Jourd oj.lnt~rnationaI hfomy and Finnme (1988).

7, 221-229

The Loanable Funds Theory and the

Dynamics of Exchange Rates: The Mundell
Model Revisited

CHAU-NAN CHEN, CHING-CHONG LAI AND TIEN-WANG TSAVR*

Institute of the Tbrcc Principkr o/the People, Academia Sinica, Nankang, Taipei,
Taiwan

This paper shows that IMundell’s model of perfect capital mobility is

logically consistent only in the framework of the loanable funds theory. It
then develops a loanable funds version of the Mundell model and shows
that exchange rate overshooting or undershooting naturally occurs in
this ‘corrected’ version of the Mundell model.

This paper attempts to show that a loanable funds version of the perfect-capital-
mobility model of Mundell(l963) may g enerate overshooting or undershooting of
the exchange rate in response to a monetary shock even when there are no
expectations of changes in the exchange rate. We first show that the liquidity
preference version of Mundell’s model involves a logical contradiction. \Ye then
reinterpret the dynamics of the Mundell model along the line of the loanable funds
theory. It is demonstrated that static expectations and constant domestic prices
notwithstanding, the Mundell model, properly specified, is fully capable of
handling the dynamics of exchange rates.

I. Inconsistency of the Liquidity Preference Theory with Perfect Mobility of

Capital

We start off with the familiar Mundell-Fleming model:

(1) I(r) -S(J) + &_Y, e) = 0

(2) W,A = M
(3) B(J, c) + K(r -r*) = 0

where Z=investment, S=saving, L=demand for money, M=money supply,

B = balance of trade, K = net capital imports, r= domestic interest rate, r* =foreign
interest rate,_v = income, r =exchange rate. Corresponding to the static system (1)
to <3), we can write the customary dynamic system along the line of the liquidity

* We are indebted to the referees for their stimulating and helpful comments and suggestions.
0261-5606/88/02/0221-O9Sn3.000 Butterworth & Co (Publishers) Ltd
222 Thr Loanable Funds Throry and the Dynamics of Exchaqe Ratrs .

preference theory as

(4) n_vint = k,, [I(r) --s(J) + B(y, r)],

(5) cirjfir = kJL(r,_y) --i\l],

<6) nrjnt = --k,[B(y, e)-tK(r--r*)],

where the ks are the positive speeds of adjustment.

Under conditions of perfect capital mobility, ,& = ?Kj?(r - r*) -+ % , the central
bank has no ability to conduct sterilization operations. And in the absence of
central bank intervention, the exchange rate has to adjust instantaneously (k, -+ r;)
to clear the exchange market. The characteristic equation of the system (4) to <6>
with K, + X, and k, -+ x is

<7) k,k?L, = 0.

Given that k,, > 0 and L, > 0, (7) implies that k:, =I). The system is internally
inconsistent in that we start off with the liquidity preference theory (k2 >O) but
end up with rejecting it (k2 =O). If we iollow Dornbusch (1976) in further
assuming that the interest rate also adjusts instantaneously, i.r., k2 -+ IC, we obtain

(7’) k, L, = 0.

Given that L, > 0, we now end up with k, =O, which is inconsistent with equation
<4).’
From equation (6) we know that the domestic interest rate is fixed from outside
at the level of the foreign interest rate when capital is perfectly mobile, for r= r*, if
k, --, r~ and K, -+ c/3. Given that the interest rate is fixed, the level oi income is
fixed at all times as long as money supply is fised and the money market clears
instantaneously, for, equation <5> now becomes an identity L(r*,_y)rM when
k?-+x. The system of the liquidity preference version of the asset market
approach is not workable. Intuitively, we know that if capital flows move infinitely
with any change in the interest rate, then by assumption the bond market must
always be in equilibrium. An)- non-zero escess supply of bonds tends to move the
domestic r from the foreign r*, and K quickly moves to equilibrate the bond
market. Thus, it is logically impossible to also assume that dr/dt=k2[L --‘I!].
There is an obvious way to change such a model to make it well behal-ed: that is to
assume that r and e clear the escess supply of securities and the excess demand for
foreign exchange, respectively -the loanable funds model.2

II. The Loanable Funds Theory and the Mundell Model

In this section, we will reinterpret the Rlundell model in light of the loanable funds
theory. By invoking the K’alras law, we know that the excess supply of securities is
the sum of the excess demands for goods, for money, and for foreign exchanges
(Hahn, 1977; Xliller, 1981). Thus, equation (5) is replaced by the loanable funds
theory formulation of interest rate

(5’) drjdt = ki[I(r) -SO) +u(L(r,_y) -Af) -K(r-r*)]

where 19is the rate of adjustment converting stocks into flow~.~ The characteristic
 CHAU-NAN CHES rt al. 223

equation of the dynamic system <4>, (5’) and (6) with ,&, + of is

<s> j_’ +(k,~ --k;l, -k;vL, +k;K,)j. +k,k$(L,K, --sL, -L-,1,) = 0.

Perfect mobility of capital in the Mundell model implies both perfect

substitutability (K, + m) and instantaneous adjustment (ki + CO). In fact, the
latter assumption has to go along with the former, although the reverse is not true.
If we let K, + CC without letting k; + CC, equation (8) will reduce to

<S’> i. +k,vL, = 0.

One of the latent roots is missin . We therefore have to make both assumptions
(ki + CC and K, + a) so that (8’5 be consistent with the overall dynamic system.
Recapturing the above results, we now can explicitly express the dynamic system
of the Mundell model. From equation (5’) with the assumption of instantaneous
adjustment (k,’ -+ w), we obtain the identity:

(9) I(r) - S(JJ) + v( L(r,_v) - ?~l) - K(r - r*) E 0.

With the additional assumption of perfect substitutability (K, + CO), (9) reduces
to

(10) r E r* 7

which states that the security market is at instantaneous equilibrium with the
domestic interest rate fixed from outside. Furthermore, by substituting (9) into
(6) with k, -+ X, we have

(11) I(r) -S(y) +B(J c) +v(L(r,y) -M) = 0.

As the security market and the exchange market are both in instantaneous
equilibrium, the sum of the excess demands in the goods market and the money
market always equals zero. Any excess demand in the goods market is
instantaneously offset by an equal amount of excess supply in the money market.
The dynamic system for the Mundell model now consists of equations <4>, <lo>
and (1 l>, whose characteristic equation is (8’). Output,y, is no longer fixed at all
times but moves in response to the excess demand for goods, or what is the same
thing, the excess supply of money.”
We are now ready to deal with the overshooting problem in the framework of
the LMundell model. Consider the long-run effect of an unanticipated permanent
monetary expansion. Defining the steady state values of r of the model by 2, it is
easily verified that

(12) &/AM = (_r+m)/B,&, > 0,

where m = - dB/ay > 0, and where B, = i?B/de > 0 if the Marshall-Lerner condition
is satisfied.5 An increase in n/r leads to an increase iny by (l/L,)&%1, which in turn
generates an excess supply in the goods market by [(J +m)/L,]dAf. To correct the
disequilibrium, a change in the exchange rate is required so as to cause an
improvement in the balance of trade by an amount equal to B,d;. Equating these
two terms provides the long-run effect of an increased money supply on the
exchange rate, i.e., (12).
In the short run, however, owing to the presum tion that income is sluggish,
i.e., dy=O in the short run, it can be derived from (11 7 with r=r* that the exchange
h comparison of (12) and (13) gives:

(1-o

The exchange rate may overshoot, directly move to, or undershoot its equilibrium
value in response to an increase of money supply as PL, $s+~.
To illustrate the condition PL,. $s+n/ more intuitively, let us define the
overshooting and undershooting of eschange rates in an alternative way. The
exchange rate t’ overshoots (undershoots) if, after the initial jump, o keeps on falling
(rising) until it reaches the new steady state value. From (1.3) we already know that
an increase in ~\1 will cause a jump in r momentarily. After this initial iump,y \vill
increase graduallv in response to the escess supply of money (excess demand for
goods). From (1 i> we know that as y increases, the sum of the csccss demands in
the goods and money markets will change by the amount of [PL, - (5 +M)]~J. \Yith
t.and i\J fixed, P has to change to correct this disequilibrium. IflvL, >s+N,J, c has to
fall (overshooting); if I*L, <s+o~, L’has to rise (undershooting).

III. The Diagrammatic Analysis

The results can be illustrated by a diagram similar to that used by Dornbusch

(1’9’6). We shall consider the overshooting case only. In Figure 1, SS plots the
relation between the eschangc rate and income along ahich there is no cscess
demand in the goods market for the fiscd interest rate. The SSschedule is upward
sloping, since a depreciation of the currcy raises income by generating an
improvement in the trade balance. s The FF schedule gives the instantaneous
equilibrium condition for the goods and money markets combined, for a given
money supply as well as a given interest rate. The \‘I’ schedule is downward
sloping, since, given money supple and interest rate, a higher income increases the
combined escess demand (assuming that uL, >s+#/), which has to be offset bv a
deterioration in the trade balance generated by an appreciation of the currenc)-.
This is clearly seen from (11) with r=r*.i
,4n increase in money supply, in the long run will increase income and depreciate
the currency. This implies that the I;I; schedule will be pushed up to FF’ and that
the final long-run equilibrium will be at point E*. In the short run, however, an
increase in money supply will lead to an escess supply of money, which has to be
offset by an equal amount of escess demand for goods caused by a sufficient trade
surplus generated by a jump of the eschange rate. This is indicated at point E’
whet-c the eschange rate has depreciated in escess of its new long-run level. The
momentary equilibrium E’ is left to the SS schedule, implying an escess demand
in the goods market. As income increases in response to the escess demand in the
goods market, the currency will appreciate and the trade balance will deteriorate
until the new equilibrium E * is reached. This has already been anticipated at the
end of the preceding section.
To be more faithful to Alundell’s original model, we now use the IS- IA\I- BP
 225
e

e’

e
,

Y* Y
Yo
FICI.RE 1.

diagram to illustrate the same results. Perfect mobility of capital implies that the
domestic rate of interest is practically and consistently fixed from outside and that
the security market is always at equilibrium. This is illustrated in Figure 2 by the
horizontal SS schedule with a height of r*, which confines the moving path of the
economy. The locus for balance-of-payments equilibrium, BB, must coincide with
SS. If the escess supply of securities goes off toward positive or negative infinite as
r exceeds or falls short OPT”, then the escess supply of foreign eschange must move
toward negative or positive infinite simultaneously inasmuch as the excess supply
of goods and of money fails to do so. This can be seen clearly from the Kalrasian
identity.n Insofar as the security market and the exchange market are both in
instantaneous equilibrium, the economy is always on SS (and BB). The FF
schedule, which is obtained by ‘adding’ the IS and LAf schedules, graphs identity
(1 I> for given Al and e. It is useful for determining how far IS will shift (how much
c will jump) in response to a shift of Ll\f (an increase in M). The FF schedule is
upward sloping if vL, >s +nt, because an itzrrasr inl will produce a combined
escess demand for goods and money which has to be offset by an equal amount of
escess supply induced by an incrrasr in r. s The economy is also always on FF
because the sum of the escess demands in the goods market and the money market
always equals zero. The economy is therefore always at the intersection of S’S and
FF.'O
Starting from an initial equilibrium at point E,,, which corresponds to A1= M,,
and e =P,,, consider now a monetary expansion indicated by a rightward shift of the
LM schedule to LizI’. With the money supply increased from AJ,, to Al,, t must
jump to a value c’ in order to maintain the zero sum of the excess demands in the
goods and money markets given thaty is fixed momentarily. The depreciation of
the currency (the rise in e from e,, to c’) shifts the IS schedule rightward to IS’. The
new IS’ schedule must pass through the intersection of the LA!’ schedule and the
FF’ schedule which now corresponds to the increased money supply ‘11, and the
depreciated eschange rates e’ but coincides with FF.” Immediately after Al
increases from M,,, to ‘\f,, c junps from r,, to P’ to create an escess demand in the
goods market in equal amount to the excess supply in the money market caused by
the increased money supply, thus leaving the functional relationship between r and
Y in <ll> unchanged.‘?
Although c has jumped,Y is momentarily fised. The economy is now at E’ which
coincides with E,, because they both correspond toY,, and T*. E’ now is left to both
IS’ and LAJ’. Income thus starts rising in response to the excess demand in the
goods market, or what is the same thing, the excess supply in the money market.
The increase in income, however, generates a net increase in the combined excess
demand for goods and money when uLI > I +m. To eliminate disequilibrium, the
currency must appreciate. As & falls, the IS schedule shifts leftward and the FF
schedule downward until they both hit the point E*, the intersection of the LM’
schedule and the SS schedule. Notice that as P is falling from r’ to K*, the economy
moves along E’E *, that is,Y increases fromY,, toY *. It should be pointed out that
E,,, E’ and E* in Figure 2 correspond to the same points in Figure 1. The
 CH.IL.-5.1s CHES rt nl. 227

undershooting case where the slope of FF is reversed (vL, < s +m) in both diagrams
will be left as an esercise for the interested reader.

IV. Concluding Remarks

This paper has demonstrated the logical contradiction of the liquidity preference
model for an open economy with perfect capital mobility and flexible exchange
rates. Where eschange rates are freely flexible, the money supply is exogenousl)
fixed. The dynamic formulation of interest rate along the line of the liquidity
preference theory, in effect implies that the capital flow, however interest elastic it
may be, has no direct influence whatsoever on the interest rate (Chen, 1974). The
loanable funds theory overcomes this deficiency, for the excess supply of securities
consists of net capital imports and excess spending in addition to the excess demand
for money. The Mundell model, unmodified but properly interpreted, may
generate overshooting or undershooting of the exchange rate following a monetary
disturbance.‘3 Our result, once again, confirms Krueger’s (1983, p. 77) assertion
that ‘eschange rate dynamics, or “overshooting”, can occur in any model in which
some markets do not adjust instantaneously.‘lJ In Mundell’s model, the asset
markets clear instantaneously while the goods market does not. The most
interesting portion of our results probably is that undershooting is a possibility.
For an open economy like Taiwan where s> 0.3, PI> 0.4 and L, cO.3,
undershooting would be more likely than overshooting should capital control be
deregulated.

Notes

1. If we let k? -+ %, ki + x and derive the characteristic equation:

i.-(k, :L,)(&,K,-sL,-_L,I,) = 0

and then let K, + % (as is done by Chen, 197-t). we lvill have

i. = - %
Both results imply thatJ is fixed at all times.
2. Another way is to include r within the excess demand for money by adding expectations of
exchange rate changes as a factor in the demand for money (Frenkel and Rodriguez, 1982) or b!
making the price deflator in part a function of the home price of imports (hlathieson, 1777). It
may be alleged that the underlying model of Dornbusch (1976) is also a loanable funds model in
that he assumes that r clears the security market uhile r clears the money market. However, this
type of modeling will lead to the annoying conclusion that the balance ofpayments does not have
to be in instantaneous equilibrium. Rewriting (9) in the test as

(9,) I--s+B+v(L-‘\f)-~--_ E 0.

In view of the assumption that

(93 reduces to

B+K = I-S+R.

Thus, the balance of payments balances only when the goods market is in equilibrium. This
contradicts the assumption of perfect capital mobility \vhere central bank sterilization operations
are impossible and absent.
3. Within a stock-flow model, in addition to u(L - ;\I), we should also consider the pure flow excess
378 Pbr Loanal~lr Funds Thor-y and thr Dynamics of‘ Escbaqe Ratrj

demand for money. dL dt-d.\l,‘df. i.r., the total flow excess demand for money equals
L’(L - .\I) +(dL.dt -d.\l h). But this will give a very complex model.
4. That is. 4 dt==k,[I(r*) -S(y) +B(y, c)] =k,~,[.lI- L(r*.9)].
5. Definethesteady starevalueofr,r,and,y by;, i.and_y’. Substitute i=r* into(j) with&&=0and
(11) and d’ff I errntiate the resulting system. \\;‘e then have
- (J. + m)

( -(s+m) +vL, :: j[Zj = (s,Ij

which gives

4: 1 ff; s+nr
_=- _=~
d‘,\f L, ’ d.\l B,L,

6. Differentiating (1) with r=r* gives

Ijy:dy = (s+m) B, > n.

Differentiating (11) with r=r* and n,\f=0 gives

(ly+fy = (s+m-uL,),‘B,$@ as CL, $s+m.

8. See Hahn (1977) and hlillcr (1981). S ec also 111llcr (1986) uhich further develops the ideas
therein.
9. From (11) with &=(I and d~\l=O we can derive

nr 5 +m -l’L, >
-_= as t*la? 5 s + N/
I, +rl_, To
3
I tn. The economy staying at the intersection ofS.T, BB and FF implies that the W’alrasian identity is
violated at no time.
Il. The upward sloping Ff-(FF’) ensures that the intersectton \vill be northeast to E’. thus IS’ has to
shift leftuard (r has to fall) after the initial iump of c to r’.
12. It can be verified that the Ff’schedule does not shitt either horizontally or vertically immediately
after .\I increases. Given that &=O, differentiation of (1 I> with respect to ,\I gives

[PL,. -(I+m)](~~idz\I) +B,(dt/di\f) --I’ = 0.

But from (13) in the test, we know that dtjd,\f=~;B,. Thus, we obtain o”~dAJ=O, ix., FF does
not shift horizontally. On the other hand, given that dy=O, ae obtain from (1 I> that

(I, +r,L,)(&+fM) + B,(&,‘d.\f) -I’ = 0.

i\gain, we have Ar/d,\f=O, i.r., FF does not shift vertically. Therefore, FF stays put and FF’
coincides with FF.
13. It can be verified that while the condition for determining whether the exchange rate overshoots
or not is independent of exchange rate expectations, the extent of overshooting does depend on
the magnitude of the speed of adjustment of expectations.
14. Elsewhere, Chen and Lai (1985) have demonstrated that an ‘older’ model of quantity theory of
mane): where the exchange markets are assumed to clear instantaneously, will likely produce
overshooting of the exchange rate following an increase in the money supply, even when
expectations are static.

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