Mundell-Fleming Model/Open Economy

The book from class International Finance by Keith Pilbeam has a slightly different IS curve equation:
S + M = I + G + X
Leakages = Injections (Absorption)
S = S(a) + sY
Savings equals autonomous savings plus a function of the income level (Y).
M = M(a) + mY
Imports equals autonomous savings plus a function of the income level (Y).
I = I(r)
Investment is solely a function of interest rates (r).
The IS curve is downward-sloping from left to right...

This is because high levels of income generate higher levels of leakages requiring a fall in the interest rate to generate increased investment to maintain equality of injections to leakages.

And the LM curve...

The LM schedule is upward-sloping from left to right because a high income levels require relatively large transaction balances, which for a given money supply can only be drawn out of speculative balances by a relatively high interest rates.

Factors shifting the LM Schedule:
Shift to the right with an increase in MS.
A depreciation of the exchange rate will shift the LM schedule to the left.

The IS curve:

"The marginal propensity to import (m) influences the slope of the IS curve. The second new element of aggregate demand is exports, which are treated as exogenous; the exogenous volume of exports influences the position (but not the slope) of the IS curve."

Pilbeam notes two changes to the LM curve but the study book notes:

Net holdings of foreign exchange are an element in the supply of money; the supply of money increases if there is an inflow of foreign exchange because eithe it is deposited in banks in exchange for domestic deposts, or the central bank buys the foreign exchange with domestic currency which increases the total stock of the latter.

Factors shifting the IS Schedule:
Right ward shift in there is an increase in investment, government expenditures or exports also if an autonomous fall in savings or imports.

Another important factor that causes a rightward shift of the IS schedule is a depreciation of devaluation of the exchange rate, provided that the Marshall-Lerner condition holds; this is because a depreciation of the exchange rate leads to a reduction of import expenditures and an increase in export sales, so that injections then exceed leakages requiring an increased level of income to bring them back into equality.

The BP curve:

Every point on the BP schedule shows a combination of domestic income and rate of interest for which the overall balance of payments is in equilibrium. At points to the left of the BP schedule the overall balance of payments is in surplus because for a given amount of capital flows the current account is better that that required for equilibrium as the level of income is lower. Conversely, to the right of the BP schedule the overall balance of payments is in deficit as the income level is higher than that compatible with overall equilibrium.

At this point it is worth noting that the slope of the BP schedule is determined by the degree of capital mobility internationally. The higher the degree of capital mobility then the flatter the BP schedule.

Perfect capital mobility: horizontal flat curve. Perfectly immobile capital: vertical curve.

Factors shifting the BP schedule:
An autonomous increase in exports or an autonomous decrease in imports will lead to an improvement in the current account requiring arightward shift of the BP schedule.
And a depreciation/devaluation of the exchange rate.

Monetary Policy:
Expansionary monetary policy (open market operations) leads to a fall in domestic interest rates, investment and thus Y goes up. This will lead to a deterioration of the CA by increased capital flight and as Y goes up imports increase.

Fiscal Policy:
The increased expenditure shifts the IS schedule to the right but the rise in domestic interest rates will partially offset expansion in output. Thus the precise effect is indeterminate since expansion of output will worsen the CA and the rise in interest rates will improve CA-more inflows.

4.9 Sterilized and Non-Sterilized Intervention:

With sterilized intervention the authorities offset the money-base implications of their exchange market interventions to ensure that the reserve changes due to intervention do not affect the domestic money base.

Steps:
1. Monetary expansion
2. LM shifts to the right, thus interest rates fall and Y is increased.
3. BoP deficit-new equilibrium to the right of BP schedule.
4. Excess supply of domestic currency on the world market.
5. Purchase home currencies with reserves.
6. So to "sterilize" the effects of reserve changes that reduce the money supply.
7. The exact amount of reductions in money supply is offset by a further expansion of the money supply-so that LM schedule remains at the new equilibrium.

A clear problem with a sterilization policy is that by remaining at (the new higher equilibrium) the authorities will suffer continuous BoP deficits and a continuous fall in reserves.

Fiscal Expansion Under Floating Exchange Rates

BP schedule is steeper than the LM schedule, which means that capital flows are relatively insensitive to interest-rate changes, while money demand is fairly elastic with respect to the interest rate.

Steps:
1. Expansionary fiscal policy shifts the IS schedule to the right.
2. Rise in domestic interest rate and domestic income.
3. Opposite effects on the BoP; expansion in real output-deterioration of CA, rise in interest rate improves capital account.
4. Capital flows are relatively immobile then CA is larger effects and thus BoP moves into deficit.
5. Deficit leads to depreciation of the exchange rate.
6. BP shifts to the right.
7. LM shifts to the left.
8. IS shifts further to the right.
9. Thus higher interest rates, higher output but a depreciation of the exchange rate.

LM schedule is steeper than BP schedule.
Steps:
1. Expansionary fiscal policy shifts the IS schedule to the right.
2. Rise in interest rates (but less rise since of capital mobility is higher-BP flatter) and domestic income.
3. BoP moves into surplus since increased capital inflow more than offsets the deterioration in the CA due to increases in Income.
4. Appreciation of exchange rate moves the LM to the right.
5. IS shifts to the left.
6. Thus higher output, higher interest rate and exchange rate appreciation.

Hence a fiscal expansion can, according to the degree of international capital mobility, lead to either an exchange-rate depreciation or an exchange-rate appreciation.

A Small Open Economy with Perfect Capital Mobility (BP schedule is flat)

With perfect capital mobility, any attempt to pursue a sterilization policy leads to such large reserve losses that it cannot be pursued. Hence, with perfect capital mobility and fixed exchange rates, monetary policy is ineffective at influencing output.

Floating Exchange Rates and Perfect Capital Mobility

...with perfect capital mobility and floating exchange rate, fiscal policy is ineffective at influencing output.
...
The result that fiscal policy is very effective at influencing output under fixed exchange rates and monetary policy is very effective under floating exchange rates with perfect capital mobility.
...
Monetary policy is ineffective at influencing output under fixed exchange rates, while it alone can influence output under floating exchange rates. By contrast, fiscal policy alone is effective at influencing output under a fixed exchange rate, while it is ineffective under floating exchange rates.

Limitations of the Mundell-Fleming Model
1. The Marshall-Lerner condition is assumed to be correct even though in the short-term it is least likely to be true. (MF model is that absolute values of elasticities of demand for exports and demand for imports is >1.
2. Interaction of stocks and flows. Capital inflows does mean at some time that repayments plus interest must be paid back. Can not count on the world to continue indefinitely financing the national debt through capital inflows.
3. Neglect of long-run budget constraints. The government over time has to balance it budgets eventually.
4. Wealth effects, fall in foreign assets associated with a current account deficit.
5. Neglect of supply-side factors. There is an implicit assumption that supply adjusts in accordance with changes in demand.
6. Treatment of capital flows. ..capital inflows are a function of the change in the interest differential rather than the differential itself. Portfolio allocation changes but does not continually change unless the interest rates changes again to change the portfolio allocation.
7. Exchange-rate expectations assumes that "static exchange-rate expectations" are zero.
8. Flexibility of policy instruments.

Links:
Exchange Rate
Theories

TOPICS TO BE COVERED
The Asset Approach
Sterilization
Exchange Rates and the Trade Balance
Overshooting Exchange Rates
Currency Substitution
The Role of News
Foreign Exchange Market Microstructure