The Mundell-Fleming Model - the Internal and External Balance - Case Study Example

Topic: "in conditions of perfect capital mobility and floating exchange rate, fiscal policy is likely to be ineffective, while monetary policy may be effective in achieving internal and external balance "- explain with reference to the Mundell-Fleming model Instructions: Mundell-Fleming model is a key part of the approach to this question, it is used in the context of small economics that have significant trade and capital flows with other countries. please structur ethe explanation of teh scenarios outlined in the quote and particularly the workings of fiscal and monetary policy. The Mundell-Fleming Model: The impact of fiscal and monetary policies on the internal and external balance. Introduction This paper shall discuss the Mundell-Fleming Model as applied to a specific condition of floating exchange rates in an open small economy and perfect capital mobility, with special attention to how fiscal and monetary policies impact the macroeconomy. The writer shall attempt to test and explain the proposition that “fiscal policy is likely to be ineffective, while monetary policy may be effective, in achieving internal and external balance. " The Mundell-Fleming model uses the Hicksian IS and LM framework to analyze the effectiveness of fiscal and monetary policies for small open economies under fixed and flexible exchange rates, assuming perfect capital mobility. The seed of the model is found in his published article (Mundell 1962), which later appeared in his book in 1968 and a collection of macroeconomics essays in 1970. An attempt will be made to discuss some basic concepts relevant to the topic with the aim of leading the reader towards a clearer understanding of the premises and the relationships that underpin the effectiveness, or lack thereof, of fiscal and monetary policies in bringing about the desired changes that would result in an internal and external balance. Basic Concepts The problem faced by many economies concerns the achievement of internal stability and balance of payments equilibrium. Mankiw (1997) defines stabilization policy as public policy aimed at keeping output and employment at their natural rate levels. Fiscal and monetary policy can be used as instruments to attain these objectives if capital flow responds to differences in interest rates among the economies. An appropriate policy mix should be one where a country with balance of payments surplus and facing inflationary pressures will attempt to ease the monetary situation through selling in open market operations and at the same time raising taxes, thereby reducing money supply. A deficit country with unemployment problem or less than full employment will reduce interest rates and lower taxes or increase government spending. According to Mundell (1962) internal balance requires that aggregate demand for domestic input be equal to aggregate supply at full employment. Such balance is required because there can be either inflationary pressure or recessionary potential. In the former case it means aggregate demand exceeds aggregate supply; and with regard to the latter, the converse case holds. During the state of disequilibrium, inventories are running short where demand exceeds supply, or they are accumulating where supply exceeds demand. Maschek (2002) states that internal balance occurs when output is at full employment. Krugman and Obstfeld (1991) maintain that a country is in internal balance when its productive resources are fully employed and its price level is stable. External balance, according to Mundell (1962) implies that the balance of trade equals net capital exports at the fixed exchange parity. If the balance of trade exceeds capital exports, there will be a balance of payments surplus and a tendency for the currency to appreciate. If the balance of trade is less than capital capital exports, there will be a deficit, with the corollary tendency of the currency to depreciate. In the case of a BOP surplus the central bank normally accumulates foreign exchange (e.g., in the case of the UK, the purchase of US dollars, which reflects the sale of British pounds, thus correcting the tendency of the British pound to appreciate.) In the case of a balance of payments deficit, the central bank will sell foreign exchange, thereby supporting the British pound by buying it. Another view of external balance is that it occurs when balance of payments is close to balance (BOP = 0) (maschek 2002). The central bank buys or sells reserves, as the case may be, in order to maintain a target exchange rate. In order for a government to conduct an internal stabilization policy, it is necessary to use its taxing and spending powers to influence the aggregate demand side of the economy. Its fiscal policy is its plan for spending and taxation designed to steer demand in some desired direction. Active stabilization policy can be implemented through the employment of means that tend to expand the size of government through its expenditures and taxes, or reduce the size of government by the same means. The net effect on a governments fiscal policy on aggregate demand depends on whether the expansionary effects of government spending are greater (or smaller) than the contractionary effects of its taxes. However, while expansionary fiscal policy can attempt to check recessions, it normally is accompanied by higher. inflation. The government can also significantly influence aggregate demand through the use of monetary policy, particularly on interest rates as well as the level of investment and aggregate demand. The governments central bank is an independent body that determines monetary policy. It uses mainly three methods to control money supply: 1) open market operations, 2) reserve requirements, and 3) and lending policy through its discount window. Of these three, the most frequently used is open market operations. The central bank (the Bank of England in UK) increases money supply by purchasing government securities (Treasury bills, notes or bonds) in the open market, thus providing banks with reserves; on the other hand, money supply is reduced by the sale of government securities. Also, when the central bank buys bonds, bond prices rise and interest rates fall; and when it sells bonds, bond prices fall and interest rates rise. The central bank can also allow banks to borrow at low interest rates or reduce reserve requirements in order to increase money supply. According to the Keynesian model, raising the money supply leads to lower interest rates, which stimulate investment spending, which because of the multiplier, raises aggregate demand. Investment spending responds, whether business spending or new housing, responds to interest rates: Investment is lower when the interest rate is higher; and it is higher when interest rate is lower (See Mankiw 1997). The Mundell-Fleming Model: General Description. Authorities and writers on the model, Mankiw (1997) in particular, say that Mundell-Fleming Model as the IS-LM model for a small open economy. Both models assume that the price level is fixed and then show what causes fluctuations in aggregate income. Both stress the interaction between the goods market and the money market. The key difference is that the IS-LM model assumes a closed economy whereas the Mundell-Fleming model assumes a small open economy. The study of the model involves an assumption of fixed exchange rates, and its comparison with a floating exchange rates. Three equations make up the model: Y = C(Y – T) + I(r) + G + NX(E) IS M/P = L (r, Y) LM r = r* The first equation (IS) describes the goods market: It shows that the aggregate income Y is the sum of Consumption C, investment I, government purchases G, and net exports NX. Consumption depends on Income less tax. Investment depends, negatively, on interest rate r, and net exports depend, negatively, on the exchange rate e. When nominal exchange rate rises, foreign goods become less expensive compared to domestic goods, therefore exports fall and imports rise (See Mankiw 1997, among others, for graphical illustrations). The second equation describes the money market. It says that the supply of real money balances M/P equals demand L (r, Y). The third equation says the the world interest rate r* determines domestic interest rate r. In the graphical presentation of the Mundell-Fleming model, where the exchange rate is the vertical axis and and the output is the horizontal axis, the LM* curve is vertical while the IS* (goods market equilibrium condition) curve is downward sloping. The intersection between LM and IS shows the equilibrium level of income and the equilibrium exchange rate. Having stated the fundamental equation and the equilibrium given in this model, the writer now turns to the application of the model to real world under a flexible or floating exchange rates. With regard to fiscal policy, if the government attempts to stimulate spending by increasing purchases or cutting taxes, the IS curve shifts to the right, which would raise the exchange rate but leaving income unchanged. In a small open economy assumed by the model, r is fixed at r*, so there is only one level of income. The appreciation of the exchange rate and the fall in the net exports must fully offset the expansionary impact of the fiscal policy. With regard to monetary policy, a monetary expansion shifts the LM* curve to the right , thereby lowering the exchange rate at the equilibrium point, and raising income. In a small open economy the interest rate is fixed at r*, the world interest rate. As soon as increased money supply puts downward pressure on the domestic interest rate, capital flows out as investors seek higher returns abroad, and this prevents domestic interest from falling. The exchange rate also depreciates, making domestic goods cheaper than foreign goods and improving net exports. In this context, monetary policy influences income by altering the exchange rate rather than the interest rate. This scenario contrasts with the closed economy where an increase in money supply lowers the interest rate, stimulating investment. Implications of flexible exchange rates and perfect capital mobility The first implication is that any current account deficit must be financed by private capital inflows, and that a current account surplus is balanced by capital outflows. Adjustments in the exchange rate ensure that the sum of the current and capital account equal zero. Under fixed exchange rate regimes, balance of payments surplus/deficits are financed using market intervention by the central bank (Maschek n.d.). A second implication of flexible exchange rates is that the monetary authority is now free to set the level of money supply. There is no longer a link between monetary policy and the balance of payments. Perfect capital mobility ensures that there is only one interest rate at which the balance of payments will balance. At any other interest rate, capital flows into or out of the economy. This pushes the economy into balance of payments surplus or deficit. A surplus puts pressure on a currency to appreciate. Balance of payments deficits put pressure on a currency to depreciate. The currency appreciation decreases net exports. Summary In a seminal essay by Mundell (1962), he said that a policy system in which interest rate is used for internal stability and fiscal policy is used for external equilibrium is an unstable system. To prove his point, Mundel stated a case where a balance of payments deficit is coupled with full employment. To correct this deficit with fiscal policy, the budget surplus will have to be raised, but this will create recessionary pressure and unemployment. To prevent the latter unfavorable situation, monetary policy would lower interest rates, but again this will cause a balance of payments deficit, repeating the need for a budget surplus. The conclusion to be drawn from this argument is that monetary policy should be used for external balance, and fiscal policy for internal equilibrium. In summary, the net effect of fiscal expansion under the Mundell-Fleming model assuming floating exchange rates and perfect capital mobility is that it causes an appreciation of the exchange rate but does not affect income. Net exports drop as a result of currency appreciation where imports become cheaper. Under a fixed exchange rate, however, fiscal expansion increases output but does not affect (or has no relevance in respect of) the exchange rate or net exports.(See Mankiw 1997) The net effect of monetary expansion under the model assuming floating exchange rates and perfect capital mobility is that it causes an increase in both income (or output) and net exports, but causes a decline in the exchange rate. Under a fixed exchange rate regime however, monetary policy is completely irrelevant – that is, it has no influence on income, the exchange rate, and net exports. To reiterate, a fiscal policy of expansion will cause the appreciation of a currency and a decline in net exports but will have no effect on income. Only monetary policy can affect income and net exports in a positive manner. It is perhaps in this context that the proposition – that fiscal policy is likely to be ineffective, while monetary policy may be effective, in achieving internal and external balance – finds its basis. BIBLIOGRAPHY Baumol, WJ & Blinder AS 2001, Macroeconomics: Principles and policy, 8th edn., Harcourt College Publishers, Orlando , FL Case, KE & Fair, RC 2002, Principles of Macroeconomics, Prentice Hall, Upper Saddle River, NJ Krugman, PR & Obstfeld, M 1991, International economics:Theory and practice, HarperCollins, New York Liang-Shing Fan & Chuen-Mei Fan, 2002, The Mundell-Fleming Model Revisted, American Economist, vol. 46, Mankiw, NG 1997, Macroeconomics, 3rd edn, Worth Publishers, NY Maschek, MK, n.d. Mundell-Fleming model of open economies with perfect capital mobility, viewed 10 April 2009 at http://www.sfu.ca/~cfu/LECTURE.pdf Mundell, RA 1962, The appropriate use of monetary and fiscal policy for internal and external stability, in W.L.Smith and R.L. Teigen, eds., Money, national income, and stabilization policy, 1970, Richard Irwin, Inc., Homewood, IL Read More