.
• Easy monetary policy in US and other
major industrialized countries (low i*)
-- BP shifts down.
• Big boom in mineral & agricultural commodities
(esp. Africa & Latin America)
-- BP shifts right.
Causes of BoP Surpluses in Developing Countries
1990-1997,
2003-08 &
2010-13
“Pull” Factors (internal causes)
I.
1. Monetary stabilization
=> LM shifts up
2. Removal of capital controls => κ rises
3. Spending boom
=> IS shifts out/up
II.
“Push” Factors (external causes)
1.
Low interest rates in rich countries
=> i* down =>
2.
Boom in export markets =>
•
}
BP
shifts
down
out
```