MUNDELL FLEMING MODEL

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  • WAQAS AHMED M.Sc Economics UOG
  • MUNDELL FLEMING MODEL

    1. 1. Chapter 13 The Mundell-Fleming Model -NOSSCIRE-
    2. 2. The Mundell-Fleming Model <ul><li>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. </li></ul><ul><li>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. </li></ul>-NOSSCIRE-
    3. 3. Mundell-Fleming Model, Slide 2 <ul><li>The model thus suggests that a combination of fiscal expansion and monetary contraction would boost the value of the currency and reduce net exports. </li></ul><ul><li>Conversely, fiscal contraction and monetary expansion would boost net exports and reduce the value of the currency. </li></ul><ul><li>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. </li></ul>-NOSSCIRE-
    4. 4. How the Model Works <ul><li>To understand the M-F model, return to the I = S identity, which can be written as: </li></ul><ul><li>Domestic Saving – Investment = Current Account Balance (which is the negative of net foreign saving) </li></ul><ul><li>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. </li></ul>-NOSSCIRE-
    5. 5. Fiscal Expansion <ul><li>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. </li></ul>-NOSSCIRE-
    6. 6. Monetary Easing <ul><li>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. </li></ul>-NOSSCIRE-
    7. 7. The M-F Model Under Reagan and Clinton <ul><li>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. </li></ul><ul><li>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. </li></ul>-NOSSCIRE-
    8. 8. The Role of Expectations <ul><li>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. </li></ul><ul><li>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. </li></ul>-NOSSCIRE-
    9. 9. The Repercussion Effect <ul><li>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. </li></ul><ul><li>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. </li></ul>-NOSSCIRE-
    10. 10. The Depreciation Effect <ul><li>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. </li></ul><ul><li>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. </li></ul>-NOSSCIRE-
    11. 11. The concept of forced saving <ul><li>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. </li></ul>-NOSSCIRE-
    12. 12. Shifts Caused by Changes in Productivity <ul><li>An increase in productivity will boost aggregate demand, but at the same time will reduce the rate of inflation. </li></ul><ul><li>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. </li></ul>-NOSSCIRE-
    13. 13. Economic Impact of a Change in Net Exports <ul><li>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. </li></ul><ul><li>1. Foreign growth rises </li></ul><ul><li>2. Domestic growth shrinks </li></ul><ul><li>3. Lower inflation </li></ul><ul><li>4. Weaker currency </li></ul>-NOSSCIRE-
    14. 14. Foreign Growth Rises <ul><li>. 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. </li></ul>-NOSSCIRE-
    15. 15. Domestic Growth Shrinks <ul><li>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. </li></ul>-NOSSCIRE-
    16. 16. Lower Inflation <ul><li>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. </li></ul>-NOSSCIRE-
    17. 17. Weaker Currency <ul><li>. 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. </li></ul>-NOSSCIRE-
    18. 18. Long-Term Effects <ul><li>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. </li></ul>-NOSSCIRE-
    19. 19. Economic Impact of Devaluation <ul><li>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. </li></ul><ul><li>If wages and prices rise by less than the drop in the currency, the standard of living declines. </li></ul><ul><li>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 </li></ul>-NOSSCIRE-
    20. 20. Summary comments on devaluation <ul><li>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. </li></ul>-NOSSCIRE-

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