Readings: Chapters 26 and 27
In this lecture we introduce the IS/LM/BP model of the open economy. We can then use it to examine the effectiveness of monetary and fiscal policy under fixed and flexible exchange rates, and under different assumptions about capital mobility.
Assumptions:
The IS curve
shows the combination of interest rates and national income that result in equilibrium in the goods market.
(IS) Y = C(Y, t) + I(i) + G + X(R) -M(R, Y), where R is the real exchange rate (eP* /P)
The IS curve slopes downward because increases in the interest rate cause investment to fall, and thus reduce income through the multiplier. The slope depends of the responsiveness of investment to changes in the interest rate, and the magnitude of the autonomous investment multiplier.
The LM curve
(LM) a(DR + IR) = L(Y, i, P, O), where O is all other influences on the demand for money.
The LM curve slopes upward because increases in income increase the demand for money, leading to a rise in the interest rate
The BF curve
(BP) B = 0 = X(R) - M(R, Y) + CA(i)
CA is capital inflows.
The economy may in equilibrium at the intersection of the IS, LM and BP curves, but there may be unemployment or inflationary pressures that require government intervention.
Monetary policy is completely ineffective under fixed exchange rate, regardless of the degree of capital mobility. In each case the increase in money supply leads to a B of P deficit, which causes a loss of reserves, and restores the money supply to its previous level.
Currency depreciation causes expenditure switching from foreign goods to domestic goods. The BP curve shifts right. The improvement in competitiveness leads to B of trade surplus, and an increase in international reserves. Money supply increase. Also, as net exports increase the IS curve shifts right. Equilibrium is restored at higher income levels. Devaluation is most effective at raising income when capital is perfectly mobile.
Under fixed exchange rates disequilibrium in the foreign sector leads to changes in the money supply. Under flexible exchange rates B of P adjustment automatically takes place, through changes in the exchange rate, which, due to the assumption of fixed prices, leads to changes in international competitiveness.
Monetary policy is always effective when exchange rates are flexible, regardless of the degree of capital mobility
Expansionary monetary policy shifts the LM curve to the right. Downward pressure on interest rates causes capital outflows, while the higher income levels increases imports. This causes depreciation in the exchange rate, shifting the BP curve to the right. The improvement in international competitiveness shifts the IS curve to the right, until equilibrium is restored at a higher income level.
In the modern world capital is highly mobile. In this case the effectiveness of monetary and fiscal policy can be characterized thus:
Under fixed exchange rates fiscal policy is effective, and monetary policy is completely ineffective.
Under flexible exchange rates fiscal policy is ineffective, and monetary policy is effective.
We are often interested in the effects of external shocks on the domestic income level. External shocks are transmitted to the domestic economy though changes in the B of P in the case of fixed exchange rates, and by changes in the exchange rates when these are flexible. Of particular interest is the question of which regime has the best insulation properties.
A foreign price increase improves international competitiveness and shifts the BP curve to the right. The IS curve also shifts to the right.
Under fixed exchange rates the resultant balance of payment surplus generates an increase in the money supply. The LM curve shifts right. Equilibrium is restored at a higher income level. If the economy was already at full employment this shock will translate into higher domestic prices. This will restore international competitiveness, and thus income, to its former level. With fixed exchange rates the external shock is transmitted in the form of either higher income or prices.
Under flexible exchange rate the incipient B of P surplus leads to an appreciation of the exchange rate. International competitiveness is restored to former levels. Income is unchanged, and there is no pressure on domestic prices.
Flexible exchange rates insulate domestic income and prices from external price shocks.
Consider an increase in the foreign interest rate. This generates capital outflows, and leads to an upward shift in the BP curve.
Under fixed exchange rates the resulting B of P deficit reduces the money supply, shifting the LM curve upward, and restoring equilibrium at a lower income level.
Under flexible exchange rates the same external shock will increase domestic income. The incipient B of P deficit causes exchange rate depreciation which shifts both the BP curve and the IS curve to the right. The new equilibrium occurs at both higher income and domestic interest rates.
Neither regime insulates the economy from foreign interest rates shocks. However, foreign interest rates shocks have opposite effects depending on the exchange regime.
Policy coordination
Increased trade and capital mobility has necessitated increased coordination of national economic policies.
The Mundell-Fleming model provides insight into the workings of the open economy. It is limited by the assumptions it is based on, in particular, that of fixed prices. However it remains a good framework for the discussion of the effects of policy and other exogenous changes. This is especially true in the short run.