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Macroeconomic Policy Under Regime of Free Capital Flows Surajit Das

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Mundell-Fleming Framework - Open Economy IS-LM Model: Y r O r* r Y* Y L M I0I0 S0S0 I1I1 S0S0 2

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The Mundell-Fleming model can be described as follows: r = r* … … … (A) Ms = L(Y, r) … … … (B) Y = C(Y – t.Y) + I(r, Y) + G + NX(Y, e) … … … (C) NX(Y, e) = - k.e … … … … … … … … … (D) But, the foreign capital inflow in a particular economy and in a particular period of time should more realistically be assumed to be exogenously given rather than assuming it to be solely dependent on the domestic interest rate or interest rate differential or interest rate differential net of exchange rate fluctuation etc. The direction and destination of flows of international finance capital would be driven by profit motive based on expected capital gains and or various kinds of country risks. In such a case, in addition to the three equations there has to be a fourth one for the balance of payment equilibrium: 3

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Source: Handbook of Statistics on Indian Economy – 2006, RBI. FI in US $ Mn 4

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Source: Handbook of Statistics on Indian Economy – 2006, RBI and Bombay Stock Exchange. 5

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e K Balance of Payment Equilibrium: 6 O

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e K 7 K K O

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e K e1e1 e0e0 8 K K UVO G F

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e K M(Y), X C 45 0 e1e1 e0e0 Balance of Payment Equilibrium: 9 K K UV U V P Q O G F

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Y e K M(Y), X C 45 0 e1e1 e0e0 XX Y0Y0 Y1Y1 Balance of Payment Equilibrium: 10 T T M M J L K K UV U V P Q O G F

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Y e K M(Y), X C 45 0 Y Y e1e1 e0e0 Z0Z0 Z1Z1 XX Y0Y0 Y1Y1 Balance of Payment Equilibrium: 11 T T M M J L K K UV U V P Q O G F

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Y e K M(Y), X C 45 0 Y Y e1e1 e0e0 Z0Z0 Z1Z1 XX Y0Y0 Y1Y1 Balance of Payment Equilibrium: 12 T T M M J L K K K K UV U V P Q O G F

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Y e K M(Y), X C 45 0 Y Y e1e1 e0e0 Z0Z0 Z1Z1 XX Y0Y0 Y1Y1 Balance of Payment Equilibrium: 13 T T M M J L K K K K UVW D U V P Q O I H G F

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Y e K M(Y), X C 45 0 Y Y e1e1 e0e0 Z0Z0 Z1Z1 XX Y0Y0 Y1Y1 Balance of Payment Equilibrium: 14 T T M M J L K K K K UVW D U V W D P Q R S O I H G F

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Y e K M(Y), X C 45 0 Y Y e1e1 e0e0 Z0Z0 Z1Z1 XX Y0Y0 Y1Y1 Y2Y2 Y3Y3 Balance of Payment Equilibrium: 15 T T M M J L B N K K K K UVW D U V W D P Q R S O I H G F

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Y e K M(Y), X C 45 0 Y Y Y Ye1e1 e0e0 Z0Z0 Z1Z1 Z2Z2 Z3Z3 XX Y0Y0 Y1Y1 Y2Y2 Y3Y3 Balance of Payment Equilibrium: 16 T T M M J L B N K K K K UVW D U V W D P Q R S O I H G F

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Y e K M(Y), X C 45 0 Y Y Y Ye1e1 e0e0 Z0Z0 Z1Z1 Z2Z2 Z3Z3 XX Y0Y0 Y1Y1 Y2Y2 Y3Y3 Balance of Payment Equilibrium: 17 T T M M J L B N K K K K UVW D U V W D P Q R S O I H G F

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Y e K M(Y), X C 45 0 Y Y Y Y XX Balance of Payment Equilibrium: 18 T T M M K K K K O

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Y e K M(Y), X C 45 0 e* Z* Z XX Y* Y Balance of Payment Equilibrium with Fixed Exchange Rate: T T M M L N K K K K V D V D Q S O I 19 G

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Product Market Equilibrium: e Y O I S Y = C + I + G + X – M 20

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Simultaneous Equilibrium in Both Markets: e Y O I S 21 Case I Y Y

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e Y O I S 22 Simultaneous Equilibrium in Both Markets: Case II Y Y

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Y = C(Y – T) + I(r, Y) + G + X(e) – M(Y, e) … … … … (1) T = t.Y … … … … (2) The national income identity or the commodity market equilibrium condition Standard tax function, when the tax-GDP ratio is assumed to be given The consumption as a positive function of disposable income C = θ + c.(Y – T) = θ + c.Y(1 – t) … … … … (3) The investment function is assumed to depend positively on Y and negatively on r I = λ + α.Y – β.r = δ + α.Y … … … … (4) The export function is given as positive function of the exchange rate X = μ + e.x … … … … (5) 23

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M = ρ + m.Y – e.n … … … … (6) Y.[1 – c.(1 – t) – α + m] = φ + e.(x + n) … … … … (7) Where, φ = θ + δ + G + μ –ρ. The import as a positive function of Y and negative function of exchange Rate Therefore, from (1) we get the commodity market equilibrium condition as, Y = θ + c.Y(1 – t) + δ + α.Y + G + μ + e.x – (ρ + m.Y – e.n) The equilibrium condition for the BoP in foreign exchange market ρ + m.Y – e.n – (μ + e.x) = k.e = K … … … … (8) From (7) we get the slope of the commodity market equilibrium condition as de/dY = [1 – c.(1 – t) – α + m]/(x + n) … … … … (9) From (8) we get the slope of BoP equilibrium condition de/dY = m/(x + n + k) … … … … (10) 24

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Since, [1 – c.(1 – t) – α] > 0 (the multiplier) i.e. [1 – c.(1 – t) – α](x + n + k) + m.k > 0 (all x, n, k & m >0) i.e. [1 – c.(1 – t) – α + m]/(x + n) – m/(x + n + k) > 0 i.e. [1 – c.(1 – t) – α + m]/(x + n) > m/(x + n + k) i.e. slope of commodity market equilibrium condition > slope of BoP equilibrium condition. i.e. IS curve is steeper than YY curve. For simultaneous equilibrium in both the markets we get, e* = (φ.m – μ.m – μ.ξ)/[ξ.(x + n +k) + m.k] … … … … (11) and Y* = [(φ.m – μ.m – μ.ξ).(k + n + x)]/[m.{ξ.(x +n +k) + m.k}] + μ/m [from (8)] …….. (12) where, ξ = [1 – c.(1 – t) – α] 25

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Macroeconomic Policy: e Y O I0I0 S0S0 Y Y e0e0 E0E0 Y0Y0 26

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Macroeconomic Policy: e Y O I0I0 S0S0 Y Y Y Y e0e0 e1e1 E0E0 E Y0Y0 Y 27

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Macroeconomic Policy: e Y O I0I0 S0S0 I1I1 S1S1 Y Y e0e0 e2e2 E0E0 E1E1 E* Y0Y0 Y* 28

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Macroeconomic Policy: e Y O I0I0 S0S0 I1I1 S1S1 Y Y Y Y e0e0 e1e1 e2e2 E0E0 E1E1 E E* Y0Y0 Y Y* 29 e

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Macroeconomic Policy: e Y O I0I0 S0S0 I1I1 S1S1 I2I2 S2S2 Y Y Y Y e0e0 e1e1 e2e2 E0E0 E1E1 E E2E2 E* Y0Y0 Y Y* Y2Y2 30 e

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Macroeconomic Policy: e Y O I0I0 S0S0 I1I1 S1S1 I2I2 S2S2 Y Y Y Y I3I3 S3S3 e0e0 e1e1 e2e2 E0E0 E1E1 E E2E2 E* E3E3 Y0Y0 Y Y* Y2Y2 Y3Y3 31 e

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ΔY*/ ΔG = (k + n + x)/[{1 – c.(1 – t) – α}.(x +n +k) + m.k] … … … (13) Δe*/ ΔG = m/[.[{1 – c.(1 – t) – α}.(x +n +k) + m.k] … … … … (14) If G rises by Δ G, from (12) we get, ΔY* = ΔG.m.(k + n + x)/[m.{ξ.(x +n +k) + m.k}] And if G rises by ΔG, from equation (11) we get, Δe* = ΔG.m/[ξ.(x +n +k) + m.k] Δe*/ ΔG = m/[ξ.(x +n +k) + m.k] Therefore, we get, (ΔY*/ ΔG)>0 as well as (Δe*/ ΔG)>0. Hence, if G increases, ceteris paribus, both Y and e unambiguously rises and vice-versa for any given level of net capital inflow k under Flexible exchange rate. 32

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Y 1 * = [Δk(φ.m – μ.m – μ.ξ) + (k + n + x).(φ.m – μ.m – μ.ξ)]/[ Δk.m.(ξ +m) + m.{ξ(k + n + x) + m.k} + μ/m … … … … (15) e 1 * = (φ.m – μ.m – μ.ξ)/[ Δk.(ξ +m) + ξ.(k +n +x) +m.k] … … … … (16) Now, Y1* would be less than Y* if the percentage rise in the numerator is less than the percentage increase in the denominator (hence the ratio comes down) and vice-versa. Δk(φ.m – μ.m – μ.ξ)/[(k + n + x).(φ.m – μ.m – μ.ξ)]<{Δk.m.(ξ +m)}/ {m.{ξ(k + n + x) + m.k} i.e. Δk/(k + n + x) < Δk.(ξ +m)/{ξ(k + n + x) + m.k} i.e. 1/(k + n + x) < (ξ +m)/{ξ(k + n + x) + m.k} i.e. ξ(k + n + x) + m.k < (k + n + x).(ξ +m) i.e. mk < (k + n + x).m i.e. k < k + n + x i.e. n + x > 0, but this is always true because by assumption both n and x are positive. If K rises by ΔK, and Y* becomes Y* 1 from (12) we get, Therefore, if net capital inflow increases, then necessarily Y declines and unambiguously the exchange rate appreciates, ceteris paribus, to keep both the product and the foreign exchange market in equilibrium. If K rises by ΔK, and e* becomes e* 1 from (11) we get, Now, e* > e 1 * if Δk.(ξ +m) > 0, this is always true because Δk, ξ, and m are positive. 33

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Policy Conclusions: The net foreign capital inflow is not really directly dependent on the interest rates differentials; rather it would be more realistic to assume that the net capital flows to be exogenously determined at any particular period of time in any particular nation state. In case of fixed exchange rate, the foreign exchange market alone can determine unique level of Y; as happens, for example, in case of foreign exchange constraint economies. In case of Flexible exchange rate, if the government expenditure increases, ceteris paribus, the level of activity and employment unambiguously increases. In case of Flexible exchange rate, if capital inflow increases, ceteris paribus, the level of activity and employment unambiguously decreases although in case of capital outflow the reversal does not happen. The level of activity is determined by goods market and foreign exchange market equilibria and the money market would always be in equilibrium at any administered rate of interest or in other words the money supply would be endogenously determined. 34

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Any independent demand constrained nation State saddled with involuntary unemployment would not be necessarily able to increase its employment and output by undertaking autonomous expansionary fiscal policy alone; along with that it has to have some control over the capital account of balance of payment. Therefore, the expansionary fiscal policies coupled with some control over foreign capital flows are recommended under such a situation as opposed to contractionary fiscal stance along with absolutely reckless capital flows, which we are witnessing today. Thank You _____

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© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick OBrien1 st ed. Prepared by: Fernando & Yvonn Quijano c h a p t e r.

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick OBrien1 st ed. Prepared by: Fernando & Yvonn Quijano c h a p t e r.

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