LECTURE 2:

THE MUNDELL-FLEMING MODEL

WITH A FIXED EXCHANGE RATE
Keynesian Model of the trade balance TB & income Y.
Key assumption: P fixed => Y Y .

Mundell-Fleming model
Key additional assumption:
international capital flows KA respond to interest rates i .

Questions:
Effect of fiscal expansion or other  A .
Effect of monetary expansion  M / P .
ALTERNATE APPROACHES TO DETERMINATION
OF EXTERNAL BALANCE

 Elasticities Approach to the Trade Balance

 Keynesian Approach to the Trade Balance
 Mundell-Fleming Model of the Balance of Payments
 Monetary Approach to the Balance of Payments
  NonTraded Goods or Dependent-Economy
Model of the Trade Balance
 Intertemporal Approach to the Current Account
KEYNESIAN MODEL OF THE TRADE BALANCE
Import demand is a function of the exchange rate & income.
The same for exports: =>  TB = X(E, Y*) – IM(E, Y),
where IM is here defined to be import spending expressed in domestic terms.
 
dX dIM
0 0
dE dE
.
dX dIM
 m*  0 m0
dY * dY

If the domestic country is small, Y* is exogenous;

drop for simplicity. Rewrite TB = X ( E )  mY.
Notationally, we embody all E effects (whether via exports or imports) in X ;
dX
And we assume the Marshall-Lerner condition holds: 0 .
dE
 Empirical estimates of sensitivity of
exports and imports to E & Y

log X

log( EP * / P )
• For empirical purposes, we estimate by OLS regression
– with allowance for lags, giving J-curve;
– shown in logs, giving parameters as:
• price elasticities, and
• income elasticities.
• Illustration: Marquez (2002) finds for most Asian countries:
– Marshall-Lerner condition holds, after a couple of years, and
– income elasticities are in the 1.0-2.0 range.
 Estimated price
elasticities (LR)
satisfy the
Marshall-Lerner
Estimated income Condition.
elasticities
are mostly
between 1.0 - 2.0.
Trade Balance = TB = X (E) – mY.
Aggregate output = domestic Aggregate Demand + net foreign demand:
Y = A(i, Y) + TB(E, Y),
dA dA
where  0 and c0 .
di dY
 
More specifically, let A(i, Y) = Ā - b(i) + cY ,
where the function -b( ) captures the negative effect of
the interest rate i on investment spending, consumer durables, etc.

Combining equations,
Y = A  b(i )  cY  X ( E )  mY

Solve to get the IS curve:

A  b(i )  X ( E )
Y
sm where s  1 – c is the marginal propensity to save.
 IS curve: An inverse relationship between i and Y
consistent with the equilibrium that supply = demand in the goods market.

A  b(i )  X ( E )
Y
sm

A,
 The Mundell-Fleming model introduces capital flows
The overall balance of payments is given by
BP = TB + KA  X ( E )  mY  KA   (i  i*) ,
dKA
 where  , the degree of capital mobility > 0.
d (i  i*)
We want to graph BP = 0. Solve for the interest rate:

(i  i*)  (1 /  )( X  KA)  (m /  )Y

slope = m/
Finally, the LM curve is given by
__ __
M /P = L ( i, Y)
 
dL dL
where 0 0
di dY

LM´
→ A monetary

expansion shifts
the LM curve
to the right .
 Causes of Capital Flows to Emerging Markets
I. “Pull” Factors (internal causes)
1. Monetary stabilization => LM shifts up
2. Removal of capital controls => κ rises
3. Spending boom => IS shifts out/up
Application of 4. Domestic privatization, => IS or BP shift out
deregulation & liberalization
the Mundell-

}
Fleming model II. “Push” Factors (external causes) BP
1. Low interest rates in rich countries
to payments shifts
2. Desire to diversify
=>by
i* global
down investors => down
surpluses =>
=>
experienced
by emerging
markets.
 Causes of 2003-08 and 2010-11 Capital Flows
to Developing Countries
• Strong economic performance (especially China & India)
-- IS shifts right.

• Easy monetary policy in US and other

major industrialized countries (low i*)
-- BP shifts down.

• Big boom in mineral & agricultural commodities (esp.

Africa & Latin America)
-- BP shifts right.