International Finance — Mundell–Fleming and Open-Economy Policy

International Finance — In an Open Economy, the Same Fiscal Policy Does Different Things Under Different Exchange-Rate Regimes

The closed-economy IS-LM model is in macroeconomics chapter 23. Once borders open, interest rates and exchange rates are linked through capital flows, and net exports push IS again. Mundell–Fleming is a model that simplifies that link as short-run, sticky-price and static.

1. The BP curve is the set of interest-rate and output combinations at which the foreign-exchange market is in equilibrium

With perfect capital mobility, the domestic interest rate cannot depart from the world rate $r^*$ , and BP is horizontal. With imperfect capital mobility, higher output raises imports and worsens the current account, so a higher interest rate is needed for balance and BP slopes upward.

BP equilibrium (simple)

NX(Y, E) + KA(r-r^*) = 0

E is won per unit of foreign currency. A rise in E (depreciation) improves NX, and a rise in r increases capital inflows. Fix the quotation convention first.

The exchange-rate and balance-of-payments accounting of chapters 1–2 enters the IS side here. The point that the assumption of depreciation immediately improving NX depends on Marshall–Lerner and on lags still applies.

2. Under a fixed exchange rate, monetary policy is tied to the foreign-exchange market

With a fixed rate and perfect capital mobility, a cut in domestic interest rates triggers capital outflows and creates depreciation pressure. To defend the rate, the central bank sells foreign currency and absorbs base money. LM returns to where it was. There is no independent monetary policy.

A fiscal expansion pushes IS to the right, and upward pressure on interest rates draws in capital. To prevent appreciation, base money must expand, so LM follows. The output effect is larger.

Perfect capital mobility, short-run sticky prices
Shock	Floating rate	Fixed rate
Fiscal expansion	Appreciation crowds out net exports, weak output effect	Money follows, large output effect
Monetary expansion	Depreciation raises net exports, large output effect	Neutralized by FX intervention
Rise in world interest rates	Capital outflows, depreciation	Reserves fall, tightening

Under a floating rate, 10 trillion won of government spending creates upward pressure on interest rates, and when capital inflows appreciate the won, net exports fall. With perfect capital mobility, the appreciation continues until the domestic rate returns to $r^*$ , so net exports fall by close to 10 trillion won and output barely rises. If capital mobility is imperfect and the appreciation cuts net exports by only 4 trillion won, the first-round increase in net demand is 6 trillion won. The more open the economy and the more mobile capital, the larger this crowding out.

3. What this model leaves out

Price adjustment, exchange-rate expectations, foreign-currency liabilities on balance sheets and the zero lower bound are not included. When an emerging economy has borrowed in dollars, depreciation increases the debt burden before it improves net exports. In that case the result that “monetary policy is effective under a floating rate” may not hold.

Check your understanding

Does a fiscal expansion raise output in a fixed-rate country where capital barely moves? If BP is steep, the rise in imports from higher output outweighs the capital inflows from higher interest rates, and the balance of payments goes into deficit. When the central bank sells foreign currency to defend the rate, the money supply falls, LM shifts left and the output effect weakens. “Fiscal policy is strong under a fixed rate” is a result of the perfect-mobility assumption.

References

Robert Mundell, “Capital Mobility and Stabilization Policy under Fixed and Flexible Exchange Rates,” Canadian Journal of Economics (1963)
J. Marcus Fleming, “Domestic Financial Policies under Fixed and Floating Exchange Rates,” IMF Staff Papers (1962)
IMF, Annual Report on Exchange Arrangements and Exchange Restrictions