Wednesday, March 27, 2013

mealy fur face declares war on bob mundell's golden oldie

 
 
 
 "I have complained before about IS-LM being the first macromodel most students encounter, when no major current central bank fixes the money supply. The textbook version of Mundell Fleming (TMF) [1] is the first, and often the last, short run open economy model students are taught, and it shares the same deficiency. However the problem with
TMF is even greater. It is inconsistent with Uncovered Interest Parity (UIP),
and if we use modern macro as our yardstick, this makes it simply wrong.


Lets take a topical issue: the impact of a temporary increase in government spending. We
should be immediately worried that TMF makes no distinction between temporary
and permanent increases. It says both have no impact on output. So every student
learns that fiscal policy is ineffective under flexible exchange rates. For a temporary increase in spending this is incorrect.


The logic of the TMF proposition is usually demonstrated by shifting various curves, but it
is in fact trivial. In TMF money demand must equal a fixed money supply. If
money demand depends on prices, output and interest rates, and the first is
fixed in the short run and the last is tied to world rates, then output cannot
change either. This complete crowding is achieved through an appreciation in the
real exchange rate.


But why should domestic interest rates equal world interest rates? UIP tells us they need not. A temporary increase in government spending will raise output, which given a
fixed money supply will raise interest rates. This will lead to an appreciation,
but the temporary nature of the shock means that the long run exchange rate is
unchanged. So the current appreciation implies an expected depreciation, which
offsets the additional return offered by higher interest rates. The result is a
short run equilibrium where output and domestic interest rates are higher. There
is partial crowding out through an appreciation but not full crowding
out.


Now you might say what is so great about UIP. But at least UIP is based on something: a simple arbitrage theory. As far as I can see the TMF assumption that domestic and world
interest rates are equal has no equivalent foundation.


We only get some crowding out in the experiment above because the money supply is fixed. If interest rates are fixed instead then we get none. With fixed interest rates,
UIP implies the current exchange rate is unchanged when government spending
increases, so there is no crowding out. We get exactly the same result as with
fixed exchange rates - the complete opposite of what TMF
suggests.


Now you might plead in mitigation for TMF that at least it gets the impact of a permanent increase in government spending right. I think this is a very weak defence. A permanent
increase in government spending, assuming it increases aggregate demand, is
crowded out because in a small open economy the real exchange rate equates the
demand and supply of domestic output
in the long run, which is a more basic
result than anything in TMF. [2]


Another weak defence of teaching incorrect theories is that they are simpler than better
theories. However it we combine this basic idea about the determination of the
medium/long run real exchange rate with UIP, we have a complete theory of the
small open economy which is no more complicated than TMF. So why does TMF
survive?


Perhaps one reason is an addiction to two dimensional, and preferably static, diagrams. Yet
the system I’m describing can be represented by just two equations and two
periods. The first equation is the familiar aggregate demand curve. It is
static, so we have


y = f ( g, r, e )


where g is a shift variable like government spending, r is the real interest rate and e is
the log of the real exchange rate. Use stars to denote second period
(medium/long run) values:


y* = f( g*, r*, e* )


Now here I can say that r* is equal to the world real interest rate rw (because of UIP and a constant real exchange rate), and y* is determined by some classical supply side, so this
equation determines the second period real exchange rate - the basic result I mentioned above.
The only other equation I need is UIP:


e = e* + rw - r


where e is defined so that an increase is a depreciation. Policy determines the
short term domestic real interest rate, and therefore the short term real
exchange rate.


The aggregate demand curve is already familiar to students, and the adaptation to an open
economy is intuitive. UIP is easy to teach: any interest rate differential is
offset by expected capital gains or losses. So it seems to me something like
this should become our standard introductory short run open economy macromodel.
And TMF should disappear."