Ec3115 Monetary Economics : Review Assessment Answers

Answer:

Introduction:

The Mundell-Fleming model can be referred as the IS-LM BOP model, which is the extension of IS-LM model. It is known that IS-LM model deals with the closed economy, whereas Mundell-Fleming model considers a small open economy. As per this model, it can be mentioned that highlights the short run relationship among the country’s nominal exchange rate, level of output and the rate of interest (Aruoba et al. 2016). On the other hand, IS-LM model only considers the association between the rate of interest and the level of output. In this point, the Mundell-Fleming model has criticized that an economy would not be able to maintain fixed exchange rates, free capital movement and independent monetary policy. This principle can be discussed with the concept of Mundell-Fleming Trilemma or the impossible trinity.

According to Johnson (2013), it can be mentioned that this model highlights two concepts such as capital mobility and the stabilization policy under the capital mobility and stabilization policy under the fixed and the flexible exchange rates. This study has highlighted whether re-emergence of capital controls refers that the Mundell-Fleming trilemma is dead. In this context, Mundell-Fleming has highlighted with a fixed exchange rate and it refers to the interference with the free movement of international capital flows with the imposition of capital control for regaining the monetary autonomy (Fand 2014).

Discussion

This model would highlight the distinction between the perfect and the imperfect capital mobility and also between the fixed and flexible exchange rates. In both of these cases, the expansionary fiscal policy and monetary policy are considered within the economy. As per the case study, it can be argued that Mundell-Fleming trilemma would reduce the capital control. As per the statement of Pierce and Tysome (2014), it can be mentioned that Mundell-Fleming model deals with the perfect mobility.

Fixed exchange rate is a type of exchange rate regime where the valuation of the currency is fixed against the value of the single currency. Therefore, fixed exchange rate system is helpful to control the behavior of the currency, by controlling the rate of inflation.

According to Machlup (2013), an expansionary monetary policy will shift the LM curve to LM1 and this will move the equilibrium from E0 to E1. Nevertheless, it can be argued that at any below point of the BP curve, the economy will suffer from the balance of payment deficit. Since the exchange rates of the economy are remaining constant, therefore, it can be mentioned that government intervention is needed. In this point, it can be suggested that the government will purchase the domestic currency and can also sale the foreign currency. This will drop the supply of money and hence, the LM curve will be shifted from the initial position. This will make the equilibrium to move to E2. Therefore, monetary policy has no impact under the circumstances.

Figure 1: Impact of fixed exchange rate

(Source: Created by author)

An expansionary fiscal policy will move the IS curve from IS to IS1. The equilibrium point will be moved from point E0 to E1. Therefore, the economy will suffer from the balance of payment surplus as the exchange rate is fixed. The government will intervene in the opposite direction. Therefore, the foreign currency will be purchased and the government would in turn sale the domestic currency (Lengnick 2015). This would raise the supply of money of the economy. In this way, the LM curve would shift to the rightward. The final equilibrium would reach at the point E2. At this point, it can be mentioned that the rate of interest will be same and the production rate will be increased (Dymski 2013). Therefore, it can be mentioned that the fiscal policy would work perfectly under this kind of circumstances.

Figure 2: Impact of expansionary fiscal policy

(Source: Created by author)

Flexible exchange rate system is a monetary system, which allows the monetary system to be estimated by the demand and supply.  

Under flexible exchange rate, an expansionary fiscal policy will move from LM curve to LM1. This will in turn move the equilibrium from E0 to E1. Nonetheless, Lothian (2016) argued that the exchange rates are flexible and the balance of payment deficit would depreciate the domestic currency. This would raise the net exports, as the foreigners will buy more of the products in the equal amount of money. This would shift the IS curve in the rightward ay the IS1. Therefore, the final equilibrium would reach at the E2 point. In this point, the interest rate will be equal and this will increase the production. Rey (2015) mentioned that the monetary policy works perfectly under this environment.

Figure 3: Impact of flexible exchange rate

(Source: Created by author)

An expansionary fiscal policy will move the IS curve from IS to IS1 and the equilibrium point will be moved from E0 to E1. The economy will suffer from the balance of payment surplus, and in this point, the flexible exchange rate will appreciate the domestic currency. This will reduce the net exports and this will able to import more amounts of products due to the less amount of money (Serrano and Summa 2015). Therefore, the foreigners would import less of the products due to the appreciation of the domestic currency. This reduction in the net export will move the IS1 curve equilibrium E2, which is corresponded to the initial position.

Figure 4: Effect of expansionary fiscal policy

(Source: Created by author)

Therefore, it can be inferred that these are the reasons why Mundell-Fleming model is known as the Mundell-Fleming trilemma. As opined by Farhi and Werning (2014), the three stages of an economy such as perfect capital mobility, fixed exchange rates and independent and the efficient monetary policy are not existing in the economy. Under the assumption of perfect capital mobility and also in order to have efficient monetary policy, the exchange rate would be flexible. Therefore, it can be assumed that monetary policy would not be efficient.

2.1 Fixed exchange rate

Under the fixed exchange rates, the central bank intervenes in the exchange market in terms of selling and the buying reserves at the exchange parity. In addition, the exchange margins are referred as zero.

In this case, the expansionary fiscal policy will be moved from LM curve to LM1 and this will also move the equilibrium point from E0 to E1. Nevertheless, if the economy is lying below the BP curve, then the economy will suffer from the balance of payment deficit (Disyatat and Rungcharoenkitkul 2016). As the exchange rate is fixed, then the government will purchase the domestic currency and then sale the foreign currency. This will reduce the supply of money within the economy and the LM1 curve will shift to it’s previous position. Therefore, this will again hold the equilibrium at the position of E2. Dymski (2013) mentioned that the monetary policy would not has any impact on the capital mobility and therefore, it does not matter whether the capital mobility is great or small.

Figure 5: Effect of fixed exchange rate under imperfect capital mobility

(Source: Beckmann et al. 2016)

According to Globan (2014), it can be mentioned that the expansionary fiscal policy would shift the IS curve to IS1 and this will also move the equilibrium from the point E0 to E1. Now, in this connection it can be stated that under the capital mobility the economy will suffer from the balance of payments of surplus. In the following figure, it can be observed that BP+ refers the higher capital mobility. On the other hand, BP- will refer as the smaller capital mobility or the balance of payment deficit. As the exchanges rates are fixed therefore, government will require to intervene (Fernandez and Garcia 2016). Therefore, the acquisitions and the disposals of the domestic and the foreign currency will shift the LM curve from LM’ to LM*. In this point, Johnson (2013) opined that the balance of payment surplus will be equivalent as in the fiscal policy along with the perfect capital mobility and the fixed exchanges rates, as the balance of payments deficit is equivalent to the monetary policy scenario. On the other hand, in the following figure it can be observed that under these circumstances, the fiscal policy will be completely efficient. More specifically, it can be added that it is highly efficient due to the higher capital mobility (Farhi and Werning 2014).

Figure 6: Effect of expansionary fiscal policy under fixed exchange rate of imperfect capital mobility

(Source: Pierce and Tysome 2014)

2.2 Flexible exchange rate:

Flexible exchange rate is determined by the market, which can rapidly change the supply and demand of the currency, which is pegged or not controlled by the market.

In the opinion of Fand (2014), it can be stated that an expansionary fiscal policy will move the LM curve from LM to LM’, which will in turn shift the equilibrium from E0 to E1. On the contrary, Machlup (2013) questioned that as the exchange rate is flexible, therefore, the balance of payment will depreciate the domestic currency. This will in turn raise the net exports and shift the IS curve from IS to IS’. In this context, it can be mentioned that the domestic assets are assumed to be less expensive and therefore, the BP curve will shift to the rightward. This movement will be at either BP+ or BP-. As a result, it can be inferred that with the higher capital mobility, the ultimate equilibrium will be at point E2. According to Lengnick (2015), it can be stated that the monetary policy works significantly under these circumstances. It is highly effective due to the higher capital mobility.

Figure 7: Effect of flexible exchange rate under imperfect capital mobility

(Source: Lothian 2016)

On the other hand, the expansionary fiscal policy will shift the IS curve from IS to IS’ and this will move the equilibrium from E0 to E1. Based on the capital mobility, the economy will suffer from under balance of payment surplus, when the positive BP curve refers the higher capital mobility or the balance of payment deficit, which refers smaller capital mobility such as the BP curve is negative. In this connection, Rey (2015) cited that due to the balance of payment surplus and including the flexible exchange rate, the economy will suffer from the appreciation of the domestic currency. This will in turn reduce the net exports, which will in turn shift the IS curve to the leftward at the IS’ position. As the domestic assets are assumed to be highly expensive, therefore the BP+ curve will shift to the leftward. In this point, it can be mentioned that the final equilibrium will occur at the E2 point. However, if the balance of payment of an economy is at deficit, therefore, the outcome will be same with the monetary policy (Serrano and Summa 2015).

Conclusion:

This study has highlighted the concept of the re-emergence of capital controls refers that the Mundell-Fleming trilemma is dead. From the above analysis, it can be observed that under fixed exchange rate, Mundell-Fleming model highlights that interest rate in the domestic economy would not deviate from the other countries under the perfect capital mobile situation. In addition, it can be mentioned that under the fixed exchange rate region and in case of perfect mobility of capital, monetary policy within a small economy is ineffective, which would reflect the capital of the country, the level of national income and also the rate of employment. On the other hand, the central bank of a country would be able to reduce the rate of interest by the expansion of supply of money. This would in turn lead to the massive capital outflow for the depreciation of the domestic nation. This is occurred due to the reduction of the supply of money from the original level along with the domestic economy in order to attain the equilibrium at the initial level. On the other hand, in case of flexible exchange rate, the central bank of an economy would not intervene in the foreign exchange market. Therefore, the exchange rate would bring the demand and supply of foreign exchange in the equilibrium.

References:

Aruoba, S.B., Davis, M.A. and Wright, R., 2016. Homework in monetary economics: Inflation, home production, and the production of homes. Review of Economic Dynamics, 21, pp.105-124.

Beckmann, J., Ademmer, E., Belke, A. and Schweickert, R., 2016. The Political Economy of the Impossible Trinity. European Journal of Political Economy.

Disyatat, P. and Rungcharoenkitkul, P., 2016. Financial globalisation and monetary independence.

Dymski, G.A., 2013. The Eurozone Crisis as a Trilemma Forcefield: Fleming, Mundell, and Power in Finance.

Fand, D.I., 2014. Some issues in monetary economics. PSL Quarterly Review, 22(90).

Farhi, E. and Werning, I., 2014. Dilemma not trilemma? Capital controls and exchange rates with volatile capital flows. IMF Economic Review, 62(4), pp.569-605.

Fernandez, R. and Garcia, C., 2016. The Importance of Capital Inflows in the Origin of the Spanish Financial Crisis.

Globan, T., 2014. Testing the ‘trilemma’in post-transition Europe–a new empirical measure of capital mobility. Post-Communist Economies, 26(4), pp.459-476.

Johnson, H.G., 2013. Further Essays in Monetary Economics (Collected Works of Harry Johnson) (Vol. 4). Routledge.

Lengnick, M., 2015. Essays in Agent-Based Macro and Monetary Economics (Doctoral dissertation, Kiel, Christian-Albrechts-Universität, Diss., 2015).

Lothian, J.R., 2016. Milton Friedman's monetary economics: Theory and empirics. Milton Friedman: Contributions to Eco-nomics and Public Policy. Oxford University Press, Oxford (forthcoming).

Machlup, F., 2013. International Monetary Economics (Vol. 11). Routledge.

Pierce, D.G. and Tysome, P.J., 2014. Monetary economics: theories, evidence and policy. Butterworth-Heinemann.

Rey, H., 2015. International credit channel and monetary policy autonomy. IMF Economic Policy Review.

Serrano, F. and Summa, R., 2015. Mundell–Fleming without the LM curve: the exogenous interest rate in an open economy. Review of Keynesian Economics, 3(2), pp.248-268.