Fixed Exchange Rate and Mundell-Fleming Model - Essay Example

In order to derive the pros and cons of fixed and flexible exchange rates, the article describes the Mundell Fleming model with perfect capital mobility under fixed and flexible exchange rate and the Dornbush model. Fixed exchange rate and Mundell-Fleming Model When the capital is perfectly mobile between countries, a slightest interest rate differential will initiate a huge capital inflow or outflow. Under fixed exchange rate regime, the central bank of a country cannot use independent monetary policy as a policy measure. (Obstfeld and Stockman, 1985) Suppose the central bank of a country under perfect capital mobility and fixed exchange rate increases the money supply. With increased supply of money, people will transform that non interest-bearing asset, money into interest bearing assets, bonds. Therefore, the demand for bonds will rise. That will lead to an increase in bond price. (Obstfeld and Rogoff, 1984) Due to the inverse relationship between bond price and market rate of interest, the market rate of interest will fall. This fall in market rate of interest will be followed by a huge capital outflow. Now, same amount of domestic money will run after less amount of foreign currency resulting in domestic currency depreciation. To maintain the domestic currency at a fixed level, the central bank will have to sell its foreign currency reserve in exchange of domestic money. This phenomenon will lead to a contraction in money supply and it will continue till the market rate of interest rises to its initial level, that is, till the initial expansionary monetary policy gets fully crowded out. (Obstfeld, 2000) From the above, it is clear that the monetary policy will be fully ineffective under fixed exchange rate regime. Now, if the government chooses a fiscal expansion through a rise in government expenditure, then income rises. With a rise in income, transaction demand for money increases. With a rise in transaction demand for money, people will sell bonds in order to meet that increased transaction demand. So, bond supply will rise, bond price will fall and market rate of interest will rise. With the increase in market rate of interest a huge capital inflow will occur, resulting in a currency appreciation. In order to maintain the fixed exchange rate the central bank will purchase that extra supply of foreign exchange. It will result in an increase in money supply, increasing the demand for bond, which will eventually lower the initial rise in interest rate to its initial level. However income will be higher than the initial level. So fiscal policy will be fully effective. Flexible exchange rate and Mundell-Fleming Model Under flexible exchange rate regime, the central bank does not intervene into the following exchange rate market. The exchange rate is clearly determined by the market forces. Under flexible exchange regime, absence of intervention on behalf of the central bank implies a zero balance of payment. A current account deficit or surplus is balanced by private capital inflow or outflow. The exchange rate adjusted in this manner ensures that the sum of current and capital account if zero. (Friedman, 1954) Let us assume that the central bank of a country has taken an expansionary monetary policy. As explained above, it will result in exchange rate depreciation for the domestic currency. Now the central bank does not have any headache to maintain the exchange rate at a certain level. Due to this depreciation of domestic currency, volume of export will be increased, as domestic goods are now relatively cheaper than foreign goods. (Mundell, 1963) Similarly, volume of import will fall. This increase in net exports will result in a rise in income for the domestic residents. This rise in income will lead to an increase in transaction demand for money. Thus, people will sell bonds to meet that increased transaction demand for money. Supply of bonds will rise and so its price will fall. Again, due to the inverse relationship between the bond price and market rate of interest, market rate of interest will rise. This will continue till the initial fall in market rate of interest gets fully crowded out. However income will be set at a higher point than the initial level. (Obstfeld and Rogoff, 1984) Now, if the government restores to an expansionary fiscal policy, it will result in an initial rise in income. So transaction demand for money will rise. To meet this excess demand for transaction people will sell bond. That will lead to a fall in the price of bond and eventually a rise in market rate of interest. Under perfect capital mobility, a huge capital inflow will occur. Therefore domestic currency will appreciate. Demand for export will fall and that for import will rise, resulting in a fall in net export that will lower the domestic income to its initial level. This decrease in domestic income will result in falling transaction demand and increased demand for bond. So bond price will rise and the market rate of interest will fall to its initial level as well. So far what we have analyzed using the Mundell-Fleming model indicates the reservation of both fixed and flexible exchange rates. From the viewpoint of a policymaker, monetary policy will be fully ineffective under fixed exchange rate regime while fiscal policy will be fully effective. On the other hand under flexible exchange rate regime, monetary policy will be fully effective and fiscal policy fully ineffective. So both the exchange rate regime have their own set up pros and cons. (Obstfeld and Rogoff, 1995) The Dornbush Model The Dornbush model may be considered as a hybrid model, which is featured in the short run as Mundell-Fleming model and in the long run, as the monetary model. Dornbush model is characterized by the dichotomy between the speeds of adjustment in goods’ market. And financial markets. The goods market adjusts slowly while the financial market adjusts spontaneously. In Dornbush model, the long run equilibrium is characterized by the equality between aggregate demand supply. In the long run, domestic and foreign interest rates remains at the same and the equilibrium real exchange rate clear the balance of payment, that is, there is of surpus or deficit in the balance of payments. If I consider a monetary expansion in Dornbush model, the adjustment process follows as – The long run equilibrium will be on the vertical supply curve as aggregate demand is equal to aggregate supply in the long runs and aggregate supply is constant in the long run. As the world’s rate of interest (r*) has not changed, so in the long rug equilibrium, r=r*, where r is the domestic interest rate. To ensure that increase in money supply requires a proportional increase in price level (it implies that the IS and LM curve will also go back to her initial equilibrium level.). As the IS curve depends slowly and only on the real exchange rate, IS curve goes back to its original equilibrium level. Therefore, real exchange rate returns to its original exchange rate. (Dornbusch, Fischer, and Samuelson, 1977) It was the Dornbush model that kept the Mundell Fleming model popularized for a long time and breathed a new life into it. He was amongst the first to introduce rational expectations in the international macroeconomic scenario. Next he combined the idea of rational expectation with sticky prices theory. His treatment contrasted the canonical Mundell Fleming model, which gave the basic structure for the analysis of Dornbush model. In Mundell Flaming model the domestic level of price was considered fixed and wealth accumulation would only be responsible for any dynamics in the model. Dornbush sues a price adjustment mechanism. The model was lucrative to the policy makers now and the concept of exchange rate overshooting in response to monetary shock was introduced on grounds of rationality. Besides Dornbush’s model was elegant, useful and path breaking and gave a new dimension to the Mundell Fleming model. Quoting from Krugman: “Rudi was, first of all, the economist who the modern world. The workhorse of pre Dornbusch open-economy macro, the Mundell-Fleming model, was a fine thing.. But it didn’t capture the volatility of a floating-exchange rate world, the way currencies can soar or plunge not because big things have already happened, but because things are expected to happen.. Rudi’s famous “overshooting” paper changed it all…” (“Models of Exchange Rate Determination: Lecture 1”, 2006) The impact – effect: Owing to the liquidity effect increase in money supply is accompanied a decrease in domestic interest rates. This decrease in domestic interest rates happens to accommodate the excess supply of real money balance. This excess supply happens due to the sticky prices. (Obstfeld and Rogoff, 1976) The uncovered parity points to the fact that the following domestic interest rate mode is possible only if there is an equilibrating change in the nominal exchange rate. The household expectation regarding the nominal exchange rate movement along the long run equilibrium path indicates an appreciation that is necessary for that the household can keep the domestic assets in their portfolio. To generate that expectation of appreciation the nominal exchange rate over depreciates. It helps to bring the expectation of appreciation in near future. This depreciation in nominal exchange rate results in the downward movement of the IS curve. The excess demand for goods and services lead to a rise in the price level in the domestic economy. That will further lead to a loss in comparative advantage. Moreover the increase in price level reduces the real (money) balance, shifting the LM curve backwards to its predisturbance level. This process leads to an appreciation of real interest rate. Finally, along this adjustment path, the nominal exchange rate appreciates at a diminishing rate shifting the IS curve back to its initial position that reduces the current account surplus and equilibrium is restored. The Dornbush model explains the reasons behind the high fluctuation and volatility usually embedded in the flexible exchange rate regime. (Dornbusch, 1976) Conclusion: The fixed and the flexible exchange rate regime have their own set of advantages and disadvantages. Exchange rate changes often behave like a tax imposed on trade and on the investment in traded goods industry. Although this risk can be hedged, it requires knowledge of the size of foreign currency exposure. Another argument that got fixed rates may originate from here. A change in rate gives rise to protectionist pressures and thus prevents the realization of gains from trade. (Obstfeld and Rogoff, 1983) A fixed exchange rate helps in neutralizing monetary shocks. A nation with fixed exchange rate system will keep the shocks under control by practicing import and export of money during shifts in demand and supply. Some central banks, which are incompetent, might borrow credibility from other banks with the help of balance in your account. It has also been argued that fixing the exchange rates help in achieving an immediate fall in inflation in a nation. In absence of fixed exchange rate, the inflation induces depreciation of domestic currency, which further initiates inflation. Due to these complexities associated with both fixed and flexible exchange rates, most of the nations pursue a managed float kind of exchange rate system. References: Dornbusch, Rudiger, Stanley Fischer, and Paul Samuelson, 1977, "Comparative Advantage, Trade, and Payments in a Ricardian Model with a Continuum of Goods," American Economic Review, Vol. 67 (5), pp. 823-39. Dornbusch, Rudiger, 1976, "Expectations and Exchange Rate Dynamics," Journal of Political Economy, Vol. 84, pp. 1161-76. -, 1976b, "Exchange Rate Expectations and Monetary Policy," Journal of International Economics, Vol. 6, pp. 231-44. Friedman, Milton, 1953, "The Case for Flexible Exchange Rates," In Essays in Positive Economics, pp. 157-203. (Chicago: University of Chicago Press). “Models of Exchange Rate Determination: Lecture 1”, 2006. retrieved on November 15, 2007 from: http://my.liuc.it/MatSup/2006/F83523/liuc%20lezione%201%202006.pdf Mundell, Robert, 1963, "Capital Mobility and Stabilization Policy under Fixed and Flexible Exchange Rates," Canadian Journal of Economics, 29, pp. 475-485. Obstfeld, Maurice, and Alan Stockman, 1985, "Exchange-Rate Dynamics," R. Jones and P. Kenen (eds.), Handbook of International Economics, Vol. 2. (Amsterdam: North-Holland) Obstfeld, Maurice and Kenneth Rogoff, 1983, "Speculative Hyperinflations in Maximizing Models: Can We Rule Them Out?" Journal of Political Economy, 91, (August) pp. 675-687. -, 1984, "Exchange Rate Dynamics with Sluggish Prices under Alternative Price-Adjustment Rules," International Economic Review 25 (February), pp. 159-174. -, 1995, "Exchange Rate Dynamics Redux," Journal of Political Economy, 103, pp. 624-660. -, 1995, "The Mirage of Fixed Exchange Rates," Journal of Economic Perspectives, 9, pp. 73-96. -, 1996, Foundations of International Macroeconomics (Cambridge, Massachusetts: MIT Press). Obstfeld, Maurice, 2000, "International Macroeconomics: Beyond the Mundell-Fleming Model," IMF Staff Papers, Vol. 47, Special Issue. 1st Annual Research Conference, Mundell-Fleming Lecture. Read More