LECTURE 5: THE MUNDELL-FLEMING MODEL UNDER FLOATING RATES & HIGH CAPITAL MOBILITY Effects of Monetary and Fiscal Expansion

IS curve: Y = 𝐴 − 𝑏𝑖 + 𝑋 (𝐸) 𝑠+𝑚 The Mundell-Fleming Model, once more Another mechanism of adjustment: the exchange rate IS curve: Y = 𝐴 − 𝑏𝑖 + 𝑋 (𝐸) 𝑠+𝑚 LM curve: 𝑀1 𝑃 = L(i, Y) An increase in E, by stimulating Net Exports, shifts both the IS and BP curves. BP curve: 0 = 𝑋 (𝐸) - mY + κ(i-i*) .

The IS curve shifts right, To study depreciation: What is the effect of a change in E in Mundell-Fleming? Answer: The IS curve shifts right, but the BP=0 curve shifts right by more. Rightward shift in IS curve: 𝑑𝑌 𝑑𝐸 = 1 𝑠+𝑚 𝑋 ' Rightward shift in BP curve: 𝑑𝑌 𝑑𝐸 = 1 𝑚 𝑋 ' Intuitively, when a devaluation increases net exports and Y, the TB improves despite the marginal propensity to import; hence the balance of payments improves at a given interest rate.

𝑀 / 𝑃 ↑ FIGURE 23.3 BP<0 BP<<0 BP<0 BP<<0 • • • • • • BP<<<0 BP<<<0 When exchange rates float, capital mobility enhances monetary policy’s effect.

𝐴 ↑ FIGURE 23.1 • • • • • • When exchange rates float, capital mobility reduces the effect of fiscal policy.

Recap of key results under floating κ lowers effect of G on Y because conventional crowding out (i ↑=> A↓) is supplemented by new crowding out (apprec. => 𝑋 ↓). κ raises effect of M on Y because conventional domestic stimulus (i ↓=> A↑) is supplemented by new foreign stimulus (deprec.=> 𝑋 ↑).

Mundell-Fleming with perfect capital mobility As  → ∞, BP=0 curve becomes flat. i Y i=i* BP

Interpretation of BP curve also changes: Now the BP curve is the statement i=i* (with i* exogenous, from the viewpoint of a small country). Points above BP (or below) now correspond to “infinite” surpluses (or deficits), rather than finite. Put differently, international financial arbitrage always forces the economy rapidly back onto the BP curve.

• • • • Fiscal expansion. Monetary expansion. If E is fixed, money inflow (instantaneous & immune to sterilization) brings i back down => full multiplier effect on Y; no crowding out. Monetary expansion. If E is fixed, money outflow (instantaneous & immune to sterilization) brings i back up => effect on Y = 0. FIGURE 23.4 • • If E floats, instantaneous appreciation brings i back down => effect on Y =0; 100% crowding out. If E floats, instantaneous depreciation brings i back up => maximum effect on Y . • •

The Impossible Trinity, a “Trilemma” We can attain any two of the three desirable attributes, but not all three: Perfect Capital Mobility (Financial Integration) Fixed Exchange Rates (Currency Integration) Monetary Independence (Full National Sovereignty)

• • • The “Impossible Trinity” Full capital controls Monetary Union Pure Float

Appendix: Why does i ≠ i*, in practice? Country factors, e.g., as measured by: sovereign spread or local i $ - US i $ . Capital controls Taxes on financial transactions Transaction costs Imperfect information Default risk Risk of future capital controls. Currency factors, e.g., as measured by: local i local currency - local i $. Expected currency depreciation Exchange risk premium.