Keynesian Model of the trade balance TB & income Y.

Key assumption: P fixed => .

Mundell-Fleming model Key additional assumption: international capital flows KA respond to interest rates i.

LECTURE 2:The Mundell-Fleming Model with a Fixed Exchange Rate

YY

M

A

P

Questions: Effect of fiscal expansion or other .

Effect of monetary expansion / .

ALTERNATE APPROACHES TO DETERMINATION OF EXTERNAL BALANCE

Elasticities Approach to the Trade Balance

Keynesian Approach to the Trade Balance

Mundell-Fleming Model of the Balance of Payments

Monetary Approach to the Balance of Payments

NonTraded Goods or Dependent-Economy Model of the Trade Balance

Intertemporal Approach to the Current Account

KEYNESIAN MODEL OF THE TRADE BALANCE Import demand is a function of the exchange rate & income. The same for exports: => TB = X(E, Y*) – IM(E, Y), where IM is here defined to be import spending expressed in domestic terms.

.

If the domestic country is small, Y* is exogenous; drop it for simplicity. Rewrite TB = .

0dE

dX

0**

mdY

dX0m

dY

dIM

X

mYEX )(

0dE

dIM

0dE

Xdand we assume the Marshall-Lerner condition holds: .

Notationally, we embody all E effects (whether via exports or imports) in ;

STYLIZED J-CURVES

With instantaneouspass-through to import prices

With delayedpass-throughto import prices

Empirical estimates of sensitivity of exports and imports to E & Y

• For empirical purposes, we estimate by OLS regression– with allowance for lags, giving J-curve;– controlling for income Y & Y* as well as E,– shown in logs, giving parameters as:

• price elasticities & income elasticities.

• Illustration: Marquez (2002) finds for most Asian countries:– Marshall-Lerner condition holds, after a couple of years, and – income elasticities are in the 1.0-2.0 range.

)/*log( PEP

log X

Estimated price elasticities (LR)

satisfy the Marshall-Lerner

Condition.Estimated income elasticities are mostly

between 1.0 - 2.0.

An application of the marginal propensity to import:

Bussière, Callegari, Ghironi, Sestieri, & N.Yamano, 2013,"Estimating Trade Elasticities: Demand Composition and the Trade Collapse of 2008-2009."

Why did trade fall so much more sharply than income in the 2008-09 global recession?

2009

Bussière, Callegari, Ghironi, Sestieri, & Yamano, 2013, "Estimating Trade Elasticities: Demand Composition and the Trade Collapse of 2008-09."

Why did trade fall so sharply in the 2008-09 global recession?

The usual explanations involve trade credit, inventories, and trade in intermediate inputs.

Behavior of real components of GDP in the 2008-09 recession

Demand, adjusted for import-intensity

GDP

Investment

Imports & Exports

Bussière, Callegari, Ghironi, Sestieri, & N.Yamano, "Estimating Trade Elasticities: Demand Composition and the Trade Collapse of 2008-2009.“

Bussière et al (2013) argue that Investment, which declined much more in 2009 than the other components of GDP, has

a higher marginal propensity to import than the other components.

Trade Balance = TB = (E) – mY.

Aggregate output = domestic Aggregate Demand + net foreign demand: Y = A(i, Y) + TB(E, Y),

More specifically, let A(i, Y) = Ā - b(i) + cY ,

where the function -b( ) captures the negative effect of the interest rate i on investment spending, consumer durables, etc.

Solve to get the IS curve:

where s 1 – c is the marginal propensity to save.

X

ms

EXibAY

)()(

where and .0di

dA0c

dY

dA

mYEXcYibA )()(Combining equations,

Y =

msEXibA

Y )()(

IS curve: An inverse relationship between i and Y consistent with the equilibrium that supply = demand in the goods market.

,AAn increase in spending, Ā,e.g., a fiscal expansion, shifts IS

to the right by the multiplier 1/(s+m).

The overall balance of payments is given by

BP = TB + KA ,

where , the degree of capital mobility > 0.

We want to graph BP = 0. Solve for the interest rate:

*)()( iiKAmYEX

*)( iid

dKA

YmKAXii )/())(/1(*)(

The Mundell-Fleming model introduces capital flows:

slope = m/

Finally, the LM curve is given by = L ( i, Y)

where , . 0

dY

dL0

di

dL

A monetary expansion shifts the LM curve to the right .

LM´

• Do central banks actually set M?• Supposedly they set M1, in the 1980s heyday of monetarism.• Also the monetary base made a comeback after 2008: Quantitative

Easing.

• Normally they think in terms of setting i.• Still, the role of the LM equation can be taken by a Taylor Rule,• which describes central banks as setting i in response to Y & inflation.

→

Appendix: Causes of Developing Country BoP Surpluses 2003-08 & 2010-13

• Strong economic performance (especially China & India) -- IS shifts right.

• Easy monetary policy in US and other major industrialized countries (low i*)

-- BP shifts down.

• Big boom in mineral & agricultural commodities (esp. Africa & Latin America)

-- BP shifts right.

Causes of BoP Surpluses in Developing Countries1990-1997, 2003-08 &2010-13

I. “Pull” Factors (internal causes)1. Monetary stabilization => LM shifts up

2. Removal of capital controls => κ rises

3. Spending boom => IS shifts out/up

II. “Push” Factors (external causes)1. Low interest rates in rich countries

=> i* down

=>2. Boom in export markets =>

BP shifts downout}

•