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# Lecture 6 Elasticity Approach to the Balance of Payment Mundell-Fleming Model

Which are the e®ects of a depreciation/devaluation on the current account? ² we assume the prices of goods and services are ¯xed so that changes in the nominal exchange rate imply corresponding changes in the real exchange rate; (i.e. we assume that the supply elasticities for the domestic export good and foreign import good are perfectly elastic so that changes in demand volumes have no e®ect on their price). ² Current account: CA = P £ X ¡ eP ¤ £ M where P (P ¤ ) is the domestic (foreign) price level; e is the nominal exchange rate; X is the volume of domestic exports; M is the volume of domestic imports.

² We de¯ne the price elasticity of demand for exports as the percentage change in exports over the percentage change in prices (here the nominal exchange rate): ´x = dX = de X e ² Similarly for imports: ´m = ¡ dM = de M e . ² We have that M depends negatively on the exchange rate: dM < 0: When the exchange rate de depreciates domestic residents ¯nd foreign goods more expensive.² We have that X depends positively on the exchange rate: dX > 0: When the exchange rate de depreciates foreign residents ¯nd domestic goods cheaper.

Divide both side by M : dCA 1 dX e dM 1 = ¡e ¡1 de M de M de M So that dCA 1 = ´ x + ´m ¡ 1 de M Marshall-Lerner condition says that.Now we want to examine the e®ect of a change in the nominal exchange rate on the current account. . a depreciation will improve the current account only if the sum of the of the two elasticities is greater than unity. dCA dX dM = ¡e ¡M de de de Suppose that we are initially in a balanced current account X = eM. starting from a position of equilibrium in the current account.

Two e®ects: 1) Price e®ect contributes to a worsening of the current account because imports become more expensive: for a given M we have that eM ". so that the price e®ect dominates leading to a worsening of the current account following a depreciation of the exchange rate. The evolution of the current account following a depreciation is illustrated by a J-curve. J-curve: in the short-run the Marshall-Lerner condition might not hold. 2) Volume e®ect contributes to improving the current account because exports become cheaper from a foreign country's perspective: " X and # M. In the short-run exports and imports volume do not change that much. .

The J-Curve Current Account Surplus Time Deficit .

² PPP does not hold and the size of the current account surplus depends positively on the real exchange rate and negatively on the real income: CA = CA Y. Balance of Payment: ² the current account is determined independently of the capital account. Building blocks: Aggregate supply is °at: ² it implies that prices are ¯xed. e Ã ¡ + ! . Ã eP ¤ P ! = CA Y .Mundell-Fleming model: keynesian tradition in the sense that aggregate economic activity is determined by aggregate demand.

² exchange rate expectations are static.-note that we have assumed that the MarshallLerner condition holds. ² Capital Account: we distinguish two situations: a) Perfect capital mobility: if capital if perfectly mobile then UIP condition always hold and since we assume that expectations are static it has to be r = r¤ b) Imperfect capital mobility: ¯nite °ows of capital depends only on interest rate di®erential across countries K = K r ¡ r¤ + Ã ! . -shift to tastes and foreign income are exogenous factor that can be incorporated into the CA equation.

e + K r ¡ r ¤ = 0 ¡ + + Ã ! Ã ! IS curve in open economy: From the national income accounting identity we have that: Y = C + I + CA + G where C is our keynesian consumption function in which consumption depends on disposable income: dC <1 dY Investment depends negatively on the real interest rate: dI I = I (r) <0 dr C = C (Y ¡ T ) . 0< .Balance of Payment: equilibrium when the °ow of capital ¯nance the current account surplus or de¯cit BP = CA Y .

e Ã ¡ + ! and G. LM curve in open economy -same as in the closed economy case: money market equilibrium determines the equality between money supply and money demand M = L Y. IS locus describe the combination of income and real interest rate for which savings are su±cient to cover the ¯nancing required by investment (domestic and foreign). public expenditure is taken as exogenous.and CA = CA Y . r + ¡ P Ã ! -LM locus describes the combination of income and real interest rate so that the money market is in equilibrium. .

BOP Equilibrium Locus under Imperfect Capital Mobility r BP (e0 ) BP (e1 ) Y .

Dependence of the IS curve on the nominal exchange rate r IS (e1 ) IS (e0 ) y .

the level of income. . and the Central bank has to conduct o±cial foreign exchange intervention to maintain the exchange rate ¯xed. Remember in the following analysis: a) external equilibrium: BoP is zero. adjusts in order to keep the zero balance of payment condition. intersection between LM and IS curve). r. and the third endogenous variable depends on the exchange rate regime assumed.Equilibrium: In general there are three endogenous variables in this model. b) internal equilibrium is given by the goods market and money market equilibrium (i. We will analyze monetary and ¯scal policies depending on the exchange rate regime and on the degree of capital mobility. Y . The interest rate. a) Floating exchange rate regime: e. b)Fixed exchange rate regime: e is given.e. the nominal exchange rate.

² an improvement in the current account of the balance of payment. . ² an increase in income. ² a fall in the real interest rate as long as capital is imperfectly mobile.Monetary Expansion under a Floating Exchange Rate Regime: E®ects: ² depreciation of the nominal exchange rate.

Monetary Expansion under a Floating Exchange Rate Regime r LM (M 0 ) LM (M 1 ) BP (e0 ) 0 BP (e1 ) 2 1 IS (e0 ) IS (e1 ) Y .

we do not observe any change in the real interest rate. Output e®ects are bigger the higher is the degree of capital mobility. Income increase is the counterpart of price rise in the monetary model. Comparison with the monetary model: same qualitative results in terms of exchange rate changes. This will induce a capital out°ows and decrease demand for domestic currency. In order to restore the equilibrium in the balance of payment we need to depreciate the exchange rate so that the current account improves. All the adjustment takes place through the nominal exchange rate. With perfect capital mobility. an increase in money supply requires lower interest rates. .Adjustment mechanism: ² Since prices are ¯xed.

Fiscal Expansion under a Floating Exchange Rate Regime: E®ects: ² appreciation of the nominal exchange rate. . ² an increase in income. ² a deterioration the current account of the balance of payment. ² an increase in the real interest rate as long as capital is imperfectly mobile.

This will induce capital in°ows and an increase in the demand for domestic currency. This e®ect is stronger the higher is the degree of capital mobility. the IS curve can move only temporarily. In order to restore the equilibrium in the balance of payment we need to appreciate the exchange rate so that the current account deteriorates. Change in the exchange rate is such that the expansionary e®ect of public spending is o®set. Increase in public spending crowds out external demand. . Comparison with closed economy: output expansion is lower because of crowding out e®ect of exchange rate appreciation on external demand. All the adjustment takes place through the nominal exchange rate. With perfect capital mobility. No impact on output.Adjustment mechanism: ² An increase in public spending implies higher interest rates.

In doing so. the de¯cit in the balance of payment will induce a decrease in the demand for domestic currency. ¢F X = ¢DC). we observe a fall in foreign reserves but no change on output. the less are the short-run e®ects.e. the interest rate falls. it reduces the money supply. interest rate and the balance of payment. The Central bank intervenes to keep the exchange rate ¯xed by selling foreign reserves for domestic currency. provided that capital is not completely mobile. (i. Adjustment mechanism: once money supply increases. The higher the degree of capital mobility. . income increases and the balance of payment deteriorates in the current account and in the capital account. ² in the long run.Monetary Policy under Fixed Exchange Rate Regime: ² in the short-run.

FX 0 ) 1 IS Y . FX 0 ) BP 0 LM (DC1 .Monetary Expansion under a Fixed Exchange Rate Regime r LM (DC1 . FX 1 ) LM (DC 0 .