1. Lecture 4 Exchange Rate Determination Mundell-Fleming Model

2. The Mundell-Fleming Model
The Mundell-Fleming Model is an extension of the IS/LM model to include joint determination of net exports and the value of the currency.
Inflation and inflationary expectations are still assumed to be stable.
The overall result of this model shows that fiscal stimulus is likely to have little effect on the value of the currency but reduce net exports, while monetary stimulus is likely to have little effect on net exports but reduce the value of the currency.

3. Mundell-Fleming Model
The model thus suggests that a combination of fiscal expansion and monetary contraction would boost the value of the currency and reduce net exports.
Conversely, fiscal contraction and monetary expansion would boost net exports and reduce the value of the currency.
The problem with this model is it does not take expectations into account.
In particular, if fiscal contraction is accomplished by tax increases, the dollar would rise far less than if it were accomplished by reduced government spending.

4. How the Model Works
To understand the M-F model, return to the I = S identity, which can be written as:
Domestic Saving – Investment = Current Account Balance (which is the negative of net foreign saving)
If foreign saving rises – i.e., if the current account deficit rises – then investment can rise, consumers can spend more, or the government can run a bigger deficit.
To turn it around, if the government deficit increases, investment declines, domestic saving rises, or foreign investors pick up the tab -- if they are willing.

5. Fiscal Expansion
With that in mind, consider an increase in the budget deficit.
Assume for the moment that inflationary expectations are unchanged.
As shown in the IS/LM diagram, two things happen. First, income rises, which reduces net exports.
Second, interest rates rise, which attracts more foreign capital and boosts the value of the domestic currency (for example dollar).
But that gain may be offset by the reduction in net exports. Hence the value of the currency probably will not change very much.

6. Monetary Easing
Now consider monetary easing. Interest rates decline, which reduces the value of the dollar
Real income increases, which boosts imports, which also reduces the value of the dollar.
The lower value of the dollar raises exports and offsets some of the gain in imports, so net exports may not change very much.

7. The Mundell-Fleming Model
Small open economy.- domestic real interest rate is equal to the worldwide real interest rate r=r*.
Net exports are inversely related to the nominal exchange rate NX(e), where e is amount of foreign currency per a unit of domestic currency.
Since prices are fixed in the short run, it is equivalent to assuming that net exports depend on real exchange rate.

8. Equilibrium in the Mundell-Fleming modelY e
LM*
IS*
equilibrium
exchange
rate
equilibrium
level of
income

9. Impact of Policy Changes
Three scenarios:
Fiscal Expansion
Monetary Expansion
Trade Restriction
Interest rate differential is a key to the adjustment.
Whenever there is a pressure for domestic interest rate to rise, there are capital inflows appreciating exchange rate.
Whenever there is a pressure for domestic interest rate to fall, there are capital outflows depreciating exchange rate.

10. Floating & fixed exchange rates
In a system of floating exchange rates, e is allowed to fluctuate in response to changing economic conditions.
In contrast, under fixed exchange rates, the central bank trades domestic for foreign currency at a predetermined price.
Next, policy analysis –
first, in a floating exchange rate system
then, in a fixed exchange rate system 10

11. Floating vs. fixed exchange rates
Argument for floating rates:
allows monetary policy to be used to pursue other goals (stable growth, low inflation).
Arguments for fixed rates:
avoids uncertainty and volatility, making international transactions easier.
disciplines monetary policy to prevent excessive money growth & hyperinflation. 11

12. Fiscal policy under floating exchange rates
At any given value of e, a fiscal expansion increases Y, shifting IS* to the right. G↑; Y↑; L(r*,Y)↑; pressure on r*↑; e↑; NX↓; Y↓ Y e e2 e1
Intuition for the shift in IS*:
At a given value of e (and hence NX), an increase in G causes an increase in the value of Y that equates planned expenditure with actual expenditure.
Intuition for the results:
As we learned in earlier chapters, a fiscal expansion puts upward pressure on the country’s interest rate. In a small open economy with perfect capital mobility, as soon as the domestic interest rate rises even the tiniest bit about the world rate, tons of foreign (financial) capital will flow in to take advantage of the rate difference. But in order for foreigners to buy these U.S. bonds, they must first acquire U.S. dollars. Hence, the capital inflows cause an increase in foreign demand for dollars in the foreign exchange market, causing the dollar to appreciate. This appreciation makes exports more expensive to foreigners, and imports cheaper to people at home, and thus causes NX to fall. The fall in NX offsets the effect of the fiscal expansion.
How do we know that Y = 0? Because maintaining equilibrium in the money market requires that Y be unchanged: the fiscal expansion does not affect either the real money supply (M/P) or the world interest rate (because this economy is “small”). Hence, any change in income would throw the money market out of whack. So, the exchange rate has to rise until NX has fallen enough to perfectly offset the expansionary impact of the fiscal policy on output.
Results:
e > 0, Y = 0 Y1

13. Lessons: “Crowding out”
closed economy: Fiscal policy crowds out investment by causing the interest rate to rise.
small open economy: Fiscal policy crowds out net exports by causing the exchange rate to appreciate.
In a small open economy with perfect capital mobility, fiscal policy cannot affect real GDP.

14. Monetary policy under floating exchange rates
An increase in M shifts LM* right because Y must rise to restore equilibrium in the money market. M↑; pressure on r*↓; e↓; NX↑; Y↑ Y e Y1 e1
Suggestion: Treat this experiment as an in-class exercise. Display the graph with the initial equilibrium. Then give students 2-3 minutes to use the model to determine the effects of an increase in M on e and Y.
Intuition for the rightward LM* shift:
At the initial (r*,Y), an increase in M throws the money market out of whack. To restore equilibrium, either Y must rise or the interest rate must fall, or some combination of the two. In a small open economy, though, the interest rate cannot fall. So Y must rise to restore equilibrium in the money market.
Intuition for the results:
Initially, the increase in the money supply puts downward pressure on the interest rate. (In a closed economy, the interest rate would fall.) Because the economy is small and open, when the interest rate tries to fall below r*, savers send their loanable funds to the world financial market. This capital outflow causes the exchange rate to fall, which causes NX --- and hence Y --- to increase. e2
Results:
e < 0, Y > 0 Y2

15. Lessons:
Monetary policy affects output by affecting the components of aggregate demand:
closed economy: M  r  I  Y
small open economy: M  e  NX  Y
Expansionary monetary policy does not raise world aggregate demand, it merely shifts demand from foreign to domestic products.
So, the increases in domestic income and employment are at the expense of losses abroad.

16. Trade policy under floating exchange rates
At any given value of e, a tariff or quota reduces imports, increases NX, and shifts IS* to the right. NX↑; Y↑; L(r*,Y)↑; pressure on r*↑; e↑; NX↓; Y↓ Y e e1 Y1 e2
Intuition for results:
At the initial exchange rate, the tariff or quota shifts domestic residents’ demand from foreign to domestic goods. The reduction in their demand for foreign goods causes a corresponding reduction in the supply of the country’s currency in the foreign exchange market. This causes the exchange rate to rise. The appreciation reduces NX, offsetting the import restriction’s initial expansion of NX.
How do we know that the effect of the appreciation on NX exactly cancels out the effect of the import restriction on NX? There is only one value of Y that allows the money market to clear; since Y, C, I, and G are all unchanged, NX = Y-(C+I+G) must also be unchanged.
Or looking at it differently: As we learned in chapter 5, the accounting identities say that NX = S - I. The import restriction does not affect S or I, so it cannot affect the equilibrium value of NX.
Results:
e > 0, Y = 0

17. Lessons Import restrictions cannot reduce a trade deficit.
Even though NX is unchanged, there is less trade:
the trade restriction reduces imports.
the exchange rate appreciation reduces exports.
Less trade means fewer “gains from trade.”

18. Lessons, cont.
Import restrictions on specific products save jobs in the domestic industries that produce those products, but destroy jobs in export-producing sectors.
Hence, import restrictions fail to increase total employment.
Also, import restrictions create “sectoral shifts,” which cause frictional unemployment.

19. Fixed exchange rates
Under fixed exchange rates, the central bank stands ready to buy or sell the domestic currency for foreign currency at a predetermined rate.
In the Mundell-Fleming model, the central bank shifts the LM* curve as required to keep e at its preannounced rate.
This system fixes the nominal exchange rate. In the long run, when prices are flexible, the real exchange rate can move even if the nominal rate is fixed. 19

20. Fiscal policy under fixed exchange rates
Under floating rates, a fiscal expansion would raise e.
Under floating rates, fiscal policy is ineffective at changing output.
Under fixed rates, fiscal policy is effective at changing output. Y e
To keep e from rising, the central bank must sell domestic currency, which increases M and shifts LM* right. e1
Results:
e = 0, Y > 0 Y1 Y2

21. Monetary policy under fixed exchange rates
Under floating rates, monetary policy is effective at changing output.
Under fixed rates, monetary policy cannot be used to affect output.
An increase in M would shift LM* right and reduce e. Y e Y1 e1
To prevent the fall in e, the central bank must buy domestic currency, which reduces M and shifts LM* back left.
The monetary expansion puts downward pressure on the exchange rate. To prevent it from falling, the central bank starts buying domestic currency in greater quantities to “prop up” the value of the currency in foreign exchange markets. This buying removes domestic currency from circulation, causing the money supply to fall, which shifts the LM* curve back.
Another way of looking at it: To keep the exchange rate fixed, the central bank must use monetary policy to shift LM* as required so that the intersection of LM* and IS* always occurs at the desired exchange rate. Unless the IS* curve shifts right (an experiment we are not considering now), the central bank simply cannot increase the money supply.
Results:
e = 0, Y = 0

22. Trade policy under fixed exchange rates
Under floating rates, import restrictions do not affect Y or NX.
Under fixed rates, import restrictions increase Y and NX.
But, these gains come at the expense of other countries: the policy merely shifts demand from foreign to domestic goods.
A restriction on imports puts upward pressure on e. Y e Y1 e1
To keep e from rising, the central bank must sell domestic currency, which increases M and shifts LM* right.
Suggestion: Assign this experiment as an in-class exercise. Give students 3 minutes to work on it before displaying the answer on the screen.
Results:
e = 0, Y > 0 Y2

23. Summary of policy effects in the Mundell-Fleming model
type of exchange rate regime:
floating
fixed
impact on:
Policy Y e NX
fisc. expansion  
mon. expansion
imp. restriction
Table 12-1 on p (“M-F” = “Mundell-Fleming”)
This table makes it easy to see that the effects of policies depend very much on whether exchange rates are fixed or flexible.

24. Interest-rate Differentials (θ)
Domestic interest rate may differ from the world rate r* for many reasons. In particular, it may reflect:
country risk: The risk that the country’s borrowers will default on their loan repayments because of political or economic turmoil. Lenders would require a higher interest rate to compensate them for this risk.
expected exchange rate changes: If a country’s exchange rate is expected to fall, then its borrowers must pay a higher interest rate to compensate lenders for the expected currency depreciation.

25. Differentials in the M-F model
Modify equations: r = r* + θ
Y= C(Y – T) + G + I(r* + θ) + NX(e)
M/P = L(r* + θ, Y)
Increase in θ shifts IS to the left and LM to the right. Let’s see why:

26. The effects of an increase in 
IS* shifts left, because
  r  I Y e Y1 e1
LM* shifts right, because
  r  (M/P)d,
so Y must rise to restore money market equilibrium.
; e↓; NX↑; Y↑
Intuition:
If prospective lenders expect the country’s currency to depreciation, or if they perceive that the country’s assets are especially risky, then they will demand that borrowers in that country pay them a higher interest rate (over and above r*).
The higher interest rate reduces investment and shifts the IS* curve to the left.
But it also lowers money demand, so income must rise to restore money market equilibrium.
Why does the exchange rate fall? The increase in the risk premium causes foreign investors to sell some of their holdings of domestic assets and pull their ‘loanable funds’ out of the country. The capital outflow causes an increase in the supply of domestic currency in the foreign exchange market, which causes the fall in the exchange rate. Or, in simpler terms, an increase in country risk or an expected depreciation makes holding the country’s currency less desirable. e2
Results: e < 0, Y > 0 Y2

27. Caveats (warnings)
Self-fulfilling depreciation: it happens because people thought it would happen.
An increase in output is caused by exchange rate depreciation.
That does not happen necessarily:
The central bank may try to prevent the depreciation by reducing the money supply.
The depreciation might boost the price of imports enough to increase the price level (which would reduce the real money supply).
Consumers might respond to the increased risk by holding more money.
These factors shift LM to the left.

28. Case Study: The M-F Model Under Reagan and Clinton
According to M-F model, the combination of fiscal ease and monetary tightness in the early 1980s under Reagan would have resulted in a sharply higher dollar and a big decline in net exports. That is precisely what happened.
However, the fiscal contraction and monetary ease during the Clinton era would have resulted in a lower dollar and an increase in net exports, which is not what happened.
Instead, the opposite happened: the dollar strengthened and net exports declined, the same as in the early 1980s. Let’s see why:

29. This is where expectations play a major role.
Under Reagan, business and investor optimism increased because it was expected that the tax cut would stimulate economic growth, which indeed turned out to happen.
Under Clinton, business and investor optimism increased after 1994, when the Republicans gained control of Congress, because of expectations that the reductions in government spending would stimulate economic growth, which was also the case.
Note that the dollar declined during the first two years of the Clinton Administration, as the initial tax increases did not boost confidence.
So, expectations matter a lot!

30. Economic Impact of a Change in Net Exports
A rise in net exports does not necessarily boost GDP. Four cases are considered under which net exports would rise.
1. Foreign growth rises
2. Domestic growth shrinks
3. Lower inflation
4. Weaker currency

31. Economic Impact of Devaluation
If wages and prices rise by the same amount as the currency is devalued, the standard of living is unchanged.
However, foreign saving falls, investment is decreased, and the standard of living rises less rapidly.
If wages and prices rise by less than the drop in the currency, the standard of living declines.
In the long run, devaluation never has a positive impact – unless the currency had been overvalued and is returning to equilibrium.
At best, it serves as a wake-up call for the country to get its domestic affairs in order

32. Just as there is “no free lunch”, in the long run, countries cannot boost growth by devaluing the currency any more than they can boost growth by increasing government spending or printing more money.
Indeed, by reducing foreign capital inflows, devaluations invariably reduce capital formation and the overall growth rate.

33. The Impossible Trinity
A nation cannot have free capital flows, independent monetary policy, and a fixed exchange rate simultaneously.
A nation must choose one side of this triangle and give up the opposite corner.
Free capital flows
Independent monetary policy
Fixed exchange rate
Option 1 (U.S.)
Option 2 (Hong Kong)
See pp
“Option 1” is allowing free capital flows and maintaining independent monetary policy, but giving up a fixed exchange rate. An example of a country that chooses this option is the United States.
“Option 2” is allowing free capital flows keeping a fixed exchange rate, but giving up independent monetary policy. A country that chooses this option is Hong Kong.
“Option 3” is keeping monetary policy independent, yet fixing the exchange rate. Doing this requires limiting capital flows. An example of a country that practices this option is China.
Option 3 (China) 33

34. CASE STUDY: The Chinese Currency Controversy
: China fixed its exchange rate at 8.28 yuan per dollar, and restricted capital flows.
Many observers believed that the yuan was significantly undervalued, as China was accumulating large dollar reserves.
U.S. producers complained that China’s cheap yuan gave Chinese producers an unfair advantage.
President Bush asked China to let its currency float
From pp 34

35. CASE STUDY: The Chinese Currency Controversy
A nation cannot have free capital flows, independent monetary policy, and a fixed exchange rate simultaneously.
China obviously wishes to have independent monetary policy. So it must choose one side of the triangle and choose either free capital flows or a fixed exchange
If China lets the yuan float, it may indeed appreciate. But if it also allows greater capital mobility, then Chinese citizens may start moving their savings abroad.
Such capital outflows could cause the yuan to depreciate rather than appreciate.
So it is a tough decision ! 35

36. Chapter Summary Mundell-Fleming model Fiscal policy
the IS-LM model for a small open economy.
takes P as given.
can show how policies and shocks affect income and the exchange rate.
Fiscal policy
affects income under fixed exchange rates, but not under floating exchange rates.

37. Interest rate differentials
Monetary policy
affects income under floating exchange rates.
under fixed exchange rates, monetary policy is not available to affect output.
Interest rate differentials
exist if investors require a risk premium to hold a country’s assets.
An increase in this risk premium raises domestic interest rates and causes the country’s exchange rate to depreciate.

38. Fixed vs. floating exchange rates
Under floating rates, monetary policy is available for purposes other than maintaining exchange rate stability.
Fixed exchange rates reduce some of the uncertainty in international transactions.