Chapter 11: Internatinoal Capital Flows and Macroeconomic Equilibrium
1. Overview
Mundell-Fleming model = the small open-economy version of the IS-TR model.
When there is free trade in financial assets without capital controls, a fully financially
integrated economy loses the control of its own interest rate.
Small (as in small open economy) means that the economy has no discernable impact on the
rest of the world.
2. International Financial Flows
Example: consider a typical international investor (FE: large bank) which routinely borrows
and lends all over the world. The domestic interest rate is i, while the international rate of
return is i*. (! i* is rate of return not an interest rate).
- i < i* : International investor borrows at homoe, where the interest rate is low, and
invests abroad, pocketing the difference. As they do so, they raise the demand for
money at home and i will raise towards i*. Possibly, i* will decline towards i because
large amounts of money flow into foreign financial markets. This will go on as long as
i<i*.
- I > i* : Money will flow from the rest of the world into our high-interest rate country,
pushing i down and i* up.
Neither i>i* nor i<i* is possible. i = i*. This is the interest rate parity condition.
In contrast to the purchasing power parity condition, which takes time to assert itself
because good prices move slowly, the interest parity condition is a property which applies
even in the very short run.
The interest rate parity condition is depicted as the horizontal international financial
markets (IFM) line. For a small financially open economy, i* is exogenous.
Above the IFM line: capital flows in (i on the y-axis, Y on the x-axis)
Underneath the IFM line: capital flows out (i* marks the IFM line)
The IFM line describes the international financial equilibrium.
Capital controls = restrictions on financial accounts. FE: national currency inconvertible, limit
investing abroad. With capital controls, the interest rate parity need not hold.
National sharing of a currency – a monetary union – is the ultimate form of fixed exchange
rate regimes.
The other extreme form of exchange rate policy is to allow the exchange rate to float freely.
This means that the central bank takes no direct responsibility for the value of its currency,
which is set on foreign exchange markets.
1. Overview
Mundell-Fleming model = the small open-economy version of the IS-TR model.
When there is free trade in financial assets without capital controls, a fully financially
integrated economy loses the control of its own interest rate.
Small (as in small open economy) means that the economy has no discernable impact on the
rest of the world.
2. International Financial Flows
Example: consider a typical international investor (FE: large bank) which routinely borrows
and lends all over the world. The domestic interest rate is i, while the international rate of
return is i*. (! i* is rate of return not an interest rate).
- i < i* : International investor borrows at homoe, where the interest rate is low, and
invests abroad, pocketing the difference. As they do so, they raise the demand for
money at home and i will raise towards i*. Possibly, i* will decline towards i because
large amounts of money flow into foreign financial markets. This will go on as long as
i<i*.
- I > i* : Money will flow from the rest of the world into our high-interest rate country,
pushing i down and i* up.
Neither i>i* nor i<i* is possible. i = i*. This is the interest rate parity condition.
In contrast to the purchasing power parity condition, which takes time to assert itself
because good prices move slowly, the interest parity condition is a property which applies
even in the very short run.
The interest rate parity condition is depicted as the horizontal international financial
markets (IFM) line. For a small financially open economy, i* is exogenous.
Above the IFM line: capital flows in (i on the y-axis, Y on the x-axis)
Underneath the IFM line: capital flows out (i* marks the IFM line)
The IFM line describes the international financial equilibrium.
Capital controls = restrictions on financial accounts. FE: national currency inconvertible, limit
investing abroad. With capital controls, the interest rate parity need not hold.
National sharing of a currency – a monetary union – is the ultimate form of fixed exchange
rate regimes.
The other extreme form of exchange rate policy is to allow the exchange rate to float freely.
This means that the central bank takes no direct responsibility for the value of its currency,
which is set on foreign exchange markets.
