1. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University LECTURE 3: THE MUNDELL-FLEMING MODEL -- MONETARY & FISCAL POLICY, AND ADJUSTMENT Question 1: What are the implications of monetary & fiscal policy for income & the balance of payments, at a given exchange rate? Question 2: Mechanisms of adjustment. How does a country adjust to BoP imbalance, and what are further implications for the economy? Key parameter: κ, degree of capital mobility Key results (after some adjustment has taken place): κ raises effect of G on Y under fixed E (but lowers it under floating). κ lowers effect of M on Y under fixed E (but raises it under floating).

2. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Recap slopes down slopes up Monetary expansions shifts LM to the right. LM′ Slope = m/κ

3. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University

4. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University +

5. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Monetary and fiscal policy in the Mundell-Fleming model with a fixed exchange rate -- Summary Fiscal expansion shifts out IS curve. –Result: Y ↑, –though by less than simple Keynesian multiplier because i ↑ => crowding out. Monetary expansion shifts out LM curve. –Result i ↓ => Y ↑. Magnitudes of ∆Y do not depend on degree of capital mobility, κ. Result for external balance i) Y ↑ => TB ↓ ii) With an open KA: Fiscal expansion => i ↑ => KA ↑ · Monetary expansion => i ↓ => KA ↓ Effect on overall BP (=CA+KA) depends on degree of capital mobility.

6. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Automatic mechanisms of adjustment  Reserve flows R -- as under the MABP.  Price level P -- we assume for the moment that price adjustment is very slow.  Indebtedness -- rising debt will eventually force a reduction in spending. We omit this factor from the analysis.  Exchange rate E -- if flexible. MABP (The Monetary Approach to the Balance of Payments)  Defining assumption: Reserve flows are not sterilized.  Another assumption sometimes associated with MABP: PPP.

7. Insulated.

8. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University MABP : If reserve outflow is not sterilized, then MB falls, LM shifts back, and i rises over time, until in the long run we are back where we started. This offset to the increase in MB happens more quickly, the higher is κ.

9. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University The authorities must choose among several options for managing inflows. (Each option has its own drawback). Alternative ways to manage inflows (with disadvantages) A. Allow money to flow in. (Can be inflationary) B. Sterilize intervention. (Artificially prolongs disequilibrium) C. Allow currency to appreciate. (Lose competitiveness) D. Reimpose capital controls. (Lose financial integration gains) A country at point B -- as were many developing countries in 1990-96, 2003-08, or 2010-11 -- has a BoP surplus.

10. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Examples of attempts to sterilize capital inflows, to dampen real appreciation In the early 1990s, Colombia, Korea, Indonesia and others sterilized for a year or two and then gave it up. More recently, China successfully sterilized for five years … until 2007-08, 2010-11.

11. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University A recent example of sterilization against money inflows: China, 2003-2011

12. 12 Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008 The Balance of Payments ≡ rate of change of foreign exchange reserves (largely $), rose rapidly in China from 2004 on, due to all 3 components: trade balance, Foreign Direct Investment, & portfolio inflows Reserves

13. FX reserves of the PBoC climbed higher than any central bank in history http://viableopposition.blogspot.com/2012/03/chinas-holdings-of-us-treasuries-what.html

14. Sterilization of foreign reserves: People’s Bank of China sold sterilization bills Data: CEIC Source: Zhang, 2011, Fig.4, p.45.

15. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University => The MB growth rate was kept down to the growth rate of the real economy (≈ 10%/year), so there was little inflationary pressure. In 2003-04, forex inflows accelerated rapidly. (Both TB & KA >> 0.) Initially, the PBoC had no trouble sterilizing the inflows.

16. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University In 2007-08 China had more trouble sterilizing the reserve inflow (as predicted) PBoC began to have to pay higher domestic interest rates –and to receive lower interest rate on US T bills –=> quasi-fiscal deficit. Inflation became a serious problem in 2007-08. –True, global increases in food & energy prices were much of the explanation for inflation. –But China’s overly rapid growth itself contributes. Appreciation is a good way to put immediate downward pressure on local prices of agricultural & mineral commodities. Price controls are inefficient and ultimately ineffective. Also a “bubble” in the Shanghai stock market.

17. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Sterilization faltered in 2007 & 2008 Growth of China ’ s monetary base & its components: Source: HKMA, Half-Yearly Monetary & Financial Stability Report, June 2008 Money growth accelerated sharply, 2007-08

18. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University China ’ s CPI accelerated in 2007-08 Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008 Inflation 1999 to 2008

19. Sterilization of foreign reserves: Decreases in PBoC’s domestic assets thus offset increases in foreign assets Source: Zhang, 2011, Fig.7, p.47.

20. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Further tools: Source: HKMA, Half-Yearly Monetary & Financial Stability Report, June 2008 “financial repression” { while continuing to underpay depositors: It also raised lending rates The PBoC raised reserve ratios required of banks, thus sterilizing in the broad sense of slowing M1

21. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University China ’ s inflation broke sharply in 2009, (<= big one-year loss of China’s exports due to global recession), But took off again in 2010-11. Inflation 2001 to 2011

22. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University After the interruption of mid-2008 to mid-2009 overheating resumed: rapid rise of land prices in 2010 Real Beijing land prices

23. When house prices rise relative even to rents, that suggests a bubble or easy money Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Scott Reeve blog

24. China in 2010 resumed attempts to sterilize money inflows by raising banks’ reserve requirements -- to slow M1 growth even while MB is growing rapidly. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University

25. Chinese inflation, once again, began to ease off after mid-2011

26. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Appendix I: Examples of sterilization of inflows, from the early-1990s (1) Central bank sells sterilization bonds during period of sterilization

27. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Examples of sterilization of inflows, early-1990s (2) Interest rates are high during sterilization period, but fall thereafter.

28. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Examples of sterilization of inflows, early-1990s (3) Reserves rise rapidly during sterilization period; slow down thereafter

29. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University While reserves (NFA) rose rapidly, the growth of the monetary base was kept to the growth of the real economy – even reduced in 2005-06. Appendix II: Sterilization in China ΔReserves↑

30. Further, the PBoC raised banks’ required reserve ratios, thus sterilizing in the broad sense of slowing M1, even if M Base grew rapidly Source: Zhang, 2011, Fig.6, p.46.

31. China’s tightened control of the money supply to help head off rising inflation in 2004, 08, and again in 2011. Fxtimes.com

32. Chinese inflation eased off in 2008-09, and again after mid-2011