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Introduction:
When conducting monetary and fiscal policy, policymakers often look beyond their own countrys borders. Even if domestic prosperity is their sole objective, it is necessary for them to consider the rest of the world. The international flow of goods and services and the international flow of capital can affect an economy in profound ways. Policymakers ignore these effects at their peril. The model developed to study this, called the MundellFleming model, is an open-economy version of the ISLM model. The key difference is that the ISLM model assumes a closed economy, whereas the MundellFleming model assumes an open economy.
The Key Assumption: Small Open Economy With Perfect Capital Mobility
Mundell-Fleming begins with the assumption of a small open economy with perfect capital mobility. This assumption means that the interest rate in this economy r is determined by the world interest rate r*. Mathematically, we can write this assumption as r = r*. This world interest rate is assumed to be exogenously fixed because the economy is sufficiently small relative to the world economy that it can borrow or lend as much as it wants in world financial markets without affecting the world interest rate. Imagine that some event were to occur that would normally raise the interest rate (such as a decline in domestic saving). In a small open economy, the domestic interest rate might rise by a little bit for a short time, but as soon as it did, foreigners would see the higher interest rate and start lending to this country. The capital inflow would drive the domestic interest rate back toward r*. Similarly, if any event were ever to start driving the domestic interest rate downward, capital would flow out of the country to earn a higher return abroad, and this capital outflow would drive the domestic interest rate back upward toward r*. Hence, the r = r* equation represents the assumption that the international flow of capital is rapid enough to keep the domestic interest rate equal to the world interest rate.
Y2 (a) (c)
Y1
e2
e2
e1
e1 IS*
NX (e2)
NX (e1)
Y2
Y1
Explanation:
The IS curve is derived from the net-exports schedule and the Keynesian cross. Panel (a) shows the net-exports schedule: an increase in the exchange rate from e1 to e2 lowers net exports from NX (e1) to NX (e2). Panel (b) shows the Keynesian cross: a decrease in net exports from NX (e1) to NX (e2) shifts the planned expenditure (AD) schedule downward and reduces income from Y1 to Y2. Panel (c) shows the IS* curve summarizing this relationship between the exchange rate and income: the higher the exchange rate, the lower the level of income.
This equation states that the supply of real money balances, M/P, equals the demand, L(r, Y ).The demand for real balances depends negatively on the interest rate, which is now set equal to the world interest rate r*, and positively on income Y. The money supply M is an exogenous variable controlled by the central bank, and because the MundellFleming model is designed to analyze short-run fluctuations, the price level P is also assumed to be exogenously fixed. We can represent this equation graphically with a vertical LM* curve, as in panel (b) of Figure below.
r = r*
Output
Explanation:
Panel (a) shows the standard LM curve [which graphs the equation M/P = L(r, Y)] together with a horizontal line representing the world interest rate r*. The intersection of these two curves determines the level of income, regardless of the exchange rate. Therefore, as panel (b) shows, the LM* curve is vertical.
LM*
e*
IS* Y Y*
Explanation:
This graph of the MundellFleming model plots the goods market equilibrium condition IS* and the money market equilibrium condition LM*. Both curves are drawn holding the interest rate constant at the world interest rate. The intersection of these two curves shows the level of income and the exchange rate that satisfy equilibrium both in the goods market and in the money market.
Fiscal Policy
Suppose that the government stimulates domestic spending by increasing government purchases or by cutting taxes. Because such expansionary fiscal policy increases planned expenditure, it shifts the IS* curve to the right, as in Figure. As a result, the exchange rate rises, whereas the level of income remains the same.
e LM*
e2 e1 IS2* IS1* Ye
Monetary Policy
Suppose now that the central bank increases the money supply. Because the price level is assumed to be fixed, the increase in the money supply means an increase in real balances. The increase in real balances shifts the LM* curve to the right, as in Figure below. Hence, an increase in the money supply raises income and lowers the exchange rate.
LM1* e1 e2
LM2*
IS* Y1 Y2
Trade Policy
Suppose that the government reduces the demand for imported goods by imposing an import quota or a tariff. What happens to aggregate income and the exchange rate? Because net exports equal exports minus imports, a reduction in imports means an increase in net exports. That is, the net-exports schedule shifts to the right, as in Figure.
e LM*
e2 e1 IS2* IS1* Ye
This shift in the net-exports schedule increases planned expenditure and thus moves the IS* curve to the right. Because the LM* curve is vertical, the trade restriction raises the exchange rate but does not affect income.
Fiscal Policy
Lets now examine how economic policies affect a small open economy with a fixed exchange rate. Suppose that the government stimulates domestic spending by increasing government
purchases or by cutting taxes. This policy shifts the IS* curve to the right, as in Figure, putting upward pressure on the exchange rate. But because the central bank stands ready to trade foreign and domestic currency at the fixed exchange rate, arbitrageurs quickly respond to the rising exchange rate by selling foreign currency to the central bank, leading to an automatic monetary expansion. The rise in the money supply shifts the LM* curve to the right. Thus, under a fixed exchange rate, a fiscal expansion raises aggregate income.
e LM1* LM2*
e IS2* IS1* Y1 Y2
Monetary Policy
Imagine that a central bank operating with a fixed exchange rate were to try to increase the money supplyfor example, by buying bonds from the public. The initial impact of this policy is to shift the LM* curve to the right, lowering the exchange rate, as in Figure.
e LM*
IS* Y
Because the central bank is committed to trading foreign and domestic currency at a fixed exchange rate, arbitrageurs quickly respond to the falling exchange rate by selling the domestic currency to the central bank, causing the money supply and the LM* curve to return to their initial positions. Hence, monetary policy as usually conducted is ineffectual under a fixed exchange rate. By agreeing to fix the exchange rate, the central bank gives up its control over the money supply.
A country with a fixed exchange rate can, however, conduct a type of monetary policy: it can decide to change the level at which the exchange rate is fixed. A reduction in the value of the currency is called devaluation, and an increase in its value is called a revaluation. In the MundellFleming model, a devaluation shifts the LM* curve to the right; it acts like an increase in the money supply under a floating exchange rate. Devaluation thus expands net exports and raises aggregate income. Conversely, a revaluation shifts the LM* curve to the left, reduces net exports, and lowers aggregate income.
Trade Policy
Suppose that the government reduces imports by imposing an import quota or a tariff. This policy shifts the net-exports schedule to the right and thus shifts the IS* curve to the right, as in Figure 12-10. The shift in the IS* curve tends to raise the exchange rate. To keep the exchange rate at the fixed level, the money supply must rise, shifting the LM* curve to the right.
e LM1* LM2*
e IS2* IS1* Y1 Y2
The result of a trade restriction under a fixed exchange rate is very different from that under a floating exchange rate. In both cases, a trade restriction shifts the net-exports schedule to the right, but only under a fixed exchange rate does a trade restriction increase net exports NX. The reason is that a trade restriction under a fixed exchange rate induces monetary expansion rather than an appreciation of the exchange rate. The monetary expansion, in turn, raises aggregate income. As the accounting identity NX = S - I. When income rises, saving also rises, and this implies an increase in net exports.
We can discuss it with the help of an example which is the study of economics of Robinson Crusoe.
Conclusion:
In above simple story,
a) The fluctuations in output, employment, consumption, investment and productivity all the natural desirable response of an individual to the inevitable change in his environment. b) Crusoes economy is eliminated the role of monetary policy, sticky prices or any type of market failure.
Where, I.R.W. = temporarily comparison between the wage rate of first time with the wage rate if 2 nd time W1 = real wages in first time. W2 = real wages in second time. r = real interest rate. The wages/ interest rate determine whether to do work or to enjoy. Critics of RBC theory believe that fluctuations in employment do not reflect changes in the amount people want to work. They point out that the unemployment rate fluctuates substantially over the business cycle. The advocates of RBCT argue that unemployment statistics are difficult to interpret. The mere fact that the unemployment rate is high does not mean the intertemporal substitute of labour in un-important.
In View of Critics: The critics were of the view that many wages and prices are not flexible. So, due to inflexibility of wages and prices both unemployment and non-neutrality of money exists.
Classicals View:
They are of the view that always full employment exists in the economy. They are not in favour of government intervention. So they use a term which is invisible hands in the economy which determines the full employment level in the economy.
Conclusion:
The RBCT is an explanation of short run economic fluctuations built on the assumptions of the classicals model, including the classicals dichotomy and the flexibility of wages and prices. According to this theory economic fluctuations are the natural and efficient response of the economy to changing economic circumstances, especially changes in technology. RBCT emphasize intertemporal optimization and forward looking behaviour. Advocates and critics of RBCT disagree about whether employment fluctuations represent intertemporal substitutions of labour, whether technology shocks cause most economic fluctuations.
1 - Lags in implementation and effects of policies. When we adopt some policy it needs some time to be implementing, so that time duration is called lags in implementations. Policy makers would simply adjust their instruments to keep the economy on the desired path. Economists distinguish between two lags; 1. Inside lags 2. Outside lags Inside Lags: The inside lag is the time between a shock to the economy and the policy action responding to that shock. This lag arises because It takes time for policymakers first to recognize that a shock has occurred Then to put appropriate policies into effect. Outside Lags The outside lag is the time between a policy action and its influence on the economy. This lag arises because policies do not immediately influence spending, income, and employment. Example: Making economic policy, however, is less like driving a car than it is like piloting a large ship. A car changes direction almost immediately after the steering wheel is turned. By contrast, a ship changes course long after the pilot adjusts the rudder, and once the ship starts to turn, it continues turning long after the rudder is set back to normal. Economic policymakers face the problem of long lags. Indeed, the problem for policymakers is even more difficult, because the lengths of the lags are hard to predict. 2 Difficult Job of Economic Forecasting: Successful stabilization policy requires the ability to predict accurately future economic conditions. If we cannot predict whether the economy will be in a boom or a recession in six months or a year, we cannot evaluate whether monetary and fiscal policy should be adopted.
Another way forecasters look ahead is with macro econometric models, which have been developed both by government agencies and by private firms for forecasting and policy analysis. 3 Ignorance, Expectations and Locus Critique: Ignorance means whenever the economists estimate the effects of alternative economic policies they are not confident about them. Expectation play crucial role in the economy because they influence all mot all sorts of economic behaviour. Lucas Critique Robert Lucas is an economist. He emphasized the issue of how people form expectations of the future. When policy makers estimate the effect if any policy, they need to know how people expectation respond to them. The criticism on macro econometric (traditional) model is known as Lucas Critique. Expectations based on two types 1- adoptive 2- Rational According to Lucas, we should adopt rational expectations. An important example of the Lucas Critique arises in the analysis of disinflation. The cost of reducing inflation is often measured by sacrifice ratio.
Inflation decreases then GDP decreases Lucas Critique leaves us two lessons Narrow Lesson: The narrow lesson is that economists evaluating alternative policies need to consider how policy affects expectations and, thereby, behaviour. Broad Lesson: The broad lesson is that policy evaluation is hard, so economists engaged in this task should be sure to show the requisite humility. 4 Historical Record: If the economy has experienced many large shocks, active policy should be clear. If the economy has experienced few large shocks, then the case for passive policy should be clear. In other words, our view of stabilization policy should be influenced by whether policy has historically been stabilizing or destabilizing. The historical record often permits more than one interpretation. The Great Depression is a case in point. Some economists believe that a large contractionary shock to private spending caused the Depression. Other economists believe that the large fall in the money supply caused the Depression. Great Depression can be viewed either as an example of why active monetary and fiscal policy is necessary or as an example of why it is dangerous.
The debate over rules versus discretion is distinct from the debate over passive versus active policy. Policy can be conducted by rule and yet be either passive or active. Rule for Monetary Policy: Monetary policy is a policy adopted by central bank. Rules suggested by Policy Makers: 1. Role of Ms. 2. Nominal GDP targeting. 3. Inflation targeting. Role of Ms: According to monetarists: Ms should be increased at constant/steady rate (every year). Because it is the Ms which brings distortion/discrepancy in the economy so in order to stabilize the economy Ms should be increased steadily and constantly. But according to few economists that along with a steady increase in M s the velocity of circulation of money also be kept constant in order to stabilize the economy. Nominal GDP Targeting: If nominal (actual) GDP (8%) > targeted GDP (7%) So, D AD P Inflation If nominal GDP (6%) < targeted GDP (7%) So, D AD L Y unemployed P Deflation. Rule: Ms will have to be increased. If actual GDP = targeted GDP So, Ms will not be changed. Inflation Targeting: If actual inflation > targeted inflation Rule: Ms should be decreased. If actual inflation < targeted inflation Rule: Ms should be increased. If actual inflation = targeted inflation Rule: Ms should be kept constant.
Conclusion:
So many economists think that the economic policies be saved from the clutches of politicians. These economists are in favour of adopting fiscal and monetary policy following some rule rather than discretion.