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20170906015241lecture_notes.pptx1
3) The Mundell-Fleming Model (IS-LM-FE)
International Finance
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In the 1960s and early 1970s
Orthodox (or neoclassical) economists were split between Monetarist economists (the minority, including Milton Friedman) and Neo-Keynesian economists (the majority, including Paul Samuelson)
Monetarists believed if central banks kept control of the money supply, they would control inflation; that the economy naturally tends towards full employment; that government should balance their budgets; and that exchange rates should float.
Neo-Keynesians believed economies could remain below full employment for a long time; that governments should run fiscal deficits when needed to achieve close to full employment; that monetary policy was not a reliable mechanism for controlling demand; and (in many but not all cases) preferred fixed exchange rates
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Introducing IS-LM (Neo-Keynesian)
The closed economy model of aggregate demand developed by John Hicks in the late 1930s, just after Keynes’ General Theory
It was the standard ‘working model’ used by economists when discussing macroeconomic policy from the 1940s to the 1980s. Some, like Krugman, prefer it to more recent models even now.
In the 1960s, Mundell and Fleming developed an open economy version (The ‘Mundell-Fleming’, or IS-LM-FE Model)
There are many things wrong with it. It is not used widely in modern orthodox macroeconomics, and people like me have even greater objections, but we need to take a look at it.
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Open Economy IS-LM
IS (G,Q, y*)
y
r
r0
y0
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‘Money Market Equilibrium’ (for a given real money supply)
‘Goods Market Equilibrium’ (for a given real exchange rate and fiscal policy)
‘Equilibrium’ in both markets
IS-LM-FE Model
An open economy version of the ‘Neo-Keynesian’ model, which dominated macroeconomics in the 1960s, but still frames the thinking of many modern economists.
The standard version is a ‘fixed price’ or short run model – the price level is held constant.
There is no role for expectations of changes in exchange rates, and so no currency crises.
It does allow for a comparison of the effectiveness of fiscal and monetary policies under fixed and floating exchange rates – the monetary model assumes only monetary policy matters, but the comparison is flawed and possibly misleading, as we shall see.
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Money Market Equilibrium
LM curve = locus of combinations of y and r for money market equilibrium, given a constant M/P (upward sloping and derived from the money market equilibrium diagram)
LM (M/P)
y
r
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Money market equilibrium diagram
M/P
L (r,y)
Rate of interest
Real Money Stock
r
Real money supply
Real money demand
For a constant real money supply, if y increases, so must r, to hold L constant.
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Goods Market Equilibrium
IS curve = locus of combinations of y and r for goods market equilibrium, given a constant G and Q (real exchange rate) [downward sloping and derived from output = expenditure].
IS (G,Q)
y
r
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Foreign Exchange Market Equilibrium with Perfect Capital Mobility
r
y
r*
If there were ‘perfect capital mobility, then since there are by assumption no expected changes in exchange rates, r must equal r*
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FE equilibrium with ICM
Imperfect capital mobility would mean risk aversion, home bias, or capital controls implied net capital flows would depend on (r-r*)
Higher y implies a higher demand for imports and trade deficit, so if E is constant, r must rise relative to r*, for an offsetting NKI, for foreign exchange market equilibrium
If E rises, FE shifts downwards.
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Foreign Exchange Market Equilibrium with Imperfect Capital Mobility
r
y
r*
y
Appreciation
Depreciation
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IS-LM-FE (PCM)
r
y
IS
LM
FE
y
r*
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IS-LM-FE (ICM)
r
y
IS
LM
FE (given E)
y
r
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r
y
IS0
LM0
FE
y0
r
Expansionary Fiscal Policy under Fixed Exchange Rates with PCM
IS1
0
1
2
LM1
y1
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r
y
IS0
LM0
FE (given E)
y0
r0
Expansionary Fiscal Policy under Fixed Exchange Rates with ICM
IS1
0
1
2
LM1
y1
r1
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Fiscal expansion with a fixed exchange rate
In the M-F model of a fixed exchange rate, fiscal expansion causes:
A net capital inflow
An increase in reserves, and in the domestic monetary base
An increase in income
A trade deficit
A rise in interest rates, provided capital is not completely mobile.
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r
y
IS
LM0
FE
y0
r
Expansionary Monetary Policy under Fixed Exchange Rates with PCM
0
1
2
LM1
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r
y
IS
LM0
FE (given E)
y0
r
Expansionary Monetary Policy under Fixed Exchange Rates with ICM
0
1
2
LM1
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Monetary expansion with a fixed exchange rate
In the M-F model of a fixed exchange rate, monetary
expansion causes:
A fall in foreign exchange reserves, which reduces the monetary base again, and offsets the monetary expansion. This happens, regardless of the level of capital mobility in this model.
With perfect capital mobility, it would happen instantaneously. With imperfect capital mobility, the expansion would be reversed gradually over time, as reserves fell.
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In summary
Under fixed exchange rates, in the Mundell-Fleming model, fiscal policy is highly effective under PCM and ICM (assuming the FE curve to be more interest-elastic than the LM curve)
Monetary policy is completely ineffective under PCM, and has only a temporary effect (at the cost of falling foreign exchange reserves, for an attempted monetary expansion) under ICM. This reminds us of ‘the impossibly trinity’.
When the economy moves off the FE curve, the central bank must intervene on the FE market to hold the exchange rate fixed, which changes the money supply and shifts the LM curve
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r
y
IS0
LM0
FE
y0
r*
IS1
0
1
2
Expansionary Fiscal Policy under Floating Exchange Rates with PCM
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r
y
IS0
LM0
FE0
y0
r0
Expansionary Fiscal Policy under Floating Exchange Rates with ICM
IS2
0
1
y1
r1
IS1
2
FE1
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Fiscal expansion with a floating exchange rate
In the M-F model of a floating exchange rate, fiscal expansion causes:
an appreciation in the exchange rate
an increase in income provided capital is not completely mobile (what if it were?)
a rise in the interest rate provided capital is not completely mobile (what if it were?)
a deterioration in the trade balance (current account towards deficit and capital account towards surplus)
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r
y
IS0
LM0
FE
y0
r*
Expansionary Monetary Policy under Floating Exchange Rates with PCM
0
1
LM1
IS1
2
y1
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r
y
IS0
LM0
FE0
y0
r0
Expansionary Monetary Policy under Floating Exchange Rates with ICM
0
1
LM1
FE1
IS1
2
y1
r1
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Monetary expansion with a floating exchange rate
In the M-F model of a floating exchange rate, an increase in the money supply causes:
a depreciation in the exchange rate
an increase in income
a fall in the interest rate, provided capital is not completely mobile (what if it were?)
an improvement in the trade balance (current account move towards surplus and capital account towards deficit)
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In summary
Under floating exchange rates, in the Mundell-Fleming model, fiscal policy is completely ineffective under PCM and less effective than in a closed economy under ICM (assuming the FE curve to be more interest-elastic than the LM curve)
Monetary policy is highly effective under PCM and under ICM. This reminds us of ‘the impossibly trinity’.
When the economy moves off the FE curve, the exchange rate changes. An appreciation shifts IS left and FE up. A depreciation shifts IS to the right and FE down.
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Treat these results with care
This model, like the Monetary Model (to come), ignores exchange rate expectations (or assumes that no future change is ever expected).
It also ignores the in practice horizontal LM curves of central banks pursuing interest rates targets (not controlling the money supply).
With horizontal LM curves, the model predicts fiscal policy is highly effective under floating exchange rates, with fiscal expansion causing a currency depreciation (not appreciation). Can you demonstrate this and explain it?
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A modern version – IS-MP
Romer and Mankiw, modern day ‘New Keynesian’ economists, have incorporated ‘endogenous money’ and a central bank setting a policy interest rates into the model, by renaming the LM curve the MP (monetary policy) curve.
Still slopes upwards – higher y implies a central bank reacts with higher r.
Otherwise, this model is IS-LM.
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What next?
The 1970s saw the breakdown of fixed exchange rates and a shift in macroeconomics towards the monetary model.
Neo-Keynesian economics lost influence, and in particular the active use of fiscal policy to manage demand went out of fashion.
Floating exchange rates proved more volatile than had been expected (by advocates of the Monetary Model)
Dornbusch’s Overshooting Model emerged as a compromise between IS-LM-FE and the Monetary Model.
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r
E
y
FE
