Macroeconomic Policy Under Regime of Free Capital Flows Surajit Das

Macroeconomic Policy Under Regime of Free Capital Flows

Surajit Das

Mundell-Fleming Framework - Open Economy IS-LM Model:

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The Mundell-Fleming model can be described as follows:

r = r* … … … (A)

Ms = L(Y, r) … … … (B)

Y = C(Y – t.Y) + I(r, Y) + G + NX(Y, e) … … … (C)

NX(Y, e) = - k.e … … … … … … … … … (D)

But, the foreign capital inflow in a particular economy and in a particular period of time should more realistically be assumed to be exogenously given rather than assuming it to be solely dependent on the domestic interest rate or interest rate differential or interest rate differential net of exchange rate fluctuation etc. The direction and destination of flows of international finance capital would be driven by profit motive based on expected capital gains and or various kinds of country risks.

In such a case, in addition to the three equations there has to be a fourth one for the balance of payment equilibrium:

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Chart I: Interest Rate, Exchange Rate & Net Capital Inflow in India

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Exchange Rates, Rupees per US$

Exchange Rate Fluctuations (%)

Interest Rates (%)

Interest Rates net of Exchange Rate Fluctuations

Total Foreign Investment in US$ Million

Source: Handbook of Statistics on Indian Economy – 2006, RBI.

FI in US$ Mn

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Chart II: Movements in Total Net Foreign Investment and SENSEX in India

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Total Foreign Investment in US$ Million SENSEX

Source: Handbook of Statistics on Indian Economy – 2006, RBI and Bombay Stock Exchange.

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e

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Balance of Payment Equilibrium:

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Balance of Payment Equilibrium with Fixed Exchange Rate:

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Product Market Equilibrium:

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Y = C + I + G + X – M 20

Simultaneous Equilibrium in Both Markets:

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21Case I

Y

Y

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Simultaneous Equilibrium in Both Markets:

Case II

Y

Y

Y = C(Y – T) + I(r, Y) + G + X(e) – M(Y, e) … … … … (1)

T = t.Y … … … … (2)

The national income identity or the commodity market equilibrium condition

Standard tax function, when the tax-GDP ratio is assumed to be given

The consumption as a positive function of disposable income

C = θ + c.(Y – T) = θ + c.Y(1 – t) … … … … (3)

The investment function is assumed to depend positively on Y and negatively on r

I = λ + α.Y – β.r = δ + α.Y … … … … (4)

The export function is given as positive function of the exchange rate

X = μ + e.x … … … … (5)23

M = ρ + m.Y – e.n … … … … (6)

Y.[1 – c.(1 – t) – α + m] = φ + e.(x + n) … … … … (7)

Where, φ = θ + δ + G + μ –ρ.

The import as a positive function of Y and negative function of exchange Rate

Therefore, from (1) we get the commodity market equilibrium condition as, Y = θ + c.Y(1 – t) + δ + α.Y + G + μ + e.x – (ρ + m.Y – e.n)

The equilibrium condition for the BoP in foreign exchange market

ρ + m.Y – e.n – (μ + e.x) = k.e = K … … … … (8)

From (7) we get the slope of the commodity market equilibrium condition as

de/dY = [1 – c.(1 – t) – α + m]/(x + n) … … … … (9)

From (8) we get the slope of BoP equilibrium condition

de/dY = m/(x + n + k) … … … … (10)24

Since, [1 – c.(1 – t) – α] > 0 (the multiplier)

i.e. [1 – c.(1 – t) – α](x + n + k) + m.k > 0 (all x, n, k & m >0)

i.e. [1 – c.(1 – t) – α + m]/(x + n) – m/(x + n + k) > 0

i.e. [1 – c.(1 – t) – α + m]/(x + n) > m/(x + n + k)

i.e. slope of commodity market equilibrium condition > slope of BoP

equilibrium condition.

i.e. IS curve is steeper than YY curve.

For simultaneous equilibrium in both the markets we get,

e* = (φ.m – μ.m – μ.ξ)/[ξ.(x + n +k) + m.k] … … … … (11) and

Y* = [(φ.m – μ.m – μ.ξ).(k + n + x)]/[m.{ξ.(x +n +k) + m.k}] + μ/m [from (8)]

…….. (12) where, ξ = [1 – c.(1 – t) – α]

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Macroeconomic Policy:

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ΔY*/ ΔG = (k + n + x)/[{1 – c.(1 – t) – α}.(x +n +k) + m.k] … … … (13)

Δe*/ ΔG = m/[.[{1 – c.(1 – t) – α}.(x +n +k) + m.k] … … … … (14)

If G rises by ΔG, from (12) we get,

ΔY* = ΔG.m.(k + n + x)/[m.{ξ.(x +n +k) + m.k}]

And if G rises by ΔG, from equation (11) we get,

Δe* = ΔG.m/[ξ.(x +n +k) + m.k]

Δe*/ ΔG = m/[ξ.(x +n +k) + m.k]

Therefore, we get, (ΔY*/ ΔG)>0 as well as (Δe*/ ΔG)>0.

Hence, if G increases, ceteris paribus, both Y and e unambiguously

rises and vice-versa for any given level of net capital inflow k under

Flexible exchange rate.

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Y1* = [Δk(φ.m – μ.m – μ.ξ) + (k + n + x).(φ.m – μ.m – μ.ξ)]/[ Δk.m.(ξ +m) + m.{ξ(k + n + x) + m.k} + μ/m … … … … (15)

e1* = (φ.m – μ.m – μ.ξ)/[ Δk.(ξ +m) + ξ.(k +n +x) +m.k] … … … … (16)

Now, Y1* would be less than Y* if the percentage rise in the numerator is less than the percentage increase in the denominator (hence the ratio comes down) and vice-versa.Δk(φ.m – μ.m – μ.ξ)/[(k + n + x).(φ.m – μ.m – μ.ξ)]<{Δk.m.(ξ +m)}/ {m.{ξ(k + n + x) + m.k}i.e. Δk/(k + n + x) < Δk.(ξ +m)/{ξ(k + n + x) + m.k}i.e. 1/(k + n + x) < (ξ +m)/{ξ(k + n + x) + m.k}i.e. ξ(k + n + x) + m.k < (k + n + x).(ξ +m)i.e. mk < (k + n + x).mi.e. k < k + n + xi.e. n + x > 0, but this is always true because by assumption both n and x are positive.

If K rises by ΔK, and Y* becomes Y*1 from (12) we get,

Therefore, if net capital inflow increases, then necessarily Y declines and unambiguously the exchange rate appreciates, ceteris paribus, to keep both the product and the foreign exchange market in equilibrium.

If K rises by ΔK, and e* becomes e*1 from (11) we get,

Now, e* > e1* if Δk.(ξ +m) > 0, this is always true because Δk, ξ, and m are positive.

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Policy Conclusions:

• The net foreign capital inflow is not really directly dependent on the interest rates differentials; rather it would be more realistic to assume that the net capital flows to be exogenously determined at any particular period of time in any particular nation state.

• In case of fixed exchange rate, the foreign exchange market alone can determine unique level of Y; as happens, for example, in case of foreign exchange constraint economies.

• In case of Flexible exchange rate, if the government expenditure increases, ceteris paribus, the level of activity and employment unambiguously increases.

• In case of Flexible exchange rate, if capital inflow increases, ceteris paribus, the level of activity and employment unambiguously decreases although in case of capital outflow the reversal does not happen.

• The level of activity is determined by goods market and foreign exchange market equilibria and the money market would always be in equilibrium at any administered rate of interest or in other words the money supply would be endogenously determined.

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Any independent demand constrained nation State saddled with Any independent demand constrained nation State saddled with involuntary unemployment would not be necessarily able to involuntary unemployment would not be necessarily able to

increase its employment and output by undertaking autonomous increase its employment and output by undertaking autonomous expansionary fiscal policy alone; along with that it has to have expansionary fiscal policy alone; along with that it has to have some control over the capital account of balance of payment. some control over the capital account of balance of payment. Therefore, the expansionary fiscal policies coupled with some Therefore, the expansionary fiscal policies coupled with some

control over foreign capital flows are recommended under such a control over foreign capital flows are recommended under such a situation as opposed to contractionary fiscal stance along with situation as opposed to contractionary fiscal stance along with

absolutely reckless capital flows, which we are witnessing today.absolutely reckless capital flows, which we are witnessing today.

Thank YouThank You_____

Documents

Macroeconomic Policy Under Regime of Free Capital Flows Surajit Das