Mundell-Fleming Research Articles

‘Twin Deficits’ Hypothesis

Higher and persistent level of fiscal deficit and current account deficit is the problem of the day for Indian economy. There exists an argument that higher fiscal deficit is the major factor behind worsening balance of payments position. However, there is no identical perception on the relationship between fiscal deficit and current account deficit both theoretically and empirically. Hence this article is a revisit to the existing debate to see whether fiscal deficit and current account deficit can be called as ‘twin deficits’ pertaining mainly to Indian economy. Using long-term annual data for the period 1980–1981 to 2012–2013 on Indian economy and using vector error correction method, this article seeks to prove that there exists long-term positive association between fiscal deficit and current account deficit, and hence can be called as ‘twins’. Using structural VAR method it has been proved here that fiscal deficit is in line with the pattern illustrated in Keynesian absorption theory and Mundell–Fleming model in regard to its impact on current account deficit. This article negates the relevance of Ricardian equivalence theory in Indian context.

Capital Flows: Expansionary or Contractionary?

The workhorse open-economy macro model suggests that capital inflows are contractionary because they appreciate the currency and reduce net exports. Emerging market policy makers, however, believe that inflows lead to credit booms and rising output; the evidence appears to go their way. To reconcile theory and reality, we extend the set of assets in the Mundell-Fleming model to include both bonds and non-bonds. At a given policy rate, inflows may decrease the rate on non-bonds, stimulating financial intermediation and, potentially, output as well. We explore the implications, and find support for the key predictions in the data.

Testing the Empirical Validity of the Mundell-Fleming Model

Testing the Empirical Validity of the Mundell-Fleming Model

Not all international monetary shocks are alike for the Japanese economy

This paper examines the influence of monetary aggregates shocks in the U.S., China and the Euro area on Japan. China's monetary expansion has significant effects on Japan's economy that are quite different from those of the U.S. and Euro area. In line with the implications of the Mundell–Fleming model when there are capital controls in place, Chinese monetary expansion is found to primarily affect Japan through trade. The income absorption effect of China's monetary expansion is substantial for Japan. China's monetary expansion results in significant increases in Japan's industrial production, exports and inflation, and decreases in the trade-weighted yen. After 24months, monetary shocks in China forecast 20% of the variation in Japan's real trade balance. In contrast, U.S. monetary expansion results in contraction in Japan's industrial production, exports and trade balance (expenditure-switching). Monetary expansion in the Euro area does not significantly affect Japan. Structural vector error correction models and a factor-augmented model are estimated to establish robustness of results.

Are Capital Inflows Expansionary or Contractionary? Theory, Policy Implications, and Some Evidence

The workhorse open-economy macro model suggests that capital inflows are contractionary because they appreciate the currency and reduce net exports. Emerging market policy makers however believe that inflows lead to credit booms and rising output, and the evidence appears to go their way. To reconcile theory and reality, we extend the set of assets included in the Mundell-Fleming model to include both bonds and non-bonds. At a given policy rate, inflows may decrease the rate on non-bonds, reducing the cost of financial intermediation, potentially offsetting the contractionary impact of appreciation. We explore the implications theoretically and empirically, and find support for the key predictions in the data.

MONETARY AND FISCAL POLICY ANALYSIS: WHICH IS MORE EFFECTIVE?

Fiscal policy is an adjustment in the income and expenditure of government as stipulated inthe state budget in order to achieve better economic stability and pace of development. Themain objective of this study was to measure and analyze Fiscal and Monetary Policy of theGross Domestic Product (GDP). Fiscal Policy Multiplier (FPM) and Monetary PolicyMultiplier (MPM) are used to answer the debate where more effective between fiscal policy andmonetary policy. Short-term models derived through error correction model (ECM), which alsoforms the derivative equation. A system of simultaneous equations two stage least squares(TSLS), is used to describe the sensitivity analysis (response) of shocks to the policy change ofimportant macroeconomic indicators. The results showed that during the study period,Indonesia's monetary policy more effective than fiscal policy.Keywords: monetary policy, fiscal policy, Mundell-Flemming Model

MONETARY AND FISCAL POLICY ANALYSIS: WHICH IS MORE EFFECTIVE?

Fiscal policy is an adjustment in the income and expenditure of government as stipulated inthe state budget in order to achieve better economic stability and pace of development. Themain objective of this study was to measure and analyze Fiscal and Monetary Policy of theGross Domestic Product (GDP). Fiscal Policy Multiplier (FPM) and Monetary PolicyMultiplier (MPM) are used to answer the debate where more effective between fiscal policy andmonetary policy. Short-term models derived through error correction model (ECM), which alsoforms the derivative equation. A system of simultaneous equations two stage least squares(TSLS), is used to describe the sensitivity analysis (response) of shocks to the policy change ofimportant macroeconomic indicators. The results showed that during the study period,Indonesia's monetary policy more effective than fiscal policy.Keywords: monetary policy, fiscal policy, Mundell-Flemming Model

An Assessment of the Real Exchange Rate Misalignment in Egypt: A Structural VAR Approach

This paper calculates the equilibrium real effective exchange rate for the Egyptian economy during the period (1974-2012). The paper reviews the evolution of Egypt’s exchange rate policy and the most significant developments of its real effective exchange rate during the same period. Using a structural vector auto-regression model identified with long-run restrictions, it evaluates the relative importance of real supply, demand and nominal shocks to the disturbances of Egypt’s real effective exchange rate. The identified shocks and their impulse responses are consistent with the theoretical priors stemming from the Mundell-Fleming model. The main contribution to the fluctuations of the real effective exchange rate, roughly 80 percent, comes from both real demand and supply shocks. The model is used to check if the real exchange rate in Egypt is misaligned during the period under investigation. It shows that the actual real effective exchange rate has deviated from the equilibrium real effective rate with various degrees during the estimation period

An Analysis of the Effects of the Economic Policy in Serbia by the Mundell-Fleming Model

Abstract The global economic crisis has affected the whole world, including Serbia. Countries with different degrees of development reacted with different measures of economic policy, both monetary as well as fiscal. Economic authorities in Serbia have encountered certain limiting factors in the selection of measures, first of all taking into account the unfinished transition process. This paper will examine whether the applied monetary and fiscal policy in Serbia is adequate according to the position which Serbia occupies by the Mundell-Fleming model, as well as to identify the starting position for future economic policy measures.

Are Capital Inflows Expansionary or Contractionary? Theory, Policy Implications, and Some Evidence

The workhorse open-economy macro model suggests that capital inflows are contractionary because they appreciate the currency and reduce net exports. Emerging market policy makers however believe that inflows lead to credit booms and rising output, and the evidence appears to go their way. To reconcile theory and reality, we extend the set of assets included in the Mundell-Fleming model to include both bonds and non-bonds. At a given policy rate, inflows may decrease the rate on non-bonds, reducing the cost of financial intermediation, potentially offsetting the contractionary impact of appreciation. We explore the implications theoretically and empirically, and find support for the key predictions in the data.

Are Capital Inflows Expansionary or Contractionary? Theory, Policy Implications, and Some Evidence

The workhorse open-economy macro model suggests that capital inflows are contractionary because they appreciate the currency and reduce net exports. Emerging market policy makers however believe that inflows lead to credit booms and rising output, and the evidence appears to go their way. To reconcile theory and reality, we extend the set of assets included in the Mundell-Fleming model to include both bonds and non-bonds. At a given policy rate, inflows may decrease the rate on non-bonds, reducing the cost of financial intermediation, potentially offsetting the contractionary impact of appreciation. We explore the implications theoretically and empirically, and find support for the key predictions in the data.

Effects of Fiscal Policy under Different Capital Mobility

Mundell-Fleming model is a standard open macroeconomic theory that tries to describe the effects of fiscal and monetary policies. It is believed that, under assumptions of small country and perfect capital mobility, fiscal policy is strong under fixed exchange rate while monetary policy is strong under floating exchange rate. This article extends assumptions of this theory, discusses effects of fiscal policy in a big, open economy under different capital mobility situations.

A Mundell-Fleming Study of Japan's Monetary Expansion

With the new government, Japan has announced plans for massive monetary expansion through expansion of money base. In this paper after reviewing Japan’s monetary policy I use Mundell-Fleming model under assumptions of high capital mobility and flexible exchange rates to demonstrate the changes affiliated with Japan’s monetary expansion.

Endogenous money and public foreign debt during the Argentinean Convertibility

This paper tries to demonstrate that the endogeneity of money in the Argentinean currency board, known as Convertibility, was compatible with the heterodox endogenous money approach. The Argentinean Convertibility was interpreted by the conventional view as a pure case of the Mundell–Fleming model with fixed exchange rate (MFFER). This approach points out that domestic money became ‘endogenous’ because the central bank loses the ability to determine the monetary policy. However, this last endogenity process has nothing to do with the heterodox endogenous money approach. While the MFFER endogeneity is ‘supply-led’ (balance of payment effect), the heterodox approach is ‘demand-led’ (bank credit effect). So, given the structural external constraint (not only due to the historical Argentinean balance of payments constraint, but also increased by the need for backing the monetary base with foreign reserves) the Central Bank of Argentina operated as a lender of last resort to an unsustainable expansion of public foreign indebtedness. The dollar credit rationing to the government was the limit to the central bank's accommodation policy.

Why does monetary policy respond to the real exchange rate in small open economies? A Bayesian perspective

To estimate how monetary policy works in small open economies, we build a dynamic stochastic general equilibrium model that incorporates the basic features of these economies. We conclude that the monetary policy in a group of small open economies (including Australia, Chile, Colombia, Peru, and New Zealand) is rather similar to that observed in closed economies. Our results also indicate, however, that there are strong differences due to the shocks from the international financial markets (mainly risk premium shocks). These differences explain most of the variability of the real exchange rate, which has important reallocation effects in the short run. Our results are consistent with an old idea from the Mundell–Fleming model: namely, a real depreciation to confront a risk premium shock is expansive or procyclical, in contradiction to the predictions of the balance sheet effect, the J curve effect, and the introduction of working capital into RBC models. In line with this last result, we have strong evidence that only in one of the five countries analyzed in this study does not intervene the real exchange rate, the case of New Zealand.

Emerging Asia’s Version of the Mundell-Fleming Model

This paper explains the Mundell-Fleming model in the context of Emerging Asia economies management of capital mobility. Central Banks and Financial Regulators in Emerging Asia adopt a modified version of the model that incorporates two vital levers, a policy driven and a market driven method that is adaptable to the magnitude of capital flow. A policy combination mix of both policy and market driven provides smooth monetary policy signal transmission to exchange rates.

Open Economy Monetary Policy Reconsidered

The standard policy rule of the Mundell-Fleming model states that under a flexible exchange rate regime with perfectly elastic capital flows, monetary policy is effective and fiscal policy is not. The rule ignores the effect of a change in the nominal exchange rate on the domestic price level. The price level effect is noted in some textbooks, but not formally analyzed. When subjected to a rigorous analysis, the interaction of the exchange rate and the domestic price level substantially changes the standard policy rule. The logically correct statement would be, with a flexible exchange rate and perfectly elastic capital flows, the effectiveness of monetary policy depends on the marginal import propensity and the sum of the trade elasticities. Typical values for these parameters suggest that the effectiveness of monetary policy under flexible exchange rates can be low even if capital flows are perfectly elastic. Because these same parameters have the opposite effect on fiscal policy, the relative effectiveness of fiscal and monetary interventions under a flexible exchange rate is an empirical issue that cannot be determined a priori.

Short and medium run effects of fiscal policy in an economic and monetary union : the case of a small country

We analyze the effectiveness of fiscal policy in an economic and monetary union. On the basis of a simple static and dynamic Mundell-Fleming model, we show that expansionary fiscal policy is very effective in the short run, but in the medium run all positive effects are "exported" abroad due to impaired competitiveness. These results are illustrated by numerical simulations. High short-run effectiveness of fiscal policy may have contributed to excessive deficits in many EMU countries. (original abstract)

The Fiscal Stimulus of 2009–2010: Trade Openness, Fiscal Space, and Exchange Rate Adjustment

The global crisis of 2008–2009 focused attention on the role of fi scal policy at times of collapsing aggregate demand. Concerns about experiencing a reincarnation of the great depression induced the Organization for Economic Cooperation and Development (OECD) (highincome group) and emerging market countries to invoke extraordinary policies for extraordinary times. Countries adopted sizable fi scal stimuli, augmented by unprecedented monetary expansions supported by elastic swap lines between the Federal Reserve and the European Central Bank, and between the Fed and four emerging markets. The fl ight to quality and the shortage of dollar liquidity posed a special challenge for emerging markets, inducing them to supplement these policies with both large sales of foreign currencies at the height of the crisis and with sizable depreciations. Yet there has been a remarkable heterogeneity in the magnitudes of the fi scal stimuli, and of the exchange rate depreciation. The differential patterns of response are traced in table 1, summarizing the fi scal stimulus/GDP and the depreciation rate in 32 countries, chosen by data availability. The fi rst three columns overview the crisis related fi scal stimulus / GDP, 2009–2011, in OECD countries and emerging markets. The crisis led to a signifi cant fi scal stimulus in the United States, Japan, and Germany, the magnitude of which increased from 2009 to 2010, refl ecting various lags associated with fi scal policy. The fourth and the fi fth columns report the massive “bailout” transfers to the banking system in the United States, Germany, and the United Kingdom that attempted to stabilize the fi nancial panic. It is noteworthy that the size of

An Interactive Primer on the Macroeconomics of Financial Crises

This learning package brings the macroeconomic implications of financial crises to the undergraduate classroom. It equips even apprentices of macroeconomics with tools enabling them to be active and constructive participants in discussions of the current crisis. It should also encourage undergraduate instructors to use the 2007 subprime crisis and its global effects as an extended case study, emphasizing the applied nature of macroeconomics and its potential to make developments and policy discussions in the real world more transparent. The package assumes familiarity with two workhorses of the undergraduate curriculum: the IS-LM and the Mundell-Fleming model. Extending textbook versions of these models, it shows how the emergence of financial crises, defined as deteriorations of confidence that lead to increasing risk premiums, affects money markets (via the LM curve) and capital markets (via the IS curve). Starting with an empirical comparison of key macroeconomic variables during the Great Depression of 1929-1933 and the current crisis, users then enter the interactive segment of the package. The Java applet that sits at the heart of this central section features a crisis version of the Mundell-Fleming model (to represent a small open economy) that is connected to a likewise modified IS-LM model (to represent the rest of the world). After being cautioned that financial crises come in many shapes (depending on the exchange rate sys-tem, on whether they erupt in the banking or corporate sector, at home or abroad) students may expe-riment with a variety of crises, experiencing their macroeconomic repercussions, and gaining hands-on experience as central bankers and government policy makers. This way students find out under what conditions financial crises threaten to generate major recessions, when textbook policy recom-mendations work or are turned upside down, and what kind of financial crises may even destabilize the economy with the prospect of an outright depression. [http://www.fgn.unisg.ch/eurmacro/xercises/crisis.html Link zum interaktiven Lernpaket / link to the interactive package]