ch 18--policy under fixed exchange rates.pdf

18 - Policy under Fixed Exchange Rates

18.1

Chapter 18Policy under Fixed Exchange Rates

Learning objectives

By the end of this chapter you should be able to understand:

the mechanism of the open economy Mundell-Fleming model

the impact of sterilizing versus non-sterilizing in the very short run

the importance of capital controls on policy outcomes

the impact of capital mobility on domestic interest rates

the effects of monetary and fiscal policy under fixed exchange rates

the difference between devaluation to get an edge and devaluation as a last resort

how to find the right fiscal and monetary policy to achieve full employment underfixed exchange rates

The models of the earlier chapters are now extended to the financial sector. Inaddition to considering the goods market and the current account only, the newmodels include the financial markets and the full balance of payments (currentaccount plus financial account). The overall equilibrium of the economy is threepronged, involving the goods market, the financial markets, and the balance ofpayments (or external sector). The mechanics to achieve these three equilibriaand the policy implications are elegantly captured by the Mundell-Flemingmodel. Robert Mundell (Nobel Laureate in Economics, 1999) developed themodel with Marcus Fleming in the early 1960s while visiting the IMF.1

The so-called Mundell-Fleming model is simply the IS-LM model adaptedto the open economy. To extend the traditional IS-LM model to the openeconomy, Robert Mundell and Marcus Fleming added one further element to theanalysis, the balance of payments equilibrium, BP 0 . The closed economy IS-LM model thus turned into the open economy Mundell-Fleming model, allowingfor an effective discussion of the effects of various economic policies in the openeconomy.

At first sight, the Mundell-Fleming model may seem uncomplicated, sincewe are simply adding the balance of payments equilibrium to the basic IS-LMmodel. However, the inclusion of the balance of payments generates additionalassumptions allowing us to consider an array of different cases. We will use theMundell-Fleming framework to analyze the effect of monetary policy, fiscalpolicy, or exchange rate policy on the economy. The outcomes will be shown to

1 For a history of the Mundell-Fleming Model, that eventually led to the Nobel Prize for Robert A.Mundell, see “The History of the Mundell Fleming Model: Keynote Speech,” IMF Staff Papers,International Monetary Fund, Vol. 47 (Special Issue, 2001), pp. 215–27.

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depend on i) the exchange rate regime (fixed or flexible), and ii) the degree ofcapital mobility (low, high, or perfect). A preview of all the possible cases that wewill consider is provided in a box.

Menu of the potential alternative combinations of assumptionsstipulated in the specific cases presented in chapters 18 and 19.

First choose the exchange rate regime in 1. Then pick the degree of capitalmobility in 2. Finally, the impact of a specific policy in 3., given theseassumptions (1. and 2.), will be assessed as a separate case below.

1. Exchange Rate

Fixed (chapter 18)

Flexible (chapter 19)

2. Degree of Capital Mobility

Low Capital Mobility, Steep BP (steeper than LM)

High Capital Mobility, Flat BP (flatter than LM)

Perfect Capital Mobility, Horizontal BP

3. Policy

Monetary Policy

Fiscal Policy

Exchange Rate Policy

This chapter considers a fixed exchange rate regime and the next chapter(chapter 19) examines the case of a flexible exchange rate regime. We also makesome additional assumptions that will be relaxed later on: we first focus on thesmall country case and assume a short-run model where prices are fixed. A two-country case as well as a flexible price adjustment will be developed in the nextchapter.

Since the Mundell-Fleming (MF) model is an extension of the closedeconomy IS-LM model, we first review this basic model taught in intermediatemacroeconomics classes and then add to it the international sector. The threemarkets considered in the MF model are: A) the goods market illustrated by theIS curve, B) the financial (money-bonds) markets summarized by the LM curve,and C) the newly introduced notion of external balance or BP=0 (see chapter 17)represented by the BP curve.


18.3

A Review of the Building Blocks: the IS, the LM, and the BP curves

The IS curve is defined as the relationship between interest rates, i, and income,Y, such that capital investment, I, equals total national savings, Sn, (therefore theinitials “IS”). When investment equals total savings, the supply of goods in theeconomy equals the demand for goods. In the open economy, this equilibrium inthe goods market is achieved when domestic income Y equals total aggregatedemand for domestic goods - consumption, C(Y), investment, I(i), governmentdemand, G, in addition to net foreign demand for domestic goods, X-M(Y) - or

Y C(Y ) I (i) G X M (Y )

Note that we specify investment as dependent (negatively) on the interest rate, i,as this formulation provides the link between the goods and the financialmarkets. Since we first assume the small open economy case, exports areexogenous, X X . Finally, since we are looking at fixed exchange rates, we donot need to specify the exchange rate, E, openly in the equation; instead, weconsider this term implied in the X-M component. Given our definitions of theconsumption and imports functions in chapter 14, we can rewrite the previousequation as2

IS: Y C I (i) G X M

s m(18.1)

The IS curve is downward sloping in the income and interest space (Figure 18.1):i.e. higher interest rates are associated with lower levels of output. Since higherinterest rates discourage investment, reducing aggregate demand, a contractionin output i.e. in income, Y, is then necessary to restore equilibrium in the goodsmarket.

The LM curve corresponds to the financial markets defined as the moneyand the bonds markets. Since equilibrium in one market automatically warrantsequilibrium in the other, we can concentrate on the money market. The LMcurve is defined as the relationship between the interest rate, i, and income, Y,such that money demand (or liquidity, L) and money supply, MS, are equal(therefore the initials “LM”). The nominal domestic money supply, MS, is amultiple of the central bank's issuance of domestic credit, DC, plus its foreignreserve holdings, RES, as shown in chapter 13.

M S (DC RES) (18.2)

Note that any change in foreign reserves impacts the domestic money supply.Real money supply is given byM S / P , where P is the price level – the bar above Pconfirms our earlier assumption of fixed prices.

2 A similar equation (14.6) was derived in chapter 14. The only difference is that it included tax,T. We ignore tax here – we will be content to use change in government spending as our fiscalpolicy variable.

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Nominal money demand, MD, is derived according to the theory ofliquidity preference: it depends on the transactions demand (increasing inincome, as richer people usually hold more cash balances on hand) and on theprecautionary demand (decreasing in the interest rate - a higher interest rateincreases the opportunity cost of holding cash). The nominal money demandincreases proportionally with the price level. Using a specific functional form, wecan express the nominal money demand as

M D P(Y hi)

The real money demand can thus expressed as Y hi where the coefficients and h measure how sensitive money demand is to changes in income and theinterest rate, respectively. Equilibrium in the money market (in real terms) thenimplies

LM: hiYP

M S

(18.3)

The LM curve is upward sloping in the income and interest space of Figure 18.1because an increase in income, Y, causes an increase in the demand for money.Since the supply of money is fixed, the price of money (the interest rate) rises torestore equilibrium on the money market.

Finally, the international sector is characterized by the balance ofpayments, BP, equal to the sum of the current account (CA) and the financialaccount (FA)3. The external balance BP=0, is reached when the supply of and thedemand for foreign exchange are equal at the fixed exchange rate. When theforeign exchange market is in equilibrium at the fixed exchange rate, the level offoreign reserves (consequently the money supply) is stable as the central bankdoes not need to intervene to uphold the exchange rate. We have derived theexternal balance in chapter 17, defining it in the interest and income space to beconsistent with the IS-LM curves and we reproduce it here as equation (18.4)

BP: i (M X FA)k

mkY i *

ck

(R * R) (18.4)

Simply expressed, the external balance defines the equilibrium in the foreignexchange market. In the previous chapter, we have shown that the externalbalance line, BP, is upward sloping when drawn in the interest and income spaceof Figure 18.1. We also discussed that its steepness depends on the degree ofcapital mobility measured by the coefficient k: fewer capital controlscorresponding to a flatter external balance line. In the limit, the absence of anycontrol on the movements of international capital - i.e. full or perfect capitalmobility - corresponds to a horizontal external balance line.

Finally, let us also review the essentials of fixed exchange rate regimesintroduced in chapter 13. Whenever the balance of payments does not equal to

3 For simplicity, we ignore the capital account as in the previous chapter and we let the balance oftrade stand for the current account.

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zero, there is excess supply of (or demand for) the domestic currency on theforeign exchange market. In order to maintain a fixed price for the domesticcurrency, the central bank then has to intervene, buying or selling foreigncurrency. Any intervention by the central bank affects the quantity of foreignreserves held by the central bank and consequently the domestic money supply(as shown in equation 18.2).

From equation (18.3), we can see that changes in the money supply resultin shifts of the LM curve. Therefore, it is crucial to clarify whether the centralbank is allowed to sterilize or not. In chapter 13, sterilization is defined as anopen market operation by the central bank that neutralizes the effects of foreignreserve flows on the domestic money supply. The objective of such an openmarket operation is to maintain a stable money supply at all times, so 0 SM :as already explained in chapter 13, this implies from equation (18.2) that anychanges in foreign reserves is offset by an opposite change in domestic credit,RES DC (equation 13.2).

Now that we have defined the three main elements of the model, we candraw a graph (Figure 18.1) in the i/Y space illustrating all the equilibrium pointsin each of the three sectors: the goods market (along the IS curve), the financialmarkets (along the LM curve), and the external sector (along the BP curve).Since there are three curves, all three will have to go through a common point, a,to reach a common equilibrium.

Figure 18.1: The Basic IS-LM-BP Model in Equilibrium

The Mundell-Fleming Model

i

Y

BP

IS

LM

a

At point a, the goods markets (IS), the financial markets (LM), and the foreign exchange market (BP) are allin equilibrium.

Now that we have developed the basic model, we can analyze the impact ofmonetary and fiscal policy on output under various degrees of capital mobility.Since we assume fixed exchange rates, we can also use the model to investigate

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how a devaluation or a revaluation would affect the economy. Recall that adevaluation/revaluation is a decision by the central bank to change the price ofthe domestic currency with respect to foreign currencies for some specific reasonor goal, so it is a deliberate policy decision; we thus investigate so-calledexchange rate policy. Finally, we will examine the most important aspect of themodel for policy makers: how to use it to determine the right mix of fiscal andmonetary policy to achieve full employment while maintaining the externalbalance.

Monetary Policy under Fixed Exchange RatesWe start with the unique equilibrium for the three markets: goods market,financial markets, and foreign exchange market (external balance). Suppose that,to facilitate the reasoning, point a in Figure 18.2 corresponds not only to anequilibrium in the balance of payments, but also that it represents balancedcurrent and financial accounts (CA=0 FA=0 BP=0). An increase in the moneysupply then lowers the interest rate through the money market and shifts the LMcurve to the right in Figure 18.2. The two graphs correspond to differentdegrees of capital mobility, but the basic mechanism is the same. As shown in theprevious chapter, low capital mobility is associated with steep BP curves (left-hand graph) and high capital mobility with flat BP curves (right-hand graph).From the graphs, we can immediately read off the impact of the increase in themoney supply. There are two distinct effects:

i) Income increases because capital investment, a component of aggregatedemand, is stimulated by low interest rates (this is a movement along the IScurve). This increase in income raises imports, because imports arepositively related to income in our import demand function. The increase inimports then causes a deterioration of the balance of trade.

ii) As the interest rate falls, financial capital flows out of the country since thereturn on financial investment is now greater abroad (recall our interestparity discussion). The larger the degree of capital mobility, the larger thecapital outflows, and the larger the financial account deterioration.

Figure 18.2: Monetary Expansion under Fixed Exchange Rates,

Low and High Capital Mobility

Low capital mobility High capital mobility

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i i

Y Y

IS IS

LM LMBP

BPa

a

LM'LM'

bb

With low capital mobility, the external balance (BP) is steeper than LM and, with high capital mobility, BP isflatter than LM. In either case, expansionary monetary policy leads to a loss in foreign exchange reserves asthe economy approaches point b, corresponding to a BP deficit. Under non-sterilization, the foreignexchange reserve outflows translate into a decrease in the money supply and LM must shift back until thethree markets are again in equilibrium at point a. The adjustment will happen faster in economies with highcapital mobility. Whatever the degree of capital mobility, monetary policy has no long-term effect on outputunder fixed exchange rates. Only with sterilization, can the economy remain, albeit temporarily, in b.

Both the current and financial accounts decline; this implies that the balance ofpayments must be negative as the economy reaches point b. Indeed, theequilibrium in the goods and financial market at point b, where the IS and thenew LM’ curve now intersect, lies below the BP curve (the area of BP deficits).

The balance of payments deficit implies excess demand for the foreigncurrency (generated by importers and investors). In order to avert a rise in theprice of foreign currency (a depreciation of the domestic currency), the centralbank must intervene by tapping into its foreign currency reserves and sellingthem to the market at the fixed exchange rate. Importers and investors purchaseforeign currency by selling their domestic currency to the central bank. Asreserves fall, the money supply is reduced (see equation 18.2), thus affecting theeconomy. So the central bank has to decide whether it plans to sterilize thereserve outflows or not, i.e. whether it wants to either severe or retain the directlink between reserves and money supply. We examine both cases.

Monetary Policy, Fixed Exchange Rates, and Sterilization

The reduction in the money supply mentioned above has a contractionary impacton the economy. The central bank may try to sterilize the effects of balance ofpayments deficit on the money supply to stop the contraction resulting from theintervention from happening. To do so, the central bank executes an openmarket operation - purchasing bonds from the public - that exactly offsets theloss in foreign exchange reserves. This neutralizes the impact of the decline in


18.8

reserves on the domestic money supply (there is no change in the money supplyas -∆RES=∆DC). Why would a central bank want to sterilize? The answer issimple: by sterilizing the effects of the capital outflows resulting from the tradedeficit, the central bank keeps the money supply constant at point b in Figure18.2 and the economy can maintain its higher level of output.

Sterilization does not, however, solve the basic problem of the balance ofpayments deficit. It is not a long-term strategy. The longer the balance ofpayments deficits last, the more foreign exchange the central bank has to sell tokeep the exchange rate fixed. Eventually, foreign reserves are depleted andsterilization is no longer an option.

Monetary Policy, Fixed Exchange Rates, and Non-Sterilization

When the central bank decides not to sterilize reserve outflows, the Mundell'sincome reserve-flow mechanism sets in (the mechanism was described in themonetary approach to the balance of payments in chapter 15). There, the linkbetween the foreign reserves changes and its impact on the money supply is notsevered. As the central bank supports its exchange rate by selling foreigncurrency, reserves fall, and, in the absence of open market operation changingdomestic credit, the money supply declines proportionately (equation 18.2). TheLM curve shifts back, as the money supply contracts.

The decline in the domestic money supply continues as long as the foreignexchange market is in disequilibrium at the fixed exchange rate (i.e. as long as thecountry’s balance of payments in negative i.e. BP<0) and the central bank has tosell reserves (intervene). The process comes to a halt only when the LM curve hasshifted all the way back to its original equilibrium level at a, where externalbalance is restored i.e. the foreign exchange market is in equilibrium at the fixedexchange rate and BP=0.

The decline in the money supply also raises the interest rate. The rise inthe interest rate has two effects: income decreases (lowering the trade deficit),and the financial account improves because capital flows into the domesticeconomy, attracted by the higher interest rate. Both developments have a positiveimpact on the balance of payments. Ultimately, the interest rate must rise to itsoriginal level as the balance of payments is returned to its equilibrium, point a.

As is apparent from Figure 18.2, under fixed exchange rate regimes,monetary policy is neutral, in that it cannot be used to affect the level of outputpermanently. Expansionary monetary policy simply sets in motion an automaticadjustment mechanism quite similar to the economic interactions described inthe monetary approach to the balance of payments studied in chapter 15. In sum,expansionary monetary policy leads to a negative balance of payments, thattriggers reserve outflows; the impact on the money supply and on interestultimately reverse the effect of the monetary policy.

Up to now, we have not tried to track the difference in the adjustmentaccording to the various degrees of capital mobility. Figure 18.2 shows that, with


18.9

either low or high capital mobility, the automatic adjustment mechanism willtake place under non-sterilization, eventually wiping away the impact of themonetary policy. Nevertheless, the degree of capital mobility does matter in asubtle way. In the case of no capital mobility, that was covered in chapter 15,monetary policy is reversed only through the trade effects, described above in i);however, in this chapter, the financial effects, outlined in ii), must also be takeninto account.

What difference does it make whether capital mobility is low or high? As itturns out, the final outcome is the same, but the speed of adjustment is different.With low capital mobility, capital trickles out of the country as the interest ratefalls from point a to b. With high capital mobility, capital gushes out of thecountry to create massive financial account, thus balance of payments, deficits.The larger the balance of payments deficit, the faster the outflow of foreignreserves and the decline in the money supply. With high capital mobility, capitaloutflows will take place as soon as the interest rate starts dropping. Although thetwo graphs in Figure 18.2 seem very similar except for the slope of the BP curve,there is an important difference between the two cases. As reserves are lost at afaster rate in the high capital mobility case, the adjustment back to the originalequilibrium will also take place at a faster speed. Given this insight, we can inferwhat would happen in the case of perfect (or full) capital mobility.

With perfect capital mobility, the financial account effect dominates themechanism. From the previous chapter, we know that the BP curve is horizontalat the world interest rate i* in the small country case4. As soon as LM startsshifting to the right, the interest rate drops. In this case, the slightest interestdifferential triggers infinite capital outflows and immediate pressures on thedomestic exchange rate to depreciate. This cannot be allowed with a fixedexchange rate system, so the central bank must intervene right away and LMcannot shift out: LM’ does not exist except in the imagination of the policymaker! With fixed exchange rate and perfect capital mobility, monetary policydoes not work at all – the economy never leaves point a. Note that it is notrelevant to discuss the case of sterilization under perfect capital mobility.Sterilization is a form of monetary policy and we have just learned that the LMcan never shift out under perfect capital mobility.

4 The equation of the BP=0 line is i (M X FA)k

mkY i *

Perfect capital mobility corresponds to k . In this case the first 2 terms on the right tendstowards zero and i tends towards i*. So with perfect capital mobility the horizontal BP line mustalways stay put at i=i*, the world interest rate.


18.10

Figure 18.3: Monetary Expansion under Fixed Exchange Rates andPerfect Capital Mobility

i

Y

LM

BP

IS

LM'

i*a

Under perfect capital mobility, the external balance line (BP) is horizontal. An increase in the money supplycan never succeed in shifting the LM curve to LM’. Under perfect capital mobility, any infinitesimal increasein the money supply must be reversed immediately because the interest rate cannot deviate from the worldinterest rate i* without triggering infinite capital flows (or outflows) to maintain a balance of paymentsequilibrium.

Currency Boards RevisitedThis discussion makes it clear that, with fixed exchange rates (and non-sterilization), a country loses its sovereignty over its monetary policy. The higherthe degree of capital mobility, the more powerless the central bank becomes.Acknowledging that, countries keen on pegging their currency on a vehiclecurrency often opt for a currency board to hold their peg. They are aware that thecentral bank has no power to carry out any independent monetary policy to meetspecific domestic goals; its only role is to carry out intervention operations touphold the peg. So the central bank might as well give up altogether trying tomanage the money supply and let a currency board take care of managing boththe exchange rate and the money supply. In this case there is no need forintervention and no adjustment mechanism, the currency board manages themoney supply directly and pick the level that corresponds to a specific exchangerate. If the economy moves away from the BP line, all what the currency boarddoes is to adjust the LM curve, so that the economy goes back to an IS-LM-BPequilibrium where the foreign exchange market is in equilibrium at the fixedexchange rate.

In conclusion, monetary policy is not a policy option under fixed exchangerates. Its impact is duly reversed and the greater the degree of capital mobility,the faster its effect is wiped away. Does this mean that policy makers have no


18.11

way to stimulate their economy when capital is allowed to flow internationally?Maybe fiscal policy is more successful.

Fiscal Policy under Fixed Exchange RatesAn increase in government spending stimulates aggregate demand resulting in arise in national income as the IS curve shifts to the right. To keep things simple,we again assume that both current and financial accounts are initially balanced atpoint a. The increase in income has two effects:

i) It increases the demand for imports; this leads to a deterioration in thebalance of trade and consequently in the current account.

ii) It raises the transactions demand for money; this constitutes a movementalong the LM curve. Any increase in money demand, while money supplyremains constant, raises the interest rate to keep the money market inequilibrium. The increase in the interest rate then generates capital inflowsso the financial account improves.

To disentangle the effects on the balance of payments, we first note thatthe impact on the current account is negative while the financial accountimproves. Since the balance of payments is defined as BP = CA + FA, the overallimpact of the expansionary fiscal policy on the balance of payments is ambiguousCA 0, FA 0 . To ascertain the net effect on the balance of payments, we

have to identify whether the financial inflows offset the trade deficit or notFA or < CA . Whether financial inflows are sufficiently large to offset the

current account deficit depends crucially on the degree of capital mobility. Againwe consider three cases: low, high, and perfect capital mobility to investigatewhether capital movements in form of a trickle, steady flow, or flood generatedifferent results.5

Fiscal Policy, Fixed Exchange Rates, and Low Capital Mobility

In countries with low degrees of capital mobility, the increase in the interest ratedue to the increase in government spending generates only modest capitalinflows. Figure 18.4, where the BP curve is steeper than the LM curve, illustratesthis case. The increase in government spending shifts the IS curve to the rightand the new equilibrium of the goods and money markets occurs at point b.Point b lies below and to the right of the BP curve in the area where BP<0. Due tonumerous capital controls, the trickle of capital inflows (creating a financialaccount surplus) is insufficient to finance and offset the current account deficit.Thus the balance of payments slips into deficit (BP<0), causing excess demandfor the foreign currency.

With excess demand for the foreign currency, there is pressure on thedomestic currency to depreciate. The only way for the central bank to prevent the

5 The case with no capital mobility was tackled in chapter 15.


18.12

depreciation and uphold the fixed exchange rate is to intervene on the foreignexchange market. The central bank must draw on their reserves and sell theforeign currency on the foreign exchange market at the fixed exchange rate. Thisincreases the supply of foreign currency and equilibrates the foreign exchangemarket again.

Just as in the case of expansionary monetary policy, the central bank couldattempt to sterilize the effects of the foreign exchange reserve outflows tomaintain a constant money supply. In this case, the economy can maintain itshigher level of income at point b – but only temporarily. As we know,sterilization requires the central bank to inject domestic credit6 to offset the lossof foreign reserves so that the LM curve stays put. However, since the balance ofpayments remains in disequilibrium, the central bank will eventually deplete itforeign currency reserves, demonstrating again that sterilization is not a long-term strategy. At that point, either the central bank has to stop sterilizing, or itwill have to allow the exchange rate to adjust, as it can no longer satisfy theexcess demand for foreign currency. However, if the country is truly committedto a fixed exchange rate, the only option is to stop sterilizing and the impact ofintervention, as described below, cannot be avoided.

Under non-sterilization, the central bank sales of foreign currency reducethe foreign currency reserves, causing a decline in the domestic money supply.This shifts the LM curve back to the left. The decrease in the money supply raisesthe interest rate to higher levels, affecting both the current and the financialaccounts. The higher cost of borrowing induces firms to cut their equipmentinvestment, causing the economy to contract, thus lowering the trade deficit andimproving the current account (a move along the new IS curve). Higher interestrates trigger further financial capital inflows and the financial account continuesto improve.

Both effects have a positive impact on the balance of payments. To reachthe new equilibrium where the goods market equilibrium, the money marketequilibrium, and the external balance are achieved at point c, the interest ratemust rise sufficiently until the financial account surplus exactly offsets thecurrent account deficit.

Figure 18.4: Fiscal Expansion under Fixed Exchange Rates and LowCapital Mobility

6 This corresponds to an open market purchase of bonds from the public.


18.13

LM

IS

IS'

BPi

Y

LM'

a

b

c

Yo Y1Y2

i2

i1

i0

With low capital mobility, a fiscal expansion generates a balance of payments deficit as the economy movesfrom point a to point b. It happens because the financial account surplus triggered by higher interest rates isnot large enough to offset the current account deficit generated by the increase in income as the economymoves to point b. To preserve a fixed exchange rate, the central bank has to sell foreign currency and thereduction in reserves lowers the money supply. The money supply contracts until the interest rate has risensufficiently so that the financial account surplus exactly offsets the current account deficit. Note the increasein output from Y0 to Y2: therefore, fiscal policy is somehow effective in raising output under fixed exchangerates with low capital mobility.

The new equilibrium in the goods, money, and external markets at point cdoes not coincide with the original level of output at point a. Indeed fiscal policyis moderately effective in raising output under fixed exchange rates and lowdegrees of capital mobility since income increased from Y0 to Y2. We also knowthat, since we have moved from point a to point c on the BP=0 line, the tradedeficit has increased (due to a higher level of output Y), and it is now financed bylarger capital inflows (the interest rate in c is higher than in a). The capitalinflows are thus financing the trade deficit such that FA CA to restore BP=0.

Fiscal Policy, Fixed Exchange Rates, and High Capital Mobility

In the case of high capital mobility, the BP curve is flatter than the LM curve asshown in Figure 18.5. An increase in the interest rate due to the increase ingovernment spending generates massive capital inflows in countries with highdegrees of capital mobility. The large capital inflows creating financial accountsurpluses more than compensate for the deficit in the current account at point b,so much so that there exists an overall balance of payments surplus, BP>0. Theexcess supply of the foreign currency exerts downward pressure on the price of


18.14

the foreign currency. The central bank must therefore intervene to maintain thefixed exchange rate - this time by buying foreign currency in exchange fordomestic currency to soak up the excess foreign currency supply. This impliesthat the domestic foreign reserves increase, in turn triggering a monetaryexpansion (see equation 18.2). The LM curve shifts to the right.

Again the central bank has the choice to sterilize the reserve flows (andremain at point b) or to adopt non-sterilization. Sterilization implies that thecentral bank has to reduce domestic credit by selling bonds to the general public.With high capital mobility, such sales may have to be massive and may not besustainable for any length of time. In this case, the rationale for sterilizing isunclear. Indeed, when the monetary expansion needed to restore the balance onthe foreign currency markets at the fixed exchange rate is unleashed, theeconomy undergoes further expansion from point b to point c. In this respect,fiscal policy under fixed exchange rate with non-sterilization is highly effective.


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Figure 18.5: Fiscal Expansion under Fixed Exchange Rates, and HighCapital Mobility

A fiscal expansion shifts out the IS curve and increases income and the interest rate moving the economy from point ato point b. With high capital mobility, the financial account surplus (caused by capital inflows triggered by the higherinterest rate) more than offsets the current account deficit (created by the increase in income). To maintain a fixedexchange rate, given the balance of payments surplus, the central bank has to accumulate reserves and the moneysupply expands to restore equilibrium in the goods, money, and external markets. Under high degrees of capitalmobility both, the initial increase in government spending and the ensuing monetary expansion fueled by capitalinflows, stimulate the economy resulting in a sizable expansion.

Fiscal Policy, Fixed Exchange Rates, and Perfect Capital Mobility

Under perfect capital mobility, the BP curve is horizontal and the slightestincrease in the domestic interest rate over the world rate i* sets off infinitely largecapital inflows. The balance of payments shoots into surplus and the excessdemand for domestic currency (e.g. excess supply of foreign currency) explodes.The central bank must intervene immediately (setting up a parallel monetaryexpansion) to stop the domestic currency from appreciating. The central bankmust acquire immediately the excess supply of foreign currency at the fixedexchange rate; this, in turn, increases the money supply and depresses theinterest rate insuring that the domestic rate of interest remains at parity with theworld rate of interest. Such adjustment results in maximum impact for the fiscalpolicy. In figure 18.6, the economy goes directly from point a to point c withouttransitioning through point b. The LM curve shifts to the right along with the IS

LM

IS

IS'

BP

i

Y

LM'

a

b

c

Y0 Y1 Y2

i1

i2

i0


18.16

curve. With perfect capital mobility, sterilizing is not a policy option sincesterilizing such large global capital flows is not feasible.

Figure 18.6: Fiscal Expansion under Fixed Exchange Rates, andPerfect Capital Mobility

LM

IS

IS'

BP

i

Y

LM'

a

b

ci*

Y0 Y1

Under perfect capital mobility, the increase in output is maximized in the case of a fiscal expansion. Thedomestic interest rate must always equal the world interest rate; any deviation from such interest parityresults in massive capital flows. To avoid that, the central bank must carry out a monetary policy thatneutralizes at all time any deviation from the world interest rate. As a result, the IS and the LM curves haveto shift together tracing the BP curve.

Comparing open economy models with and without capital mobilityunder fixed exchange rates and non-sterilization.

In Chapter 15, we studied a simpler model of the open economy with fixedexchange rates and non-sterilization; we also assumed no capital mobility. Thekey result was that neither fiscal nor monetary policy had any effect on output.Now that we have extended the model to include the international flow of capitaland considered the various degrees of capital mobility, we find that monetarypolicy still does not affect output, but fiscal policy with non-sterilization can, afterall, affect output. This happens, in the case of fiscal expansion, because currentaccount deficits can now be offset, to a smaller or larger degree, by financialaccount surpluses.


18.17

In the absence of capital flows, the deficits created by a fiscal expansion cannot befinanced at all and lead to equally large reserve outflows. With capital mobility,the fiscal expansion generates a current account deficit, but the higher interestrate causes capital inflows that essentially finance the current account deficit andallow the economy to maintain a higher level of output.

In 1979, Ireland became a member of a joint peg system with other Europeancountries meaning that they fixed their exchange rate. In the first half of the80ies, Ireland experienced current account deficits at the same time as largecapital inflows - FDI from the US and European Union subsidies. During thisperiod up to the second half of the 80ies, the Irish government prolific spending,taxing, and borrowing was out of hand. Capital inflows were the basic way tofinance the budget deficit. After 1987, The Irish government adopted responsiblepolicies and Ireland became the successful Celtic tiger we know now.

Why is fiscal policy more effective in raising output than monetarypolicy under fixed exchange rates?

We simplify the discussion by looking at expansionary policies and assumingthat, initially, the economy displays balanced trade. Expansionary fiscal policy, aswell as expansionary monetary policy, stimulates income, thus creating currentaccount deficits. Under fixed exchange rates, current account deficits lead to aloss in foreign exchange reserves, triggering a contraction in the money supply.While expansionary fiscal and monetary policy have the same impact through thegoods market side – creating balance of trade deficits and losses in reserves thathave contractionary effects - their impact on capital flows is diametricallyopposed.

Expansionary fiscal policy raises interest rates, generating foreign capitalinflows that finance the current account deficit. If these capital flows are large(high capital mobility), not only will the current account deficit be fully financed,but these flows will contribute to further expansion in the economy.Expansionary monetary policy lowers the interest rate, causing capital outflowsand further losses in foreign reserves as domestic investors want to move theirassets abroad into a different currency. Therefore the LM curve has to shift backto its original level (the policy is neutral as all the real variables are back to theiroriginal level).

Another interesting way to look at this issue is to note that the IS curve isthe instrument of fiscal policy while the adjustment mechanism takes placethrough the LM curve – these 2 curves are independent of each other. On theother hand, with monetary policy, the LM curve is involved in carrying out thepolicy and it is also shifting as a result of the adjustment process: it cannot playboth roles effectively.


18.18

Table 18.1: Summary Impact of Monetary and Fiscal Policyunder Fixed Exchange Rates

Kmobility Effect on LM IS BP

line Y i CA FA BP

Mon

etar

yE

xpan

sion Low

or high

ImmediateShiftsright

--- ---

InterventionShiftsback

--- ---

OverallOriginal

level--- --- Original level BP=0

Perfect Immediate andoverall

Cannotshift

--- --- No change BP=0

Fisc

al E

xpan

sion

Low

Immediate ---Shiftsright

---

InterventionShifts

left--- ---

OverallLeft oforiginal

Right oforiginal

--- BP=0

High

Immediate ---Shiftsright

---

InterventionShiftsright

--- ---

OverallRight oforiginal

Right oforiginal

--- BP=0

Perfect

Immediate andintervention

Shiftsright

Shiftsright

--- --- BP=0


Right oforiginal

--- --- BP=0

The danger of a pegged exchange rate: the Argentinean crisis

In the 90ies, the Argentinean government passed a law fixing the peso to thedollar: the one-to-one peg was upheld by a currency board controlling the moneysupply directly. This was accompanied by other economic reforms –privatization and free movement of capital. Although the impact of such a movewould be anti-inflationary, there were some dangers; chronic government deficitsand a costly pension reform attempt pointed to a fiscal policy that was not soprudent. Argentinean international competitiveness became damaged by anovervalued peso. Eventually, these policies triggered three years of recession andby 2001-2002 income per capita had dropped by some 22% from 1998,unemployment risen to around 20% and the banking system all but collapsed. Itis well-known that international capital flows into emerging economies are quitefickle and capital flights were massive: as Argentina defaulted on its external


18.19

debt, the IMF scrambled to come to the rescue in rather inconsistent ways. Besetby similar woes, Brazil, Argentina’s main export market, did not hesitate toforsake its dollar peg and float, seriously hurting Argentina’s exports. TheArgentinean government was reluctant to give up their peg to the dollar; theywere hoping for an automatic adjustment – decrease in the money supply anddeflation – to sort out their problem. However the severity of the economic crisisled to civil unrest and to the unavoidable devaluation of the peso. Thisdevelopment bore a huge cost on the public; the Argentinean economy was highlydollarized with the bulk of loans and deposits denominated in dollar. To ease thepain on the debtors, the government allowed a one-to-one conversion on loans,but a different conversion rate for deposits: the outcome was a shamble.Eventually, the peso plunged to 3.18/$ resulting in a major upheaval in theeconomy. Fortunately, the rejection of the dollar peg, coupled with moreprudent policies, eventually paid off. By 2005, the economy had regained its1998 level, the budget deficit had turned into a surplus and the public debt wasrestructured. Exports strengthened and the country is now categorized as amanaged floating economy by the IMF. A caveat is in order: the devaluationtriggered an inflation spike resulting in a fall in the real wages and a permanentincrease in some basic prices; in sum, a redistribution effect causing higherpoverty and greater income inequality.

Exchange Rate PolicySo far we have considered the impact of monetary and fiscal policy, but there is athird policy that governments can use to stimulate or slow down their economyunder fixed exchange rates. The third policy is a devaluation or revaluation of thecurrency. This is not to say that the government allows the exchange rate tochange and float freely. A devaluation or revaluation is simply a statement on thepart of the government that instead of holding the price of foreign currency atexchange rate E0, it will now hold it at exchange rate E1 E0 . It is a policybecause the government changes the peg unilaterally from E0 to E1 for a specificreason.

An increase in the price of foreign currency is called a devaluation (moreunits of domestic currency are necessary to buy one foreign currency unit) and adecrease is a revaluation. A devaluation makes domestic exports more attractiveand this is why countries, at times, engage in competitive devaluations to protecttheir domestic producers as well as giving their exporters an edge. A correctivedevaluation is instead one that aligns the real exchange rate with the nominalexchange rate after periods of high inflation. We consider the economic theorybehind these two forms of devaluation within the framework of the Mundell-Fleming model. We also assume that the Marshall-Lerner conditions are met:the devaluation results in an improvement in the balance of trade.

Competitive devaluation


18.20

In this case, the economy is initially experiencing an overall equilibrium: at thisspecific level of output and interest rate, the goods market, the money market,and the foreign exchange market (BP=0) are in equilibrium. At the same time,however, the policymaker is faced with high levels of unemployment and wishesto stimulate the economy. The country can increase/redefine its peg from Ef0 toEf1 (see Figure 18.7), hoping that the devaluation, by stimulating exports anddiscouraging imports, generates a higher level of output and employment7.

To raise the price of foreign currency, the central bank simply buys foreigncurrency with domestic currency; this reduces the supply of foreign currency onthe foreign exchange market, strengthening the foreign currency and weakeningthe domestic currency. The supply of foreign currency shifts to the left and theexchange rate increases to the desired new peg, Ef1, as shown in Figure 18.7. Theresulting increase in the foreign reserves and the ensuing increase in themonetary base can also be observed on the central bank’s balance sheet on theright side of Figure 18.7.

Figure 18.7: Impact of a Competitive Devaluation on the ForeignExchange Market and on the Central Bank Balance Sheet

E

Q

S

D

ES

Ef0

Ef1

Central Bank

Assets Liabilities

DC

RES

MB

S'

Starting from equilibrium on the foreign exchange market at Ef0, the central bank announces a new pegcorresponding to a higher price for the foreign currency, Ef1. The central bank achieves this higher price bypurchasing the foreign currency on the foreign exchange market, thus reducing its supply on the market. Ascentral bank foreign reserves increase, so does the money supply.

7 This scenario is not altogether unrealistic. In the 1930s, countries attempted to escape thedepression with competitive devaluation or so called “beggar thy neighbor“ policies. Note thatany gain from a devaluation comes at the expense of the trading partner in a large country setting.


18.21

We can also analyze the effect of a devaluation within the Mundell-Fleming framework. In chapter 17, we demonstrated that a devaluation results ina downward shift of the BP curve. Now we add the new concept that, if theeconomy starts from a BP=0 equilibrium, the devaluation can only happen it thecentral bank intervene. The intervention, consisting in an accumulation offoreign reserves (RES increases), causes an increase in the money supply (as themonetary base, MB, increases). So both the BP and the LM curves shift out witha devaluation. Figure 18.8 shows the two shifts.

The devaluation has also a third impact: it improves the current accountand stimulates the economy. This is represented by a rightward shift of the IScurve as exports increase and imports are discouraged by the higher price offoreign currency. All three shifts result in a new equilibrium corresponding to aneconomic expansion from Y0 to Y1.

Figure 18.8: Economic Effects of A Competitive Devaluation

(Starting from a Balance of Payments Equilibrium)

i

Y

LM

BP(Ef0)

IS

LM'

BP'(Ef1)

IS'

Y0 Y1

ab

The competitive devaluation can be achieved only if the central bank buys foreign currency thus increasingthe domestic money supply. This raises the price of foreign currency, shifting the external balance, BP,downward while the LM curve shift to the right; the devaluation also causes an expansion in goods exportsand a reduction in imports to shift out the IS curve.

Will this new peg be permanent? Is it a better peg for the economy? What is theimpact on the trade partners and their reactions? These are further questionsthat the model does not address. In the second case, the devaluation is seen as


18.22

performing a correction. Indeed, competitive devaluation might be a thing of thepast, but corrective devaluations have not been uncommon in recent time.

Corrective devaluation

In this case, the country is facing chronic imbalances at the fixed exchange rateand is unable to remain on the BP line. Basically, the country is trying to hold onto a fixed exchange rate regime while facing a severe balance of paymentsimbalance (either a large current account deficit, or a financial account deficit, ofboth). How could the country end up in such a situation? The country could haveused expansionary policies unwisely and attempted to sterilize reserve flows or itmight be facing chronic deficits resulting from a loss in internationalcompetitiveness. The country must keep intervening to maintain its fixedexchange rate, but since the intervention consists of selling foreign currency, thecountry’s reserves will eventually be depleted. One solution to this quandary is todevalue the domestic currency. Again we can analyze the situation using a graphof the foreign exchange market together with a central bank balance sheet inFigure 18.9.

Figure 18.9: Impact of a Corrective Devaluation on the ForeignExchange Market and on the Central Bank Balance Sheet

E

Q

S

D

EDEf

0

Ef1

Central Bank

Assets Liabilities

DC

RES

MB

no interventionanymore

S'

very low

no change

The foreign exchange market is in disequilibrium at the original peg Ef0: the country has lost its internationalcompetitiveness and these imbalances are chronic. The country has sold most of its reserves to uphold theofficial peg Ef0 and has no choice but to stop intervening and readjust its peg to be in line with the realexternal balance. The peg is moved to Ef1, the exchange rate corresponding to equilibrium in the foreignexchange market. The money supply is not affected.


18.23

At the original fixed exchange rate, Ef0, there is excess demand for theforeign currency, but the reserves are too low to satisfy this excess demand. As aresult, the central bank can announce a new fixed exchange rate, this time at levelEf1 where the foreign exchange market is in equilibrium. Note that, in this case,the central bank does not need to purchase any foreign exchange as in the case ofa competitive devaluation. Here market forces drive the exchange rate up to Ef1.

In the Mundell Fleming model of Figure 18.10, we see that the devaluationhas a positive impact on the economy. In this case, the initial position of theeconomy is at point a, where IS and LM intersect below the BP line so BP<0. Atpoint a, the economy suffers from chronic balance of payments deficits. Thedevaluation shifts both the BP line and the IS curve to the right (since it increasesexports and decreases imports) as before, but the LM curve is not affectedbecause there is no need for intervention in the foreign exchange market. Theimpact of the corrective devaluation is therefore also expansionary as incomeincreases from Y0 to Y1.

Figure 18.10: Devaluation from BP<0

i

Y

LM

BP(Ef0)

IS

'

BP'(Ef1)

IS'

ab

Y0 Y1

BP shifts as the peg is redefined. There is no need to accommodate the devaluation with a change in themoney supply because, in this case, the devaluation simply confirms the new equilibrium in the foreignexchange market. The IS curve shifts as the devaluation improves the balance of trade and the economy isstimulated.

Devaluations and revaluations in Bretton-Woods era.


18.24

In modern time, it has been more frequent for countries to devalue or revaluebecause it is necessary to do so. The Bretton-Woods era (1945-1972) is repletewith such instances; in this international arrangement of the afterwar, all thecurrencies were pegged to the US dollar. In essence, countries with high rates ofinflation would lose their international competitiveness (e.g. France, Italy) andwould have to devalue to regain it. This system worked fine and imposed somesort of monetary discipline on its members: countries that used their monetarypolicy unwisely resulting in high inflation rates had to devalue in shame.However, in the sixties, the US rate of inflation also crept up and US pricesbecame significantly higher than German prices that were very stable. Thissituation was very unsettling for the Germans who had wowed to keep theirinflation in check as a result of their traumatic experience with galloping inflationin the twenties. If prices increase faster in the US than in Germany, Germangoods become more desirable and Germany runs a trade surplus leading to anaccumulation of reserves and an increase in the German monetary basis; theresult being inflationary pressures in Germany. If Germany uses contractionarymonetary policy to offset these pressures, the increase in the rate of interest leadsto capital inflows, further accumulation of reserves and further inflationarypressures: a vicious circle for Germany. The adjustment thus has to be effectedthrough a revaluation. After a number of revaluation (1961, 1969), it becameobvious to Germany that a flexible arrangement would be more suitable if theanchor, the US dollars, persisted in its erratic performance, so they eventuallyallowed their currency to float against the $ in 1971.

Table 18.2: Summary Impact of a Devaluationunder Fixed Exchange Rates

Dev

alua

tion

Type Effect on LM IS BPline Y i CA FA BP

Com

peti

tive

Sta

rt w

/ BP

=0

Immediateincluding

intervention

Shiftsright

---Shiftsright

---

Impact on trade ---Shiftsright

---


Right oforiginal

Right oforiginal BP=0

Cor

rect

ive

Sta

rt w

/ BP

<0 Immediate

no intervention--- ---

Shiftsright

Impact on trade ---Shiftsright

---

OverallOriginal

levelRight oforiginal

Right oforiginal BP=0

Harsha Vardhan

Highlight


18.25

The Policy Mix: Internal and External BalanceThe universal economic aspiration of governments is to enjoy full employment.Unfortunately we have seen that the goods and money markets equilibrium (theIS-LM intersection) may occur below or above full employment. Below fullemployment means that a lot of people do not have a job and above fullemployment means that there is excess demand for workers so that rising wagesexert inflationary pressures on the economy.

If the IS-LM-BP equilibrium of the economy does not correspond to fullemployment, is it possible to attain full employment without relying on changesin foreign currency reserves and interventions in the foreign currency market?The problem for the policy maker is then to worry about two objectives: to bringthe economy to full employment e.g. the internal balance, and to insure that thislevel of output is compatible with BP=0 e.g. the external balance, at the fixedexchange rate. We have discovered in chapter 15 that, in order to pursue twogoals, we need two policies and we discussed the policy mix in the case of theopen economy model without capital mobility. It is now time to look at thepolicy mix with the Mundell-Fleming model i.e. assuming capital mobility.

We analyze the specific case where, initially, the economy enjoys externalbalance, but not internal balance. The IS-LM-BP curves intersect below fullemployment and the policy makers plan to remedy this situation withexpansionary policies. Either expansionary fiscal or monetary policy can achievethis goal individually. However both policies affect the current account as well asthe interest rate and the financial account in the process. With eitherexpansionary policy, the current account deteriorates. However the two policieshave opposite impacts on the rate of interest and, consequently, on the financialaccount, worsening it with monetary policy and improving it with fiscal policy.

With expansionary monetary policy, the interest rate drops, triggeringcapital outflows. The overall effect is a deterioration in the balance of paymentsand internal balance is reached below the BP curve. In addition, the impact ofthe policy is reversed with non-sterilization. If we use fiscal policy only, thecurrent account deteriorates while the financial account improves as the interestrate increases with expansionary fiscal policy. Whether the financial accountimprovement will be greater or smaller than the current account deteriorationdepends on the degree of capital mobility. So the final equilibrium of theeconomy at full employment can take place either above or below the BP curve8.

Since one policy alone cannot achieve the goal of internal balance withoutlosing the external balance, we must consider a policy mix. In chapter 15, thepolicy mix consisted in fiscal and exchange rate policy. In the M-F model, weinclude monetary policy explicitly in the model by incorporating the LM curve.Exchange rates are fixed and they are not used as a policy instrument; so we pickfiscal and monetary policy to reach the internal balance, while maintaining theexternal balance.

8 It obviously would be a stroke of luck if ∆CA=-∆FA at full employment.


18.26

By using both policies together (Figure 18.11), the country can engineer anexpansion all the way to full employment at Yfe and, at the same time, control theexact change in the interest rate allowing the economy to remain on the BP line,since the policies have opposite effect on the interest rate. The policy makershave to plan and dose carefully the amount of each policy to achieve the twogoals. Since the BP curve is upward sloping, an increase in the interest rate isneeded to maintain the external balance: the deterioration in the current accountcaused by the expansion must be matched by an improving financial account.Finally, since the economy reaches a new position with internal and externalbalance, there is no need for intervention and, consequently no painful reserve-flow adjustment mechanism – the economy can remain there. The policy makershave thus achieved the stated goal: full employment (FE) with internal andexternal balance, and no foreign exchange intervention.

Figure 18.11: The Policy Mix

i

Y

IS

IS'

LM'FE

LM

Y0 Yfe

ife

i0

BP

The right dose of monetary and fiscal policy can move the economy from a position of equilibrium in thethree markets in Y0 to the more desirable position in Yfe where the economy is in equilibrium at full-employment (FE). Monetary policy is used judiciously to adjust the interest rate such that the balance ofpayments is never affected and the adjustment requires no intervention in the foreign exchange market.

However, Figure 18.11 does not really indicate precisely how we should usethe two policies. It only illustrates the initial situation and the final situation witha higher interest rate and a higher level of government spending; the graph showsthat, in principle, it should be possible to achieve both internal and externalbalance. In practice, it is not that simple. How does the policy maker know whatis the right dose of each policy? Moreover fiscal and monetary policies work theirway through the economy at very different paces – the lags involved in fiscal


18.27

policy are longer; that would make the coordination very hard to achieve. So isthere a method that would help the policy makers, in charge of the fiscal and incharge of the monetary policy, to figure out the best approach? A large amount ofliterature has been devoted to this question starting with Robert Mundell’soriginal quest9.

The Policy Mix: Internal and External Balance in the Policy Space

An alternative representation of the policy mix is to develop a graph in the policyspace that has fiscal policy and monetary policy on the two axes. We haveencountered this type of graph before, when we drew the Swan diagram ofchapter 15. Figure 18.12 measures monetary policy (represented by the level of i,the interest rate) on the vertical axis and fiscal policy (given by the level of G,government spending) on the horizontal axis.

Internal balance and external balance are represented by two lines (IB andEB) in the policy space of Figure 18.12 showing all the combinations of theinterest rate and government spending that result in internal or external balancerespectively. Along the IB line, the economy is always at full employment (Y=Yfe)and, along the EB line, the balance of payments is always zero (BP=0). Theintersection of these two lines yields a unique solution: it indicates the size of themoney supply (equivalent to the level of the interest rate) and the extent ofgovernment spending needed to reach both internal and external balancesimultaneously.

The construction of the EB and the IB lines is very similar to the approachused in chapter 15 to derive the YY and the BB line. A move out to the right onthe horizontal axis corresponds to higher government spending, thus moreexpansionary policy. A move up on the vertical axis corresponds to higherinterest rates (lower level of money supply), thus more contractionary monetarypolicy. If we start at a point Z in the left graph where the economy is at fullemployment and we increase government spending, the economy goes beyondfull employment. To restore full employment, we need to use contractionarymonetary policy: an increase in the interest rate. The internal balance line, IB,must be upward sloping. At the same level of government spending, any pointsabove the IB line (with higher interest rate) correspond to a more contractionarymonetary policy, so to a lower level of income, Y<Yfe. Conversely, all the pointsbelow the IB line correspond to Y>Yfe.

Similarly, we start with a point X on the middle graph where the balance ofpayments is balanced. A horizontal movement to the right of this point (at thesame interest rate) i.e. an increase in government spending, will cause currentaccount deficits. To restore the external balance BP=0, the financial accountneeds to improve and this is only possible with an increase in the interest rate.The external balance line, EB, is also upward sloping. If we carry out the samereasoning as above, we find out that points above the EB curve corresponding to

9 In his seminal article published in the IMF Staff Papers, in 1962, Mundell solves the assignmentquestion.


18.28

higher interest rate exhibit surplus in the balance of payments, BP>0, whilepoints below the EB line are in the balance of payments deficit area, BP<0.

Since both lines are upward sloping, we need to know where they standrelative to each other to complete the presentation on the right graph. Onlythen, can we label the four quadrants delimited by the two lines according totheir situation with respect to both balances (just as we did with the Swandiagram). The two lines intersect at a point E where both balances are achieved.If the economy moves up along the internal balance line from E to a point F, fullemployment is maintained; this is possible because the higher level ofgovernment spending is compensated by a more restrictive monetary policy, i.e. ahigher interest rate. Since output is the same, the current account is not affected,but with higher interest rates, the financial account improves and the balance ofpayments turns into a surplus i.e. a point above the external balance line. The IBline is thus steeper than the EB line and this does not depend on the level ofcapital mobility.

Figure 18.12: Construction of the Internal and External Balance

IB

EB

IB

EBE

BP>0Y<Yfe

BP<0Y>Yfe

BP<0Y<Yfe

BP>0Y>Yfe

Z X

Y<Yfe

Y>Yfe

BP>0

BP<0

Internal Balance External Balance

F

i i i

G G G

The IB and the EB lines correspond to all the combinations of i and G that maintain the economy at fullemployment or in external balance (BP=0), respectively. ; i and G measure respectively the extent of themonetary or fiscal policy exercised at the time. Each of the two lines, IB and EB, divide the space into 2regions: unemployment and inflationary pressures for the IB line and balance of payments surplus anddeficit for the EB line. The IB line must be steeper than the EB line, because starting from a IB-EBequilibrium in E, an increase in interest rate along the IB line to F bring about surpluses in the balance ofpayments, so F must lie above the EB line.

Now that we have constructed the policy mix graph, we are ready to use itto figure out the policies a government should implement to steer the economytoward an IB-EB equilibrium.


18.29

The Policy Assignment Question

In the last section, we analyzed a special case where the economy had externalbalance, it was on the EB line, but was not at full-employment. We illustratedthat a combination of fiscal and monetary policy can, in principle, bring theeconomy to E. However in our previous graph (Figure 18.11), we were onlyshowing the initial and the final position. We were not showing how exactly wewould reach E. More precisely we were not sketching the path that the economyshould follow to get to E (although we hinted it in the explanations). The goal ofthe policy makers was to send the economy to the intersection point of the IB-EBlines. Still they had to use a policy mix to succeed. We now generalize theanalysis by looking at any possible situation a country could find itself in: neitherexternal nor internal balance, or one balance - but not the other.

We have two policies (fiscal and monetary policy) to reach two targets(internal and external balance). The question is which target we assign to whichpolicy. If we could answer this question, we could provide a cue to countries thathave one policy maker in charge of fiscal policy and another one in charge ofmonetary policy. In this case, it would be convenient tell the policy maker incharge of money supply to worry uniquely about bringing the balance ofpayments in balance and to tell the policy maker in charge of fiscal policy toworry uniquely about restoring full employment. Could this division of laborwork? If it did, that would also take care of the problem of different speed ofadjustment with the different policies since they are carried out independently ofeach other.

In fact, the formal model has shown that the idea of assigning a specifictarget to each policy really works. Let us try to figure out the correct assignmentintuitively. Monetary policy affects the financial account directly throughchanges in the rate of interest. On the other hand, fiscal policy does not affect thecurrent account directly. So overall, monetary policy seems to have a more directimpact on the balance of payments. Therefore, it would be a good bet to assignmonetary policy to the external balance: this is the correct assignment. It isimportant to stress that we cannot switch the policy-target match around: if thegovernment assigns the wrong target to a specific policy, the disequilibria wouldget worse.

Figure 18.13: The Assignment


18.30

A

i

G

IB

EB

E

B

Starting from A, a situation with inflationary pressures (Y>Yfe) and a balance of payments surplus (BP>0),the government assigns the correct tasks to its agencies: fiscal policy is devoted to fixing the inflationarypressures by cutting G and monetary policy to fixing the balance of payments by cutting the interest rate.The economy will be shepherded to equilibrium in E. Let us see what happens if the government ignores thecorrect assignment: from another disequilibrium point B where Y<Yfe and BP<0, had the government cutspending to restore the external balance and cut the interest rate to restore the internal balance, theeconomy would have been saddled with further disequilibria.

Starting from disequilibrium at A in Figure 18.13, the correct assignmentsends the economy back to equilibrium at E. There is a balance of paymentssurplus at A, so the central bank must cut the interest rate sending the economyon the EB line. External balance is restored on EB, but the government has toworry about inflationary pressures. The government thus cuts spending restoringthe internal balance as the economy moves to IB: in the process, a new smallerbalance of payments surplus is created. Next it is the turn of the central bank tocut the interest rate again to restore the external balance. The economy is clearlyconverging towards E as each individual adjustment is smaller and smaller.

Let us now show an example of incorrect policy assignment. Startingfrom point B, the policy choices illustrated with arrows will not work. Cuttinggovernment spending to restore external balance and cutting the interest rate tobring the economy to full employment, bring further disequilibria. The startingpoint at B was a situation with balance of payments deficits and unemployment,so these are clearly the wrong policies.

Reality Check on the Policy Mix

The principle behind the policy mix, which consists in using both fiscal andmonetary policies to reach two objectives, is straightforward and unassailable.Let us consider point B where the country suffers from a balance of paymentsdeficit in addition to unemployment. According to the assignment directive, thecentral bank simply has to raise interest from the lower levels at B to a higher


18.31

level at E to deal with the balance of payments deficit. From a domestic point ofview, this sounds like a very weird thing to do when the economy needsstimulation. This would send the economy deeper into its recession asinvestment is stifled by the policy. The idea is to compensate this adverse impacton output with massive doses of expansionary fiscal policy as fiscal policy isassigned to fixing the internal balance. Not only would this increase the budgetdeficit, but it would be criticized as a blatant example of crowding out. Howwould business or the stock market react! This is political suicide. Politicians aremore worried about unemployment than about the balance of payments; as theyignore the external sector, their instincts lead them to conduct expansionarymonetary and expansionary fiscal policy. Small very open economy may monitorclosely their external balance; but by looking at the extent of the externalimbalance exhibited by the US economy in recent years, it is clear that largeindustrial economies are not willing to take action that might destabilize theirdomestic sector (note that the theory is developed in the context of the smallopen economy).

Not only does the assignment directive affect the composition of aggregatedemand by using the interest rate as an instrument, but it also affects thecomposition of the external balance. In the process of moving towards fullemployment from point B, the current account will deteriorate and the countrywill weather large capital inflows to match these current account deficits: thecountry’s level of international indebtedness increases towards a greater foreigndebt burden implying greater interest payments to the foreigners. Thesedevelopments may not be desirable either. This is indeed a serious problem facedby the US economy.

Summary of key concepts1. With fixed exchange rate, any policy that impinges on the foreign exchange

market equilibrium, requires intervention by the central bank to neutralizethese effects

2. The Mundell-Fleming model combines the goods and money market of the IS-LM model with the external balance, BP=0, developed in chapter 17.

3. All three markets (the goods, money, and foreign exchange market) mustclear for the economy to be in equilibrium.

4. While fiscal policy can have a lasting effect on output, monetary policy canonly have a temporary effect under fixed exchange rates.

5. The higher the degree of capital mobility, the more effective fiscal policy willbe.

6. The greater the degree of capital mobility the faster the adjustment of theeconomy takes place.

7. If a country chooses to use devaluation as a mean to stimulate its economy,the process will involve an intervention in the foreign exchange market


18.32

followed by an adjustment in the money supply. The devalued exchange rateimproves the trade balance and the increase in the money supply stimulatesthe economy.

8. A devaluation can be used either to acquire a competitive edge or toacknowledge the fact that a currency may be too strong, causing chronicbalance of payments deficits that are not sustainable.

9. If a country wishes to achieve full employment (internal balance) at the sametime as external balance (BP=0) using two policy instruments, monetary andfiscal policies, it must assign a specific policy to a specific target to besuccessful.

Case studies

CASE STUDY IThe Petrodollar PegFrom The Economist print edition, Dec 7th 2006

America should worry more about fixed exchange rates in the Gulfthan the gently rising Chinese yuan.

American politicians and businessmen view China's undervalued exchange rateand its huge current-account surplus as the main cause of America's vast deficit.Thus next week a high-powered delegation led by Henry Paulson, America'streasury secretary, will fly to Beijing to persuade China to take measures toreduce its surplus. But are they heading to the right place? At the global level, thebiggest counterpart to America's deficit is the combined surpluses of the oil-exporting emerging economies. They are expected to run a total current-accountsurplus of some $500 billion this year, dwarfing China's likely surplus of $200billion (see chart).

Counting only the Middle East oil exporters, the surplus has surged from $30billion in 2002 to an estimated $280 billion this year. One reason why this getsmuch less attention than the smaller $160 billion increase in China is that only afraction of it has gone into official reserves, which are publicly reported. Most ofit is stashed in government oil-stabilisation or investment funds, such as the AbuDhabi Investment Authority, which are much more secretive than the People'sBank of China—but which probably hold just as many dollar assets.

One big difference is that China is now allowing the yuan to rise against thedollar. The exchange rate is up by an annual rate of almost 7% since September.In contrast, the six members of the Gulf Co-operation Council, or GCC (SaudiArabia, United Arab Emirates, Kuwait, Bahrain, Oman and Qatar), which accountfor virtually all of the Middle East's surplus, still peg their currencies firmly to thedollar. This is partly in preparation for the GCC's plan to adopt a single currencyby 2010. But the bizarre result is that over the past four years of soaring oilprices, their real trade-weighted exchange rates have fallen.


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The Gulf economies are running an average current-account surplus of 30% oftheir GDP, well in excess of China's surplus of 8%. Oil exporters cannot spendtheir windfall overnight and it makes sense for them to run a surplus when oilprices rise, as a buffer for when oil prices fall. Even so, one can have too much ofa good thing.

It might be best for the Gulf states as well as the world economy if theyabandoned their dollar pegs and shifted to some sort of currency basket. A moreflexible exchange-rate regime would allow them to regain control of theirmonetary policies and so cool down their overheating economies. By peggingtheir exchange rates to the dollar, they have had to adopt America's monetarypolicy, leaving real interest rates too low (often negative) for such fast-growingeconomies. Credit is growing too rapidly, inflation is rising and the prices ofassets, especially property in places such as Dubai, have exploded.

Official price indices almost certainly understate inflation. According togovernment figures, prices are rising in the UAE at an annual rate of 7%, butindependent estimates put it at 15%. The dollar's slide against other majorcurrencies is pushing up the price of imported goods. Only 10% of the GCC'simports come from America (compared with one-third each from Europe andAsia), so from a trade-weighted point of view, the dollar peg makes no sense.

In theory, a higher oil price should imply a rise in oil exporters' real exchangerates; and it is better if this occurs through a rise in the nominal rate rather thanhigher inflation. The main argument against allowing the exchange rate to rise isthat it would harm the competitiveness of the non-oil sector in economies thatneed to diversify. However, pegging to the dollar has not always been a boon tothe economies as a whole. When the dollar strengthened in the late 1990s, non-oil industries were squeezed at the same time that the price of crude was sliding.This is another reason why pegging to a trade-weighted basket would make muchmore sense.

Oiling the world's wheels

Brad Setser, an economist at Roubini Global Economics, a research firm, arguesthat the dollar pegs of the Gulf states are also preventing some necessaryrebalancing in the world economy. The recent depreciation of their trade-weighted currencies has raised the price of foreign goods and thus may be onereason why the increase in their imports has been unusually weak relative to theincrease in exports. If, as seems likely, the dollar continues to fall, it will furtherdrag down their currencies and thus keep external imbalances large.

A fully floating exchange rate would lead to too much volatility, but a bit moreflexibility could usefully help oil exporters to adjust to fluctuations in oil prices. Atrade-weighted basket, in which the euro had a large weight, would help tostabilise the real exchange rate of the GCC countries and so protect theircompetitiveness. It still would not ensure that oil exporters' currencies movedcorrectly in line with the oil price, however.

Some economists have therefore suggested that oil exporters should link theircurrencies in some way to the oil price. Currencies would rise when oil prices are


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high and fall when prices were weak. This would help to boost countries' externalpurchasing power and hence their imports when oil prices boom. It would alsothe local currency value of oil revenues and hence government income, helping toavoid big deficits in bad times and huge surpluses in good times.

Oil exporters argue that they peg to the dollar because oil is priced in dollars andthey want to avoid exchange-rate risk. But exchange-rate stability does notguarantee economic stability. On the contrary, a more flexible currency wouldallow economies to manage oil-price shocks better.

However, a rise in petro-currencies would not be a cure by itself for America'sdeficit (nor, for that matter, is a dearer Chinese yuan). The main solution toglobal rebalancing is for America to save more and for surplus countries,including both the oil exporters and China, to spend more. A rise in oil exporters'currencies could play a part in that.

Case study questions:

1. What kind of exchange rate regime have the six members of the GulfCooperation Council (GCC) adopted?

2. What is the state of their current account? How does it compare to China’s.In what form are their foreign assets and how are they held?

3. What is the impact of the GCCs exchange rate regime on each country’smonetary policy? Why is the GCC interest rate “too low” and what effect doesthis low interest rate have on their economies? Comment on the resultingimbalances and on the effect on their real exchange rate.

4. Explain the downside to for the GCC to move to a fully floating exchange rate.

CASE STUDY IIDon't Revalue the YuanBy Ronald McKinnon

Wall Street Journal, June 27, 2003

Treasury Secretary John Snow recently raised eyebrows when he suggested that"the Chinese government is interested in moving toward market-based, flexibleexchange rates," and Washington would support such a move. His June 16remarks caused a stir in the foreign exchange markets, and probably acceleratedthe conversion into yuan of privately held dollar assets in China -- thus increasingthe pressure on the yuan to appreciate from its current rate of 8.28 to the dollar.

That only goes to show how, with respect, Mr. Snow is wrong and moving to aflexible exchange rate is far from desirable. Under the present circumstances,floating the yuan would lead to repetitive appreciation. If China stops stabilizingthe exchange rate, the yuan will float upward without any well defined limit --posing possibly severe domestic deflationary consequences.


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Because further appreciations then become more likely, floating could have moreserious effects than a one-time appreciation in the yuan. That is evident from theJapanese experience. From the 1970s through to the mid 1990s, a series ofappreciations in the yen sent the Japanese economy into a deflationary tailspinand zero interest-rate liquidity trap, from which it has yet to recover.

Why would allowing the yuan to float freely lead to repetitive appreciation? Chinahas become an important international creditor, with an ongoing balance ofpayments surplus from large inflows of foreign direct investment coupled with asmall multilateral trade surplus. Because the dollar is the dominant internationalcurrency for borrowing and lending, that results in a continual buildup of liquiddollar claims on foreigners -- a surprisingly high proportion of which areprivately held, outside the direct control of the central government.

These ever-accumulating dollar balances need not disequilibriate the portfolios ofChinese savers holding both dollar and yuan assets as long as the yuan/dollarrate remains fixed within narrow band. That's because a stable exchange ratemeans Chinese savers will see dollar assets as just as safe as those in yuan.

But once the exchange rate begins to fluctuate (even if the yuan does notimmediately appreciate), the dollar assets will look riskier and private holderswill begin to dishoard them, forcing an appreciation in the value of the yuan. Andthis appreciation will repeat itself as China's balance of payments surplus -- largeinflows of FDI plus small current-account surpluses -- continues to produceliquid dollar assets that China's private sector will be less and less willing to hold.

As the appreciation continues, domestic price levels in China -- which are nowfinely balanced between inflation and deflation -- will begin to fall. And as China'sfinancial markets begin to anticipate an ever appreciating yuan and falling prices,interest rates will be pushed down to zero, making it impossible for the People'sBank of China to stop the deflation -- very much like the trap in which Japan nowfinds itself.

There's already mounting evidence that China's modest internal interest rates -- adeposit rate about 2% and a standard loan rate of 5.3% -- have become too high.As dollars are converted into yuan, the People's Bank of China has been rapidlyexpanding its domestic monetary base so that the overall supply of new depositsof Chinese households and firms held by the commercial banks now greatlyexceeds the demand for new loans. As in Japan, this puts the banks in a perilousposition. And with interest rates unable to fall below zero, the room for rate cutsto correct this supply-demand imbalance is very limited.

While many observers ask what the right level for the yuan/dollar exchange rateshould be, that's really missing the point. What's far more important than theprecise exchange rate whether it be seven, eight or nine yuan to the dollar -- isthat it remains stable, eliminating foreign-exchange risk and so making Chinesesavers more willing to continue to accumulate an indefinite future stream ofdollar assets.

Fortunately, the Chinese government has a lot of credibility invested in thepresent rate of 8.28 yuan per dollar, which it has now maintained since 1994.


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And it is important not to squander that credibility by making this central ratemore "flexible."

Apart from mercantilist considerations, what is the main analytical argumentused by supporters of an appreciation in the yuan? China has had a trade surplussince 1995, except for the first few months of this year when its trade happened tobe roughly balanced multilaterally. However, many, if not most, economistsbelieve that China's trade surplus could be reduced and even become negative --if an appreciation in the yuan made Chinese exports more expensive in dollarterms, so that fewer are sold abroad.

But this conventional wisdom is misplaced. China's trade surpluses reflect itssurplus savings, just as America's huge ongoing trade deficit reflects theextraordinarily low net savings within the American economy -- zero net personalsavings and now large government dissaving from extraordinary fiscal deficits.Changing an exchange rate does not change these net savings propensities in anyobvious way. However, in a deflationary world, if one country appreciate itscurrency against all its neighbors, the fall in its domestic-currency prices oftradable goods and services will create a downward deflationary spiral in pricesand output with a consequent fall in imports. Thus, there is no predictable effecton China's net trade surplus from appreciating the yuan.

However Mr. Snow could be right if he defines flexibility more narrowly, allowingthe market value of the yuan to fluctuate within a narrow soft band around 8.28yuan to the dollar. This would have the big advantage of devolving the task ofclearing of China's international payments to the clearing banks, and away fromthe People's Bank of China. But just as diamonds are forever, so too should be thecentral rate of 8.28 yuan to the dollar.

Case study questions:

1. What are McKinnon’s arguments against a revaluation of the yuan?

2. Is McKinnon’s primary argument based on Chinese or US factors?

3. Why could a narrow revaluation find McKinnon’s support?

4. Which part of the Chinese Balance of Payments is most affected by itsexchange rate regime?

5. Outline the relationship between savings and the Chinese balance ofpayments.

Questions for study and review1. Hong Kong managed to maintain its currency board during the East Asiancrisis. During the crisis Hong Kong had severe reserve outflows and thenexorbitant interest rates. Use the Mundell-Fleming model to show how thatcould occur. Start with a balance of payments equilibrium. Draw a graph.


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2. If a country with a fixed exchange rate has an outstanding reserve loan fromthe IMF, what does the country need to do to repay it? Draw a graph of theexchange rate market and of the Mundell-Fleming model.

3. Be an economic detective. How could the above country have ever been inneed of the reserve loan? Be specific. Use the Mundell-Fleming model and drawa graph.

4. You are a benevolent dictator in a small open economy with a massivegovernment deficit, capital controls, and a large balance of payments deficit.Given your fixed exchange rate regime, describe the policies you can use to getthe economy back to an internal and external balance. Please provide diagramsthat show your starting point and your final equilibrium.

5. Countries within the European Monetary Union have adopted a commoncurrency, the euro, and a common monetary policy dictated by the EuropeanCentral Bank. Can members raise their output using domestic fiscal andmonetary policies? Use graphs to explain both policies.

6. A small country, Pecunia, under a fixed exchange rate regime has achievedboth internal (IS-LM intersection) and external balance. Pecunia trades a lotwith the rest of the world. Pecunia’s central bank does not sterilize, but it fearsinflation. In addition, Pecunia only allows limited access to its capital marketwhile its citizens need authorizations to invest abroad. The government plans touse fiscal policy (more specifically government spending) to ease the inflationarypressures on its economy.

a. Spell out the policy carried out by the government.

b. Use a graph slowing the IS-LM-BP to illustrate the impact of the policy - pointa is the starting equilibrium. Show the shifts (if any) of the 3 curves IS-LM-BPresulting from the fiscal policy adopted.

c. Break down the effect into two stages: i. name the impact of the fiscal policyalone point b ii. name the final equilibrium point c.

What can you say about the balance of payments in point b. Compare the level ofincome in a, b and c.

7. A small country initially has achieved internal and external balance.International financial capital flows are high but not perfectly mobile. Thecountry commits to a fixed exchange arrangement and defends it throughintervention, but the country does not sterilize.

The country elects a new prime minister who happens to be an excellenteconomist with an international reputation. As a result financial capital inflowsincrease dramatically and remain higher.

a. what shift occurs to the BP curve because of the increased capital inflows.

b. what intervention is necessary to defend the fixed exchange rate?

c. as a result, how does the country adjust back to external balance? What is theeffect on the internal balance.


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d. Show all your results on a IS-LM-BP graph.

8. A small country initially has achieved both internal and external balance. Thecountry prohibits international financial capital flows, so FA=0. The country hasa fixed exchange rate regime and defends it through official intervention; it doesnot sterilize. An exogenous shock occurs: foreign demand for the country’sexports increases.

a. what is the slope of the BP curve?

b. what shift(s) occur in the IS-LM-FE set up because of the increase in foreigndemand for the country’s exports?

c. what intervention is necessary to keep the exchange rate fixed.

d. as a result, how does the country adjust back to external balance? What is theeffect on the internal balance.

d. Show all your results on a IS-LM-BP graph.

9. Use the policy mix graph to show how the policy makers can bring an economywith balance of payments surpluses and unemployment to a stable level of outputat full employment.

References and suggestions for further readingArgy, V. (1994) International Macroeconomics: Theory and Policy, New York:

Routledge.

Bank of International Settlements (2001) ‘Comparing monetary policy operatingprocedures across the United States, Japan and the euro area’, BIS Papers 9.

Bofinger, P. (1999) ‘The Conduct of Monetary Policy by the European CentralBank According to Article 105 of the Treaty versus the Real Economy’,working paper, University of Würzburg.

Buckman, R. (2003) “Weak Dollar Won't Fix Huge U.S. Trade Deficit,” WallStreet Journal, 5-22.

Buiter, W. H. (1999) ‘Alice in Euroland’, CEPR Policy Paper #

Enoch, C., and Gulde, A.(1998) ‘Are Currency Boards a Cure for All MonetaryProblems?’, Finance and Development, Dec: 40-3.

European Central Bank (1999) ‘The Stability-Oriented Monetary Policy Strategyof the Eurosystem’, ECB Monthly Bulletin, Jan: 39-50.

European Central Bank (2001) The Monetary Policy of the ECB, Frankfurt: ECB.

Fleming, J. M. (1962) ‘Domestic Financial Policies under Fixed and underFlexible Exchange Rates’, IMF Staff Papers, 369-79.

Frenkel, J. and Mussa, M. (1987) ‘The Mundell-Fleming Model a Quarter CenturyLater’, IMF Staff Papers, December: 567-620.

Friedman, M. (1988) ‘Lessons on Monetary Policy from the 1980s’, Journal of


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Economic Perspective, Summer.

Hume, D. (1752) ‘On the Balance of Trade’ reprinted in R. Cooper (ed.),International Finance: Readings (1969), Baltimore: Penguin Books.

International Monetary Fund (1996) ‘Currency Boards CircumscribeDiscretionary Monetary Policy’, IMF Survey, 5.

Issing, O., Gaspar, V., Angeloni, I. and Tristiani, O. (2001) Monetary Policy inthe Euro Area, Cambridge: Cambridge University Press.

Kenen, P. (1985) ‘Macroeconomic Theory and Policy: How the Closed EconomyWas Opened’, in R. Jones and P. Kenen (eds), Handbook of InternationalEconomics, Amsterdam: North-Holland, II: 625-78.

Krueger, A. (2002) ‘Crisis Prevention and Resolution: Lessons from Argentina.”Speech to National Bureau of Economic Research Conference on “TheArgentina Crisis.” Cambridge, MA (July 17).

http://www.imf.org/external/np/speeches/2002/071702.htm

Krugman, P. (2000) ‘Reckonings; The Shadow of Debt’, The New York Times,November 22.

Moreno, R. (2002) ‘Learning from Argentina’s Crisis’, FRBSF Economic Letter,Oct 18:2002-31.

Mundell, R. A. (1960) ‘The Monetary Dynamics of International Adjustmentunder Fixed and Flexible Exchange Rates’, Quarterly Journal of Economics,84: 227-257.

Mundell, R. A. (1963) ‘Capital Mobility and Stabilization Policy under Fixed andFlexible Exchange Rates’, Canadian Journal of Economics and PoliticalScience, 29: 475-485.

Mundell, R. A. (1962) ‘The Appropriate Use of Monetary and Fiscal Policy forInternal and External Stability’, IMF Staff Papers, March: 70-7.

Mundell, R. A. (1961) “The International Disequilibrium System,” Kyklos, 14.

Mundell, R. A. (1968) International Economics, New York: Macmillan.

Mussa, M. (2002) Argentina and the Fund: From Triumph to Tragedy. PolicyAnalyses in International Economics, 67, Washington, DC: Institute forInternational Economics.

Niehans, J. (1968) ‘Monetary and Fiscal Policies in Open Economies under FixedExchange Rates: An Optimizing Approach’, Journal of Political Economy,893-920.

Obstfeld, M., and Rogoff, K. (1995) ‘The Mirage of Fixed Exchange Rates’,Journal of Economic Perspectives 9: 73-96.

Person, T. and Svensson, L. (1995) ‘The Operation and Collapse of FixedExchange Rate Regimes’, in G. Grossman and K. Rogoff (eds), Handbook ofInternational Economics, 3:1865-911, Amsterdam: Elsevier.


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Semmler, W., Greiner, A. and Zhang W. (2006) ‘Monetary and Fiscal Policies inthe Euro-Area: Macro Modeling, Learning and Empirics’ Springer Verlag .

Turnovsky, S. J. (1977) Macroeconomic analysis and stabilization policy,Cambridge: Cambridge University Press.

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