The MundellFleming Model

Introduction:
When conducting monetary and fiscal policy, policymakers often look beyond their own countrys borders. Even if domestic prosperity is their sole objective, it is necessary for them to consider the rest of the world. The international flow of goods and services and the international flow of capital can affect an economy in profound ways. Policymakers ignore these effects at their peril. The model developed to study this, called the MundellFleming model, is an open-economy version of the ISLM model. The key difference is that the ISLM model assumes a closed economy, whereas the MundellFleming model assumes an open economy.

The Key Assumption: Small Open Economy With Perfect Capital Mobility
Mundell-Fleming begins with the assumption of a small open economy with perfect capital mobility. This assumption means that the interest rate in this economy r is determined by the world interest rate r*. Mathematically, we can write this assumption as r = r*. This world interest rate is assumed to be exogenously fixed because the economy is sufficiently small relative to the world economy that it can borrow or lend as much as it wants in world financial markets without affecting the world interest rate. Imagine that some event were to occur that would normally raise the interest rate (such as a decline in domestic saving). In a small open economy, the domestic interest rate might rise by a little bit for a short time, but as soon as it did, foreigners would see the higher interest rate and start lending to this country. The capital inflow would drive the domestic interest rate back toward r*. Similarly, if any event were ever to start driving the domestic interest rate downward, capital would flow out of the country to earn a higher return abroad, and this capital outflow would drive the domestic interest rate back upward toward r*. Hence, the r = r* equation represents the assumption that the international flow of capital is rapid enough to keep the domestic interest rate equal to the world interest rate.

The Goods Market and the IS* Curve

The MundellFleming model describes the market for goods and services much as the ISLM model does, but it adds a new term for net exports. In particular, the goods market is represented with the following equation: Y = C + I + G + NX This equation states that aggregate income Y is the sum of consumption C, investment I, government purchases G, and net exports NX. Consumption depends positively on disposable income Yd. Investment depends negatively on the interest rate, which equals the world interest rate r*. Net exports depend negatively on the exchange rate e. That is, when the nominal exchange rate appreciates (say, from 100 to 120 yen per dollar), foreign goods become cheaper compared to domestic goods, and this causes exports to fall and imports to rise. We can illustrate this equation for goods market equilibrium on a graph in which income is on the horizontal axis and the exchange rate is on the vertical axis. This curve is shown in panel (c) of Figure and is called the IS* curve. The new label reminds us that the curve is drawn holding the interest rate constant at the world interest rate r*. The IS* curve slopes downward because a higher exchange rate reduces net exports, which in turn lowers aggregate income, as shown in figure.

AS Expenditure (b) AD NX AD*

Y2 (a) (c)

Y1

e2

e2

e1

e1 IS*

NX (e2)

NX (e1)

Y2

Y1

Explanation:
The IS curve is derived from the net-exports schedule and the Keynesian cross. Panel (a) shows the net-exports schedule: an increase in the exchange rate from e1 to e2 lowers net exports from NX (e1) to NX (e2). Panel (b) shows the Keynesian cross: a decrease in net exports from NX (e1) to NX (e2) shifts the planned expenditure (AD) schedule downward and reduces income from Y1 to Y2. Panel (c) shows the IS* curve summarizing this relationship between the exchange rate and income: the higher the exchange rate, the lower the level of income.

The Money Market and the LM* Curve

The MundellFleming model represents the money market with an equation that should be familiar from the ISLM model, with the additional assumption that the domestic interest rate equals the world interest rate: M/P = L (r*, Y).

This equation states that the supply of real money balances, M/P, equals the demand, L(r, Y ).The demand for real balances depends negatively on the interest rate, which is now set equal to the world interest rate r*, and positively on income Y. The money supply M is an exogenous variable controlled by the central bank, and because the MundellFleming model is designed to analyze short-run fluctuations, the price level P is also assumed to be exogenously fixed. We can represent this equation graphically with a vertical LM* curve, as in panel (b) of Figure below.

(a) Interest rate LM

r = r*

Output (b) e LM*

Output

Explanation:
Panel (a) shows the standard LM curve [which graphs the equation M/P = L(r, Y)] together with a horizontal line representing the world interest rate r*. The intersection of these two curves determines the level of income, regardless of the exchange rate. Therefore, as panel (b) shows, the LM* curve is vertical.

Putting the Pieces Together

According to the MundellFleming model, a small open economy with perfect capital mobility can be described by two equations: Y =C (Y T) + I (r*) + G + NX (e) IS* M/P = L (r*, Y) LM*. The first equation describes equilibrium in the goods market, and the second equation describes equilibrium in the money market. The exogenous variables are fiscal policy G and T, monetary policy M, the price level P and the world interest rate r*.The endogenous variables are income Y and the exchange rate e. Figure below illustrates these two relationships. The equilibrium for the economy is found where the IS* curve and the LM* curve intersect.

LM*

e*

IS* Y Y*

Explanation:
This graph of the MundellFleming model plots the goods market equilibrium condition IS* and the money market equilibrium condition LM*. Both curves are drawn holding the interest rate constant at the world interest rate. The intersection of these two curves shows the level of income and the exchange rate that satisfy equilibrium both in the goods market and in the money market.

The Small Open Economy Under Floating Exchange Rates

Before analyzing the impact of policies in an open economy, we must specify the international monetary system in which the country has chosen to operate. We start with the system relevant for most major economies today: floating exchange rates. Under floating exchange rates, the exchange rate is allowed to fluctuate in response to changing economic conditions.

Fiscal Policy
Suppose that the government stimulates domestic spending by increasing government purchases or by cutting taxes. Because such expansionary fiscal policy increases planned expenditure, it shifts the IS* curve to the right, as in Figure. As a result, the exchange rate rises, whereas the level of income remains the same.

e LM*

e2 e1 IS2* IS1* Ye

Monetary Policy
Suppose now that the central bank increases the money supply. Because the price level is assumed to be fixed, the increase in the money supply means an increase in real balances. The increase in real balances shifts the LM* curve to the right, as in Figure below. Hence, an increase in the money supply raises income and lowers the exchange rate.

LM1* e1 e2

LM2*

IS* Y1 Y2

Trade Policy
Suppose that the government reduces the demand for imported goods by imposing an import quota or a tariff. What happens to aggregate income and the exchange rate? Because net exports equal exports minus imports, a reduction in imports means an increase in net exports. That is, the net-exports schedule shifts to the right, as in Figure.

e LM*

e2 e1 IS2* IS1* Ye
This shift in the net-exports schedule increases planned expenditure and thus moves the IS* curve to the right. Because the LM* curve is vertical, the trade restriction raises the exchange rate but does not affect income.

The Small Open Economy Under Fixed Exchange Rates

We now turn to the second type of exchange-rate system: fixed exchange rates. In the 1950s and 1960s, most of the worlds major economies, including the United States, operated within the Bretton Woods systeman international monetary system under which most governments agreed to fix exchange rates. The world abandoned this system in the early 1970s, and exchange rates were allowed to float. Some European countries later reinstated a system of fixed exchange rates among themselves, and some economists have advocated a return to a worldwide system of fixed exchange rates. In this section we discuss how such a system works, and we examine the impact of economic policies on an economy with a fixed exchange rate.

How a Fixed-Exchange-Rate System Works

Under a system of fixed exchange rates, a central bank stands ready to buy or sell the domestic currency for foreign currencies at a predetermined price. For example, suppose that the central bank announced that it was going to fix the exchange rate at 10 yen per rupee. It would then stand ready to give Rs. 1 in exchange for 10 yen or to give 10 yen in exchange for Rs.1. To carry out this policy, the CB would need a reserve of rupees (which it can print) and a reserve of yen (which it must have purchased previously). A fixed exchange rate dedicates a countrys monetary policy to the single goal of keeping the exchange rate at the announced level.

Fiscal Policy
Lets now examine how economic policies affect a small open economy with a fixed exchange rate. Suppose that the government stimulates domestic spending by increasing government

purchases or by cutting taxes. This policy shifts the IS* curve to the right, as in Figure, putting upward pressure on the exchange rate. But because the central bank stands ready to trade foreign and domestic currency at the fixed exchange rate, arbitrageurs quickly respond to the rising exchange rate by selling foreign currency to the central bank, leading to an automatic monetary expansion. The rise in the money supply shifts the LM* curve to the right. Thus, under a fixed exchange rate, a fiscal expansion raises aggregate income.

e LM1* LM2*

e IS2* IS1* Y1 Y2

Monetary Policy
Imagine that a central bank operating with a fixed exchange rate were to try to increase the money supplyfor example, by buying bonds from the public. The initial impact of this policy is to shift the LM* curve to the right, lowering the exchange rate, as in Figure.

e LM*

IS* Y
Because the central bank is committed to trading foreign and domestic currency at a fixed exchange rate, arbitrageurs quickly respond to the falling exchange rate by selling the domestic currency to the central bank, causing the money supply and the LM* curve to return to their initial positions. Hence, monetary policy as usually conducted is ineffectual under a fixed exchange rate. By agreeing to fix the exchange rate, the central bank gives up its control over the money supply.

A country with a fixed exchange rate can, however, conduct a type of monetary policy: it can decide to change the level at which the exchange rate is fixed. A reduction in the value of the currency is called devaluation, and an increase in its value is called a revaluation. In the MundellFleming model, a devaluation shifts the LM* curve to the right; it acts like an increase in the money supply under a floating exchange rate. Devaluation thus expands net exports and raises aggregate income. Conversely, a revaluation shifts the LM* curve to the left, reduces net exports, and lowers aggregate income.

Trade Policy
Suppose that the government reduces imports by imposing an import quota or a tariff. This policy shifts the net-exports schedule to the right and thus shifts the IS* curve to the right, as in Figure 12-10. The shift in the IS* curve tends to raise the exchange rate. To keep the exchange rate at the fixed level, the money supply must rise, shifting the LM* curve to the right.

e LM1* LM2*

e IS2* IS1* Y1 Y2

The result of a trade restriction under a fixed exchange rate is very different from that under a floating exchange rate. In both cases, a trade restriction shifts the net-exports schedule to the right, but only under a fixed exchange rate does a trade restriction increase net exports NX. The reason is that a trade restriction under a fixed exchange rate induces monetary expansion rather than an appreciation of the exchange rate. The monetary expansion, in turn, raises aggregate income. As the accounting identity NX = S - I. When income rises, saving also rises, and this implies an increase in net exports.

Advances in Business Cycle Theory

Introduction:
This theory is accorded as the most modern theory of trade. Basically in this theory the concepts of Classicals are proved in short run, such as:
a) b) c) d) e) f) Neutrality of money Role of money is just a medium of exchange. Changes in monetary variables will not affect real variables. Prices, wages and interest rate is also flexible in SR time period. SR fluctuations are possible due to real variables, not due to monetary variables. If the rate of monetary variables such as money, prices and inflation etc. are excluded, but as the real variables will interact with one another in such a way that it can formed the phases of business cycle.

Phases of Business Cycle:

A business cycle is furnished with four phases
1. Depression 2. Recovery 3. Boom 4. Recession

We can discuss it with the help of an example which is the study of economics of Robinson Crusoe.

Economics of Robinson Crusoe:

Robinson Crusoe is a sailor, stranded on a desert island. Crusoe lives alone. His life is simple, yet he has to make many economic decisions. (that is how his decision will change in response to the changes in circumstances. Crusoes activities are a. Enjoying leisure b. Swimming c. Catching fish d. Manufacturing nets e. His income (economys income) Y=C+I where C = Consumption of fish and I = Investment in nets f. Real GDP of Crusoe = Total No. of fish caught + Total No. of nets made.

Fluctuations in Crusoes Economy OR Fluctuating Events

Event 1: One day a big school of fish passes by the island. Affects: GDP of Crusoe will increase because
Crusoes catches more fish per hour. Crusoes employment increases. On the other hand, he reduces temporary leisure in order to work hard. This is the booming stage of Crusoes economy.

Event 2: One day a strong storm arises. Affects:

Strom makes outdoor activities difficult. Crusoe decides to wait out the storm in his hut. Consumption in fish and investment in nets both fall and finally GDP of Crusoes economy also falls. Hence, Crusoes economy is in recession/ in slump.

Event 3: One day natives attacked on Crusoe. Affects:

Crusoe has less time to enjoy leisure. Demand for defend equipments increases. Employment level especially in defence industry increases. The act of fishing and making nets is suspended for a while. Defence spending crowds out investment. GDP arises. Crusoes economy is experiencing the war time boom.

Conclusion:
In above simple story,
a) The fluctuations in output, employment, consumption, investment and productivity all the natural desirable response of an individual to the inevitable change in his environment. b) Crusoes economy is eliminated the role of monetary policy, sticky prices or any type of market failure.

REAL BUSINESS CYCLE THEORY

Introduction:
According to real business cycle theory, economic fluctuations are caused by changes in AS rather than changes in AD. The changes in aggregate supply occur due to supply side shocks. Such shocks affect productivity and production. As a result, the cost of resources changes. Thus according to this theory, random fluctuations in productivity are responsible for economic fluctuations. According RBC theory the shocks in the economy are not desirable. They are likely to occur and they are inevitable. When they occur, they certainly change the income, employment, output or real variables of the economy. Due to this, four basic issues arise. 1. Interpretation of labour market. 2. Importance of technology shocks. 3. The neutrality of money. 4. The flexibility of wages and prices.

1 - Interpretation of the Labour Market:

Real Business Cycle Theory emphasizes the idea that the quantity of labour supplied at any time is based on the incentives that workers get just as Robinson Crusoe does. When the workers are well awarded, they are willing to work more hours rather than enjoying leisure and vice versa. Temporary substitution between leisure and working is called intertemporal substitution of labour. How this intertemporal substitution of labour market affects the labour market, lets us have an example. Example: A college student has two summer vacations left before graduation. She wishes to work for one of these summers so she can buy a car after she is a graduate. How she should choose which summer to work? We can understand it with the help of the following formula Intertemporal Relative Wage

Where, I.R.W. = temporarily comparison between the wage rate of first time with the wage rate if 2 nd time W1 = real wages in first time. W2 = real wages in second time. r = real interest rate. The wages/ interest rate determine whether to do work or to enjoy. Critics of RBC theory believe that fluctuations in employment do not reflect changes in the amount people want to work. They point out that the unemployment rate fluctuates substantially over the business cycle. The advocates of RBCT argue that unemployment statistics are difficult to interpret. The mere fact that the unemployment rate is high does not mean the intertemporal substitute of labour in un-important.

2 Importance of Technology Shocks:

Crusoes economy fluctuates due to weather conditions so he works more or less accordingly. In RBCT technology is an important variable which determines over ability to turn inputs into outputs. This theory assumes fluctuations in technology so due to fluctuation in technology, output and employment also fluctuates. These technological shocks may be positive or may be negative adverse. With positive technological shocks outputs and employments increase and with adverse shocks to technology outputs and employments decreases. In recession production fall because of adverse technology shocks, so employment and earnings also reduce. In View of Critics: The critics say that it does not make any sense that technological process gets reverse. The technological knowledge process may slow down but getting reverse is not convincible. In View of Advocates: The advocates of RBCT defended in such a way that when bad weather conditions, supply shocks, fluctuations in oil prices persist in the economy even though technological fluctuations have not taken place even then employment and output reduces.

It also reduces our ability to turn inputs into outputs.

3 The Neutrality of Money:

As money did not have any role in Crusoes economy similarly it is also assumed in RBCT that role of money is neutral in short run as well. Basically here we take the money as just a medium of exchange. It means change in monetary do not influence the real variables. In View of Critics: The critics of the theory say that when M s is reduced to control inflation then employment and output decrease but unemployment increase. So, changes in monetary variables like M s have changed the real variables like employment and output. In View of Advocates: The advocates of RBCT said that critics confused the direction of causation between money and output. The advocates of RBCT claimed that Ms is an endogenous variable. It means if the level of output increase due to technological progress then demand for money by the people will increase. Hence, central bank will increase the Ms to meet the demand.

4 The Flexibility of Wages and Prices:

RBCT also assumes that wages and prices are flexible both in upward and downward direction. It means whenever any distortion comes in market, these variables like prices and wages adjust automatically to clear the market without any resistance as Robinson Crusoe used to do.

In View of Critics: The critics were of the view that many wages and prices are not flexible. So, due to inflexibility of wages and prices both unemployment and non-neutrality of money exists.

New Keynesians View:

New Keynesians think that these deviations occur because wages and prices are slow to adjust to the changing economic conditions.

Classicals View:
They are of the view that always full employment exists in the economy. They are not in favour of government intervention. So they use a term which is invisible hands in the economy which determines the full employment level in the economy.

Conclusion:
The RBCT is an explanation of short run economic fluctuations built on the assumptions of the classicals model, including the classicals dichotomy and the flexibility of wages and prices. According to this theory economic fluctuations are the natural and efficient response of the economy to changing economic circumstances, especially changes in technology. RBCT emphasize intertemporal optimization and forward looking behaviour. Advocates and critics of RBCT disagree about whether employment fluctuations represent intertemporal substitutions of labour, whether technology shocks cause most economic fluctuations.

Should Policy be Active or Passive

Keynesian View: According to them, when there exits distortion in the economy, we should adopt such type of policies which lead the economy to the stabilization situation. Whether these policies are adopted by the government sector authorities or some rules. The analysis of macroeconomic policy is a regular duty of the Council of Economic Advisors. Monetarist View: They say that the roles of amities are passive in the economy, because in their view policy should not be adopted. They give some arguments in the favour or the against of active or passive policies.

Arguments in Favour or Against Active & Passive Policies

1. 2. 3. 4. Lags in implementation and effects of policies. Difficult job of economic forecasting. Ignorance, expectations and Locus Critique. Historical background.

1 - Lags in implementation and effects of policies. When we adopt some policy it needs some time to be implementing, so that time duration is called lags in implementations. Policy makers would simply adjust their instruments to keep the economy on the desired path. Economists distinguish between two lags; 1. Inside lags 2. Outside lags Inside Lags: The inside lag is the time between a shock to the economy and the policy action responding to that shock. This lag arises because It takes time for policymakers first to recognize that a shock has occurred Then to put appropriate policies into effect. Outside Lags The outside lag is the time between a policy action and its influence on the economy. This lag arises because policies do not immediately influence spending, income, and employment. Example: Making economic policy, however, is less like driving a car than it is like piloting a large ship. A car changes direction almost immediately after the steering wheel is turned. By contrast, a ship changes course long after the pilot adjusts the rudder, and once the ship starts to turn, it continues turning long after the rudder is set back to normal. Economic policymakers face the problem of long lags. Indeed, the problem for policymakers is even more difficult, because the lengths of the lags are hard to predict. 2 Difficult Job of Economic Forecasting: Successful stabilization policy requires the ability to predict accurately future economic conditions. If we cannot predict whether the economy will be in a boom or a recession in six months or a year, we cannot evaluate whether monetary and fiscal policy should be adopted.

Another way forecasters look ahead is with macro econometric models, which have been developed both by government agencies and by private firms for forecasting and policy analysis. 3 Ignorance, Expectations and Locus Critique: Ignorance means whenever the economists estimate the effects of alternative economic policies they are not confident about them. Expectation play crucial role in the economy because they influence all mot all sorts of economic behaviour. Lucas Critique Robert Lucas is an economist. He emphasized the issue of how people form expectations of the future. When policy makers estimate the effect if any policy, they need to know how people expectation respond to them. The criticism on macro econometric (traditional) model is known as Lucas Critique. Expectations based on two types 1- adoptive 2- Rational According to Lucas, we should adopt rational expectations. An important example of the Lucas Critique arises in the analysis of disinflation. The cost of reducing inflation is often measured by sacrifice ratio.

Inflation decreases then GDP decreases Lucas Critique leaves us two lessons Narrow Lesson: The narrow lesson is that economists evaluating alternative policies need to consider how policy affects expectations and, thereby, behaviour. Broad Lesson: The broad lesson is that policy evaluation is hard, so economists engaged in this task should be sure to show the requisite humility. 4 Historical Record: If the economy has experienced many large shocks, active policy should be clear. If the economy has experienced few large shocks, then the case for passive policy should be clear. In other words, our view of stabilization policy should be influenced by whether policy has historically been stabilizing or destabilizing. The historical record often permits more than one interpretation. The Great Depression is a case in point. Some economists believe that a large contractionary shock to private spending caused the Depression. Other economists believe that the large fall in the money supply caused the Depression. Great Depression can be viewed either as an example of why active monetary and fiscal policy is necessary or as an example of why it is dangerous.

Should Policy Be Conducted By Rule or By Discretion?

A Policy will be implemented by rule if policymakers announce in advance how policy will respond to various situations and commit themselves to following through on this announcement. Policy will be conducted by discretion if policymakers are free to size up events as they occur and choose whatever policy seems appropriate at the time.

 The debate over rules versus discretion is distinct from the debate over passive versus active policy. Policy can be conducted by rule and yet be either passive or active. Rule for Monetary Policy: Monetary policy is a policy adopted by central bank. Rules suggested by Policy Makers: 1. Role of Ms. 2. Nominal GDP targeting. 3. Inflation targeting. Role of Ms: According to monetarists: Ms should be increased at constant/steady rate (every year). Because it is the Ms which brings distortion/discrepancy in the economy so in order to stabilize the economy Ms should be increased steadily and constantly. But according to few economists that along with a steady increase in M s the velocity of circulation of money also be kept constant in order to stabilize the economy. Nominal GDP Targeting: If nominal (actual) GDP (8%) > targeted GDP (7%) So, D AD P Inflation If nominal GDP (6%) < targeted GDP (7%) So, D AD L Y unemployed P Deflation. Rule: Ms will have to be increased. If actual GDP = targeted GDP So, Ms will not be changed. Inflation Targeting: If actual inflation > targeted inflation Rule: Ms should be decreased. If actual inflation < targeted inflation Rule: Ms should be increased. If actual inflation = targeted inflation Rule: Ms should be kept constant.

Distrust of Policy Makers and Political Process:

So many economists think that economic policy in fact is very important and it should be given at discretion of policy makers. But this point of view is political rather economic. It means that if in a country the politicians are inefficient and opportunist, then they should not be entrusted with the powers of using fiscal and monetary policies. Basically this is the misuse of powers. Therefore, the inefficiency attached with any economic policy raises due to many a reason. It is also said that the politicians use macro-economic policy in order to win their elections. All such means to say that the politicians in order to attain their elections, aim so often use economic policies under discretionary power. This situation is called political trade cycle. Some economists have proposed constitutional amendments, such as a balanced budget amendment that would tie the hands of legislators and insulate the economy from both incompetence and opportunism.

Conclusion:

So many economists think that the economic policies be saved from the clutches of politicians. These economists are in favour of adopting fiscal and monetary policy following some rule rather than discretion.

Discretionary Policy and Time Inconsistency:

Some experts think that that we trust our politicians, discretion policy appears superior to a fixed policy rule. This is because discretionary policy is flexible on the ground of its structures and politicians will use them following the changing circumstances. But due to time inconsistency, which are attached with any of the policy the experts consider rule approach better than discretionary approach. It has been observed that in the beginning, policy makers announce some of their policy so that economic agents could advise their expectations. In other words, we can say that they are not going to fulfil their promises. So in such situation, the rule method is better than discretionary method.

Arguments in Favour of Rules:

Firstly, both the monetary and fiscal policy affects the economy with the certain time lag. Any mistake in the circulation of the length of time lag can aggravate the intensity of the phase of the business cycle. Secondly, rules lead to economic stability and keep the private economic decision makers more accurately forecast the future. Thirdly, rule as opposed to discretion, will save the economy from the wickedness of politicians. Fourthly, variations in the rate of monetary growth strongly dominate variations in the rate of nominal economic growth, not in the real economic growth. Fifthly, errors and uncertainties associated with discretionary monetary policy are so numerous and vast that the discretion would always lead to economic instability. Lastly, discretionary policy can affect the economy only if it comes all of a sudden. Such a policy will befool the private economic decision makers and as a result scarce economic resources will be miss allocated.

Arguments in Favour of Discretionary Policy:

The proponents of discretionary policy move the following arguments in favour of discretion. 1. The velocity of Ms may change in some unfavourable way during a recession or a boom and the constant money growth rule may aggravate the intensity of the phases of the business cycle. Thus it is preferable that the central bank be given the discretion to adjust the money supply to large and small money changes in the velocity. 2. The time lag required for monetary and fiscal policy to affect the economy can be incorporated into discretionary policy by accurately forecasting the future course of economic activity.