Question

Explain the monetary model, the Mundell-Fleming model and/or the Dornbusch model and its extensions.

Answer 1

Ans.

The tendency for the rates of return on capital to become equal in financial markets of differ­ent countries as a result of perfect mobility of capital was formalized in a model in the 1960s by Robert Mundell, now a professor at Columbia University and the Late Marcus Fleming, an econo­mist at the IMF.

They assume:

(1) A small open economy

(2) Tax rates are the same everywhere,

(3) Foreign investors do not face political risk (i.e. the fear of nationalism of foreign assets, restric­tions of transfer of assets, risk of default by foreign governments).

Under these conditions and with perfect mobility of capital investors or foreign asset holders would try to invest in the asset in any country that yields the highest return. This would force rates of return on assets to become equal everywhere in the international capital markets because no one would invest at a lower return.

It may however be noted that perfect equalization of returns in different countries is crucially dependent on the twin assumptions of perfect mobility of capital and fixed foreign or world interest rate for an economy. In fact, Mundell-Fleming model assumes a small open economy which is incapable of influencing world interest rate.

Besides, it assumes perfect capital mobility.. “Capital is perfectly mobile internationally when investors can purchase assets in any country they choose, quickly with low transaction costs, and in unlimited amounts. When capital is perfectly mobile, asset holders are willing and able to move large amounts of funds across borders in search of the highest return or lowest borrowing costs.”

The assumption of a small open economy with perfect capital mobility plays an important role in Mundell-Fleming model. The assumption of a small open economy implies that the economy can borrow or lend as much as it likes in world financial markets without affecting rate of interest. Thus, for a small open economy, rate of interest is determined by the world interest rate.

Mathematically, we can state this assumption as:

r = r_f

where r stands for domestic interest rate in the economy and r_f is the world rate of interest. It is the perfect mobility of capital that makes domestic interest rate (r) equal to the world interest rate. If due to some event or economic policy domestic interest rate happens to be lower than the world interest rate, the capital outflows would drive the domestic interest rate back to the world interest rate.

On the other hand, if some event or policy causes domestic interest to exceed world interest rate, then the capital inflows would bring down the domestic interest rate to the level of world interest rate. Hence the equation r = r_f represents that international flow of capital quickly brings the domestic interest rate equal to the world interest rate.

The Mundell-Fleming model, with domestic interest rate determined by the world interest rate, focuses on the role of exchange rate in the determination of national income in the short run. Another important aspect of Mundell-Fleming model is that behaviour of the economy depends on whether it adopts the fixed exchange rate system or flexible exchange rate system.

In what follows we first explain below Mundell-Fleming model when the economy operate under the fixed exchange rate system and then analyse the model when the economy has adopted the flexible exchange rate system.

The Mundell-Fleming model of a small open economy with perfect capital mobility can be described by the following equations for IS and IM curves

IS equation:

Y = C (Y- T) + I(r_f) + G + NX(R)

LM equation:

M/P = L(r_f, Y)

The IS equation describes the goods marks equilibrium and the second LM equation describes money market equilibrium. G and Tare the variables determined by fiscal policy, M is the monetary policy variable and they are important exogenous variables. The price P and world interest rate (r₄) are the other exogenously given variables.

The interest rate being given, the intersection of IS and LM curves determine the level of national income at which both the goods market and money market are in equilibrium. Besides, in case of the variable exchange rate system, the equilibrium of the two markets also determine the exchange rate.

An important result of the Mundell-Fleming linkage model under fixed exchange rate regime is that a central bank of a country cannot pursue an independent monetary policy. Under perfect mobility, a very small difference in interest rates in different countries would cause infinite capital flows that would bring about changes in balance of payments.

These changes in balance of pay­ments will affect exchange rate between different national currencies which would eliminate interest rate differential. Take an example. Suppose Central Bank of a country tightens its monetary policy so as to raise interest rate in the economy. When with the adoption of this policy interest rate rises in the economy, foreigners will shift their investible funds to this country so as to take advantage of the higher interest rate.

With a huge inflow of capital, foreign exchange rate of the domestic currency will rise, that is, the currency of the country that adopts a higher interest rate monetary policy will appreciate. This appreciation of the currency will discourage exports and encourage imports which would have an adverse effect on balance of payments.

This will force the Central Bank of the country which is committed to maintain the exchange rate at the fixed level to intervene to prevent the appreciation of exchange rate of the national currency.

To prevent the currency from appreciation, the Central Bank will buy the foreign currency, say US dollar. This will lead to the increase in foreign exchange reserves with the Central Bank which will issue more national currency against the increase in foreign exchange reserves.

As a result, money supply in the economy will expand causing the rate of interest to fall. Thus, with the perfect mobility of capital and given a fixed exchange rate, domestic interest rate has been pushed back to the initial level.

It follows from above that, given a higher degree of capital mobility across countries; interest rates cannot be very much different. The differences in interest rates beyond a point will bring about capital flows across countries that will tend to provide world level yield in all of them.

It is important to note that under flexible exchange rate regime, the Central Bank does not intervene in the market for foreign exchange. The exchange rate adjusts itself to bring the demand for and supply of foreign exchange in equilibrium. Therefore, under flexible exchange rate system and without the intervention of the Central Bank, balance of payments must always be in equilibrium, that is, there is neither any deficit nor any surplus.

This implies that any current account deficit must be financed by private capital inflows. On the contrary, any current account surplus must be bal­anced by capital outflows. It is worth noting again that it is adjustments in foreign exchange rate under flexible exchange rate system that guarantees that sum of current and capital accounts of balance of payments is zero.

A second important consequence of fully flexible exchange rate regime is that under it the Central Bank can pursue its independent monetary policy, that is, it can expand or contract the money supply at will according to its assessment of the needs of the domestic economy. Since under flexible exchange rates, there is no obligation for the Central Bank to intervene there is no any link between the balance of payments and the money supply in the economy.

In Mundell-Fleming model the assumption of perfect capital mobility ensures that at only one interest rate which is equal to world interest rate (i = i_f) the balance of payments is zero, that is, in equilibrium (BP = 0). At any rate of interest other than this causes a change in the real exchange rate through its effect on capital flows for the domestic economy.

Assuming that domestic and foreign prices of goods (p and p_f) remain constant, decline in the domestic interest rate below the world interest rate (i.e. i_f) will cause unlimited capital outflows and bring about depreciation in the ex­-change rate. Exchange rate is a determinant of net exports (NX) which in the open economy affects aggregate demand and therefore determines level of open-economy IS curve (IS curve : Y = (Y, i) + NX(Y,Y_f R) where R stands for real exchange rate and NX for net exports).

Now, depreciation in the exchange rate following capital outflows when i < i_f will raises exports and reduce imports and will cause increase in net exports (NX). The increase in net exports will shift the ‘S curve to the right and thereby affect national income and output.

On the contrary, if i >i_f, there will be unlimited capital inflows causing appreciation in the exchange rate which will reduce exports and increase imports and will thus lead to the reduction in net exports (NX). The reduction in net exports (NX) as a result of appreciation in the exchange rate causes a shift in the IS curve to the left and will therefore affect national income and output.

In the small open economy with international linkages in terms of trade of goods and capital flows, our open economy model under flexible exchange rate regime consists of the following three equations.

IS curve: Y = A (Y, i) + NX (Y, Y_f, R) . . .(i)

BP = NX (Y, Y_f R) + CF (I – i_f) . . .(ii)

i = i_f . . .(iii)

where CF stands for capital flows.

With this Mundell-Fleming linkage model of a small open economy under flexible exchange rate regime we explain below the effect on national income (output), interest rate and exchange rate of the following factors and policies.

1. Exogenous increase in exports

2. Fiscal policy

3. Monetary policy

Exogenous Increase in Exports under Flexible Exchange Rate:

The effect of exogenous increase in exports, say due to the increase in world demand for our goods, is shown in Initially, the economy is in equilibrium at point E with national output equal to Y₀and interest rate i which is equal to world interest rate i_f (i=i_f). When there is exogenous increase in our exports, IS curve shifts to the right to IS’.

Now, new IS’ curve interests LM curve at point E’ where both goods and money markets clear. It may be noted that at this new equilib­rium point, E’, national income increases. The increase in national income also induces the rise in equilibrium interest rate above the world inter­est rate i_f.

This higher domestic interest rate will lead to the capital inflows which will exert pres­sure on the exchange rate. These capitals inflows, as seen above, will cause the domestic currency to appreciate. The appreciation in exchange rate will make our exports relatively expensive and imports cheaper than before. As a result, demand shifts away from domestic goods and as a result net exports (NX) to decline.appreciation of exchange rate and consequently decline in net exports will cause a shift in the IS curve back to the left. The capital inflows will continue and net exports will go on declining as a result of appreciation of domestic currency until is curve shifts back to the original level IS and equilibrium level of national income and output is restored at OY₀ level which is consis­tent with monetary equilibrium at the world rate of interest.

It follows from above that under conditions of perfect capital mobility, increase in exports of a small open economy has no lasting effect on the equilibrium level of national income and output. Increase in net exports (NX) causes interest rate to rise through increase in level of national income.

This induces capital inflows which result in appreciation of the exchange rate and reduces net exports. This cancels out the effect on national income of the initial exogenous increase in exports of a country.

Effect of Expansionary Fiscal Policy in a Small Open Economy under Flexible Exchange Rate:

We can use the Mundell-Fleming linkage model to analyse the effect of expansionary fiscal policy in a small open economy under flexible exchange rate system. Expansionary fiscal policy has the same effect as that of exogenous increase in exports. Under expansionary fiscal policy either government expenditure is increased or taxes are reduced.

This fiscal expansion leads to the increase in aggregate demand and causes a shift in the IS curve to the right. This, given the LM curve, induces the interest rate to rise and invites capital inflows into the economy. These capital inflows result in appreciation of the exchange rate.

This appreciation of the exchange rate induced by higher interest rate leads to reduction in exports and increase in imports. As a result, there is the reduction in net exports which completely offsets the impact of fiscal expansion on national income and output.

We arrive at an important conclusion from our above analysis. Real disturbances such as exogenous increase in exports or expansion in government expenditure or a tax cut does not affect equilibrium level of income in a small open economy under flexible exchange rate system with perfect capital mobility.

Under the fixed exchange rate regime, expansion­ary fiscal policy in a small open economy is highly effective in increasing the level of national income. However, under flexible exchange rate system with conditions of perfect capital mobility, equilibrium level of aggregate income or output remains unaffected as a result of expansionary fiscal policy.

Under flexible exchange rate fiscal expansion causes appreciation of exchange rate which causes exports to decrease and imports to increase and thus leads to a shift in the composition of domestic demand towards foreign goods and away from domestic goods.

Mundell-Fleming Model: Expansionary Monetary Policy in a Small Open Economy under Flexible Exchange Rates:

In sharp contrast to the expansionary fiscal policy, in Mundell-Fleming model expansionary monetary policy under flexible exchange rate regime is highly effective in raising the level of na­tional income or output. This favourable affect of expansion in money supply on the level of national output comes through its causing depreciation in exchange rate of domestic currency.

Con­sider where to begin with IS and LM curves interest at point E and determine level of national income Y₀ and rate of interest i, (i = i_f). Now, suppose there is increase in the nominal quantity of money supply M. Since we are assuming that prices of goods remain constant, increase in money will bring about increase in real money balances, M/P .

With this at the equilibrium point E, there will be excess supply of real money balances. To restore equilibrium, rate of interest will have to fall or aggregate income will have to rise. As a result LM curve shifts to the right to the new position LM’. The new LM’ curve intersects the original IS curve at new point E’.

At the new point E’, whereas goods and money markets are in equilibrium (at the initial exchange rate), rate of inter­est has fallen below the world interest rate i_f. This will cause capital outflows from the country.

These capital outflows will reduce the supply of foreign exchange (say US dollars) and lead to the depreciation of the domestic currency. The depreciation of domestic currency will make exports of the country relatively cheaper and its imports relatively expensive than before. This will lead to increase in exports and reduction in imports of the country resulting in larger net exports (NX).

Increase in net exports (NX), which is a component of aggregate demand, will cause IS curve to shift to the right. The point E’ is really not a final equilibrium point as adjust­ment process is not complete at point E. IS curve will continue shifting to the right until the joint equilibrium of goods market and money market is established at the rate of in­terest which is equal to the world interest rate.

If equilibrium is reached at point E” at which new LM and IS curves intersect and determine rate of interest i = i_f. It will be seen from that at the new final equilibrium point E”, level of na­tional income (or aggregate output) Y₁ is greater than the initial income Y₀.

It is interesting to compare in case of a small open economy the impact of expansion in money supply under flexible rate system with that under fixed exchange rate regime. Under the fixed exchange rate regime the expansionary monetary policy is quite ineffective in rais­ing national income or aggregate output.

Any attempt to increase money supply lowers rate of interest below the world interest rate which causes unlimited capital outflows. These capital out­flows lead to the reversal of increase in money supply so that finally the equilibrium of the economy is restored at the initial level of income or output.

On the other hand, under flexible exchange rate system where Central Bank does not inter­vene, increase in money supply, as seen above, is not reversed in the foreign exchange market. Capital outflows that take place in the foreign exchange market following the fall in the rate of interest below the world rate of interest leads to depreciation of domestic currency.

This deprecia­tion causes exports to increase and imports to decline resulting in increase in net exports (NX). Consequently, expansion in income or output actually occurs assuming fixed prices. Thus, ability of the Central Bank to control money supply under flexible exchange rate is an important effect of the flexible exchange rate system.

The monetary policy causes depreciation of domestic currency and thereby leads to increase net exports and therefore an increase in income and employment in the economy. Depreciation of domestic currency causes a shift in demand from foreign goods towards domestic goods.

As a result, income (or output) and employment abroad decline. That is, one country gains at the expense of the other country. Therefore, expansion in net exports and therefore in income and employment as a result of depreciation has been called beggar thy-neighbour policy. That is, increase in output and employment in one country takes place by creating unem­ployment and loss of output in other countries.

It follows from above that depreciation in exchange rate is mainly a way of shifting demand from foreign goods towards domestic goods rather than increasing the level of world demand. Exchange rate adjustment can play an important role in promoting economic stability at full employment level when different countries find themselves in different phases of business cycles.

That is, some are in boom phases and experiencing over full employment while others are in recession phase of business cycles. In this case, if the countries experiencing recession depreciate their do­mestic currencies, they will shift foreign demand to their domestic products. In this way this will remove divergence from full employment in each country.

Of course, from the angle of an individual country depre­ciation of domestic currency shifts foreign demand to it self and is able to increase its output and employment. But, if one country can raise its output and employment by depreciating its currency, others can also do so. This leads to competitive depreciation by different countries for attracting world demand for their goods at the expense of others.

DORNBUSCH’S   IT’S EXTENTION EXCHANGE RATE MODEL (DBM) The equations and variables of DBM The dynamic equations of the model consist of IS, LM, and Phillips curves, plus the uncovered interest parity (UIP) condition and an expectations equation for the exchange rate. Two versions of the last-mentioned equation are given: the first, Equation is an error-correction mechanism in which the domestic currency is expected to appreciate if the current exchange rate places it below its long-run value, and to depreciate in the contrary situation. The second, the rational-expectations relationship.

The method used to solve EDBM is a variant of the shooting algorithm.4 Given an initial post shock value for the exchange rate, the equations of motion given in Table 1 make it straightforward to trace the subsequent trajectory of EDBM’s endogenous variables. Terminal values are known for several variables.

The starting point for D4M is a simplified two-equation price system based on MM’s specification of price dynamics. This allows the inflationary impact of the initial devaluation to be calculated and then used as the stimulus, which leads, via the money demand function, to the post devaluation rise in the interest rate that follows its instantaneous initial drop. These interest rate movements trigger responses in the goods market, and thereby on the real side of the macro economy.