International Money and Finance

Lecture 3/IMF
Outline

Open Economy Macroeconomics

Baseline Mundell-Fleming
Large country case
Regressive Expectations

BB-NN Model

1
Baseline MF Model
Assumptions

I Small Open Economy

I Unemployed Resources
I Perfectly Elastic Supply
I Four Assets:
I Two Bonds (perfect substitutes)
I Two Monies (non substitutes)
I Static Expectations (∆S e = 0)
I Arbitrage always possible
I Perfect Capital Mobility (Ci = ∞)
i = i∗

2
Money Market Equilibrium
Money Demand

MD
= L = L (i, Y ) ;
P
Li < 0, Ly > 0
M D → Demand for Money
P → Price of Domestic Output.

3
Money Market Equilibrium
Money Supply

MS = D + F
M S → Money Supply
D → Domestic component of the money stock
F → Forex Reserves expressed in domestic currency
Clearly, changes in M S will be due to changes in D and F :

∆M = ∆D + ∆F

4
Equilibrium
I Money Market Equilibrium
M
L=
P
Demand for real money balances equals real supply of money
balances
I Goods Market Equilibrium

Y = D = A(i, Y ) + T (Q, Y ) + G
A →Absorption
T →Trade Balance
G →Government Spending
Q →Real Exchange Rate

Q = SP ∗ /P)

5 Ai < 0, 1 > Ay > 0, TQ > 0, Ty < 0

Equilibrium
Balance of Payments

C →Capital Account

B = T (Q, Y ) + C (i)
TY < 0, TQ > 0, Ci = ∞
Ci = ∞ → Perfect capital mobility
B = ∆F if the exchange rate is fixed
B = ∆F = 0 if the exchange rate is flexible

6
XX

XX →Locus of points in the S, Y space along which there is

equilibrium in the goods market
If Y ↑⇒ES of domestic goods⇒ S ↑
S
6
ED of domestic goods XX

ES of domestic goods

-
Y

7
LL

LL → Locus of points consistent with MM equilibrium

Only one level of Y at which MM clears (price assumed constant)
S
6
LL

-
Y

8
FF

FF⇒Locus of points in the S, Y space along which there is BoP

equilibrium
If Y ↑⇒ CA ↓⇒ required S ↑
S
6
Capital Outflow
BoP>0
6
FF

BoP<0 Capital Inflow

?

-
Y

9
MF Stability

XX steeper than FF ensures stability

In X BoP<0 and ED. A rise in production cures both.

S
6 LL

ED XX
ES
BoP>0 A FF
BoP<0

X -
6

-
Y

10
MF model
S
6 LL

ED XX
ES
BoP>0 A FF
BoP<0

X -
6

-
Y
LM IS

i∗
F A F

11 i ?
Flex - Monetary Expansion
MECHANICS: incipient decline in i, capital outflow (FF ↑ FF 0 ),
S ↑, TB ↑, IS ↑ IS 0 , where MM equilibrium is restored at higher Y
S
6 LL
XX
FF’

A FF

-
-
Y
LM LM’ IS
IS’
i∗
F A F

i ?

12
Fix - Monetary Expansion
MECHANICS: Incipient decline in i, capital outflow. Now S is fixed
at S̄ and the authorities lose reserves. M S falls and LM 0 ↓ LM
S
6 LL
XX

A FF

-
LM’ Y
LM IS

i∗ F F
A


i ?

13
Fix - Fiscal Expansion
MECHANICS: Incipient increase in i, capital inflows, reserves
increase (given S̄), and LM ↑ LM 0
S
6 LL
XX
XX’
FF
FF’
A

-
LM’ Y
LM IS IS’

i∗ F F
A

i ?

14
Flex - Fiscal Expansion
MECHANICS: IS ↑ IS 0 , incipient increase in i, capital inflow, S ↓,
via Marshall-Lerner TB ↓, IS 0 ↓ IS
S
6 LL
XX
FF
A

-
Y
LM IS IS’

i∗ F F
A

i ?

15
Conclusions on BS-MF

I Under fixed exchange rates:

I MP is not effective at raising real income
I FP is effective at raising real income
I Under flexible exchange rates:
I MP is effective at raising real income
I FP is not effective at raising real income

MP FP
FIX X X
FLEX X X

X→ Correctly paired
X → Incorrectly paired

16
MF assumptions and alternatives

Some of the assumptions of the basic Mundell-Fleming model are

too stringent. In the following we will see what happens to the
conclusions reached by the model when we release some of the
assumptions.
In particular, we will analyse:
I Large Country
I Regressive Expectations

17
Large Country

I A large country is a price maker with respect to interest rates

I Reconsider the effectiveness of correctly paired instruments

18
FIX - Monetary Expansion

I Increase in M S in the US, induces a sizeable capital outflow

I M S increases in the RoW, and i RoW ↓
I Output expands in the US and in the RoW

i 6 M1 M2 6 M1RoW M1RoW

i0 i0RoW

i1 i1RoW
- -

19
Large Country - FIX, MP
S
6 LL
XX
XX’

FF
S̄ A

-
LM’ Y
LM IS
i1∗
F’ F’
i0∗
F A F

20
i ?
Large Country - FLEX, FP

I A fiscal expansion in the US leads to i US ↑ and sizeable inflows

of capital
I However, i RoW ↑
I the expansionary effects of a fiscal stimulus are shared between
the US and the RoW

21
Large Country - FIX, FP

I Fiscal expansion ⇒ itUS ↑

I However, also itRoW ↑
I capital inflows and money supply increase are smaller than in
BS-MF

22
Large Country - FLEX, MP

I Monetary expansion ⇒ itUS ↓, but also itRoW ↓

I The BoP deficit for the US will reduced with a lower required
depreciation of the exchange rate
I There is a smaller S ↓ and IS shifts less to the right than in
BS-MF

23
Large Country - Conclusions

I Incorrectly paired instruments have some degree of

effectiveness
I Correctly paired instruments have a lower effectiveness than in
the small country case

24
Regressive Expectations

I Relax assumption that ∆S e = 0

I Assume expectations are inelastic (regressive) in the SR:

∆S e = θ(S̄ − S) 0<θ<1

S̄ → “Old” equilibrium exchange rate

S → the exchange rate established after a shock
θ → proportionate adjustment to the expected S in successive time
intervals
θ = 1, ER changes immediately by S (expected and current
coincide)
θ = 0, Expectations are static
0 < θ < 1, Fractional adjustment, and S e 6= S

25
Regressive Expectations

Now:
Se − S
i = i∗ +
S
If expected appreciation,
Se − S
Se < S ⇒ <0
S
i can fall relative to i ∗

26
Regressive Expectations - MP
MP effectiveness is reduced in the SR

With static expectations, i = i ∗

With regressive expectations, i can fall and play a role in
equilibrating the MM
Hence, smaller Y increase required to clear MM
i
6 LM IS’
IS LM’


J
i∗

i
K


0 -
Y0 Y2 Y1 Y
27
Regressive Expectations - FP

Increase in G, S ↓. With regressive expectations, S e ↑, S e − S > 0,

and i > i ∗
Rise in i, reduced M D , Y must ↑ increase to clear the MM

i 6 IS’
IS LM
B
i
FF’
i∗ A
FF

-
0 Y0 Y1 Y

28
BB-NN Model

I provides a first notion of Equilibrium Real Exchange Rate

(ERER), as the rate that equilibrates both internal and
external positions
I allows understanding of implications of misalignment under
fixed exchange rate systems
I Features
I RER → relative cost of similar goods in two different countries
I international capital mobility (r = r ∗ ) ⇒ focus on relative
wages
I internal → labour market
I external → Balance of Payments (BoP)

29
BB - External Balance

competitiveness
6
surplus

- deficit
a

-
AD

30
NN - Internal Balance

competitiveness
6 - overheating

unemployment

-
AD

31
BB-NN

6 overheating

surplus
-
s
w
A BB

?
?
deficit
unemployment
B
D

overheating
surplus

6 C
6
-  NN

deficit
unemployment

-
AD

A - Overheating and BoP Surplus (O,S)

B - Overheating and BoP Deficit (O,D)
C - Unemployment and BoP Deficit (U,D)
D - Unemployment and BoP Surplus (U,S)
32
BB-NN
Policy

I First → Diagnose: A, B, C, D
I Then → decide what to do:
I do nothing
I do something:
I move AD (fiscal and/or monetary policy)
I change exchange rates or wages

33
BB-NN. Dynamic Properties

s 6
w

overheating

6 ?

unemployment NN

-
AD
I Under fixed exchange rates
I When there is unemployment, wages should decrease and ws ↑
I When there is overheating, wages should increase and ws ↓

34
BB-NN. Dynamic Properties
s
w
6
surplus
-


deficit

-
AD
I Under fixed exchange rates
I Starting from a deficit, international reserves decline ∴
I money supply (=D+F) declines ≡ restrictive monetary policy
I i ↑⇒ Y ↓⇒← AD i.e. a BoP deficit makes the citizens of a country
poorer ⇒consumption decreases.

35
BB-NN. Dynamic Properties

s
6 (O,S)
w
-
?
6  (O,D)
-
(U,S)
?
6
 U,D
NN

I -
The economy approaches equilibrium through a spiral path, and it can take many years

before internal and external equilibrium is reached (if ever!)

I Starting from (U,D), for example, there will be more recession before things turn better.
I Things can be fixed immediately through a devaluation, but a devaluation can be undesirable.

I Starting from (U,S), things can be fixed moving AD

36
Why do curves shift?

I Changes in the labour force:

I epidemic
I migration
I changes in labour regulations
I +ve oil shock (for oil exporters)
I +ve productivity shock to exporting sector
I Let’s say we observe an appreciation. When is it sustainable?
I It is if caused by a shift of BB or NN
I It is not if caused by internal inflation, but no devaluation
I Can be sustainable in the Short Run if we expect BB to move
any time soon

37
Social Peace Curve

s/w
6

social problems

social peace

-
AD

38
Social Peace Curve
s/w
6

IMF

EU Populism

-
AD
I Three Intersections: IMF, EU, Populism (None sustainable in
the Long Run)
I Populism→IMF→EU→Populism
I Solutions: move IMF down (productivity increase moves BB
down, migration moves NN down) or keep dissatisfaction
39 (moving SP up!!!)