In this essay I will be discussing the way in which free capital flows can cause constraints on monetary policies. I will be looking at the balance of payments and how when it is applied to the Keynesian IS/LM model produces the Mundell – Fleming model. The Mundell – Fleming model shows the relationship between exchange rates and national income. Additionally, to further investigate this situation I will be looking into the ways in which monetary policies behave according to various exchange rate schemes, namely fixed and floating exchange rates.
The balance of payments consists of the current account and the capital account. In theory, these two accounts should balance. The current account concerns the imports and exports of goods and services. The largest component of the current account is net export and therefore the current account balance, which is the difference between exports and imports, moves with net exports.
Exports are mainly affected by foreign economic conditions, for instance, when incomes rise in foreign countries, demand for exports will increase, therefore exports are exogenous. Imports however depend on domestic income, for instance when domestic incomes rise, consumers will buy more imported goods and services. Net export is equal to exports minus imports; therefore there is an inverse relationship between imports and net exports. Another important component of the balance of payments is the capital account which is inflow and outflow of financial capital which will flow into countries that have high rate of return, which can be reflected through interest rates. (Colander & Gamber, 2006, pages 273-274)
The Balance of payments curve is a curve that represents combinations of interest rates and income levels at a given exchange rate at which the private balance of payments is in equilibrium. The balance of payments curve is derived from how the current account and the private capital account change with various interest rates. The reason for this is because we assume that the official reserve transaction is zero, so the balance of payments curve is determined only by the private balance of payments account.
The following diagram shows a balance of payments curve. If incomes increase domestically, imports will increase and therefore the current account will go into deficit. In order for this deficit to be offset, the capital account will have to be in surplus. Therefore when incomes rise, interest rates will also rise. This is shown by a movement from point A to point B. In the instance when incomes fall domestically, the current account will go into surplus, and as a reflex, the capital account will be in deficit. Therefore when incomes fall, interest rates will also fall and this is shown by a movement from point A to point C. (Colander & Gamber, 2006, pages 274-276)
In the diagram above, the left of the curve shows a situation where the balance of payments is in surplus and any region to the right of the curve shows a situation where the balance of payments is in deficit. The balance of payments may be in a situation of surplus because interest rates are higher than the interest rate that is coherent to the balance of payments equilibrium; Capital flows will flow into the country which will offset the current account deficit.
The governing body that sets the interest rates are interested in the slope of the balance of payments curve. When the curve is too steep, in order to maintain the equilibrium, the interest rates will have to increase by a lot relatively. If the balance of payments curve is relatively flat however, in order to maintain the balance of payments equilibrium, the interest rate will have to increase by a little amount relatively. In summary, the balance of curve slope is determined by the responsiveness of capital movements to domestic and world interest rates and the responsiveness of imports to income. (Colander & Gamber, 2006, pages 277-278)
The Mundell-Fleming model was established by Robert Mundell, for which he was awarded the Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel in 1999. The Mundell-Fleming model shows the relationship between the real exchange rate and the national income according to changes in IS (investment and saving) and LM (liquid money). The Mundell-Fleming model has two main assumptions. The first assumption is that the model is based around a small, open economy, and the second is that there is perfect mobility in capital. Therefore implying that domestic interest rates (r) is equal to world interest rates (r*). Before analysing the constraints of free capital movements on monetary policy, I believe it is important to show how the Mundell Fleming is derived. (Mankiw, 2007, pages 334-335)
The IS* curve is the goods market equilibrium and the LM* curve is the money market equilibrium. Due to the fact that the goods market equilibrium is derived from the following equation,
Y = C(Y – T) + I(r*) + G + NX (e)
Which shows that national income is equal to consumption, which is a function of income minus tax, and investment, which is determined by world interest rates, government expenditure and net export which is determined by nominal exchange rate, which is the foreign currency per unit of domestic currency. Therefore, when the nominal exchange rate falls, net exports will increase, ceteris paribus, national income will rise. Therefore, the IS* curve is shown as a downward slope with nominal exchange rate on the y axis and national income on the x axis. The LM* curve on the other hand is shown as a vertical line because at a given rate of world interest, there is only one value of national income which will equate money demand and supply, regardless of what the nominal exchange rate is. Compiling the two together, we have the Mundell-Fleming model which is shown in the following diagram. (Mankiw, 2007, pages 336-338)
In order to understand the impact free capital mobility has on monetary policy, I will first examine capital mobility and what it entails, and then show how this affects monetary policy in a fixed and floating exchange rate scheme. Perfect capital mobility is when investors can buy and sell all the assets they want across countries at no additional cost or risk. When capital is perfectly mobile, real interest rates are the same across all countries because capital flows will eliminate any interest rate disparity. In the past two or three decades, capital movements have increased greatly.
The reason for the fast growth of capital movements is due to the removal of exchange rate controls, Bretton woods, in most industrialised countries which led to the growth of transnational financial transactions. Other reasons for the growth of capital movements have been due to the growth of the free market philosophy and the recognition that the efficient functioning of capital markets is a central element in improving resource allocation in the real economy. (Crockett, 1993, pages 492-494) Returning back to the assumption of the Mundell-Fleming model, capital can be injected into the domestic economy from abroad when domestic interest rate is higher than that of the rest of the world. As mentioned earlier when discussing the balance of payments, the capital account shows investors transferring their funds from country to country, depending in the returns of their investment.
The following diagram shows the workings of the capital account under this assumption. In the following diagram, the interest rate of perfect capital mobility is at r* which is the world interest rate. The reason for this is because when capital is free to flow in and out of all countries, interest rates will always return to the world interest rates due to reasons explained earlier. In the case of imperfect mobility however, when interest rates rise, there is a surplus in the capital account because capital will flow into the country and vice versa. (Hillier, 1991, pages 203-226)
Monetary policy is a policy used by the central bank regarding the supply of money in order to affect interest rates to achieve or contain economic growth and to control inflation. It can also be used to affect exchange rates but this will be discussed later on in the essay. Monetary policy has very different effects when it is applied to a fixed exchange rate scheme or a floating exchange rate scheme. A fixed exchange rate is an exchange rate that is set by the central bank’s willingness to buy and sell domestic currency for foreign currencies at a predetermined price. However, a floating exchange rate is one that the central bank allows to change in response to changing economic conditions and economic policies. Instead the exchange rate adjusts to the supply and demand for the domestic currency on the foreign exchange market so the balance of payments is always balanced. (Mankiw, 2007, pages 342-343)
The first case that we will examine is an expansionary monetary policy under a floating exchange rate. An increase in the money supply will shift the LM* curve to the right because national income must rise to restore the equilibrium in the money market. This causes a decrease in the nominal exchange rate and an increase in the national income. This is the case in a small open economy.
However, expansionary monetary policy does not raise world aggregate demand, it merely shifts demand from foreign to domestic products. When money supply increases, interest rates will fall which leads to an increase in investment and therefore an increase in national income. When there is a lower interest rate in the country, it is expected that financial capital will float out of the country and therefore setting the capital account at a deficit. Due to the fact that investment is a component of IS, the decrease in interest rates and the increase in investment will cause the IS to shift upwards, offsetting the interest rate decrease and the depreciation of the currency, this can be seen in the following diagram. (Colander & Gamber, 2006, pages 290-292)
Comparing this situation with a situation where there is imperfect capital mobility and an expansionary monetary policy is implemented under fixed exchange rate. In this case, expansionary monetary will increase national income from Y1 to Y3. This will decrease the interest rate and also cause depreciation of the currency. The depreciation of currency will cause net exports to rise because foreign goods are relatively more expensive and exported goods will be relatively cheaper. This then will shift IS1 to IS2, however due to imperfect capital mobility; this will cause interest rates to rise, but not to the world level. The balance of payments curve can shift down and depreciate to maintain the equilibrium at the lower domestic interest rate. (Colander & Gamber, 290-292)
The next hypothetical example that we will examine is an expansionary monetary policy under fixed exchange rates. According to the Mundell-Fleming model, the LM* will shift to the right when money supply is increased. This leads to lowering the exchange rate as it can be seen in the following diagram. However, in order to maintain the fixed exchange rate, the LM* curve will move back to the original position where the equilibrium exchange rate is where the IS* curve meets the LM* curve because arbitrageurs will sell domestic currency to the central bank, causing the money supply to shift back to LM*. Therefore monetary policy is usually ineffective under fixed exchange rate. (Hillier, 1991, pages 208-214)
To conclude this essay, free capital flows do pose as a constraint when the monetary committee tries to set a rate of interest through money supply. However, capital flows only affect monetary policy under floating exchange rates. Under fixed exchange rates, monetary policy is not effective in shifting the LM curve therefore capital mobility does not play a role in this constraint. Assuming a floating exchange rate system, perfect capital mobility will always bring back the initial interest rate. Therefore monetary policy is not effective in the long run in setting the interest rate; however in the short run it is successful.