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Contreras, Gonzalo CF313 IMF & Economic Policy 201 Session 1 CF313#2013#Session1#!1, 1$ %ecem&er 2013 2 ()

Introduction What is the theoretical background behind the IMF stabilization approach? This essay will analyse two of the fundamental models that support these programmes: the Mundell-Fleming and the olak model! " lot of attention has been paid to the importance of controlling monetary supply in order to reduce deficits in the balances of payment! #ut$ is this fully consistent with the theoretical architecture behind those models? What are the main sources of critics of the IMF suggested policies in the framework of the stabilization programmes? To answer these %uestions each model will be briefly e&plained! 'e(ertheless$ the main efforts will be made e&ploring the policy implications of both models! Finally$ it will be depicted some of the ma)or limitations wield by the main critics!

A. Considerations regarding the Mundell-Fleming model: to what extent an active monetary policy can be considered as the key policy to achieve external balance? The Mundell-Fleming model was de(eloped at the beginning of the *+,-s through the work of .obert Mundell /*+,01 and Fleming Marcus /*+,21! Its main purpose was to show how monetary and fiscal policies can be used as instruments to achie(e internal and e&ternal ob)ecti(es! This model is$ in essence$ a formal integration of the e%uation of the balance of payments to the I3-4M model of fi&ed prices! Monetary and fiscal policies will ha(e different effects in an economy with a system of fi&ed or fle&ible e&change rate and depending on the capital mobility conditions! In the conte&t of a fi&ed e&change system$ what the model predicts about implementing acti(e monetary or fiscal policies? Within the model$ the implications of running monetary policies need to consider firstly the mobility of capital conditions! With perfect capital mobility$ the monetary e&pansion will lead to a mo(e of the 4M rightwards in a first moment! 5utput will e&pand generating a decrease of the internal interest rate and the worsening of the current account balance due to an increase of total imports! 6onse%uently a deficit in the

balance of payment emerges! These changes will create the circumstance in which capital outflows will occur! To achie(e e&ternal balance without altering the fi&ed e&change rate$ the 6entral #ank needs to inter(ene selling foreign currency! "s a result$ the money supply will be reduced$ causing the 4M cur(e to mo(e leftwards! In the case of imperfect capital mobility$ an e&pansion of monetary policy will also produce a mo(e to the right of the 4M cur(e in a first moment! In this case$ there is only one effect: imports would e&pand due to the marginal propensity to import of income$ and this in connection with the impossibility to recei(e e&ternal capital will result in a balance of payments deficit! 4ikewise in the pre(ious case$ the 6entral #ank needs sell foreign reser(es to achie(e e&ternal balance to stick to the peg! Therefore$ the conse%uent reduction of money supply will mo(e the 4M cur(e leftwards to the initial point! "ll in all$ it can be concluded that with fi&ed e&change rate monetary policy seems to be ineffecti(e in the long run as in not achie(es the effects on the le(el of output and the interest rate that were e&pected 7independently of capital mobility! #y contrary$ the net effect obtained in the way has been a net loss in foreign reser(es! Therefore$ the control of the monetary supply is in fact illusionary under this case as the impossible trilogy predicts /e&plained below1!
Monetary e&pansion with: a1 perfect 6apital mobility! b1 Imperfect 6apital mobility

5n the other hand$ the alternati(e to monetary policies in the conte&t of fi&ed e&change rate systems would be to e&pand fiscal policy! The effects of this policy action depend on the capital mobility conditions! With freedom of mobility$ an e&pansion of go(ernment spending based on public borrowing will entail an e&pansion in the money demand and a subse%uent augment of interest rate produced by the issuing of public bonds! "t higher interest rate$ foreign capitals will be attracted$ creating a balance of

payments surplus and therefore increasing the stock of foreign reser(es! Monetary supply will e&pand by conse%uence and 4M will then mo(e rightwards! The result is an increase in the le(el of output with the same le(el of interest and e&change rates$ pro(ing the effecti(eness of this approach! #y contrary$ if capital does not mo(e free perfectly$ the fiscal stimulus mo(es the I3 cur(e to the right in the first moment as in the pre(ious case causing an augment of the national interest rate! 8owe(er$ a subse%uent decline in the balance of payments 7 (ia the current account deficit caused by a rise in imports through the marginal propensity to import of the income increase- cannot be offset by international capital inflows! Therefor$ this will re%uire the 6entral bank to diminish the le(el of international reser(es in order to obtain e&ternal balance$ and decreasing the monetary supply as a result! This will cause the 4M cur(e to mo(e to the left$ reducing the le(el of output and increasing the interest rate at the e%uilibrium point /intersection of I3-4M-# schedules1! Therefore$ the fiscal stimulus fails to achie(e its aim of increasing output resulting in an ineffecti(e policy!
Fiscal e&pansion with: a1 perfect 6apital mobility! b1 Imperfect 6apital mobility

Taking all aspects de(eloped abo(e into consideration$ it is worth analysing how fi&ed e&change rate systems beha(e in de light of the 9impossible trilogy: 7or the macroeconomic trilemma as stated in ilbeam /2--,1! Following the hypothesis of this theory$ a country can only get at the same time two of these three ob)ecti(es: a fi&ed e&change rate$ an independent monetary policy and perfect mobility of capitals! It is assumed that these three options are desired at the same time by e(ery e&change rate regime! In short$ the reasoning behind the macroeconomic trilemma is that due to the arbitration process and when capital is perfectly mobile$ interest rates will be the same in different countries! This is because 9the key result of unco(ered interest parity was that interest rates differentials e%ual e&pected e&change rate depreciations and under a

fi&ed e&change rate system$ the e&pected de(aluation is zero: /Miles$ 3cott and #reeden$ 2-*21! Therefore$ in a conte&t of perfect capital mobility and under a fi&ed e&change rate regime$ the component of the trilogy left aside would be an independent monetary policy! Monetary policy in this conte&t seems to be ineffecti(e independent of the conditions regarding the mobility of capitals! More o(er$ the Mundell-Fleming model predicts that acti(e fiscal policy would only be effecti(e in perfect conditions of capital mobility! If that is not the case$ fiscal and monetary policies are e&pected to be ineffecti(e! Therefore$ IMF;s assumption that monetary policy is presumed to be the key for achie(ing e&ternal balance would be true$ but the %uestion would still be if this would ha(e a positi(e impact on the economy as the results obtained by monetary policies in the model ha(e demonstrated to be ineffecti(e for output e&pansion! In this case$ the Mundel-Fleming model will suggest running a fiscal e&pansion policy!

. Considerations regarding the !olack model: is the key stabilisation policy "or reducing a balance o" payments de"icit? The four identities on top of which the model is based are the national balance /*1$ the e&ternal balance /21$ the monetary balance /01 and the fiscal balance /<1! The relations of (ariables are as follows*: /*1 = > 6 ? I ? @ - A /21 B . ? B 'F" > /@ 7 A1 7 I' - 'T. /01 B M > B . ? B C6g ? B C6p /<1 3g 7 Ig> B 'F"g 7 B ' #g 7 B C6g It is important to mention that these identities do not pro(ide by themsel(es orientation on how the ad)ustment programmes should be /the empty box mentioned in the literature1! For that purpose$ olak;s model sets the following rele(ant assumptions: /D1 The demand for money is stable$ it depends on nominal income and constant (elocity of money: EMd > E=F( /,1 Import is a constant fraction of income: A > m = /G1 Money market is in e%uilibrium /closure e%uation1: EMd > EMs
*

Where$ => 'ational Income'F" > 'et Financial assetsC6g > Comestic credit to go(ernment 6 > consumptionI' > Interest payments C6p > Comestic credit to pri(ate sectorI > In(estment'T.> 'et transfers' # > 'et pri(ate lending@ > H&portsA > imports.> Foreign reser(es

3ome additional but important implications of this set of assumptions are that: i1 changes in national income are determined by changes in money supply$ ii1 sa(ings and in(estment are not considered e&plicitly and there is no capital market and iii1 sa(ings are supposed to be immediately in(ested! The policy implications of the olak model focuses on the links between changes in money supply and changes in the e&ternal balance! Thus$ if a certain le(el of reser(es is set$ it is possible to establish the limit of domestic credit by the monetary identity /Tarp$ *++<1! In other words$ e&ternal balance can only be achie(ed by restraining domestic credit! From an operational point of (iew$ the olak Model allows to obtain the (alue of domestic credit that is consistent with a desired balance of payments position! When a #alance of ayment target is set -(ia target in the le(el of reser(es- only a specific e&pansion in credit would be permissible! With this elements the IMF set the 6redit ceiling in their stabilization programmes! The mechanics of the olak models operates in the sense that an increase in public credit needs to be reflected in the same amount as an increase in the monetary supply /e%uation 01! This increases national income /e%uation D1! Then$ through e%uation ,$ the le(el of imports increases resulting in a worsening position in the #alance of ayments /e%uation 21! The result is a fall in the international reser(es le(el! Thus$ an e&pansion of money supply /trough domestic credit1 is offset by an opposite fall of international reser(es! If the le(el of borrowing by go(ernment is not controlled$ the balance of payment will be in deficit producing conse%uently a fall in reser(es by the temporary augment of imports! "ll in all$ in the light of the sentence discussed in this essay$ it could be argued that the control of the money supply through domestic credit is the key stabilisation policy for reducing a balance of payments deficit! Targeting of international reser(es and credit ceilings is therefore essential in the IMFIs stabilization approach under the olak model! "s it was recognized by the IMF /*+J,1$ 9the original olak model has a number of simplifications$ howe(er$ its fundamental approaches in con)unction with the absorption approach will guide stabilization programs promoted by the IMF until well into the se(enties:!

C. Alternative approaches to stabili#ation. 6ritics on the stabilization programmes designed by the IMF 7 and which are based on

the olak and the Mundell-Fleming models 7 are manifold! "mong them$ probably one of the most comprehensi(e is risen by the structuralist economic approach! In a general sense$ the critic to the stabilization programmes of the IMF are built up on the e&cessi(e weight or attention paid to the e&ternal balance! 3tructuralists recognise that elegant efforts ha(e been made to link money supply and e&ternal balance$ but during that )ourney some rele(ant elements ha(e been missed! These loose ends include the links with real economy not e&plicitly considered neither in olak nor in Mundell-Fleming models! More o(er$ the main instruments proposed by stabilization programmes to achie(e e&ternal e%uilibrium are restricti(e fiscal and monetary policies andFor e&change rate de(aluation! Hmpirical analysis points to the fact that in may cases the implementation of such policies has led to undesired internal balances$ resulting in what structuralists called 9stagnation:! This phenomenon consists in low le(els of output$ high le(els of unemployment and inflation! They argue that that is because policies are designed to attack the effects of imbalances but not the underlying causes - which are normally link with the economic and social structure! More particularly$ the main critic made to stabilization programmes based on the olak model is that it ignores output (ariation and determination of process from the side of costs /Taylor$ *++*1! #esides that$ the assumption of constant (elocity has also been ob)ect of hard debates$ as it will weaken the real power of monetary policy managed by go(ernment! #ut most importantly$ it has been discussed the effecti(eness of the fiscal austerity suggested by the IMF interpretation of the model! The main critics from structuralism to the IMF application of Mundell-Fleming model$ has to be with the practical interpretation of the internal e%uilibrium concept stated in the model! Thus$ the model is aimed to achie(e a balance where there is no e&cess in the demand or the supply side without inflation or unemployment! 'otwithstanding$ the IMF stabilization programmes seems to be biased towards inflation control rather than employment! "dditional critics from other approaches apart from structuralism appoints to the shortterm nature of the Mundell-Fleming model! Thus$ interaction of stocks and flows of capital to finance a current account deficit are not taking into account! Frenklen and .azin /*+JG1 add that long-run constraints of public and pri(ate sector are not considered$ and thus$ within a scenario of no money-creation policy pri(ate sector spending will lower present in(estments anticipating future ta&es! "dditionally and

likewise in the case of the olaks model$ the absence of consideration of supply-side factors is also criticized$ among other factors! "ll in all$ the critics in the IMF application of both olack and Mundell-Fleming models seem to agree on the danger of using e&clusi(ely these models for all conte&t and all moments! The common result of these models is to apply austerity measures without considering carefully the impacts of those measures in the longer run! The introduction of additional measures not included in the models - like trade liberalization or hands-off policies - within the stabilization programmes has also been widely criticized!

Conclusion "s it has been discussed along the essay$ the control of money supply is considered an important element in both theoretical models! 8owe(er$ the Mundell-Fleming model shows that in the conte&t of a fi&ed e&change rate system in the case of perfect mobility of capital fiscal policy is the most important element! 6ontrol of the monetary supply is in fact illusionary under these circumstances as the impossible trilogy predicts! .egarding the olack model$ it could be argued that the control of the money supply through domestic credit is the key stabilisation policy for reducing a balance of payments deficit! Therefore$ targeting a certain le(el of international reser(es and credit ceilings is essential in the IMFIs stabilization approach under the olak assumptions! IMF stabilization programmes are mainly - but not only as neoliberal agenda is also regularly attached- based on these two models! 6ritics appoints to the dangers of using these models as the only theoretical support for financial programming for all conte&t along the board! This is e(en more important bearing in mind their conceptual limitations and assumptions!

.HFH.H'6H3 Ca(id Miles$ "ndrew 3cott$ Francis #reedon /2-*21! Macroeconomics: Knderstanding the Llobal Hconomy$ 0rd Hdition Fleming$ M! Marcus /*+,21! NComestic financial policies under fi&ed and floating e&change ratesN! IMF 3taff apers +: 0,+70G+! .eprinted in 6ooper$ .ichard '!$ ed! /*+,+1!International Finance! 'ew =ork: enguin #ooks! Frenklen and .azin /*+JG1 The Mundell-Flemming Model: " Ouarter 6entury 4ater Macob "! Frenkel$ "ssaf .azin '#H. Working aper 'o! 202* /"lso .eprint 'o! r**,21 IMF P/*+J,1: Theoretical "spects of the Cesign fo Fund 3upported "d)ustment rograms! ilbeam$ Q! /2--,1 RMacroeconomic olicy in an 5pen Hconomy;$ from 6hapter < of International Finance .! "! Mundell /*+,01 96apital Mobility and 3tabilization olicy under Fi&ed and Fle&ible H&change .ates: The 6anadian Mournal of Hconomics and olitical 3cience F .e(ue canadienne dSHconomi%ue et de 3cience politi%ue$ Tol! 2+! Tarp$ F! /*++<1 6hapter 2 RMacroeconomic 6onsistency and "d)ustment olicies;$ and 6hapter 0 RFinancial rogramming and 3tabilization;$ from 3tabilization and 3tructural "d)ustment: Macroeconomic Frameworks for "nalyzing the 6risis in sub-3aharan "frica! Taylor$ 4! /*++*1 6hapter 2: RMacroeconomic 3hocks and the 3ocial Matri&; and 6hapter D: R8ow 3tabilisation 6an be Made to Work #etter;$ from Tarieties of 3tabilization H&perience: Towards 3ensible Macroeconomics in the Third World