The Foreign Sector and Balance of Payments Notes
5.1 Mundell- Fleming Model
This is an open – economy version of the IS- Lm model. Both the Mundell-
Fleming Model And IS-LM model assume that the price level is fixed and
then show what cause short – run fluctuation in aggregate income. The
key difference is that the IS- LM model assumes a closed economy,
whereas the Mundell- Fleming model assumes an open economy.
The Key Assumptions of the model
- The model assumes that the economy being studied is a small open
economy with perfect capital mobility. That is, the economy can
borrow or lend as much as it wants in the world financial market
and, as a result, the economy‗s interest rate is determined by the
world interest rate. Mathematically we can write this assumption as
r= r* - The world interest rate is assumed to be exogenously fixed because
the economy is sufficiently small relative to the world economy that
it can borrow or led as much as it wants in world financial markets
without affecting the world interest rate. Perfect capital mobility
implies that if some events were to occur that would normally raise
the interest rate such as a decline in domestic saving in a small
open economy , the domestic interest rate might rise by a little bit
for a short time, but as soon as it did , foreigners would see the
higher interest rate and start lending to this country by instance buying the country‘s bonds. The capital inflow would drive the interest rate back toward r. Similarly if there were any event that were to start driving the domestic interest rate downwards, capital would flow out of the country to earn a higher abroad , and capital outflow, would drive the domestic interest rate back toward , the r= r equation
represents the assumption that the international flow of capital is
sufficiently rapid as to keep the domestic interest rate equal to
the world interest rate. - The model also assumes that price levels at home and abroad are
fixed , this means that the real exchange rate appreciate , foreign
goods become cheaper compared to domestic goods and this cause
export to fall and import to rise.
5.2 The Goods Market and the IS Curve
The Mundell- Fleming model is describes the market for goods and
services much as the IS- LM model does, but it adds a new term for net
export. In particular, the goods market is represented with the
following equation.
Y= C(Y-T) +Ir* + G+NX (e)
This equation states that aggregate income is the sum of consumption C,
investment I, government purchase G, and net export NX.
- Consumption depends positively on disposable income-T.
- Investment depends negatively on the interest rate, which equals
world interest rate r*. - Net exports depend negatively on the nominal exchange rate e. As
before, we define the exchange rate the amount of foreign currency
per unit of domestic currency. For example, e might be Kshs 75 per
dollar.
From the diagram below, the IS curve slopes downward higher interest
rate reduce net export which in turn reduce the aggregate income. Using
the diagram below a change in the exchange rate from e1 to e2 lowers net
from NX (e) to NX (e2). In panel b the reduction falls from Y2 to Y2.
The IS curve summarizes this relationship between the exchange rate and
the level of income Y in panels c.
The figure above shows the standard way of representing the LM curve,
together with a horizontal line representing the world interest rate r*
. The intersection of the two curves determines the level of income
regardless of the exchange rate. Therefore the LM curve is
vertical.
A small Economy Short Run Equilibrium
According to the model – fleming model, a small open with perfect
capital mobility can be described by two equation:
Y= C(Y-I) +I(r) + -G-NX(e)………………………………………….IS MP=L(r,Y)…………………………………………………………………..LM
The first equation describe the goods market ,and the second equation
describe the money market . The exogenous valuable are fiscal policy G
and T , monetary policies M, the price level P and the world interest
rate r* . The endogenous variable are income Y and the exchange rate.
These two relationship are illustrated together in the figure below.
The intersection of the IS curve and the LM curve shows the exchange
rate and the level of income at which both the goods market and the
money market are in equilibrium.
5.4 Effects of Fiscal Policies in A Small and Open Economy
Before analyzing the impacts of policies in an open economy, it is
important to specify the interaction monetary system in which the
country has chosen to operate. There are three systems that a country
operates:
- Floating exchange rates
- Fixed exchange rate
- Flexible exchange rates
The most common is the floating exchange rate, where the exchange rate
is allowed to fluctuate freely in response to changing economic conditions.
*Effects of fiscal policy on the Floating Exchange Rates.
Consider an increase as in government purchase or a tax cut. An
expansionary fiscal policy increased planned expenditure, & shift the IS
curve to the right. As a result, the exchange rate appreciates, while
the level of income remains the same.
This yields very difference results from those of closed economy. As
soon as the interest rate to increase above world interest rate, capital
flows in from abroad. This capital inflow increase the demand for
domestic currency in the market for foreign
currency exchange and , thus bids up the value of the domestic currency
. The appreciation of the exchange rate makes domestic goods expensive
relative to foreign goods, and this reduces net export. The fall in net
export offsets the effects of the expansionary fiscal policy on income.
The reasons why the fall in net export is so great to render fiscal
policy completely powerless to influence income has to do with the money
market . At the world interest rate, there is only one level of income
that can satisfy the level of real money balance due this level of
income does not change when fiscal policy change . Thus when an
expansion fiscal policy is pursued , the appreciation of the exchange
rate and the fall in net export must be exactly large enough to offset
fully the normal expansionary effects of the policy on income
Effects of Monetary policy on floating exchange rates
Now let‘s consider an increase in money supply by central bank. Because
the price level is assumed to BE fixed, the increase in the money supply
means an increase in real balances. The increase in balances shifts the
LM curve to the right.
Although monetary policy influence income in an open economy , as it
does in a closed economy , the monetary transmission mechanism is
different from a small open economy , because the interest rate is fixed
by the world interest rate. As soon as an increase in money supply puts
downwards pressure on the domestic interest rate , capital flows out of
the economy as investors seek a higher return elsewhere. This capital
outflow prevents the domestic interest rate from falling. In addition ,
because the capital outflow increases the supply of the domestic
currency in the market for foreign – currency exchange rate makes
domestic goods inexpensive relative goods and thereby , stimulate net
export . Hence, in a small open economy, monetary policy influences
income by altering the exchange rate rather than the interest rate.
Effect of Trade Policy on floating exchange rates
Suppose that the government reduces the demand for imported goods by
imposing an import quota or a tariff. Because net export equals export
minus import, a reduction in imports means an increase in net that is ,
the net export schedule shift to the right . This shift in the net
export schedule increases planned expenditure and thus moves the IS
curve to the right . Because the LM curve is vertical, the trade
restriction raises the exchange rare but does not income. Often a stated
goal of policies to restrict trade to alter the trade balances NX. Such
policies do not necessarily have that effect. The same conclusion holds
in the Mundell- Fleming model under floating exchange rates. Recall that.
Nx(e) =Y-C(Y-T) –I(r*)-G
Because a trade restriction does not effects income , consumption ,
investment or government‘s purchases , it does not affects the trade
balance. Although the shift in the net export schedule tends to raise NX
, the increase in the exchange rate reduces NX by the same amount.
5.5 The Small Open Economy under Fixed Exchange Rates
We now turn to the second type of exchange rate – system fixed exchange
rates. This system was in operation in the 1950s and 1960s and was later
by floating exchange rate system .Later in the 1970s some European
countries reinstated this system and some economic have advocated a
return to a worldwide system of fixed exchange rates
In this section we discuss how
this system works, and we examine the impact of economic policies on an
economy with a fixed exchange rate.
*A Fixed exchange Rate System
Under a fixed system of fixed exchange rates, a central bank stands
ready to buy or sell the domestic currency for foreign currencies at a
predetermined price. Suppose, for example hat the central bank of Kenya
announced that it was going to fix the exchange rate at Ksh 20 per
dollar. It would then stand ready to give kshs20 shilling in exchange
for a dollar or give out dollar in exchange for Kshs.20 .to carry out
policy , the Central Bank of Kenya would need a reserve of Kenya
shilling ( which it can print) and a reserve of dollars ( which it must
have purchased previously)
A fixed exchange rate dedicates a country‘s monetary policy to the
single goals of keeping the exchange rate at the announced level. In
other words , the essence of a fixed – exchange rate system is he
commitment of central bank to allow the money supply to adjust to
whatever level will ensure that the equilibrium exchange rate equals the
announced rate . Therefore so long as the central bank is ready to buy a
sell foreign currency at the fixed exchange rate, the money supply
adjusts automatically to the necessary level.
Fiscal Policy and Fixed exchange Rate System Let‘s now examine how a
fiscal policy affects a small open economy with a fixed exchange rate.
Consider an increase in government spending. This policy shifts the IS
curve to the right as in the figure below.
This puts an upwards pressure on the exchange rate. But because the
central bank stands ready to trade foreign and domestic currency at the
fixed exchange rate, arbitrageurs quickly respond to the rising exchange
rate by selling foreign currency to the central bank , leading to an
automatic monetary expansion . The rise in money supply shifts the LM
curve to the right and raise aggregate income.
Monetary Policy and fixed exchange Rate System
Consider an increase in money supply by the central bank for example by
buying bonds from the public. The initial impacts of this policy to
shift the LM curve to the lowering the exchange rate.
But because the central bank is committed to trading foreign and
domestic currency at a fixed exchange rate, arbitrageurs quickly respond to the falling exchange rate by selling the domestic currency to the central bank , causing the money supple and LM curve to return to their initial position. Hence monetary policy is ineffective under a fixed exchange rate. By agreeing to fix the exchange rate, the central bank gives up control over the money supply.
A country with a fixed exchange rate , can , however , conduct a type of
monetary policy ; it can decide to change the level at which the
exchange rate is fixed . A reduction in the value of the currency is
called devaluation; an increase in the value of the currency is called a
revaluation
Trade policy and fixed exchange Rate System
Suppose the government reduces imports by imposing an import quota or a
tariff. This policy shifts the net export schedule to the right and this
shifts the IS curve to the right as in the figure below.
The shift in the IS curve tends to raise the exchange rate. To keep the
exchange rate at the fixed level, the money supply must rise, shifting
the LM curve to the right. Thus a trade restriction under a fixed
exchange rate system induces monetary expansion rather than an operation
in the exchange rate. The monetary expansion in turn increases aggregate
income. When income rises, saving also rises, and this improves an
increase in net exports.
5.6 The Mundell- Fleming Model with a Changing Price Level
So far we have been using the Mundell – Fleming model with study the
small open economy in the short run when the price level is fixed. To
examine price adjustment in an open economy, we must distinguish between
the nominal exchange rate e , which equals ep/p* . We can then write the
Mundell- Fleming model as
Y= C(Y-T) I(r) +G+NX (E)……………………………….IS M/P= L(r, Y)……………………………………………….LM
The figure below shows what happens when the price level falls. Because
a lower level raise the level of money balances, the LM shifts to the
right. The exchange rate depreciate and the equilibrium level of income
rises. The aggregate demand curve summarizes this income shifts the
aggregate demand curve to the right . Policies that lower income shift
the aggregate demand curve to the left.
