Keynesian Model of the trade balance TB & income Y. Key assumption: P fixed =>. Mundell-Fleming model Key additional assumption: international capital flows KA respond to interest rates i. LECTURE 2: The Mundell-Fleming Model with a Fixed Exchange Rate Questions: Effect of fiscal expansion or other . Effect of monetary expansion  /.

ALTERNATE APPROACHES TO DETERMINATION OF EXTERNAL BALANCE  Elasticities Approach to the Trade Balance  Keynesian Approach to the Trade Balance  Mundell-Fleming Model of the Balance of Payments  Monetary Approach to the Balance of Payments  NonTraded Goods or Dependent-Economy Model of the Trade Balance  Intertemporal Approach to the Current Account

KEYNESIAN MODEL OF THE TRADE BALANCE Import demand is a function of the exchange rate & income. The same for exports: => TB = X(E, Y*) – IM(E, Y), where IM is here defined to be import spending expressed in domestic terms.. If the domestic country is small, Y* is exogenous; drop it for simplicity. Rewrite TB =. and we assume the Marshall-Lerner condition holds:. Notationally, we embody all E effects (whether via exports or imports) in ;

STYLIZED J-CURVES With instantaneous pass-through to import prices With delayed pass-through to import prices

Empirical estimates of sensitivity of exports and imports to E & Y For empirical purposes, we estimate by OLS regression – with allowance for lags, giving J-curve; – controlling for income Y & Y* as well as E, – shown in logs, giving parameters as: price elasticities & income elasticities. Illustration: Marquez (2002) finds for most Asian countries: – Marshall-Lerner condition holds, after a couple of years, and – income elasticities are in the range. log X

Estimated price elasticities (LR) satisfy the Marshall-Lerner Condition. Estimated income elasticities are mostly between

An application of the marginal propensity to import: Bussière, Callegari, Ghironi, Sestieri, & N.Yamano, 2013, "Estimating Trade Elasticities: Demand Composition and the Trade Collapse of " Why did trade fall so much more sharply than income in the global recession? 2009

Bussière, Callegari, Ghironi, Sestieri, & Yamano, 2013, "Estimating Trade Elasticities: Demand Composition and the Trade Collapse of " Why did trade fall so sharply in the global recession? The usual explanations involve trade credit, inventories, and trade in intermediate inputs.

Behavior of real components of GDP in the recession Demand, adjusted for import-intensity GDP Investment Imports & Exports Bussière, Callegari, Ghironi, Sestieri, & N.Yamano, "Estimating Trade Elasticities: Demand Composition and the Trade Collapse of “ Bussière et al (2013) argue that Investment, which declined much more in 2009 than the other components of GDP, has a higher marginal propensity to import than the other components.

Trade Balance = TB = (E) – mY. Aggregate output = domestic Aggregate Demand + net foreign demand: Y = A(i, Y) + TB(E, Y), More specifically, let A(i, Y) = Ā - b(i) + cY, where the function -b( ) captures the negative effect of the interest rate i on investment spending, consumer durables, etc. Solve to get the IS curve: where s  1 – c is the marginal propensity to save. where and. Combining equations, Y =

IS curve: An inverse relationship between i and Y consistent with the equilibrium that supply = demand in the goods market. An increase in spending, Ā, e.g., a fiscal expansion, shifts IS to the right by the multiplier 1/(s+m).

The overall balance of payments is given by BP = TB + KA, where  , the degree of capital mobility > 0. We want to graph BP = 0. Solve for the interest rate: The Mundell-Fleming model introduces capital flows: slope = m/

A monetary expansion shifts the LM curve to the right. LM´ Do central banks actually set M? Supposedly they set M1, in the 1980s heyday of monetarism. Also the monetary base made a comeback after 2008: Quantitative Easing. Normally they think in terms of setting i. Still, the role of the LM equation can be taken by a Taylor Rule, which describes central banks as setting i in response to Y & inflation. →

Appendix: Causes of Developing Country BoP Surpluses & Strong economic performance (especially China & India) -- IS shifts right. Easy monetary policy in US and other major industrialized countries (low i*) -- BP shifts down. Big boom in mineral & agricultural commodities (esp. Africa & Latin America) -- BP shifts right.

Causes of BoP Surpluses in Developing Countries , & I.“Pull” Factors (internal causes) 1. Monetary stabilization => LM shifts up 2. Removal of capital controls => κ rises 3. Spending boom => IS shifts out/up II. “Push” Factors (external causes) 1.Low interest rates in rich countries => i* down => 2.Boom in export markets => BP shifts down out }