LECTURE 4:
THE MUNDELL-FLEMING MODEL -MONETARY & FISCAL POLICY, AND ADJUSTMENT
Question 1: What are the implications of monetary & fiscal policy
for income & the balance of payments, at a given exchange rate?
Question 2: Mechanisms of adjustment. How does a country
adjust to BoP imbalance? What further implications for the economy?
Key parameter: κ, degree of capital mobility
The Monetary Approach to the Balance of Payments
-- One result: under fixed E, κ contributes to offset of money expansion.
The Mundell-Fleming Model
IS curve:
Y=
slopes down
𝐴 − 𝑏𝑖 + 𝑋
𝑠+𝑚
An increase in spending, e.g., fiscal expansion,
shifts IS right, by the multiplier, 1/(s+m).
slopes up
LM curve:
𝑀1
𝑃
Recap
LM′
= L(i, Y)
Monetary expansion shifts LM right.
BP curve:
(i-i*) =
1
κ
slopes up
𝑚
κ
slope = m/κ
[−𝐾𝐴 − 𝑋 ] + ( ) Y .
API-120 - Prof. J.Frankel
𝐴↑
 0
m /  
•
 0
  0
  m /   0
•
API-120 - Prof. J.Frankel, Harvard
•
m /  0
𝑀/𝑃 ↑
 0
m /  
 0
  0
  m /   0
m /  0
•
•
API-120 - Prof. J.Frankel, Harvard
•
Monetary & fiscal policy in the Mundell-Fleming
model with a fixed exchange rate -- Summary
• Fiscal expansion
shifts out IS curve.
𝐴↑
– Result: Y↑ ,
– though by less than simple Keynesian
multiplier because i ↑ => crowding out.
Result for external balance
i) Y↑ => TB ↓
ii) With an open KA:
• Fiscal expansion
=> i ↑ => KA ↑
• Monetary expansion
shifts out LM curve.
– Result i ↓ => Y↑.
𝑀/𝑃↑
• Magnitudes of ∆Y do not depend
on degree of capital mobility, κ.
API-120 - Prof. J.Frankel, Harvard
• Monetary expansion
=> i ↓ => KA ↓
Effect on overall BP
(=CA+KA) depends
on degree of
capital mobility.
Automatic mechanisms of adjustment
 Indebtedness -- Rising debt will eventually force a reduction
in spending. We omit this factor from the course for now.
 Price level P – We assume for the moment
that price adjustment is very slow.
 Exchange rate E – Important if the rate is flexible.
 Reserve flows R -- Important under the MABP.
MABP
(The Monetary Approach to the Balance of Payments)
Defining assumption: Reserve flows are not sterilized.
Definitions:
BP ≡ dR/dt
Monetary Base: Liabilities of CB  assets held by CB
MB  R + NDA
where R ≡ International Reserves
& NDA ≡ Net Domestic Assets.
Broad Money Supply (M1):
Liabilities of entire banking system
M1 = a multiple of MB <= fractional reserve banking.
Sterilization:
Changes in reserves (i.e., BP) counteracted by NDA ,
dNDA/dt = - dR/dt, so MB unchanged.
Non-sterilization: dMB /dt = dR /dt.
MABP: If reserve outflow is not sterilized, then MB falls, LM shifts back,
Without sterilizing reserve flows
and i rises over time, until in the long run we are back where we started.
𝑀/𝑃↑   0
••
 0
••
  0
••
This offset to the increase in MB happens more quickly, the higher is κ .
API-120 - Prof. J.Frankel, Harvard
A country at point B
•
-- as
were many developing
countries in 1990-96,
2003-08, or 2010-13 --
has a BoP surplus.
The authorities must choose
among several options
for managing inflows.
(Each option has
its own drawback).
Alternative ways to manage inflows (with disadvantages)
A. Allow money to flow in.
(Can be inflationary)
B. Sterilize intervention. (Artificially prolongs disequilibrium)
C. Allow currency to appreciate.
(Lose competitiveness)
D. Reimpose capital controls. (Lose financial integration gains)
API-120 - Prof. J.Frankel, Harvard
An example of attempts to sterilize
reserve inflows
• China began in 2003 to run large
balance of payments surpluses
• and tried to sterilize the reserve inflows …
successfully for several years.
API-120 - Prof. J.Frankel, Harvard
In 2003,
forex
inflows
accelerated
rapidly.
(Both TB & KA >> 0.)
Initially, the PBoC had no trouble sterilizing the inflows.
=> The MB growth rate was kept down to the growth rate of the
API-120 - Prof. J.Frankel,
Harvard was little inflationary pressure.
real economy (≈ 10%/year),
so there
Appendix: To be continued when we pick up
the past decade of China’s macroeconomy
in Lecture 16
API-120 - Prof. J.Frankel, Harvard
The Balance of Payments
≡ rate of change of foreign exchange reserves (largely $),
rose rapidly in China from 2004 on, due to all 3 components:
trade balance, Foreign Direct Investment & portfolio inflows
Reserves
BoP
Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008
13
FX reserves of the PBoC climbed higher than
any central bank in history
API-120 - Prof. J.Frankel,
Harvard
http://viableopposition.blogspot.com/2012/03/chinas-holdings-of-us-treasuries-what.html
http://qz.com/171645/the-invisible-man-managing-chinas-3-8-trillion-in-reserves-just-stepped-down
Sterilization of foreign reserves:
People’s Bank of China sold sterilization bills,
thereby taking RMB out of circulation.
Data: CEIC
Source: Zhang, 2011 ,
ITF-220 - Prof.J.Frankel
Fig.4, p.45.