Abstract

In this paper we propose a modification of the traditional Mundell-Fleming model.

The extended model introduces the implications of including the fiscal deficit and international reserves as determinants of the level of country risk

This slight modification of the traditional paradigm leads to radical changes in the effects that fiscal and monetary policies have in economies with high capital mobility under an extreme version of a fixed exchange rate regime (Currency Board).

We use the proposed model to evaluate some of the economic policies implemented between December 1999 and March 2001 by the first economic team under the Presidency of Fernando De la Rúa in Argentina.

Additionally, we suggest that some of the main results obtained from the model are applicable to other emerging economies.

Introduction

The Original Munell-Fleming Model

In a series of articles in the early sixties, two brilliant economists, R. Mundell and M. Fleming, developed the basis for what has since become known among economists as the Mundell-Fleming model, that enables analysis of different macroeconomic aspects in economies open to international trade.

• The model began by recognising that international markets in the sixties were gradually becoming more integrated because of the new developments in technology that were taking place.

• In addition, it recognised that a growing number of countries were in the process of dismantling the rigorous exchange controls that had become widespread after the Great Depression.

• On the basis of the foregoing, these authors assumed that the world was made up of economies producing differentiated goods (that is to say, goods that were not perfect substitutes) but which were subject to a high level of mobility in their capital flows.

• These authors proceeded to analyse the effects derived from alternative economic policies, under the assumption that the velocity of capital movements between countries was far higher than that of their trade flows for goods.

• In subsequent years, because of the characteristics mentioned, this model gradually became the profession’s preferred tool for the analysis of a wide range of matters related to the macroeconomics of open economies.

The Contribution of the New Model Incorporating Country Risk on Possible Effects of Alternative Monetary & Fiscal Policies on Fixed Exchange Rate Regimes while Facing a High International Capital Mobility

This article is intended as a contribution to the extensive literature that followed the acceptance of the Mundell-Fleming model as the central paradigm for the analysis of open economies.

• It does so by introducing the possibility that one of the components determining domestic interest rates, the factor known as “country risk”, is related to both the fiscal situation of the country and its level of international reserves.

• In this regard, this article represents the combination of two types of models:

1. Those in the Mundell-Fleming tradition

2. Those taken from the more modern but equally extensive literature on the topic of “country risk”.

• However, even this simple change to the Mundell-Fleming approach allows us to reach very relevant and novel conclusions on the possible effects of alternative monetary and fiscal policies on small, open economies with fixed exchange rate arrangement while facing a high international capital mobility.

How the New Model is Different

Whereas in the original Mundell-Fleming model monetary policy does not affect domestic interest rate or the level of economic activity, in our model:

• an expansive monetary policy leads to a contraction in the output level by inducing an increase in country risk and therefore in the domestic interest rate.

• In addition, in our model the traditionally positive impact on economic activity from an expansive fiscal policy would be weakened by the contractionary effect from the impact of a deteriorated fiscal situation on country risk and consequently on domestic interest rates.

The Incorrect Assumptions of the Transmission Mechanism

In recent years it has become a habit among a widening circle of economists, participants in the financial sector and even politicians and journalists involved in making or analysing proposals for the emerging country, to resort mechanically to the transmission mechanism mentioned previously as the only significant mechanism operating in such economies.

The transmission mechanism implies that a country faced by a recession (boom) must proceed to implement contractive (expansive) fiscal policies in order to reduce (increase) country risk and thus induce an increase (decline) in the output level.

One notable example of the above proposition was the sharp increase in taxation (the so-called Tax Reform) introduced by the new Argentine economic team in December 1999 with the support of most of Argentina’s international creditors (including the IMF and almost all the private credit agencies).

• The assumption behind these restrictive fiscal policies was that they would lead to a recovery in the level of economic activity, severely affected since mid-1998 by negative external shocks.

• The only grounds for such a strategy were that a stronger fiscal position would lead to a sharp drop in country risk, which would result in an equivalent reduction in interest rates and therefore a significant increase in domestic spending.

• However, and in spite of recent prior experience in Argentina, the rise in taxes turned out to be highly recessive and brought the mild economic recovery that had begun in mid-1999 to a complete standstill.

The model presented here, by including in the analysis the traditionally contractive effect that higher taxes have on domestic demand, provides a possible explanation for such episode.

In the rest of the paper we will proceed as follows:

• Section II presents our model.

• The main implications for economic policy are discussed in the three following sections.

• In Section VI we expand on the basic model with the aim of introducing a competitive domestic financial sector, in an attempt to capture the principal mechanisms that come into play when the Central Bank decides to modify the minimum reserve requirements on deposits, the only monetary policy instrument that remains under the monetary system we analyse (Currency Board). We suggest that in cases such as that of Argentina during the last decade, expansive monetary policies very probably ended up by increasing interest rates, further accentuating the decline in levels of activity.

• Section VII contains our conclusions.

Section II: The Model

Following the original Mundell-Fleming model, our model assumes the existence of an aggregate demand Y that depends negatively on interest rate i (nominal and real, as an expected zero inflation is assumed) and positively on government deficit D. It is assumed that the so-called IS curve behaves as follows:

In an economy with a fixed exchange rate, international capital mobility implies that the domestic interest rate should be equal to the international interest rate i* plus a country-risk premium k (where it is assumed that the expected exchange rate devaluation is zero):

In turn, in line with the extensive literature on “country risk” and the currently accepted fact that it grows as the public sector deficit rises and falls when international reserves rise:

Under a Currency Board scheme (such as that adopted by Argentina at the beginning of 1991 with the launch of a monetary reform known as the Convertibility Plan), the monetary base is equal to total international reserves. The base is a fraction e of total money supply M, because of the existence of a fractionary cash reserve system

In turn, money supply equals demand through the change in the stock of reserves, so that equilibrium in the money market (the LM curve) determines the level of reserves as a function of the arguments in the money demand and the fractional reserve requirements:

Therefore, given the values of the three exogenous variables D, i* and e, the equilibrium values of our three endogenous variables R, Y and i are determined exactly by the following three equations:

Section III: The Effects of Monetary Policies

Under a Convertibility System such as the one we are analysing, the monetary authority is prohibited by law from issuing domestic credit.

• Therefore, the only monetary policy possible consists of modifying the cash requirements, which leads to: 

where the notation xz means ∂x / ∂z.

Under the assumption that the system is stable (see Appendix), then

would be positive and consequently expansive monetary policies would lower reserves, increase domestic rates of interest and lower the level of economic activity.

Therefore, while in Mundell (1963) an expansive monetary policy under a fixed exchange rate and perfect capital mobility lowers international reserves in the same magnitude, without affecting either the interest rate or the level of income, here the drop in reserves has a contractive effect on the output level since country risk levels rise.

The drop in reserves would take place due to:

1.  A direct effect, which impacts by causing reserves to decline because of equation 8 (the LM curve).

2. Because of equation 7, the reduction in R would increase the country-risk premium raising domestic interest rates (the FF curve). In turn, higher interest rates imply a lower level for Y because of equation 6 (the IS curve).

3. A reduction in the money demand because of the increase induced in i and the reduction in Y. This drop in desired monetary balances would also reduce R because of equation 8.

Therefore, the traditional effect pointed out by Mundell-Fleming (point 1) has now been strengthened by two other indirect effects, both arising from the higher risk levels induced by the expansionary monetary policy.

Graphically, a reduction in cash reserves shifts the FF and LM curves upward and to the left (see Figure 1), moving the equilibrium from E0 to E1. The new equilibrium is characterised by a higher interest rate and consequently a lower level of output.

Section IV: The Effects of Fiscal Policies

Another main conclusion of the traditional Mundell-Fleming model is that with a fixed exchange rate arrangement and perfect capital mobility, expansive fiscal policies have a fully positive impact on economic activity.

• However, in our model the effect of fiscal policy on the level of economic activity is undetermined.

• While in the Mundell-Fleming model a worsening of the budget deficit does not alter the interest rate, in our model it would deteriorate country risk, thus increasing domestic interest rates.

• The final effect on the level of output will depend on the relative magnitude of both effects (i.e. the expansive effect from the increased level of absorption and the contraction induced by a higher interest rate). We would therefore have:

Even under the assumption that the expression:

were to be positive, the three signs remain indeterminate.

These results arise because an increase in D would generate:

1. The shift of the IS to the right, therefore inducing an increase in both Y and i.

2. However, at the same time, an upward shift of the FF curve induces an increase in i and a contraction in Y.

If i and Y can in principle change in any direction, the same will happen with the money demand and consequently with reserves.

Section V: The 1999-2000 Argentine Experience

As mentioned above, because of external factors that included a steady deterioration in terms of trade since 1996, and a sharp rise in country risk for emerging nations since 1998 because of the Russian crisis (see Figures 2 and 3), the Argentine economy began to decline.

This drop, similar to that observed in many other emerging countries, continued until mid-1999, when a slight recovery began (see Figures 4 and 5).