International Trade and Open Economy

Mundell-Fleming model

The Mundell-Fleming model extends the IS-LM framework to a small open economy and assumes that the price level \bar{P} is fixed in the short run. Under perfect capital mobility the domestic interest rate is tied to the world rate, r = r^*, because any gap would trigger unlimited capital flows. Goods market equilibrium is Y = C(Y) + I(r^*) + G + NX(e), and money market equilibrium is M/\bar{P} = kY - lr^*.

Under a flexible exchange rate, fiscal policy has no lasting effect on output. An expansionary fiscal policy pushes the interest rate above r^*, capital flows in, and the domestic currency appreciates. Net exports fall by the amount needed to cancel the initial rise in demand, so output returns to its original level while the nominal exchange rate appreciates. Monetary policy is effective under the same regime. An increase in the money supply lowers pressure on the interest rate, capital flows out, the currency depreciates, net exports rise, and output expands.

Under a fixed exchange rate the central bank must buy or sell foreign currency to hold e constant, so the money supply adjusts to whatever the exchange rate requires. Monetary policy is therefore neutralised, and fiscal policy becomes the effective tool.

Textbook variants change where the adjustment falls. If net exports depend on domestic income, NX(e,Y), the money market alone fixes Y, so a rise in government purchases is absorbed by appreciation and a fall in net exports. If money demand depends on disposable income Y - T, the money market fixes Y - T, so a tax cut lowers output one for one while a rise in government purchases leaves output unchanged. In both cases the exchange rate rises under fiscal expansion.

The impossible trilemma is a corollary of this framework. A country cannot simultaneously have full capital mobility, a fixed exchange rate and an independent monetary policy, and it can choose only two of the three. Full mobility combined with a fixed rate forces the domestic interest rate to equal the foreign rate, which removes monetary independence. Floating the rate or restricting capital flows restores the policy choice.

Twin deficits identity

In an open economy national income is Y = C + I + G + X - M, and private saving is the part of disposable income not consumed, S = Y - TX + TR - C. Combining the two gives the saving-investment identity S - I = (G + TR - TX) + (X - M). The first bracket is the government budget deficit, which is positive when spending plus transfers exceed taxes. The second bracket is the trade balance. The 'twin deficits' idea follows directly: if the private gap S - I is stable, a larger budget deficit is matched by a smaller trade balance, that is, a larger trade deficit.

Rearranging the same identity gives X - M = (S - I) + (T - G), which expresses the trade balance as the sum of the private surplus and the government surplus. A trade surplus therefore shrinks if private saving falls, if investment rises, if taxes fall, or if government spending rises.

For example, if government spending rises by a given amount while saving and investment stay unchanged, the trade balance must fall by the same amount, since X - M moves one for one with T - G. The link is not automatic, however. A budget deficit does not always produce a trade deficit, because a change in private saving or investment can break the relation.

Balance of payments accounts

The balance of payments records all transactions between residents and non-residents over a period. It is organised into the current account, the capital account and the financial account, and the three together sum to zero apart from errors and omissions. The current account has three parts: trade in goods and services, primary income such as interest, dividends and compensation from abroad, and secondary income. Secondary income consists of unilateral transfers, such as remittances and foreign aid, for which nothing is given in return. Merchandise trade is the largest component of the current account.

The financial account records changes in claims on and liabilities to non-residents. It includes direct investment, portfolio investment, other investment and changes in official reserve assets. A purchase of foreign securities by a private investor, or a central bank purchase of foreign currency, is a financial account transaction and not a current account transaction.

• Unilateral transfer — a one-way payment, recorded in the current account as secondary income.
• Capital transfer — a one-way transfer of capital or debt forgiveness, recorded in the capital account, not the current account.
• Official reserves — central bank holdings of foreign currency, recorded in the financial account.

The current account balance is often expressed as a share of GDP, using \frac{CA}{GDP} \times 100. The ratio must use nominal values at current prices. A negative current account balance is a deficit, and the percentage is quoted as its absolute size. GDP is computed by the expenditure approach as C + I + G + (X - M), where I includes gross fixed capital formation and changes in inventories.

Foreign exchange market mechanics

A nominal exchange rate is the price of one currency in terms of another, and the quotation convention matters. In this chapter the nominal exchange rate is the number of domestic currency units needed to buy one unit of foreign currency. Under this convention, appreciation of the domestic currency means that it buys more foreign currency, so the number falls. Depreciation means that the domestic currency buys less foreign currency, so the number rises.

Appreciation is a rise in the value of a currency against foreign currency, and depreciation is a fall in that value. The two terms describe opposite movements of the same rate. A fall in the nominal exchange rate therefore means that the domestic currency has appreciated and that the domestic-currency price of foreign currency has fallen.

Suppose the rate moves from 80 to 76 domestic units per dollar. Each dollar now buys fewer units of domestic currency, so the domestic currency has appreciated even though the number has changed by only a small amount. Students should not mix conventions. Many textbooks quote the reciprocal, foreign currency per unit of domestic currency, and in that case a rise in the number means appreciation.