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

Which are the eects of a depreciation/devaluation on the current account? 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 eect on their price). 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.

We have that X depends positively on the exchange rate: dX > 0: When the exchange rate de depreciates foreign residents nd domestic goods cheaper.

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.

We dene 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 Similarly for imports: m = dM = de M e

Now we want to examine the eect of a change in the nominal exchange rate on the current account. dCA dX dM = e M de de de Suppose that we are initially in a balanced current account X = eM. 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, starting from a position of equilibrium in the current account, a depreciation will improve the current account only if the sum of the of the two elasticities is greater than unity.

Two eects: 1) Price eect contributes to a worsening of the current account because imports become more expensive: for a given M we have that eM "; 2) Volume eect contributes to improving the current account because exports become cheaper from a foreign country's perspective: " X and # M. J-curve: in the short-run the Marshall-Lerner condition might not hold. In the short-run exports and imports volume do not change that much, so that the price eect 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.

The J-Curve

## Current Account Surplus

Time

Deficit

Mundell-Fleming model: keynesian tradition in the sense that aggregate economic activity is determined by aggregate demand. Building blocks: Aggregate supply is at: it implies that prices are xed. Balance of Payment: the current account is determined independently of the capital account; 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;

eP P

= CA Y ; e

-note that we have assumed that the MarshallLerner condition holds; -shift to tastes and foreign income are exogenous factor that can be incorporated into the CA equation; exchange rate expectations are static; 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 dierential across countries K = K r r
+

Balance of Payment: equilibrium when the ow of capital nance the current account surplus or decit BP = CA Y ; e + K r r = 0
+ +

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<

and

CA = CA Y ; e

and G, public expenditure is taken as exogenous. IS locus describe the combination of income and real interest rate for which savings are sucient to cover the nancing required by investment (domestic and foreign). 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; r + P
!

-LM locus describes the combination of income and real interest rate so that the money market is in equilibrium.

r

BP (e0 )

BP (e1 )

## Dependence of the IS curve on the nominal exchange rate

r IS (e1 )

IS (e0 )

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

## Monetary Expansion under a Floating Exchange Rate Regime: Eects:

depreciation of the nominal exchange rate; an increase in income; a fall in the real interest rate as long as capital is imperfectly mobile;

## 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 )

Adjustment mechanism: Since prices are xed, an increase in money supply requires lower interest rates. This will induce a capital outows 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. Comparison with the monetary model: same qualitative results in terms of exchange rate changes. Income increase is the counterpart of price rise in the monetary model. With perfect capital mobility, we do not observe any change in the real interest rate. All the adjustment takes place through the nominal exchange rate. Output eects are bigger the higher is the degree of capital mobility.

## Fiscal Expansion under a Floating Exchange Rate Regime: Eects:

appreciation of the nominal exchange rate; an increase in income; an increase in the real interest rate as long as capital is imperfectly mobile;

## a deterioration the current account of the balance of payment;

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

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

## Monetary Expansion under a Fixed Exchange Rate Regime

LM (DC1 , FX 1 ) LM (DC 0 , FX 0 )

BP 0 LM (DC1 , FX 0 )

1 IS