Macroeconomic Policy Under
Regime of Free Capital Flows
Surajit Das
Mundell-Fleming Framework - Open Economy IS-LM Model:
r
I1
I0
M
r’
2
r*
L
S0
S0
O
Y*
Y’
Y
The Mundell-Fleming model can be described as follows:
r = r* … … … (A)
Ms = L(Y, r) … … … (B)
Y = C(Y – t.Y) + I(r, Y) + G + NX(Y, e) … … … (C)
But, the foreign capital inflow in a particular economy and in a particular period
of time should more realistically be assumed to be exogenously given rather
than assuming it to be solely dependent on the domestic interest rate or interest
rate differential or interest rate differential net of exchange rate fluctuation etc.
The direction and destination of flows of international finance capital would be
driven by profit motive based on expected capital gains and or various kinds of
country risks.
In such a case, in addition to the three equations there has to be a fourth one
for the balance of payment equilibrium:
NX(Y, e) = - k.e … … … … … … … … … (D)
3
FI
in
25000
US
$
Mn
20000
Chart I: Interest Rate, Exchange Rate & Net Capital Inflow in India
50
40
Values, %
30
15000
20
10
10000
2005-06
2004-05
2003-04
2002-03
2001-02
2000-01
1999-00
1998-99
1997-98
1996-97
1995-96
1994-95
1993-94
1992-93
1991-92
-10
1990-91
0
-20
5000
0
Exchange Rates, Rupees per US$
Exchange Rate Fluctuations (%)
Year
Interest Rates (%)
Interest Rates net of Exchange Rate Fluctuations
Total Foreign Investment in US$ Million
Source: Handbook of Statistics on Indian Economy – 2006, RBI.
4
Chart II: Movements in Total Net Foreign Investment and SENSEX in India
25000
12,000
10,000
20000
8,000
Values
15000
6,000
10000
4,000
5000
2,000
Total Foreign Investment in US$ Million
SENSEX
2005-06
2004-05
2003-04
2002-03
2001-02
2000-01
0
1999-00
0
Year
Source: Handbook of Statistics on Indian Economy – 2006, RBI and Bombay Stock Exchange.
5
Balance of Payment Equilibrium:
e
6
K
O
Balance of Payment Equilibrium:
K
e
K
7
K
O
Balance of Payment Equilibrium:
K
e
G
e1
F
e0
K
8
K
V
U
O
Balance of Payment Equilibrium:
K
e
G
e1
F
e0
K
9
K
V
U
O
450
U
P
Q
C
V
M(Y), X
Balance of Payment Equilibrium:
K
e
G
e1
F
e0
K
10
K
V
U
O
450
X
T
U
P
Q
C
Y0
Y
Y1
X
J
M
L
V
M(Y), X
M
T
Balance of Payment Equilibrium:
K
e
G
e1
F
K
V
U
Y
O
450
P
C
Y0
X
T
U
Q
Y
Z0
e0
K
11
Z1
Y
Y1
X
J
M
L
V
M(Y), X
M
T
Balance of Payment Equilibrium:
K
K’
e
G
Z1
e1
F
Y
Z0
e0
Y
K
K’
12
K
V
U
O
450
X
T
U
P
Q
C
Y0
Y
Y1
X
J
M
L
V
M(Y), X
M
T
Balance of Payment Equilibrium:
K
e
G
K’
I
e1
F
H
Z1
Y
Z0
e0
Y
K
K’
13
K
D
W
V
U
O
450
X
T
U
P
Q
C
Y0
Y
Y1
X
J
M
L
V
M(Y), X
M
T
Balance of Payment Equilibrium:
K
e
G
K’
I
e1
F
H
Z1
Y
Z0
e0
Y
K
K’
14
K
D
W
V
U
O
450
X
T
U
P
Q
R
C
S
Y0
Y
Y1
X
J
M
L
V
W
D
M(Y), X
M
T
Balance of Payment Equilibrium:
K
e
G
K’
I
e1
F
H
Z1
Y
Z0
e0
Y
K
K’
15
K
D
W
V
U
O
450
X
T
U
P
Q
R
Y0
Y1
X
J
M
V
L
B
W
N
C
S
D
M(Y), X
Y
Y3
Y2
M
T
Balance of Payment Equilibrium:
K
e
G
K’
I
e1
F
H
Z1
Z0
e0
K
D
W
V
U
O
450
P
Q
R
Y0
X
T
U
Y’
Y’
K’
16
Z3
Z2
Y
K
Y
Y1
X
J
M
V
L
B
W
N
C
S
D
M(Y), X
Y
Y3
Y2
M
T
Balance of Payment Equilibrium:
K
e
G
K’
I
e1
F
H
Z1
Z0
e0
K
D
W
V
U
O
450
P
Q
R
Y0
X
T
U
Y’
Y’
K’
17
Z3
Z2
Y
K
Y
Y1
X
J
M
V
L
B
W
N
C
S
D
M(Y), X
Y
Y3
Y2
M
T
Balance of Payment Equilibrium:
K
e
Y
K’
K
Y
Y’
K’
18
K
Y’
Y
O
450
X
X
T
M
C
M(Y), X
M
T
Balance of Payment Equilibrium with Fixed Exchange Rate:
K
e
Z*
G
K’
e*
I
Z’
K
K’
19
K
D
V
O
450
X
X
T
M
Q
Y
Y’
Y*
L
V
N
C
S
D
M(Y), X
M
T
Product Market Equilibrium:
e
S
Y=C+I+G+X–M
20
I
O
Y
Simultaneous Equilibrium in Both Markets:
e
Y
S
Case I
21
I
Y
O
Y
Simultaneous Equilibrium in Both Markets:
e
S
Y
22
Y
I
O
Y
Case II
The national income identity or the commodity market equilibrium condition
Y = C(Y – T) + I(r, Y) + G + X(e) – M(Y, e) … … … … (1)
Standard tax function, when the tax-GDP ratio is assumed to be given
T = t.Y … … … … (2)
The consumption as a positive function of disposable income
C = θ + c.(Y – T) = θ + c.Y(1 – t) … … … … (3)
The investment function is assumed to depend positively on Y
and negatively on r
I = λ + α.Y – β.r = δ + α.Y … … … … (4)
The export function is given as positive function of the exchange rate
X = μ + e.x … … … … (5)
23
The import as a positive function of Y and negative function of exchange Rate
M = ρ + m.Y – e.n … … … … (6)
Therefore, from (1) we get the commodity market equilibrium condition as,
Y = θ + c.Y(1 – t) + δ + α.Y + G + μ + e.x – (ρ + m.Y – e.n)
 Y.[1 – c.(1 – t) – α + m] = φ + e.(x + n) … … … … (7)
Where, φ = θ + δ + G + μ –ρ.
The equilibrium condition for the BoP in foreign exchange market
ρ + m.Y – e.n – (μ + e.x) = k.e = K … … … … (8)
From (7) we get the slope of the commodity market equilibrium condition as
de/dY = [1 – c.(1 – t) – α + m]/(x + n) … … … … (9)
From (8) we get the slope of BoP equilibrium condition
de/dY = m/(x + n + k) … … … … (10)
24
Since, [1 – c.(1 – t) – α] > 0
(the multiplier)
i.e. [1 – c.(1 – t) – α](x + n + k) + m.k > 0
(all x, n, k & m >0)
i.e. [1 – c.(1 – t) – α + m]/(x + n) – m/(x + n + k) > 0
i.e. [1 – c.(1 – t) – α + m]/(x + n) > m/(x + n + k)
i.e. slope of commodity market equilibrium condition > slope of BoP
equilibrium condition.
i.e. IS curve is steeper than YY curve.
For simultaneous equilibrium in both the markets we get,
e* = (φ.m – μ.m – μ.ξ)/[ξ.(x + n +k) + m.k] … … … … (11) and
Y* = [(φ.m – μ.m – μ.ξ).(k + n + x)]/[m.{ξ.(x +n +k) + m.k}] + μ/m [from (8)]
…….. (12)
where, ξ = [1 – c.(1 – t) – α]
25
Macroeconomic Policy:
e
S0
Y
E0
e0
26
Y
I0
O
Y0
Y
Macroeconomic Policy:
e
S0
Y
Y’
E0
e0
27
Y
e1
E’
Y’
I0
O
Y’
Y0
Y
Macroeconomic Policy:
e
S0
S1
Y
E*
e2
E0
e0
28
Y
E1
I0
O
I1
Y0
Y*
Y
Macroeconomic Policy:
e
S0
E*
e2
S1
Y
Y’
E0
e0
29
e’
e1
Y
Y’
I1
I0
O
E1
E’
Y’
Y0
Y*
Y
Macroeconomic Policy:
e
S0
E2
30
Y
E1
E’
Y’
I1
I0
O
Y
E0
e0
e1
S2
Y’
E*
e2
e’
S1
Y’
I2
Y0
Y* Y
2
Y
Macroeconomic Policy:
e
S0
E3
E2
31
e1
Y
E1
E’
Y’
I1
I0
O
Y’
E0
e0
S3
Y
E*
e2
e’
S2
S1
Y’
I2
Y0
I3
Y* Y
2
Y3
Y
If G rises by ΔG, from (12) we get,
ΔY* = ΔG.m.(k + n + x)/[m.{ξ.(x +n +k) + m.k}]
 ΔY*/ ΔG = (k + n + x)/[{1 – c.(1 – t) – α}.(x +n +k) + m.k] … … … (13)
And if G rises by ΔG, from equation (11) we get,
Δe* = ΔG.m/[ξ.(x +n +k) + m.k]
 Δe*/ ΔG = m/[ξ.(x +n +k) + m.k]
 Δe*/ ΔG = m/[.[{1 – c.(1 – t) – α}.(x +n +k) + m.k] … … … … (14)
Therefore, we get, (ΔY*/ ΔG)>0 as well as (Δe*/ ΔG)>0.
Hence, if G increases, ceteris paribus, both Y and e unambiguously
rises and vice-versa for any given level of net capital inflow k under
Flexible exchange rate.
32
If K rises by ΔK, and Y* becomes Y*1 from (12) we get,
Y1* = [Δk(φ.m – μ.m – μ.ξ) + (k + n + x).(φ.m – μ.m – μ.ξ)]/[ Δk.m.(ξ +m) +
m.{ξ(k + n + x) + m.k} + μ/m
… … … … (15)
Now, Y1* would be less than Y* if the percentage rise in the numerator is less than the
percentage increase in the denominator (hence the ratio comes down) and vice-versa.
Δk(φ.m – μ.m – μ.ξ)/[(k + n + x).(φ.m – μ.m – μ.ξ)]<{Δk.m.(ξ +m)}/ {m.{ξ(k + n + x) + m.k}
i.e. Δk/(k + n + x) < Δk.(ξ +m)/{ξ(k + n + x) + m.k}
i.e. 1/(k + n + x) < (ξ +m)/{ξ(k + n + x) + m.k}
i.e. ξ(k + n + x) + m.k < (k + n + x).(ξ +m)
i.e. mk < (k + n + x).m
i.e. k < k + n + x
i.e. n + x > 0, but this is always true because by assumption both n and x are positive.
If K rises by ΔK, and e* becomes e*1 from (11) we get,
e1* = (φ.m – μ.m – μ.ξ)/[ Δk.(ξ +m) + ξ.(k +n +x) +m.k] … … … … (16)
Now, e* > e1* if Δk.(ξ +m) > 0, this is always true because Δk, ξ, and m are positive.
Therefore, if net capital inflow increases, then necessarily Y declines
and unambiguously the exchange rate appreciates, ceteris paribus, to
keep both the product and the foreign exchange market in equilibrium.
33
Policy Conclusions:
• The net foreign capital inflow is not really directly dependent on the
interest rates differentials; rather it would be more realistic to
assume that the net capital flows to be exogenously determined at
any particular period of time in any particular nation state.
• In case of fixed exchange rate, the foreign exchange market alone
can determine unique level of Y; as happens, for example, in case
of foreign exchange constraint economies.
• In case of Flexible exchange rate, if the government expenditure
increases, ceteris paribus, the level of activity and employment
unambiguously increases.
• In case of Flexible exchange rate, if capital inflow increases, ceteris
paribus, the level of activity and employment unambiguously
decreases although in case of capital outflow the reversal does not
happen.
• The level of activity is determined by goods market and foreign
exchange market equilibria and the money market would always be
in equilibrium at any administered rate of interest or in other words
the money supply would be endogenously determined.
34
Any independent demand constrained nation State saddled with
involuntary unemployment would not be necessarily able to
increase its employment and output by undertaking autonomous
expansionary fiscal policy alone; along with that it has to have
some control over the capital account of balance of payment.
Therefore, the expansionary fiscal policies coupled with some
control over foreign capital flows are recommended under such a
situation as opposed to contractionary fiscal stance along with
absolutely reckless capital flows, which we are witnessing today.
Thank You
_____