Mundell-Fleming Model in Open Economy

Mundell-Fleming Model Overview

• This model extends aggregate demand analysis to include international trade and finance dynamics.
• It serves as the primary framework for studying open-economy monetary and fiscal policies.
• Robert Mundell received the Nobel Prize in 1999 for his contributions to open-economy macroeconomics, including this model.

Key Assumption

• An important and extreme assumption is that the economy is a small open one with perfect capital mobility.
• The economy has unlimited access to borrowing and lending in global financial markets.
• The economy's interest rate is determined by the world interest rate (r = r*).
• r* is assumed to be exogenously fixed.
• If r < r*, there is capital outflow; if r > r*, there is capital inflow.

Goods Market Equilibrium (IS* Curve)

• Y = C (Y-T) + I (r*) + G + NX (e)

Nominal Exchange Rate (e)

• Expressed as foreign currency per unit of domestic currency.

Direct Quote Definition

• A foreign exchange rate quoted with fixed units of foreign currency and variable amounts of the domestic currency.
• The foreign currency is the base currency, while the domestic currency is the counter or quote currency.
• Example 1 $ = 18.60 TL
• Increase in the exchange rate means a decrease in value of currency.

Indirect Quote Definition

• Price of domestic currency expressed in terms of foreign currency.
• Amount of domestic currency received when one unit of foreign currency is sold.
• Example 1 TL = 0.054 $
• Decrease in the exchange rate means a decrease in value of the currency.

Cross-Currency Quote

• Involves two foreign currencies, or one not involving USD.
• 1 $ = 18.60 TL => $ / TL = 18.60, or 1 TL = 0.054 $ => TL / $ = 0.054

Exchange Rate Appreciation/Depreciation

• e ↑ (appreciation) => export prices (Xp) ↑ => exports (X) ↓, import prices (Mp) ↓ => imports (M) ↑, net exports (NX) ↓
• e ↓ (depreciation) => Xp ↓ => X ↑, Mp ↑ => M ↓, NX ↑

Real Exchange Rate (ε)

• Relates net exports to the relative price of goods at home and abroad, unlike the nominal rate.
• ε = e x (P/P*), where P is domestic and P* is the foreign price level.
• Mundell-Fleming assumes fixed prices at home/abroad, making the real exchange rate proportional to the nominal rate.

Impact of Price Level Changes

• (P/P*) ↑ => Xp ↑ => X ↓, Mp ↓ => M ↑, NX ↓
• (P/P*) ↓ => Xp ↓ => X ↑, Mp ↑ => M ↓, NX ↑

Terms of Trade (ToT)

• Calculated as Unit Export Price / Unit Import Price x 100.
• The base value is 100.
• If ToT > 100, foreign trade favors the country, indicating more imports for the same amount of exports.
• If ToT < 100, foreign trade is against the country, indicating less import for the same amount of exports.

LM* Curve

• M/P = L (r*, Y)
• Drawn for a given world interest rate (r*).
• Vertical shape indicates that with a given r*, only one income level (Y) equates money demand with supply, regardless of the exchange rate.

Sterilization

• Definition: Monetary action used by central banks to counter the effects of capital flows.
• Classical method: Involves open market operations.
• Capital inflows: Emerging markets can experience this when investors purchase domestic currency to buy domestic assets.
• Example: U.S. investor buys Turkish Lira (TL) to invest in Turkey -> TL value increases.
• Turkish central bank (CBRT) options: Allow fluctuation (price of Turkish exports increase) or buy foreign currency to decrease the exchange rate.
• Offsetting TL increase: Sell TL-denominated government bonds.
• When r > r*: foreign exchange intervention, demand for domestic currency, increase in "e", increase in Ms to buy foreign exchange and finally sterilization (offset increase in Ms)
• When r < r*: foreign exchange intervention, demand for foreign currency, decrease in "e", decrease in FX reserves to sell foreign exchange, to prevent depreciation in domestic currency

Equilibrium in Mundell-Fleming Model

• Y = C (Y-T) + I (r*) + G + NX (e)
• M/P = L (r*, Y)

Floating Exchange Rates

• Exchange rate (e) adjust based on changing economic conditions.

Fixed Exchange Rates

• Central bank trades domestic for foreign currency at a predetermined price.

Fiscal Policy Under Floating Exchange Rates

• Y = C (Y-T) + I (r*) + G + NX (e); M/P = L (r*, Y)
• Given "e", fiscal expansion shifts IS* to the right.
• Impact: Δe > 0, ΔY = 0
• In a small open economy with perfect capital mobility, fiscal policy cannot affect real GDP.
• Closed economy: Fiscal policy crowds out investment by causing the interest rate to rise and decreasing aggregate output (Y).
• Small open economy: Fiscal policy crowds out net exports by increasing the exchange rate (e) and decreasing aggregate output (Y).

Monetary Policy Under Floating Exchange Rates

• An increase in "M" shifts the LM* curve to the right because "Y" must rise to restore equilibrium.
• Y = C (Y-T) + I (r*) + G + NX (e); M/P = L (r*, Y)
• Impact: Δe < 0, ΔY > 0.

Output and Aggregate Demand: Monetary Policy

• Closed economy: Increase in Ms => decrease in r => increase in investment => increase in AE => increase in Y
• Small open economy: Increase in Ms => decrease in r => decrease in e => Decrease in Px; increase in Pm => Increase in X => Decrease in M => Increase NX => increase AE => increase in Y
• Expansionary monetary policy shifts demand from foreign to domestic products without raising world aggregate demand.

Trade Policy Under Floating Exchange Rates

• A tariff or quota reduces imports and increases net exports (NX), shifting IS* to the right.
• Given "e", a trade restriction shifts the NX curve outward: Increase exchange rate.
• Impact: Δe > 0, ΔY = 0

Impact of Trade Policy

• Import restrictions don't reduce trade deficit.
• Reduced Trade means fewer gains from trade which restricts imports while appreciation reduces exports
• Though no change to NX, there is less trade
• Trade restrictions save domestic jobs but destroy export jobs, creating sectoral shifts that cause frictional unemployment.
• Import restrictions fail to increase total employment.

Fixed Exchange Rates: Central Bank Role

• The central bank buys/sells domestic currency for foreign currency at a set rate.
• It shifts the LM* curve to maintain a pre-set exchange rate (e).
• Nominal exchange rate is fixed, but real exchange rate can fluctuate long-term with flexible prices.

Fiscal Policy Under Fixed Exchange Rates

• Because the fiscal expansion causes the exchange rates to rise, the central bank sells foreign currency and increases "M" to shift LM* to the right.
• Impact: Δe = 0, ΔY > 0
• Under floating rates, fiscal policy is ineffective at changing output; but under fixed rates it is very effective.
• Fiscal policy can be effective at changing output in a closed economy

Monetary Policy Under Fixed Exchange Rates

• Increase in M shifts LM* right, central bank buys foreign currency to prevent the falls of "e", and reduces M to shift LM* to the left.
• Impact: Δe = 0, ΔY = 0
• Under floating rates, monetary policy is very effective at changing output
• A closed-economy monetary policy is effective at changing the output.
• Under fixed rates, monetary policy cannot be used to affect output

Trade Policy Under Fixed Exchange Rates

• A restriction on imports puts upward pressure on e.
• The central bank sells domestic currency, increases "M" and shifts LM* to the right to keep 'e' from rising: increase in money and decrease in exchange rate
• Impact: Δe = 0, ΔY > 0
• Under floating rates, import restrictions don't affect Y/NX, but under fixed rates, import restrictions increase Y/NX.
• These gains shift demand from foreign to domestic goods at the expense of other countries.

Interest Rate Differentials

• Rates (r) differ from r* due to country risk and expected exchange rate changes.
• Country risk is the risk of borrowers defaulting due to political/economic turmoil.
• To compensate this risk, lenders need a higher interest rate.
• Expected exchange rate changes occur if a country's exchange rate is expected to fall
• To compensate this currency depreciation, borrowers must pay a higher rate.

Differentials in Mundell-Fleming

• r = r* + θ, with θ (Greek letter theta) as a risk premium assumed to be exogenous/external.
• IS* Equation: Y = C (Y-T) + I (r* + θ) + G + NX (e)
• LM* Equation: M/P = L (r* + θ, Y)

Impossible Trinity

• A nation can only have 2 of 3 options: Free Capital Flows, Independent Monetary Policy, and Fixed Exchange Rate

Big Mac Index

• Provides a measure of whether current exchange rates are at equilibrium
• Big Mac in TR is shown is above the world average in dollar terms

Aggregate Demand Curve in Mundell-Fleming Model

• P ↑ => (M/P) ↓ => LM shifts left => ε ↑ => NX ↓ => Y ↓
• AD curve has a negative slope

Short-Run to Long-Run Transition

• If Y₁ < Ỹ, there is downward pressure on prices.
• Over time, P decreases, causing (M/P) ↑, ε ↓, NX ↑, and Y ↑