The Mundell-Fleming model takes the world interest rate r as an exogenous variab
ID: 1195455 • Letter: T
Question
The Mundell-Fleming model takes the world interest rate r as an exogenous variable. Letis consider what happens when this variable changes.
(a) What might cause the world interest rate to rise?
(b) In the Mundell-Fleming model with a aoating exchange rate, what happens to aggregate income, the exchange rate, and the trade balance in a small open economy when the world interest rate rises?
(c) In the Mundell-Fleming model with a Oxed exchange rate, what happens to aggregate income, the exchange rate, and the trade balance in a small open economy when the world interest rate rises?
Explanation / Answer
Under flexible exchange rate regime
We speak of a system of flexible exchange rates when governments (or central banks) allow the exchange rate to be determined by market forces alone.
Changes in money supply
An increase in money supply shifts the LM curve downward. This directly reduces the local interest rate and in turn forces the local interest rate lower than the global interest rate. This depreciates the exchange rate of local currency through capital outflow. (Hot money flows out to take advantage of higher interest rate abroad and hence currency depreciates.) The depreciation makes local goods cheaper compared to foreign goods and increases export and decreases import. Hence, net export is increased. Increased net export leads to the shifting of the IS curve (which is Y = C + I + G + NX) to the right to the point where the local interest rate equalizes with the global rate. At the same time, the BoP is supposed to shift too, as to reflect(1)depreciation of home currency and (2)an increase in current account or in other word, the increase in net export. These increase the overall income in the local economy. A decrease in money supply causes the exact opposite of the process.
Changes in government spending
An increase in government expenditure shifts the IS curve to the right. The shift causes the local interest rate to go above the global rate. The increase in local interest causes capital inflow, and the inflow makes the local currency stronger compared to foreign currencies. Strong exchange rate also makes foreign goods cheaper compared to local goods. This encourages greater import and discourages export and hence, lower net export. As a result, the IS returns to its original level, where the local interest rate is equal to the global interest rate. The level of income of the local economy stays the same. The LM curve is not at all affected. A decrease in government expenditure reverses the process.
Changes in global interest rate
An increase in the global interest rate causes an upward pressure on the local interest rate. The pressure subsides as the local rate closes in on the global rate. When a positive differential between the global and the local rate occurs, holding the LM curve constant, capital flows out of the local economy. This depreciates the local currency and helps boost net export. Increasing net export shifts the IS to the right. This shift continues to the right until the local interest rate becomes as high as the global rate. A decrease in global interest rate causes the reverse to occur.
Under fixed exchange rate regime
We speak of a system of fixed exchange rates when governments (or central banks) announce an exchange rate (the parity rate) at which they are prepared to buy or sell any amount of domestic currency.
Changes in money supply
Under the fixed exchange rate system, the local central bank or any monetary authority only changes the money supply to maintain a specific exchange rate. If there is pressure to depreciate the domestic currency's exchange rate because the supply of domestic currency exceeds its demand in foreign exchange markets, the local authority buys domestic currency with foreign currency to decrease the domestic currency's supply in the foreign exchange market. This returns the domestic currency's exchange rate back to its original level. If there is pressure to appreciate the domestic currency's exchange rate because the currency's demand exceeds its supply in the foreign exchange market, the local authority buys foreign currency with domestic currency to increase the domestic currency's supply in the foreign exchange market. This returns the exchange rate back to its original level.
Changes in government expenditure
Increased government expenditure shifts the IS curve to the right. The shift results are a rise in the interest rate and hence, an appreciation of the exchange rate. However, the exchange rate is controlled by the local monetary authority in the framework of a fixed system. To maintain the exchange rate and eliminate pressure from it, the monetary authority purchases foreign currencies with local currency until the pressure is gone, i.e., back to the original level. Such action shifts the LM curve in tandem with the direction of the IS shift. This action increases the local currency supply in the market and lowers the exchange rate—or rather, return the rate back to its original state. In the end, the exchange rate stays the same but the general income in the economy increases.
Changes in global interest rate
To maintain the fixed exchange rate, the central bank must offset the capital flows (in or out), which are caused by the change of the global interest rate to the domestic rate. The central bank must restore the situation where the real domestic interest rate is equal to the real global interest rate to stop net capital flows from changing the exchange rate. If the global interest rate increases above the domestic rate, capital flows out to take advantage of this opportunity.(Hot money flows out of the economy) This would depreciate the home currency, so the central bank may buy the home currency and sell some of its foreign currency reserves to offset this outflow. This decrease in the money supply shifts the LM curve to the left until the domestic interest rate is the global interest rate. If the global interest rate declines below the domestic rate, the opposite occurs. Hot money flows in, the home currency appreciates, so the central bank offsets this by increasing the money supply (sell domestic currency, buy foreign currency), the LM curve shifts to the right, and the domestic interest rate becomes the global interest rate.