Exchange rates and the
Mundell-Fleming model
Imports, exports, exchange rates
From IS-LM to Mundell-Fleming
Policy in an open economy
Balance of payments and exchange rate

Up until now, we have worked only in the case
of closed economies


No trade considerations were present
However, we know that in fact trade is
important in understanding macroeconomics,
particularly so with globalisation.

As for previous models, this means we have to
introduce corrections to the model to obtain a
better understanding of what trade does to the
economy
Exchange rates and Mundell-Fleming
Imports, exports and exchange rates
Current account, capital account and
balance of payments
From IS-LM to Mundell-Fleming
Effectiveness of policy
Imports, exports and exchange rates

The first element to take into account in an
open economy is the presence of imports M
and exports X in aggregate demand


 
Y  C Y  T   I  i   G  X Y , e  M Y , e

*




These represent another possible leakage
from the circular flow of income

In particular, agents will have a propensity to
import which will have to be taken into
account when calculating multipliers
Imports, exports and exchange rates


 
Y  C Y  T   I  i   G  X Y , e  M Y , e





Second problem: in terms of national
accounting, exports / imports are not
measured in the same units:



*
We need to convert imports paid in foreign
currency into national currency
Exports towards other countries are also affected
by the value of the currency
This is where the exchange rate comes in
Imports, exports and exchange rates

The exchange rate (e) is the price of one currency in
terms of another currency

Note of caution ! There are 2 ways of working it out:

The amount of $ you can buy with 1€ :
 1€ = 1.35$

The amount of € required to buy 1$ :
 1$ = 0.75€

These two measures are equivalent, but be careful, the
second one (often used in models) is not intuitive :
 If e falls, less € are needed to purchase 1$, so the euro

has appreciated (it is worth more in $ terms)
If e increases, more € are needed to purchase 1$, so the
euro has depreciated (it is worth less in $ terms)
Imports, exports and exchange rates
The exchange rate is a price
e=price of the currency
(dollars/euro)
Supply of euros
Purchase of dollardenominated assets,
imports
Equilibrium
exchange rate e*
Purchase of eurodenominated assets,
exports
Demand for euros
Quantity
Imports, exports and exchange rates

The exchange rate is in nominal terms

It is possible to define a real exchange rate
which accounts for the price levels in the two
currency areas
e

real
$/€
 e$ / €
P€
P$
The real exchange rate gives a relative price

It expresses the relative value of a
representative basket in the euro zone to the
same basket in the USA.
Imports, exports and exchange rates

This allows us to define the purchasing power parity
(PPP) exchange rate.

The PPP exchange rate is the nominal exchange rate that
occurs when the real exchange rate is 1.
e

real
$/€
 e$ / €
P€
P$
e
PPP
$/€

P$
P€
The PPP exchange rate is often considered to be the
long run equilibrium exchange rate

It is also used to compare economic variables across
countries, particularly measures related to standards of
living or welfare
Exchange rates and Mundell-Fleming
Imports, exports and exchange rates
Current account, capital account and
balance of payments
From IS-LM to Mundell-Fleming
Effectiveness of policy
Current account and capital account


The current account is not the only element
of international trade.
The balance of payments composed of:

The current account CA:
 Tracks outflows minus inflows of goods and services
 It corresponds to the Exports – Imports component.

The capital account KA:
 Tracks inflows minus outflows of capital of a country
 Either as direct investment (building factories, etc)
 Or purchases/sales of assets
Current account and capital account

The current account was explained in the previous
section as the ‘net exports’ added to C + I + G.



What role does the capital account play ?
To understand their relation, let’s derive the
savings/investment balance for an open economy
Z  C  I  G  X

Y  C  S  T  M
Setting Z = Y :
S T  M  I G  X
Current account and capital account

This gives us the equilibrium condition in terms of
investment and savings:
S  I  G T  X  M

Simplifying assumption: the government budget is in
equilibrium (G-T = 0)



If there is a CA deficit (X-M < 0), there are not enough savings
(agents are spending too much). Some of the financing of
investment (I) must come from abroad.
If there is a CA surplus (X-M > 0), there is excess savings
(agents are not spending enough). The excess saving are used
to fund foreign investment.
The adjustment to the current account balance occurs
through an inflow or outflow of savings: This is the
capital account.
Current account and capital account

The BoP is in equilibrium
when
 CA+KA = 0
 The current account and
capital imbalances add
to 0
 As seen in the previous
slide, this is equivalent
to saying that S = I in an
open economy
Current account and capital account
Source: BIS,2007 World Report
Current account and capital account
S  I  G T  X  M

The USA have been net importers and net borrowers
since the 1980’s. The US current account deficit in 2006
was 6,6% of its GDP.

Europe has recently seen positive balances on its current
account, which reflects a relatively low level of growth.

Japan has traditionally been a net exporter and a net
lender.

The current accounts surpluses of emerging Asian
countries (particularly China) have grown during the
1990’s
Current account and capital account
S  I  G T  X  M

The amount of savings required to finance the current
account deficit of the USA has tripled since 1997.

On the other had, the emerging economies have become
net providers of savings flows.

Europe and Asia (including Japan) has covered 2/3 of the
funding needs of the USA in 2002.
Exchange rates and Mundell-Fleming
Imports, exports and exchange rates
Current account, capital account and
balance of payments
From IS-LM to Mundell-Fleming
Effectiveness of policy
From IS-LM to Mundell-Fleming

Model developed by Robert Mundell and Marcus
Fleming

It extends the IS-LM model to an open economy


 
Y  C Y  T   I  i   G  X Y , e  M Y , e

*




Aggregate demand now contains the current
account : i.e. the difference between exports
and imports.
 X(Y*,e) : Exports are a function of the income of

the rest of the world (exogenous) and the
exchange rate
M(Y,e) : Imports are a function of national
income and the exchange rate
From IS-LM to Mundell-Fleming




 
CA Y , Y , e  X Y , e  M Y , e
*



*




Determinants of the current account:
 If e increases (depreciation): exports are more competitive



and imports more expensive. The net balance of the current
account increases.
If Y increases: imports increase and the net balance of the
current account falls.
Y* is exogenous, and Y is already determined in IS-LM.
There is an extra variable to account for: the exchange
rate e.
We need to add another equation (market) in order to be
able to solve the system: we use the equilibrium condition
on the balance of payments
From IS-LM to Mundell-Fleming

Reminder: the balance of payments is the sum of the
current account and the capital account:
BP Y , Y , i , e   CA Y , Y , e   KA i , e 
*

*
The equilibrium exchange rate is achieved when BP is
equal to zero, in other words when the deficits and
surpluses of the two accounts compensate exactly.
KA i , e    CA Y , Y , e 
*


One can see that this equilibrium condition can be
expressed in the (Y,i) space of IS-LM.
We still need to relate the exchange rate e to these
variables
From IS-LM to Mundell-Fleming

The capital account (KA)




Is in surplus if the inflows of
capital are larger than the
outflows.
Is in deficit in the other case.
What determines these capital
flows ?
Intuitive answer: the earnings on savings

If savings earn a higher return in Europe compared to
the USA, one would expect American capital to flow
towards Europe.
From IS-LM to Mundell-Fleming

Investors choose between assets that pay
different interest rates in different currencies.

What is the expected return for each of the
possible investment?



Their decision needs to account for the interest
rate differentials…
…But also for the evolution of the exchange
rates between currencies.
This arbitrage mechanism produces what is
called the uncovered interest rate parity (UIRP)

This gives us a relation between interest rate
differentials and changes in the exchange rate
From IS-LM to Mundell-Fleming

You are a European investor with capital K
(in €) looking for a 1-year investment.


You can invest in €-denominated bonds, and
after a year you earn:
K  1  i € 
Or you can buy $-denominated US bonds:
 Step 1: you first convert your capital into dollars:
K  e$ / €
 Step 2: after a year, you’ve earned (in dollars):
K  e $ / €  1  i$ 
From IS-LM to Mundell-Fleming

But you need to bring you investment back
home !



In other words you need to convert your
capital in $ back into €.
In the mean time the $/€ exchange rate may
have changed
Step 3: you convert your investment into €
K  e $ / €  1  i$ 
a
e$ / €

You are indifferent if the 2 returns are equal
From IS-LM to Mundell-Fleming

You’re indifferent between $ and € assets if:
K  e $ / €  1  i$ 
K  1  i €  

Rearranging gives:
1  i€ 

a
e$ / €
e$ / €
e
a
$/€
1  i€
1  i$ 
1  i$

e$ / €
a
e$ / €
If the exchange rate is not too volatile, this
can be expressed as:
e$ / €  e$ / €
a
i €  i$ 
e$ / €
From IS-LM to Mundell-Fleming

Let’s summarise: Capital flows ensure an equalisation
of interest rates expressed in the same currency
e$ / €  e$ / €
a
Home interest rate
i €  i$ 
e$ / €
Expected exchange rate
depreciation
World interest rate

If the home interest rate is higher than world interest
rate, zero net capital flows between countries requires
investors to be expecting a depreciation of the home
currency.


If this is not the case, then capital will flow into the home
country, appreciating e until depreciation expectations occur
Only if the home rate equals the foreign rate will
depreciation/appreciation expectations be zero (equilibrium)
From IS-LM to Mundell-Fleming

i
BoP surplus
Appreciation of e

BP
On BP the balance of
payments is in
equilibrium
BP is upward-sloping


KA surplus
CA deficit

BoP deficit
Depreciation of e
Y
An increase in Y leads to a
BoP deficit (CA deficit)
Returning to equilibrium
requires a KA surplus, and
hence a higher i
The slope depends on
the internationa mobility
of capital

The lower capital mobility,
the larger the slope of BP.
From IS-LM to Mundell-Fleming
i
Perfect capital
mobility

i=i*
BoP Surplus
Appreciation of e
i*

BP

BoP Deficit
The MF model was
developped in the 60’s,
when capital mobility was
low (Bretton Woods)
As a simplification,
nowadays we assume
perfect capital mobility
However, this remains a
simplification!

Depreciation of e
Y
For certain cases (like the
case of trade with China),
The concept of imperfect
capital mobility remains
relevant.
From IS-LM to Mundell-Fleming

We now have 3 curves, IS-LM-BP :
i
LM
i*
BP
IS
Y
Exchange rates and Mundell-Fleming
Imports, exports and exchange rates
Current account, capital account and
balance of payments
From IS-LM to Mundell-Fleming
Effectiveness of policy
The effectiveness of policy

We now move to assessing the effectiveness of
policy under the possible exchange rate
settings:
Fixed
exchange
rate
Flexible
exchange
rate
Fiscal
Policy
??
??
Monetary
Policy
??
??
The effectiveness of policy

Monetary policy with fixed exchange rate:
i

LM

BP
i*
LM shifts to the right

IS
Y

The increase in the money
supply lowers the rate of
interest, leading to
depreciation pressures on e
In order to guarantee the
fixed exchange rate the CB
must immediately increase i
to i=i* by reducing money
supply
Such a policy cannot be
carried out in practice
The effectiveness of policy

Fiscal policy with fixed exchange rate:
i

LM

BP
i*
IS shifts to the right:

IS
Y

The crowding out effect
increases the rate of interest,
creating appreciation
pressures on e
In order to guarantee the
fixed exchange rate the CB
must immediately reduce i
to i=i* by increasing money
supply
Policy is effective in
increasing Y
The effectiveness of policy

Monetary policy with flexible exchange rate:
i

LM


BP
i*
LM shifts to the right
The depreciation of the
exchange rate stimulates
exports and penalises
imports

IS
Y

The interest rate falls, which
leads to a depreciation of the
exchange rate e
As a resut IS shifts to the
right
Policy is effective
The effectiveness of policy

Fiscal policy with flexible exchange rate:
i

LM

BP
i*
IS shifts to the right

The appreciation of the
exchange rate penalises
exports and stimulates
imports

IS
Y

The Central Bank doesn’t
have to react: The interest
rate increases and the
exchange rate appreciates
IS shifts left
Policy is ineffective
The effectiveness of policy


Summarising all this:
Fixed
exchange
rate
Flexible
exchange
rate
Fiscal
Policy
Effective
Ineffective
Monetary
Policy
Impossible
Effective
Even with this simple example (assumption of perfect
capital mobility), one can see that the effectiveness of
policy depends on international conditions!
The effectiveness of policy
Monetary
Union
Incompatibility
Triangle
(Mundell)
Financial
Autarky
Autonomous monetary policy
Flexible
Exchange rate