LECTURE 4: THE MUNDELL-FLEMING MODEL -- MONETARY & FISCAL POLICY, AND ADJUSTMENT Question 1: What are the implications of monetary & fiscal policy for income & the balance of payments, at a given exchange rate? Question 2: Mechanisms of adjustment. How does a country adjust to BoP imbalance? What further implications for the economy? Key parameter: κ, degree of capital mobility The Monetary Approach to the Balance of Payments -- One result: under fixed E, κ contributes to offset of money expansion.

Recap slopes down slopes up Monetary expansion shifts LM right. LM′ slope = m/κ API Prof. J.Frankel An increase in spending, e.g., fiscal expansion, shifts IS right, by the multiplier, 1/(s+m). The Mundell-Fleming Model IS curve: LM curve: BP curve:

API Prof. J.Frankel, Harvard

API Prof. J.Frankel, Harvard

Monetary & fiscal policy in the Mundell-Fleming model with a fixed exchange rate -- Summary Fiscal expansion shifts out IS curve. – Result: Y ↑, – though by less than simple Keynesian multiplier because i ↑ => crowding out. Monetary expansion shifts out LM curve. – Result i ↓ => Y ↑. Magnitudes of ∆Y do not depend on degree of capital mobility, κ. Result for external balance i) Y ↑ => TB ↓ ii) With an open KA: Fiscal expansion => i ↑ => KA ↑ Monetary expansion => i ↓ => KA ↓ Effect on overall BP (=CA+KA) depends on degree of capital mobility. API Prof. J.Frankel, Harvard

Automatic mechanisms of adjustment  Indebtedness -- Rising debt will eventually force a reduction in spending. We omit this factor from the course for now.  Price level P – We assume for the moment that price adjustment is very slow.  Exchange rate E – Important if the rate is flexible.  Reserve flows R -- Important under the MABP. MABP (The Monetary Approach to the Balance of Payments)  Defining assumption: Reserve flows are not sterilized.

Sterilization: Changes in reserves (i.e., BP) counteracted by NDA, d NDA / dt = - d R/dt, so MB unchanged. Non-sterilization : d MB / dt = d R / dt. Definitions: Monetary Base: Liabilities of CB  assets held by CB MB  R + NDA where R ≡ International Reserves & NDA ≡ Net Domestic Assets. Broad Money Supply (M1): Liabilities of entire banking system M1 = a multiple of MB <= fractional reserve banking. BP ≡ dR / dt

API Prof. J.Frankel, Harvard This offset to the increase in MB happens more quickly, the higher is κ. Without sterilizing reserve flows MABP : If reserve outflow is not sterilized, then MB falls, LM shifts back, and i rises over time, until in the long run we are back where we started.

The authorities must choose among several options for managing inflows. (Each option has its own drawback). Alternative ways to manage inflows (with disadvantages) A. Allow money to flow in. (Can be inflationary) B. Sterilize intervention. (Artificially prolongs disequilibrium) C. Allow currency to appreciate. (Lose competitiveness) D. Reimpose capital controls. (Lose financial integration gains) API Prof. J.Frankel, Harvard A country at point B -- as were many developing countries in , , or has a BoP surplus.

An example of attempts to sterilize reserve inflows China began in 2003 to run large balance of payments surpluses and tried to sterilize the reserve inflows … successfully for several years. API Prof. J.Frankel, Harvard

=> The MB growth rate was kept down to the growth rate of the real economy (≈ 10%/year), so there was little inflationary pressure. In 2003, forex inflows accelerated rapidly. (Both TB & KA >> 0.) Initially, the PBoC had no trouble sterilizing the inflows.

Appendix: To be continued when we pick up the past decade of China’s macroeconomy in Lecture 16 API Prof. J.Frankel, Harvard

13 Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008 The Balance of Payments ≡ rate of change of foreign exchange reserves (largely $), rose rapidly in China from 2004 on, due to all 3 components: trade balance, Foreign Direct Investment & portfolio inflows Reserves ITF Prof.J.Frankel BoP

FX reserves of the PBoC climbed higher than any central bank in history API Prof. J.Frankel, Harvard

Sterilization of foreign reserves: People’s Bank of China sold sterilization bills, thereby taking RMB out of circulation. Data: CEIC Source: Zhang, 2011, Fig.4, p.45. ITF Prof.J.Frankel