Keynesian Model of the trade balance TB & income Y. Key assumption: P fixed =>. Mundell-Fleming model Key additional assumption: international capital flows KA respond to interest rates i. LECTURE 2: THE MUNDELL-FLEMING MODEL WITH A FIXED EXCHANGE RATE Questions: Effect of fiscal expansion or other . Effect of monetary expansion  /.

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  NonTraded Goods or Dependent-Economy Model of the Trade Balance  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.. If the domestic country is small, Y* is exogenous; drop for simplicity. Rewrite TB =. Notationally, we embody all E effects (whether via exports or imports) in ; And we assume the Marshall-Lerner condition holds :.

Empirical estimates of sensitivity of exports and imports to E & Y For empirical purposes, we estimate by OLS regression –with allowance for lags, giving J-curve; –shown in logs, giving parameters as: price elasticities, and 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 range. log X

Estimated price elasticities (LR) satisfy the Marshall-Lerner Condition. Estimated income elasticities are mostly between

Trade Balance = TB = (E) – mY. Aggregate output = domestic Aggregate Demand + net foreign demand: Y = A(i, Y) + TB(E, Y), 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. Solve to get the IS curve: where s  1 – c is the marginal propensity to save. where and. Combining equations, Y =

IS curve: An inverse relationship between i and Y consistent with the equilibrium that supply = demand in the goods market.

The overall balance of payments is given by BP = TB + KA, where  , the degree of capital mobility > 0. We want to graph BP = 0. Solve for the interest rate: The Mundell-Fleming model introduces capital flows slope = m/

Finally, the LM curve is given by __ __ M / P = L ( i, Y) where → A monetary expansion shifts the LM curve to the right. LM´

Application of the Mundell- Fleming model to payments surpluses experienced by emerging markets. Causes of Capital Flows to Emerging Markets I.“Pull” Factors (internal causes) 1. Monetary stabilization => LM shifts up 2. Removal of capital controls => κ rises 3. Spending boom => IS shifts out/up 4. Domestic privatization, => IS or BP shift out deregulation & liberalization 2. Desire to diversify by global investors => => II. “Push” Factors (external causes) 1. Low interest rates in rich countries => i* down => BP shifts down }

Causes of and Capital Flows to Developing Countries 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.