Chapter-Five

Open Economy
Macroeconomics
 Outline
 External Sector & the Balance of Payments (Bop):
 Current account (CA).

 The capital account (KA)

 Macro Economic Policies

Fiscal and monetary policy

Open economy macroeconomics looks at the interactions between
Ethiopia and the rest of the world

Exports

Imports

Exports = The current account

keeps track of the flow
Imports = of goods and services in
and out of Ethiopia
Net Exports =
 External Sector & the Balance of Payments (Bop)

The Bops of a country is a systematic record of all its

economic transactions with the outside world in a

given Year.
 It summarizes the nations’ financial relationships with

the rest of the world.

 It shows the nation’s trading position, changes in its
net position as foreign lender or borrower, and changes
in its official reserves.
 Two major categories:

i. Current account (CA)

 The country’s CA consists of all transactions
relating to trade in goods & services and unilateral
transfers.
 That is NX=X-Z.

 This net export terms called trade balance or

current account.
ii. The capital account (KA)
 KA of a country consists of its transaction in

financial assets in the form of short- term and

long- term lending & borrowings, and private
& official investment.
 It shows the international flow of capital

(loans & investments).

 Thus the balance on capital account measures the

net inflow of capital (or funds) to purchase assets in

home country.

 The balance of payments (or foreign balance –FB)

account is, therefore, the net exports plus net capital

inflow (K). i.e. FB=NX+K

 The key macroeconomic difference between

open and closed economies,

 in an open economy, a country‘s spending in
any given year need not equal its output of
goods and services.
 A country can spend more than it produces by

borrowing from abroad, or it can spend less than

it produces and lend the difference to foreigners.
 GDP in open economy differs from that of a closed

economy because there is an additional injection-

export expenditure which represents foreign
expenditure on domestically produced goods.
 There is also an additional leakage, expenditure on

imports which represents domestic expenditure on

foreign goods and which raises foreign national
income.
 Thus the national income identity takes the form:

Y = C + I + G + X – M ............................................... (1)

Where Y is national income, C is domestic consumption, I is domestic

investment, G is government expenditure, X is export expenditure and
M is import expenditure.
 if we deduct taxation from the RHS of equation [1] we get
disposable income (Yd).

Yd = C + I + G + X – M –T …………...............….… (2);
If we denote private savings as S = Yd – C we can

rearrange equation [2] to obtain:

(X – M) = (S – I) + (T-G)....................... (3)
Where;
X-M………..….Current account balance
S-I…….…Net (dis)saving of private sector and;
T-G…………Government fiscal surplus
 Equation [3] says that a current account

deficit has a counterpart in either private

dissaving that is private investment
exceeding private saving -and/or a
government deficit- that, government
expenditure exceeding government
taxation revenue.
 Nonetheless, it is often stated that the current

account deficit is due to lack of private savings

and/or the government budget deficit.
 However, it is possible that the causation runs

the other way, with the current account deficit

being responsible for the lack of private savings
or budget deficit.
 Alternatively;

 the identity can be expressed as;

Y = C + I + G + X – M ............................... (1)

But; C= Cd + Cf , & G=Gd +Gf , I=Id+If

Thus; the NI identity becomes;

Y = ( C-Cf )+ ( I-If ) + (G- Gf ) + X, or

Y = C+I+G- (Cf + If Gf +)+X

 Here (Cf + If + Gf ) represents the value of imports (Z). thus,

Y = C+I+G+X-Z

Y = C+I+G+NX---------------(1)

Y - (C+I+G) = NX

(output) – {domestic spending = net export }----------(2)

 thus in an open economy, domestic spending need not equal the

output of goods & services.

 we can rewrite equation (2) as follows by including tax (T):

(Y-T) – (C+I+G) +T = NX, since –T+T =0.

 [ (Y-T) – C] + (T-G) –I = NX
.
[ ( Y-T)-C] + (T-G) = I+NX

Sp Sg
 The summation of the two represents national saving

Sp + Sg = I + NX,

S-I = NX ……………………………...……..3

Obviously, NX (=X-Z) is called trade balance.

 The difference between domestic saving & domestic

investment is (S-I) is called net foreign investment (NFI).

 If NFI is positive  our saving exceeds our

investment and, we are lending the excess to

foreigners.
 If NFI is negative  We are a net borrower

 Thus, NFI reflects the international flow of

funds, to finance capital account.

What’s the meaning of a trade deficit? To answer this, lets look
back at the national accounting identities…

Y = C + I + G + NX
A trade deficit signifies
Solving for Net Exports, we get that we as a country
are spending beyond
NX = Y – (C + I + G) our current income
Aggregate Expenditures
National Income

Alternatively, National Savings

S = I + (G-T) + CA CA = S – [I + (G-T)]
A deficit signifies that we are borrowing Aggregate
Borrowing
more than we are saving
 Generally;

 A trade deficit is a situation in which net exports

(NX) are negative i.e. Imports > Exports

 A trade surplus is a situation in which net exports

(NX) are positive i.e. Exports > Imports

 Balanced trade refers to when net exports are

zero—exports and imports are exactly equal.

 In an open economy, the equilibrium level of

national income is determined where the

domestic balance is equal to the external
balance.
 let’s start from;

Y = C + I + G + X –M ………….. (1)
and;
 let’s make certain additions to this equation.
 Domestic consumption is partly autonomous and partly

determined by the level of national income

 This is denoted algebraically by:

C = Ca + cY …………………………………
(4)
Where; Ca = autonomous consumption
c = marginal propensity to consume
 In this simple model, consumption is assumed to be a

linear function of income.

 Import expenditure is also assumed to be partly autonomous and

partly a positive function of the level of domestic income;

M = Ma + mY …………………….. (5)

Where; Ma is autonomous import expenditure and;

m = is the marginal propensity to import

 In this simple formulation, import expenditure is assumed to be a

positive linear function of income.

 There are several justifications for this;

i. increased income leads to increased expenditure on imports, and;

ii. more domestic production requires more imports of intermediate

goods.
 keeping G and X exogenous; because government

expenditure is determined independently by political

decisions, and exports by foreign expenditure
decisions and foreign income.
 Substituting equations [4] and [5] into equation [1]

we obtain:
Y = Ca + cY + I + G + X – (Ma + mY) ..………… (6)
 Rearranging equation [6], we have

Y- (Ca + cY + I + G) = X – (Ma + mY)

Y – AD(Y) = NX(Y) ……………………………………………

(7)

Where AD is aggregate demand which is equals to;

AD = Ca + cY + I + G and;

NX is net export defined as X – (Ma + mY).

 Equation [7] tells us that the economy would be in equilibrium

where the internal balance i.e. Y–AD is equals to the external

balance i.e. NX(Y) as net export balance associated with this
condition is the equilibrium levels of output and trade balance.
 graphically;

The graph shows the equilibrium condition in an open economy.

 The (Y-AD) curve is upward sloping since its slope is given by 1–c

which is equal to marginal propensity to save and hence positive;

the NX curve is downward sloping with the slope of

–m.
 That is;

 At the intersection of the two curves, the economy would

be in equilibrium as the internal balance is bridged up by

the external balance or vice versa.
 Y* and NX* are the equilibrium level of national income

and trade balance or net export.

 The multipliers

Assumptions

 Both domestic prices and the exchange rate are fixed.

 The economy is operating at less than full employment

so that increases in demand results in an expansion of

output, and
 The authorities adjust the money supply to changes in

money demand by pegging the domestic interest rate.

 The implication of the last assumption is that increases in

output that lead to a rise in money demand, with a fixed

money supply, lead to a rise in the domestic interest rate.
 But it is assumed that the authorities passively expand the

money stock to meet any increase in money demand so that

interest rates do not have to change.
 There is no inflation resulting from the money supply

expansion because it is merely a response to the increase in

money demand.
 Y = Ca + cY + I + G + X – (Ma + mY)

Y – cY + mY = Ca + I + G + X – Ma

(1- c + m) Y = Ca + I + G + X – Ma ……………………..(8)
 Given that (1-c) is equal to the marginal propensity to save s,

that is, the fraction of any increase in income that is saved, then
we obtain:

Y = (Ca + I + G + X – Ma) ………………… [9]

 Equation [9] can be transformed into difference form to yield:

dY = (dCa + dI + dG + dX – dMa) ………………… [10]

 The Government Expenditure Multiplier
 The first multiplier of interest is the government expenditure
multiplier, which shows the increase in national income resulting
from a given increase in government expenditure.
 This is given by:

 The equation says an increase in government expenditure have an

expansionary effect on national income, and the size depends upon
the marginal propensity to save and the marginal propensity to
import.
 Since the sum of these is less than unity, an increase in

government expenditure will result in an even greater increase

in national income.
 Furthermore, the value of the open-economy multiplier is less

than the closed-economy multiplier which is given by 1/s.

 The reason for this is that increased expenditure is spent on

both domestic and foreign goods rather than domestic goods

alone, and the expenditure on foreign goods raises foreign
rather than domestic income.
 Export Multiplier
 In this simple model, the multiplier effect of an increase in exports is

identical to that of an increase in government expenditure and is given by;

 In practice it is often the case that government expenditure tends to be

somewhat more biased to domestic output than private consumption

expenditure, implying that the value of m is smaller in the case of the
government expenditure multiplier than in the case of the export multiplier.
 If this is case, an increase in government expenditure will have a more

expansionary effect on domestic output than an equivalent increase in

exports.
 The Current Account Multiplier
 The other relationships of interest are the effects of an increase in
government expenditure and of exports on the current account balance.
 The current account (CA) is given by:

CA = X – Ma – mY ……………………………. [12]
 Totally differentiating equation [12]

d(CA) = dX – dMa – mdY

 Substituting equation [10] for dY, we obtain:

dY = (dCa + dI + dG + dX – dMa) ………………… [10]

dCA = dX – dMa – m( (dCa + dI + dG + dX – dMa))

dCA = dX – dMa – (dCa + dI + dG + dX – dMa)…………………………

(13)
 From equation [13] we can derive the effects of an increase

in government expenditure on the current account balance

which is given by;

d(CA)/dG = - m/(s + m) < 0

 That is, an increases in government spending leads to a

deterioration of the current account balance which is some

fraction of the initial increase in government expenditure.
 This is because economic agents spend part of the increase

in income on imports.
 The other multiplier of interest is the effect of an increase in

exports on the current account balance.

 This is given by the expression;

 Since s/(s +m) is less than unity, an increase in exports leads to

an improvement in the current account balance that is less than

the original increase in exports.
 The explanation for this is that part of the increase in income

resulting from the additional exports is offset to some extent by

increased expenditure on imports.
 Policy Issues
 Although economic policy-makers generally have many

macroeconomic objectives, the discussion in the 1950s and

1960s was primarily concerned with two objectives; the
internal and external balance.
 Internal balance: is concerned with achieving full

employment and stable price and;

 External balance focuses on achieving equilibrium in the

balance of payment account.

 International transactions involve the use of

different currencies among different countries

which requires the expression of one currency in
terms of the other to make exchanges.
 The rate at which one currency is exchanged for

the other is called exchange rate.

 The exchange rate between currencies may

determined by the government/monetary authority

or market forces.
 If the rate of exchange is determined and strictly

observed by the government/ monetary authority/,

the system is called fixed exchange rate system.
 In this case, the government reduces the supply of

domestic currency or supplies foreign currency for

increase in the exchange rate.
 It does the reverse for a decrease in the exchange

rate.
 If the rate of exchange is determined by the

market forces, the system is said to be

flexible/floating exchange rate system.
 In practice, the flexible exchange rate system

has not been clean floating.

 Instead, the system has been one of managed

or dirty floating, especially since 1973.

 it can also be nominal and real

i. The nominal exchange rate (e) is the relative price

of the currency of the two countries. The price of

foreign currency in terms of domestic currency
(say, Birr/$) or the other way round.
ii. The real exchange rate (E) is the relative price of

the goods of the two countries. It measures the

country’s competitiveness in the international
trade.
 It is defined as:

R= ep/ Pf

where;

P ……….. Domestic price and

Pf …………….. the price level abroad

e …………… is the dollar price of Birr ($/birr )

R…………… measures prices at home relative to those

abroad.
 The graph shows the problem of maintaining both internal and

external balance simultaneously.

 As a result of expansionary fiscal policy the [Y-AD(Y)] Curve

shifts from [Y-AD(Y1)] to [Y-AD(Y2)] and the new equilibrium

point is achieved with a higher level of output (Y**) but the
current account balance has deteriorated simultaneously to
NX**.
 The multipliers also tell us the same thing i.e

 major lesson of this simple model is that the use of one

instrument to achieve two targets internal and external

balance-is most unlikely to be successful.
 The idea that a country generally requires as many

instruments as it has target was elaborated by the Nobel

Prize-winning economist Jan Tinbergen (1952), and is
popularly known as Tinbergen’s instruments-targets rule.
 Mundell-Fleming model
 it is a model that incorporates international capital

movements into formal macroeconomic models based on

the Keynesian ISLM framework.
 It owes its origins to three papers published by James

Fleming (1962) and Robert Mundell (1962, 1963).

 Their papers led to some dramatic implications
concerning the effectiveness of fiscal and monetary
policy for the attainment of internal and external balance.
 Both the IS and LM curves have their usual shape.

 the new thing here is we introduce the balance of

payments (BP) curve.

 The balance of payments schedule shows different

combinations of rates of interest and income levels

that are compatible with equilibrium in the balance
of payments.
 The overall balance of payment is made up of three

major components:

i. the current account balance (CA),

ii. the capital account (K) and

iii. the change in the authorities‘ reserve (dR).

 By maintaining balance in supply and demand for the

currency-that is external balance-we mean that there is no

need for the authorities to have to change their holdings
of foreign exchange reserves.
 This implies that if there is a current account

deficit there needs to be an offsetting surplus in the

capital account so that the authorities do not have
to change their reserve.
 Conversely, if there is a current account surplus

there needs to be an offsetting deficit in the capital

account to have equilibrium in the balance of
payment.
 Since exports are determined exogenously

and imports are a positive function of income,

the higher the level of national income the
smaller will be any current account surplus or
the larger any current account deficit.
 The net capital flow (K) is a positive

function of the domestic interest rate.

 Assuming that the rate of interest in the rest of the world ( rf )

is fixed, the higher the domestic interest rate (r) the larger the
capital inflow in to the country or the smaller (if any) capital
outflow.
 This relationship is expressed as:

K = f(r-rf ).........................................……… [1]

 Since the balance of payment schedule shows various

combinations of levels of income and the rate of interest for

which the balance of payments is in equilibrium, then
X – M + K = 0 ……….....…………………………… [2]
 A positive K indicates a net inflow of funds,
whereas a negative K indicates a net outflow of
funds.
 The BP schedule is depicted in the figure below.
 Comparison

For a given r*, there is a current account surplus at

income level Y1 [point A] whereas at income level

Y2 [point B] there is a current account deficit.
 This is due to the fact that higher income calls for

additional demand for imports as the latter is a

function of the former.
 Similarly, in terms of interest rate, we can see that

point C represents a capital account surplus and

point D shows a capital account deficit.
 This is because higher domestic interest rate
invites capital inflow.
 In general, we can conclude that points to the left

and above the BP curve are points of surplus

while points to the right and below the BP curve
are points of deficit.
 The BP schedule is upward sloping because

higher levels of income cause deterioration in the

current account; this necessitates a reduced capital
outflow/higher capital inflow requiring a higher
interest rate.
 Every point on the BP schedule shows a

combination of domestic income and rate of

interest for which the overall balance of payments
is in equilibrium.
 The slope of the BP schedule is determined by the degree

of capital mobility internationally.

 The higher the degree of capital mobility then the flatter

the BP schedule would be.

 This is because for a given increase in income which leads

to a deterioration of the current account, the higher the

degree of capital mobility, the smaller the required rise in
the domestic interest rate to attract sufficient capital inflows
to ensure overall equilibrium.
 When capital is perfectly mobile, slight rise in the domestic

interest rate above the world interest rate leads to a massive

capital inflow making the BP schedule horizontal at the world
interest rate.
 At the other extreme, if capital is perfectly immobile
internationally then a rise in the domestic interest rate will fail
to attract capital inflows making the BP schedule vertical at the
income level that ensures current account balance.
 Between these two extremes, that is, when we have an upward

sloping BP schedule, we say that capital is imperfectly mobile.

 When the BP curve is introduced to the ISLM model it

becomes ISLMBP model and the simultaneous equilibrium of

internal and external balances is given below.
 There are two types of policies to maintain

both internal and external balances

[equilibrium] in the economy.
These are:

i. Expenditure changing policies, and

ii. Expenditure switching policies

1. Expenditure Changing Policies

 it refer to policies that change expenditure

(increase or decrease) to affect the current and/or
capital accounts to bring about change in the
balance of payment account.
 This is possible mainly by using expansionary and

contractionary fiscal and monetary policies.

 The model assumes a small country facing

imperfect capital mobility.

 Any attempt to raise the domestic interest rate leads to

capital inflow until the interest rate return to the world

interest rate.
 Conversely, any attempt to lower the domestic interest

rate leads to capital outflow as international investors

seek higher world interest rates.
 The implication of imperfect capital mobility is that

the BP schedule for a small open economy becomes

upward sloping straight line.
a. Small Open Economy With Imperfect Capital

Mobility and Fixed Exchange Rate

Monetary Policy
 The figure below depicts a small open economy

with a fixed exchange rate.

 The initial level of income and interest rate is

where the IS, LM and BP curves intersect i.e. rf

andY0.
 If the authorities attempt to raise output by a monetary

expansion, the LM curve shifts to the right from LM1 to LM2;

there is downward pressure on the domestic interest rate and this
results in capital outflow.
 This capital outflow means that there is pressure for a

devaluation of the currency, and the authorities have to

intervene in the foreign exchange market to purchase the
home currency with reserves.
 This purchases result in a reduction of the money supply

in the hands of private agents, and the purchases have to

continue until the LM curve shifts back to its original
position at LM1 where the domestic interest rate is
restored to the world interest rate.
 The reverse is true for a contractionary monetary

policy shown by panel B.

 Hence, with imperfect capital mobility and fixed

exchange rates, monetary policy is ineffective at

influencing output.
 Fiscal Policy

 Fiscal expansion shifts the IS schedule to the right

from IS0 to IS1.

 This puts upward pressure on the domestic interest rate

and leads to a capital inflow.

 To prevent an appreciation, the authorities have to

purchase the foreign currency with domestic currency.

 This means that the amount of domestic currency held by

private agents increases and the LM0 schedule shifts to the

right to Lm1.

 The increase in the money stock continues until the LM

curve passes through the IS1 curve at the initial interest

rate.

 The reverse is true for a contractionary fiscal policy as

shown by panel B.
 If the fiscal policy is expansionary, it results in a deficit

for the balance of payment account (E1 is below and to

the right of the BP curve in panel A) and if it is

contractionary, it results in a surplus for the balance of

payment (E1 is above and to the left of the BP curve in

panel B).

 Hence, under fixed exchange rates and imperfect capital

mobility an active fiscal policy alone has the ability to

achieve both internal and external balance.

 b. Small Open Economy With Imperfect Capital Mobility and
Floating Exchange Rate

Monetary policy

 A monetary expansion in panel (A) shifts the LM curve from

LM0 to LM1 leading to downward pressure on the interest rate [a

capital outflow] and a depreciation of the exchange rate.

 The depreciation leads to an increase in exports and reduction in

imports so shifting the IS curve to the right [IS0 to IS1] and the
LM curve to the left [LM1 to LM0], so that final equilibrium is
obtained at a higher level of income and interest rate.
 Higher interest rate results in surplus for the capital account while

higher income results in deficit for the current account.

 The total effect on the balance of payment account depends on the

elasticity of the BP curve.

 If the BP curve (BP1) is less elastic than the LM curve (LM0),

expansionary monetary policy results in balance of payment deficit

(E1will be below and to the right of the BP curve [BP1] in this case).

 If the BP curve (BP2) is more elastic than the LM curve (LM0),

expansionary monetary policy results in balance of payment surplus

(E1will be above and to the left of the BP curve [BP2] in this case).
 The reverse happens to a contractionary monetary policy in panel
(B).

 If the elasticity of the BP curve is known, the monetary authorities

could obtain both internal and external balance with appropriate

monetary policy.
 Fiscal policy
 Expansionary fiscal policy in panel (A) shows a shift in

the IS schedule to the right from IS0 to IS1 leading to

upward pressure on the domestic interest rate resulting in
capital inflow and an appreciation of the exchange rate.
 The appreciation of the exchange rate results in a

reduction of exports and an increase in imports, and this

forces the IS schedule back to its original position.
 The reverse is true for a contractionary fiscal policy in panel

(B).
 Hence, with imperfect capital mobility and a floating exchange

rate, fiscal policy is ineffective in influencing output.

 The result that fiscal policy is very effective at influencing output

under fixed exchange rates and monetary policy is very effective

under floating exchange rates with imperfect capital mobility is of
considerable relevance to economic policy design.

 Under fixed rates, policy makers will pay more attention to fiscal

policy than under floating rates when more emphasis will be

placed on monetary policy.

 The degree of capital mobility and the exchange rate regime both

demonstrate that appropriate economic policy design in an open

economy is very different from that in a closed economy context.
 2. Expenditure Switching Policies

 Expenditure switching policies: refer to policies

that change expenditures from one type of

commodity to another type of commodity.
This is possible mainly by manipulating the

exchange rate.
 These policies change expenditure from foreign to

domestic goods and services and vice versa.

 This is done by varying the exchange rate.

To maintain the external balance, devaluation

would be a good candidate.

 By making imports expensive in the domestic
market and by making exports cheaper in the
foreign market, devaluation can improve the
current account balance and hence the country can
maintain its external balance.
 the graph shows, devaluation shifts the demand for exports

curve outward (Dx0 to Dx1) and the supply of imports curve

inward (Sm0 to Sm1) both of which improve the current
account balance.
 However, the effectiveness of devaluation in yielding

the above solution depends on the Marshall-Lerner

condition (MLC).
 The MLC can be derived as follows.

 The current account balance (CA) when expressed in

terms of the domestic currency is given by:

CA = X – eM ………………………….. [14]
Where e is the nominal exchange rate
 Totally differentiating equation [14] we obtain

d(CA) = dX – edM – Mde

Dividing both sides by ‘de‘

 At this point we introduce two definitions; the price elasticity

of demand for exports ŋx is defined as the percentage change

in exports over the percentage change in price as represented
by the percentage change in the exchange rate; this gives:
 And the price elasticity of demand for imports ŋm is defined

as the percentage change in imports over the percentage

change in their price as represented by the percentage change
in the exchange rate;
 Substituting [16] and [17] into [15] we obtain;

 Multiplying [18] by 1/M throughout we get;

 Assuming that we initially have balanced trade X = eM and

hence X/eM = 1 and rearranging [19] yields:

 Equation [20] is known as the Marshall-Lerner Condition and

says that starting from a position of equilibrium in the current

account, a devaluation will improve the current account; that
is, , only if the sum of the foreign elasticity of demand for
exports and the home country elasticity of demand for imports
is greater than unity, that is (ŋx + ŋm >1).
 If the sum of these two elasticities is less than unity (ŋx + ŋm

< 1 then devaluation leads to a deterioration of the current

account.
 The possibility that devaluation may lead to a worsening

rather than improvement in the balance of payment led to

much research into empirical estimates of the elasticity of
demand for exports and imports.
 Economists divided up into two camps popularly known

as elasticity optimists who believed that the sum of these

two elasticities tended to exceed unity.
 It was argued that devaluation may be better for
industrialized countries than for developing countries.
 Many developing countries are heavily dependent upon

imports so that their price elasticity of demand for imports

is likely to be very low.
 While for industrialized countries that have to face

competitive export markets, the price elasticity of demand

for their export may be quite elastic.
 The implication of the Marshall-Lerner condition is that

devaluation may be a cure for some countries balance of

payment deficits but not for others.
 Even for countries that devaluation is a solution for the BOP

deficit, the initial J-curve effect may not be precluded.

 The J-curve shows that the deficit may initially rise but after a

lag of sometime the trend would be reversed so that the BOP

would be in surplus.
 The J-curve effect arises mainly as elasticities are lower in the

short run than in the long run, in which case the Marshall–
Lerner condition may only hold in the medium to long run.
 The possibility that in the short run the Marshall-Lerner

condition may not be fulfilled although it generally holds over

the long run leads to the phenomenon of what is popularly
known as the J-curve effect.
 The idea underlying the J-curve effect is that in the short run

export volumes and import volumes do not change much, so

that devaluation leads to deterioration in the current account.
 However, after a time lag, export volumes start to increase and

import volumes start to decline; consequently the current

deficit starts to improve and eventually moves into surplus.
 The issue then is whether the initial deterioration in the

current account is greater than the future improvement so that

overall devaluation can be said to work.
 There have been numerous reasons advanced to explain the slow

responsiveness of export and import volumes in the short run and

why the response is far greater in the longer run; two of the most
important are:

i. A time lag in consumer responses- It takes time for consumers

in both the devaluing country and the rest of the world to
respond to the changed competitive situation.

ii. A time lag in producer response-Even though devaluation

improves the competitive position of exports it will take time
for domestic producers to expand production of exportable
goods.
Limitations of the Mundell-Fleming Model

1. The Marshal Lerner condition: the model assumes that the Marshall Lerner
condition holds even though it is essentially of a short term model which is
the time scale under which the Marshall-Lerner conditions are least likely to
be met.

2. Interaction of stocks and flows: the model ignores the problem of the
interaction of stocks and flows. According to it a current account deficit can
be financed by a capital inflow. While such a policy is feasible in the short
run, a capital inflow over time increases the stock of foreign liabilities owed
by the country to the rest of the world, and this factor means a worsening of
the future current account as interest is paid abroad. Clearly, a country cannot
go on financing a current account deficit indefinitely as the country becomes
an ever-increasing debtor to the rest of the world.
3. Neglect of the long run budget constraints: the model fails to
take account of long run constraints that govern both the private
and public sector. In the long run, private sector spending has to
equal its disposable income, while in the absence of money
creation government expenditure has to equal its revenue from
taxation. This means that in the long run, the current account has to
be in balance. One implication of these budget constraints is that a
forward looking private sector would realize that increased
government expenditure will imply higher taxation for them in the
future, and this will induce increased private sector savings today
that will undermine the effectiveness of fiscal policy.
4. Wealth Effect: the model does not allow for wealth effects
that may help in the process of restoring long run equilibrium. A
decrease in wealth resulting from a fall in foreign assets
associated with a current account deficit will ordinarily lead to
reduction in import expenditure which should help to reduce the
current account deficit. While such an omission of wealth effects
on the import expenditure function may be justified as being
small significance in the short run, the omission nevertheless
again emphasizes the essentially short-term nature of the model.
5. Neglect of supply side factors: one of the obvious
limitations of the model is that it concentrates on the demand
side of the economy and neglects the supply side. There is an
implicit assumption that supply adjust in accordance with
changes in demand. In addition, because the aggregate supply
curve is horizontal up to full employment, increases in
aggregate demand do not lead to changes in the domestic price
level, rather they are reflected solely by increases in real
output.
6. Treatment of capital flows: the model assumes that a rise in the
domestic interest rate leads to a continuous capital inflow from
abroad. However, to expect such flows to continue indefinitely is
unrealistic because after a point international investors will have
rearranged the stocks of their international portfolios to their
desired content and once this happens the net capital inflows into
the country will cease unless accompanied by a further rise in its
interest rate. Hence a country that needs a continuous capital
inflow to finance its current account deficit has to continuously
raise its interest rate i.e. capital inflows are a function of the change
in the interest differential rather than the interest itself.
7. Exchange rate expectations: A major problem with the model is the treatment of
exchange rate expectations. The model does not explicitly model these and implicitly
presumes that the expected change is zero, which is known as static exchange rate
expectation. While this might not seem to be an unreasonable assumption under fixed
exchange rates, it is less tenable under floating exchange rates. According to the model
a monetary expansion leads to a depreciation of the currency under floating exchange
rates in such circumstances it seems unreasonable to assume that economic agents do
not expect depreciation as well. If agents expect depreciation this may require a rise in
the domestic interest rate to encourage them to continue to hold the currency which
will have an adverse effect on domestic investment-implying a weaker expansionary
effect of monetary policy than is suggested by the model. Indeed, the need to maintain
market confidence in exchange rates can severely restrict the ability of government to
pursue expansionary fiscal and monetary policies.
 the end!
Thank you for your
patience!!!