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The Mundell-Fleming Model
How international capital mobility alters the effects of macroeconomic policy Lecture 13: Mundell-Fleming model with a fixed exchange rate Fiscal expansion Monetary expansion Automatic mechanisms of adjustment Lecture 15: Practical policymaking problems Lecture 16: Mundell-Fleming model with a floating exchange rate Lecture 17: Mundell-Fleming model with perfect capital mobility
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The Mundell-Fleming equations with a fixed exchange rate
IS: Y = π΄ β π(π) + π β π π +π LM: π1 π = L(i, Y) IS LM i Y BGP-620 Prof.J.Frankel
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The Mundell-Fleming equations with a fixed exchange rate, continued
IS LM BP=0 i Y BP = TB KA New addition: capital flows respond to interest rate differential TB = π β π β mY KA = πΎπ΄ +ΞΊ (πβπβ) BP=0: π - π β mY πΎπ΄ +ΞΊ πβπβ = 0 (i-i*) = 1 ΞΊ [(β πΎπ΄ β( π β π )] + ( π ΞΊ )Y. Solve for interest differential: BGP-620 Prof.J.Frankel
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A rise in income and the trade deficit is consistent with BP=0 β¦
(i-i*) = 1 ΞΊ [(β πΎπ΄ β π β π ] + ( π ΞΊ ) Y . BP=0: i Y BP=0 The slope is (m/πΏ). ΞΊ = 0 πΏ > 0 πΏ >> 0 i BP=0 Capital mobility gives some slope to the BP=0 line:. A rise in income and the trade deficit is consistent with BP=0 β¦ if higher interest rates attract a big enough capital inflow. BGP-620 Prof.J.Frankel
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β’ β’ β’ ΞΊ = 0 πΏ > 0 πΏ >> 0 Experiment: Fiscal expansion.
BP=0 BP=0 β’ β’ β’ BP=0 Experiment: Fiscal expansion. The capital inflow is either less than enough to give a surplus in the overall balance of payments, or more than enough, depending on the degree of capital mobility. BGP-620 Prof.J.Frankel
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πΏ low πΏ high β’ β’ Example: France The Mitterrand fiscal expansion did not attract enough capital inflow to finance fully the TD. Example: Germany, The Unification fiscal expansion attracted more than enough capital inflow to finance TD. BGP-620 Prof.J.Frankel
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The overall balance of payments deficit is bigger, the bigger is k.
ΞΊ = 0 πΏ > 0 πΏ >> 0 β’ β’ β’ Experiment: Monetary expansion A capital outflow adds to BoP deficit. =>TB β The overall balance of payments deficit is bigger, the bigger is k. BGP-620 Prof.J.Frankel
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Automatic mechanisms of adjustment
Money supply (via reserve flows) Exchange rate (via demand for currency) Price level (via excess demand for goods) Indebtedness (via current account or budget deficit) BGP-620 Prof.J.Frankel
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β’ β’ 1st automatic mechanism of adjustment: Reserve flows (MABP) k low
k high β’ β’ If outflow is sterilized, economy remains at point M. If unsterilized, money flows out β β faster and faster as k is higher. β‘ βOffsetβ to monetary expansion. BGP-620 Prof.J.Frankel
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A 2nd automatic mechanism of adjustment: Floating exchange rate
If, at a given exchange rate, a country would have a BoP deficit, then under floating the currency depreciates. Enhanced competitiveness (=> π β) shifts IS & BP=0 curves right. Equilibrium occurs at: a higher level of Y. BP=0. If, at a given exchange rate, a country would have a BoP surplus, then under floating the currency appreciates. Uncompetitiveness (=> π β) shifts both the IS & BP=0 curves left. a lower level of Y. as we will see in Lecture 16. BGP-620 Prof.J.Frankel
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Appendix: Mundell-Fleming model illustrated by the example of BoP surpluses in Emerging Markets
(1) Causes of surpluses (2) Alternative ways to manage inflows. BGP-620 Prof.J.Frankel
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} β’ (1) Causes of BoP Surpluses in EM Countries BP shifts down/out
βPullβ Factors (internal causes) 1. Monetary stabilization => LM shifts up 2. Removal of capital controls => ΞΊ rises 3. Spending boom => IS shifts out/up e.g., II. βPushβ Factors (external causes) Low interest rates in rich countries => i* down => Boom in export markets => } BP shifts down/out e.g., ; β’ BGP-620 Prof.J.Frankel
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Causes of BoP Surpluses in EM countries 2003-08 & 2010-13
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. BGP-620 Prof.J.Frankel
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β’ (2) Alternative ways of managing inflows: i Y
A country at point B has a BoP surplus. i Y (Each way has a drawback.) Allow money to flow in Sterilized intervention C. Allow currency to appreciate D. Reimpose capital controls (can be inflationary) (can be difficult) (lose competitiveness) (can impede efficiency) BGP-620 Prof.J.Frankel
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China initially took its BoP surplus as fx reserves.
But it also allowed RMB appreciation ( ). BGP-620 Prof.J.Frankel
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Professor Jeffrey Frankel, Harvard University
END OF LECTURE 13: THE MUNDELL-FLEMING MODEL WITH A FIXED EXCHANGE RATE Professor Jeffrey Frankel, Harvard University
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Lecture 15: Problems/Applications of discretionary policymaking
Targets & instruments revisited Practical difficulties of policymaking Zero Lower Bound IV. The case of Chinaβs inflows
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(I) Targets & instruments revisited
When we first showed the need to have as many independent policy instruments as goals, monetary & fiscal policy were not independent. Now, with capital mobility, they have somewhat independent effects on external balance, provided it is defined as BP=0 (rather than just TB=0). The reason: they have opposite effect on capital flows, because they have opposite effects on interest rates. => Even with a fixed exchange rate, the proper combination of monetary & fiscal policy can attain internal & external balance at the same time. BGP-620 Prof.J.Frankel
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β β Y= π TB=0 BP=0 i LM IS' LM' IS Y
In theory, there exists a precise mix of monetary & fiscal policy that will hit both internal balance and BP=0. Y= π TB=0 BP=0 i β LM TD balanced by KA surplus IS' LM' β IS Y BGP-620 Prof.J.Frankel
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(II) Practical difficulties of policymaking
Lags: between the change in a policy instrument and the response in the economy Uncertainty with regard to: the current position of the economy (βbaselineβ); future disturbances (βshocksβ); the correct model (e.g., multipliers).
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(III) Liquidity trap or βZero Lower Boundβ Does monetary policy lose effectiveness?
LM LMβ i IS Y ZLB: Increases in the money supply by the central bank are absorbed without further lowering i , the short-term rate. E.g., Japan in late 1990s. US, UK, ECB BGP-620 Prof.J.Frankel
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Liquidity trap or Zero Lower Bound, continued
But central banks can still have effects via other channels: Exchange rate depreciation Boosting asset prices: equities & real estate Raising expected inflation, thus lowering the real interest rate Lowering the long-term interest rate. Especially via some βunconventionalβ tools: Quantitative Easing Forward guidance. BGP-620 Prof.J.Frankel
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(IV) The example of Chinaβs inflows, 2003-11, (including attempts to sterilize them, continued)
BGP-620 Prof.J.Frankel
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1. Sterilization of reserve inflows, 2004-06 (continued from Lecture 9)
Reserve accumulation Initially successful sterilization Declines in NDA Increases in bank reserve requirements
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API-120 - Prof. J.Frankel, Harvard
China accumulated FX reserves rapidly after 2003. BP β‘ dR/dt >> 0 API Prof. J.Frankel, Harvard
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The Peopleβs Bank of China sold sterilization bills, taking cash RMB out of circulation (dNDA/dt < 0) and so counteracted increases in Net Foreign Reserves. Source: Zhang, 2011, Fig.7, p.47.
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API-120 - Prof. J.Frankel, Harvard
In , the PBoC had little trouble sterilizing the rising reserve inflows: overall MB expansion was relatively steady (at β 10%/yr.). Growth of monetary base & its components: \ FX reserve contribution China had trouble sterilizing inflows in Source: HKMA, Half-Yearly Monetary & Financial Stability Report, June 2008 API Prof. J.Frankel, Harvard
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The sterilization showed up as a steadily rising share of foreign reserves (vs. domestic assets) in the holdings of the Peopleβs Bank of China Chang, Liu & Spiegel, Fig. 1, p.26 Chang, Liu & Spiegel, 2015, βCapital Controls and Optimal Chinese Monetary Policyβ FRB SF WP
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API-120 - Prof. J.Frankel, Harvard
Another tool: The PBoC raised banksβ required reserve ratios, thus sterilizing in the broad sense of slowing M1, even if M Base grew rapidly. Source: Zhang, 2011, Fig.6, p.46. API Prof. J.Frankel, Harvard
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(2) 2007-08: Sterilization faltered
PBoC began to have to pay higher domestic interest rates and to receive lower interest rate on US T bills => βquasi-fiscal deficitβ or βnegative carry.β Money growth accelerated. The economy overheated.
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(i) βCost of carryβ: By 2008 the cost of domestic funds exceeded the interest rate the PBoC was earning on its foreign reserves (US Treasury bills). } Cost of carry Chang, Liu & Spiegel, Fig. 2, p.27 Chang, Liu & Spiegel, 2015, βCapital Controls and Optimal Chinese Monetary Policy,β FRB SF WP
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Sterilization eventually faltered, continued
(ii) Money accelerated sharply in
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(iii) Signs of overheating in 2007-08:
Sterilization eventually faltered, continued (iii) Signs of overheating in : Real growth > 10% probably > potential. Inflation became a serious problem. Also a βbubbleβ in the Shanghai stock market and in housing prices.
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(a) Real growth > 10% in 2007-08.
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(b) Chinaβs CPI accelerated in 2007-08.
L6 appendix (b) Chinaβs CPI accelerated in Inflation 1999 to 2008 Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008 API Prof. J.Frankel, Harvard
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(c) 2007-08 bubble in Chinaβs stock market
L4 appendix (c) bubble in Chinaβs stock market Data from EconStatsTM, Reuters, and major online news outlets such as the BBC & NYT.
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(d) Apparent 2008 bubble in Chinaβs housing market.
Second-hand House Price Index, Shanghai (2003=1000) House price change, Shanghai (% change over a year earlier) Data source: eHomeday
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while continuing to underpay depositors:
L4 appendix The PBoC tightened money by raising reserve ratios and also raising lending rates while continuing to underpay depositors: { βfinancial repressionβ Source: HKMA, Half-Yearly Monetary & Financial Stability Report, June 2008
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3. Global recession & response: The macroeconomy in 2009-11
The global recession hit in 2008, 4th quarter, originating in the βNorth Atlantic financial crisis.β It cut Chinaβs exports by 1/4. Growth and inflation fell sharply. The government responded with a big counter-cyclical fiscal stimulus in 2009. The economy returned to rapid growth in 2010, even excess demand in 2011.
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China was hit by the 2009 global recession.
2005-July 2015
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Chinese government investment spending in 2009 counteracted the recession.
} A rise in public investment offset the loss of export demand in 2009. Reserve Bank of Australia
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API-120 - Prof. J.Frankel, Harvard
Chinaβs inflation broke sharply in 2009, But took off again in Inflation 2001 to 2011 API Prof. J.Frankel, Harvard
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Lecture 16: Mundell-Fleming model with a floating exchange rate
Rule: if result at a given exchange rate would be a BoP deficit, then result under floating is currency depreciation. Implications of capital mobility Monetary expansion: high ΞΊ => extra stimulus via net exports => more effect on Y. Fiscal expansion: high ΞΊ => crowding out of net exports => less effect on Y. Examples: Monetary expansion (Japan 2013, ECB 2015) & contraction (UK 1980, US 1980, Japan 1990) Fiscal expansions (US twin deficits in early 1980s) BGP-620 Prof.J.Frankel
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House of Representatives dissolved, Nov. 2012 => βAbenomicsβ
Example of monetary expansion (1): Abenomics depreciated the yen, House of Representatives dissolved, Nov => βAbenomicsβ Y/$ = Takatoshi Ito, Dec.30, 2013 , ADB Institute BGP-620 Prof.J.Frankel
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Example of monetary expansion (2):
When ECB chief Mario Draghi announced QE Jan.22, 2015, => the euro depreciated. $/β¬ BGP-620 Prof.J.Frankel
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The Mundell-Fleming equations when the exchange rate changes
IS: Y = π΄ β ππ + π (E) π +π LM: π1 π = L(i, Y) (i-i*) = ΞΊ [( πΎπ΄ + π (E)] + ( π ΞΊ )Y. BP=0: IS IS' LM i BP=0 A depreciation (rise in E) raises net exports & so shifts both the IS & BP curves to the right, assuming the Marshall-Lerner condition holds. β’ BP'=0 β’ Y BGP-620 Prof.J.Frankel
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β’ β’ β’ β’ β’ β’ π / π β ΞΊ = 0 ΞΊ > 0 ΞΊ >> 0 Monetary Expansion
π / π β ΞΊ = 0 ΞΊ > 0 ΞΊ >> 0 β’ β’ β’ β’ β’ β’ i β => capital outflow => more depreciation => higher net exports BGP-620 Prof.J.Frankel
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β’ β’ β’ β’ β’ β’ π΄ β ΞΊ = 0 ΞΊ > 0 ΞΊ >> 0 Fiscal Expansion
π΄ β ΞΊ = 0 ΞΊ > 0 ΞΊ >> 0 β’ β’ β’ β’ β’ β’ i β => capital inflow => less depreciation => lower net exports BGP-620 Prof.J.Frankel
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Examples of monetary contractions under modern conditions of high ΞΊ and floating exchange rates
Thatcher monetary contraction of Volcker monetary contraction of Japanese monetary contraction of IS ISβ LM' LM A B i y In each case, i β , r β (at A) => currency appreciated => net exports fell (B) => recession was more severe than in traditional monetary tightenings. BGP-620 Prof.J.Frankel
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Examples of monetary/ fiscal mix: 1) Reagan- omics, 1981-84;
1984 LM β’ M contrac- tion β’ 1982 β’ ISβ²β² 2) German union Late 1970s IS ISβ² Y The US shift in monetary-fiscal mix: from low real interest rate & low $ in the late 1970s, to high real interest rate & high $ in the mid-1980s. GDP composition shifts to G & C, away from I & X-M. BGP-620 Prof.J.Frankel
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We now have a causal interpretation of the twin deficits US National Saving, Investment, & Current Account as Shares of GDP, Trend: Gap widened, as NS fell relative to I BGP-620 Prof.J.Frankel
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Appendix: Japanese monetary expansion and yen depreciation 2012-15
βAbenomicsβ
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QE: The Fed doubled the monetary base in 2008.
Gov. Kuroda in Apr announced BoJ would double over 2 years. βHSBC: donβt worry, BoJ expansion will offset end of QE,β FT, Jun 14, BGP-620 Prof.J.Frankel
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Japanβs monetary easing (QQE)
raised the exchange rate (Yen/$) and stock market HR dissolved, Nov => βAbenomicsβ βOutlook Recovery on a shaky footing,β Special , Economic Research Dept., Rabobank November 13, 2013, BGP-620 Prof.J.Frankel
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Abenomics seemed to boost growth, at first.
But Japan went back into recession in 2014 Q2, perhaps because of a big increase in the consumption tax Nov => βAbenomicsβ April 2014 => Consumption tax BGP-620 Prof.J.Frankel
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Mundell-Fleming model with a floating exchange rate
End of Lecture 16: Mundell-Fleming model with a floating exchange rate
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