Transcript Chapter 13

Chapter 13
The Mundell-Fleming Model
The Mundell-Fleming Model
• The M-F model is an extension of the IS/LM
model to include joint determination of net
exports and the value of the currency. Inflation
and inflationary expectations are still assumed to
be stable.
• The overall result of this model shows that fiscal
stimulus is likely to have little effect on the value
of the currency but reduce net exports, while
monetary stimulus is likely to have little effect on
net exports but reduce the value of the currency.
Mundell-Fleming Model, Slide 2
• The model thus suggests that a combination of
fiscal expansion and monetary contraction would
boost the value of the currency and reduce net
exports.
• Conversely, fiscal contraction and monetary
expansion would boost net exports and reduce
the value of the currency.
• The problem with this model is it does not take
expectations into account. In particular, if fiscal
contraction is accomplished by tax increases,
the dollar would rise far less than if it were
accomplished by reduced government spending.
How the Model Works
• To understand the M-F model, return to the I = S
identity, which can be written as:
• Domestic Saving – Investment = Current
Account Balance (which is the negative of net
foreign saving)
• If foreign saving rises – i.e., if the current
account deficit rises – then investment can rise,
consumers can spend more, or the government
can run a bigger deficit. To turn it around, if the
government deficit increases, investment
declines, domestic saving rises, or foreign
investors pick up the tab -- if they are willing.
Fiscal Expansion
• With that in mind, consider an increase in the
budget deficit. Assume for the moment that
inflationary expectations are unchanged. As
shown in the IS/LM diagram, two things happen.
First, income rises, which reduces net exports.
Second, interest rates rise, which attracts more
foreign capital and boosts the value of the dollar,
but that gain may be offset by the reduction in
net exports. Hence the value of the currency
probably will not change very much.
Monetary Easing
• Now consider monetary easing. Interest
rates decline, which reduces the value of
the dollar. Real income increases, which
boosts imports, which also reduces the
value of the dollar. The lower value of the
dollar raises exports and offsets some of
the gain in imports, so net exports may not
change very much.
The M-F Model Under Reagan and
Clinton
• According to this model, the combination of
fiscal ease and monetary tightness in the early
1980s under Reagan would have resulted in a
sharply higher dollar and a big decline in net
exports. That is precisely what happened.
• However, the fiscal contraction and monetary
ease during the Clinton era would have resulted
in a lower dollar and an increase in net exports,
which is not what happened. Instead, the
opposite happened: the dollar strengthened and
net exports declined, the same as in the early
1980s.
The Role of Expectations
• This is where expectations play a major role. Under
Reagan, business and investor optimism increased
because it was expected that the tax cut would stimulate
economic growth, which indeed turned out to happen.
• Under Clinton, business and investor optimism increased
after 1994, when the Republicans gained control of
Congress, because of expectations that the reductions in
government spending would stimulate economic growth,
which was also the case. Note that the dollar declined
during the first two years of the Clinton Administration, as
the initial tax increases did not boost confidence.
The Repercussion Effect
• When the U.S. economy improves, imports rise.
That means exports of other countries rise, and
their GDP increases. As a result, they buy more
from the U.S., so after a lag of about one year,
U.S. exports rise.
• Consider the case of fiscal stimulus, which
diminishes U.S. net exports. The next year, the
increase in world growth boosts U.S. exports, so
some of the initial drop in net exports is offset.
The dollar remains relatively unchanged.
The Depreciation Effect
• Suppose the Treasury decides to devalue the currency.
Initially, net exports rise. However, inflation also rises, a
factor not included in the M-F model. Foreign capital
flees the country – in some cases, before the
devaluation occurs.
• Now consider the basic I = S identity. If foreign saving
drops, either domestic saving must rise – meaning less
consumption – or investment must fall. Both of these are
contractionary, and usually offset the expansionary
impact of higher net exports. As a result, depreciation
often leads to a decline rather than an increase in the
real growth rate.
The concept of forced saving
• Higher inflation redistributes income away from
poorer consumers, who do not save very much
in any case, to businesses, who benefit from
devaluation because their exports rise, and who
do save. That fills the gap – but at the expense
of reducing the standard of living for most
consumers. That is usually what happens after
devaluation. Thus the drop in foreign saving is
paid for by increased saving through income
redistribution from poor to rich.
Shifts Caused by Changes in
Productivity
• An increase in productivity will boost
aggregate demand, but at the same time
will reduce the rate of inflation.
• Thus the rise in income will raise imports,
but the lower rate of inflation will raise
exports, so in this case, faster productivity
growth may not be accompanied by a
widening trade deficit.
Economic Impact of a Change in
Net Exports
• As shown throughout this part of the text,
a rise in net exports does not necessarily
boost GDP. Four cases are considered
under which net exports would rise.
• 1. Foreign growth rises
• 2. Domestic growth shrinks
• 3. Lower inflation
• 4. Weaker currency
Foreign Growth Rises
• . The IS curve moves out and real growth
increases. There will be virtually no
impact on inflation, because the goods are
being sold to export markets: if costs and
prices did rise, then the gain in exports
would quickly disappear. Both real GDP
and net exports improve.
Domestic Growth Shrinks
• This will boost net exports, but has its
obvious drawbacks. The IS curve shifts
back, reducing real growth; private sector
agents reduce their purchases of both
domestic and foreign goods and services.
Lower Inflation
• Exports will rise because the cost of
production has fallen, assuming the ceteris
paribus condition of no change in the
value of the dollar. Since domestic goods
cost less, either imports will decline, or
foreign firms will have to cut their prices as
well.
Weaker Currency
• . At first glance this might seem to be
similar to case (3) in the sense that the
cost of production declines relative to
foreign countries. In this case, however,
the gain in net exports is caused by
devaluing the currency, which is
inflationary.
Long-Term Effects
• The key difference is that in cases (1) and (3),
when positive developments occur – faster world
growth or lower inflation – there is virtually no
repercussion effect. In cases (2) and (4) when
negative developments occur – lower growth or
higher inflation in the U.S. – the repercussion
effect is substantial. Hence these cases
reemphasize the importance of a healthy U.S.
economy for robust worldwide growth.
Economic Impact of Devaluation
• If wages and prices rise by the same amount as
the currency is devalued, the standard of living is
unchanged. However, foreign saving falls,
investment is decreased, and the standard of
living rises less rapidly.
• If wages and prices rise by less than the drop in
the currency, the standard of living declines.
• In the long run, devaluation never has a positive
impact – unless the currency had been
overvalued and is returning to equilibrium. At
best, it serves as a wake-up call for the country
to get its domestic affairs in order
Summary comments on
devaluation
• Just as there is “no free lunch”, in the long
run, countries cannot boost growth by
devaluing the currency any more than they
can boost growth by increasing
government spending or printing more
money. Indeed, by reducing foreign
capital inflows, devaluations invariably
reduce capital formation and the overall
growth rate.