CFA CFA Level 2 Confusing Mundell-Fleming Model

Confusing Mundell-Fleming Model

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    • vincentt
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      I could memorise the table on appreciation/depreciation of currencies in expansionary/restrictive monetary/fiscal policies however I don’t quite understand a couple of lines in schweser notes that’s rather contradicting.

      In expansionary fiscal policy:
      Government spending UP -> issues more bonds -> bond prices DOWN -> I/R UP -> attracts investors -> demand for currency UP

      So i assumed expansionary fiscal policy would lead to appreciation in the currency, however that line followed by, increases in growth and of course inflation leading to deterioration of current account and decrease in demand for the currency.

      Moving from currency in demand to not in demand within the same policy, wouldn’t that just lead to ‘uncertain’ outcome or ‘neutral’ ?
      Could someone explain further on effects of these policies?

    • Sophie Macon
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      Great questions as usual @vincentt, shows you’re thinking and fully understanding the meaning behind each concept. Give me 5 min and I’ll respond.

    • Sophie Macon
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      @vincentt – Mundell-Fleming model is an macroeconomic model with the added assumption of international trade and capital mobility.

      To your question, both opposing effects are right, the “net effect” depends on the extent of capital mobility.

      To take things to an extreme, if we assume floating exchange rates, fixed interest rates and perfect capital mobility, these theoretically happen instantaneously during an expansionary fiscal policy:

      1. An increase in spending puts upward pressure on domestic interest rate
      2. … which, under perfect capital mobility, attracts massive capital inflow into the country
      3. … which appreciates the local exchange rate
      4. … which worsens the current account due to fall in exports, which reduces demand for currency and GDP output
      5. … and output (and exchange rate) falls back to the original level
      6. For Mundell-Fleming model, the conclusion is that under a floating exchange rate and perfect capital mobility, fiscal policy is ineffective (in raising output).

        If you try the same reasoning for monetary expansion, you will find that monetary policy is very effective under the same assumption in this model.

    • vincentt
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      @sophie thanks for the explanation 😀 and couple more questions as usual 😛

      To confirm a few facts:

      1. Restrictive Fiscal Policy (under high capital mobility)
      – reduce spending -> less growth or less govt borrowing -> I/R DOWN -> foreign investors left -> currency depreciates

      and the contradicting part (which is the part that makes fiscal policy ineffective)

      decrease growth & inflation -> currency appreciates back up to the original level (like what you just mentioned in the expansionary fiscal policy).

      2.
      However, when there’s a restriction on the capital mobility fiscal policy will be effective?
      restrictive fiscal policy:
      Govt reduce spending -> I/R DOWN -> no in and outflow of funds from investors -> decrease growth & inflation -> currency appreciates

      3.
      Expansionary Monetary policy (low capital mobility):
      In low capital mobility we pretty much ignore interest rate and focus on imports

      money supply UP -> people’s spending more -> net import -> currency depreciates

      Why do people import more in expansionary monetary policy?

      Will expansionary/restrictive monetary policy be the same in high and low capital mobility?

    • Sophie Macon
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      No prob @vincentt.

      Yes on point 1: It’s the opposite of expansionary, given those assumptions above.

      On point 2: I’d say currency depreciates less. if you restrict capital mobility (i.e. basic closed economy model – sorry this is getting into definition for those econ students out there), it will be effective as per your correct description above. Under a closed economy model, both monetary and fiscal policies are effective.

      But in the good ol’ days, the Mundell-Fleming model was mentioned as the case where its an open economy model with capital mobility and international trade, and it points out that fiscal policy is ineffective in the case of perfect capital mobility (and various other assumptions). The model also states that monetary policy is doubly effective given those assumptions. That’s why it’s so famous till today.

      On point 3: for a given increase in money supply, we assume that spending increases, and purchases on local and imported goods increase.

      On your question on monetary policy impact under high vs. low capital mobility, the Mundell-Fleming model says that monetary policy will be very effective as the moves are not contradictory to output expansion. Let’s go through the thought process for expansionary monetary policy under MF model assumptions:

      1. An increase in money supply reduces domestic interest rate
      2. … which, under perfect capital mobility, creates massive capital outflow to other countries
      3. … which depreciates the exchange rate
      4. … which improves the current account due to increase in exports, leading to increase in GDP output
      5. … the increase in exports will continue until the exchange rate goes back up to the original level
    • vincentt
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      @sophie

      #2 depreciates less? You lost me there. Let’s clarify again, a restrictive fiscal policy in a perfect capital mobility, the local currency will depreciates and appreciates back up to the original level.
      But you’re saying with restricted capital mobility the local currency would depreciates less and never get to the second stage (reversal)?

      (I don’t mind if you go deeper into econs terminology, at least I would probably understand the underlying reasons, rather than memorising up or down)

      #3 you mentioned that under the MF model, the monetary policy are not contradictory, but in the process you listed the currency depreciates and then appreciates back to it’s original.

      4. Is MF Model a short or long run model?

      5. The monetary policy under high or low capital mobility would always react the same way (Expansionary = depreciates & Restrictive = appreciates)?

      *apologies if i’m repeating myself, I probably need to head home and draw up some diagrams and see which ‘route’ i have not covered*

    • Sophie Macon
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      To answer it random order – just because my brain is wonky at this time of the day…

      #4. MF model shows long run impact, as in a way it assumes perfect capital mobility (instantaneous adjustments to exchange rates, market prices etc). In reality of course there’s some delay, so it can be used to analyse short run impacts too.

      #5. For monetary policy, yes they act in “the same direction” for high and low capital mobility cases. There are 2 impacts as you can see from our discussions above: one is the immediate impact on interest rates, then the second impact is the FX rate on current account. For monetary policy, both this impact are reinforcing each other in both case.

      #3. Yes, that’s right. We are talking about the impact on output here, not FX rates. Let’s take a step back, the reason to have expansionary or restrictive monetary/fiscal policies is to try to impact the GDP (output) of the economy. Not the exchange rate (unless we are talking about fixed exchange rate, which is a whole new story, not in CFA syllabus but can still be discussed of course). So under MF model, there is NO impact of expansionary fiscal policy on output, whilst monetary policy both that impact (as described in #5 above) are reinforcing each other:
      –> low interest rate –> increase in consumption spending –> increase in output
      –> low interest rate –> low FX rate –> increase in exports –> increase in output

      #2. It depreciates less (than normal) because there is no capital outflow even when interest rate is low. To determine the net effect we need to go into further details about assumptions on the economy etc as you know there are many moving components… I’m afraid I’m veering too far off topic for CFA and your precious time, but happy to go into details if needed.

    • vincentt
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      #5 you confuse me a little here, I’ve always thought that only fiscal policy has the contradicting behaviour (heading into one direction followed by reversal), so that happens to monetary policy too?

      expansionary monetary policy
      I/R DOWN -> capital outflow -> currency DOWN (immediate) -> exports UP -> currency UP (long run)

      But based on the summary expansionary monetary policy the currency would depreciates, so does it mean i should ignore the current account effects?

      #3 Since in the CFA syllabus expansionary monetary policy would result in the appreciation of a currency (unlike what we discussed in #5 short run – depreciates and long run – reverse back), does it mean that in CFA they are looking at the short run effects of the MF model and i shouldn’t include the outcome of the long run?

      #2 I think I got the idea! Since capital outflow is one of the main causes of currency depreciation, with restrictions on the local currency, it isn’t able to get to it’s fullest potential to depreciates, therefore depreciates less.

    • Sophie Macon
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      @vincentt

      #5. yes only fiscal policy has contradicting behaviour under MF model of perfect capital mobility (such that it is ineffective). This does NOT happen in monetary policy. Under MF, monetary policy is very effective in expanding output.

      expansionary monetary policy
      I/R DOWN -> capital outflow -> currency DOWN (immediate) -> exports UP -> currency UP (long run)

      But based on the summary expansionary monetary policy the currency would depreciates, so does it mean i should ignore the current account effects?

      I don’t understand what you mean by ignoring current account effects. Your statement on ‘exports UP’ is the current account effect. The growth in exports will continue until the currency re-appreciates up to original level.

      On #3 – I’m confused at what you’re comparing with. What is “CFA syllabus expansionary monetary policy” vs. short run MF model? Under MF model, as there is perfect capital mobility, the effects occur instantaneously, so short = long run I suppose. I broke down the steps so you’d understand. All expansionary monetary policy, whether perfect or imperfect capital mobility, are effective in expanding output of the economy.

      #2. Yup! that’s the way to think of it – you compare what happens in the same case for when there is capital mobility and when there isn’t.

    • vincentt
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      #5 based on your respond earlier:

      1. An increase in money supply reduces domestic interest rate
      2. … which, under perfect capital mobility, creates massive capital outflow to other countries
      3. … which depreciates the exchange rate
      4. … which improves the current account due to increase in exports, leading to increase in GDP output
      5. … the increase in exports will continue until the exchange rate goes back up to the original level

      You mentioned that monetary policy doesn’t have the contradicting effect, but in list above you mentioned that the currency first depreciates which will cause foreign countries to buy more from the local (since it’s relatively cheaper) hence export of local increases which leads to increase in current account (where the local currency will appreciates).

      So isn’t that ‘reversal’ effect the same as the one you mentioned for fiscal (not the direction just the reversal effect).

      As for “ignoring the current account effect”, what I meant was instead of looking at:

      expansionary monetary policy
      I/R DOWN -> capital outflow -> currency DOWN (immediate) -> exports UP -> currency UP (long run)

      Should we be only looking at (for the sake of CFAI level 2 syllabus)
      expansionary monetary policy
      I/R DOWN -> capital outflow -> currency DOWN (immediate)

      That’s where my question of whether CFAI is only introducing MF model as a short run, hence ignoring the ‘reversal’ effect which is caused by the improving current account.

    • Sophie Macon
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      @vincentt – it doesn’t have a contradicting effect on output. We are not talking about FX rates here, the purpose of expansionary/restrictive monetary and fiscal policies are the affect the output of the economy….

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