EC312 International Economics Assessment (Q1)
Student ID: 0926451
Word Count: 1, 498

The 2008 and subsequent global economic downturns were rooted in lax monetary policies and lack of financial oversight, leading to an aftermath of widening global imbalances, global liquidity abundance and downward pressures on real world interest rates. These resulted from mercantilist trade policies and an unprecedented increase in savings and foreign reserves of emerging economies in Asia. This essay will first explain the Mundell-Fleming (henceforth M-F) model and use it to compare current account deficits under different exchange rate regimes. It will also refer to real-life contexts and discuss limitations of the model. The M-F model portrays the short-run Keynesian relationship between an economy’s key macroeconomic variables. The assumptions and implications of the model are as follows: 1. The economy operates on a perfectly elastic aggregate supply curve. This implies that the level of economic activity, Y, is solely dependent on fluctuations in aggregate demand, as per the IS-LM framework. As prices are fixed, P is normalised to 1 and M represents both real and nominal money stocks. 2. The current account (CA) is determined independently of the capital account. PPP does not hold. CA deficits, as we will later see, depends on Y and the nominal and real exchange rate, e. The higher Y is, the greater the demand for imports; and the lower e is, the more uncompetitive domestic exports will be. The combined effect, based on the Marshall-Lerner (M-L) condition, results in a CA deficit. 3. Static exchange rate expectations and central role of interest rates. International interest rate differentials are assumed to result in finite capital inflows or outflows to a country. Imperfect capital mobility results from the limited supply of arbitrage funds, tight restrictions on foreign exchange movements, and is an increasing function of the risk premium offered on domestic securities. The net capital inflow, K, is an increasing function of the extent to which domestic interest rate, r exceeds the world interest rate, r*.

The three equations describing the M-F model are described below:

Open economy IS: Y = C(Y-T) + I(r) + G + CA (Y, e) (+) (-) (-,+)
Open economy LM: M/P = L(Y,r) (+,-)
Balance of Payments: BP = CA (Y,e) + K (r-r*) = 0 (-,+) (+)
Subscripts denote the positive or negative relationship between variables in brackets and the dependent variable.
The IS and LM curves illustrate the internal equilibrium of an economy, where IS and LM curves describe all combinations of Y and r such that the goods and money market are in equilibrium.
Any point on the BP line is achieved when any current account deficit or surplus is balanced by the flow of capital across the exchanges, i.e. the sum of surplus the CA and K should always be zero. This line is upward sloping because higher incomes must be associated with higher interest rates: at any given exchange rate e, an increase in Y brings about a current account deterioration. To achieve external equilibrium, r must increase to increase K. Exchange rate appreciations shift the BP line downwards as larger current account imbalances will now require a more modest net capital inflow and lower interest rates to sustain.
The Asian Financial Crisis was catalytic to accelerating global and regional financial integration and capital account liberalization for Asian economies. Both Brunei and Bhutan now have high interest elasticity of net capital flows. This means that we would expect their BP lines to be upward sloping and relatively, but not completely flat, as increases in interest rates stimulate finite capital inflows.
In both cases, a decrease in r* triggers capital inflows and increases the demand for domestic currency. Brunei operates as a ‘Currency Board’, or a fixed regime, which is based on a currency interchangeability agreement established with Singapore to guard against running risks of exchange rate fluctuations. The Bhutan Ngultrum, however, is pegged with the Indian rupee, its subsidiary currency, without independent exchange rate vis-à-vis others. The differing exchange rate regimes have varying implications for output and domestic interest rates.
Brunei (Fixed Exchange Rate Regime)
Figure 1 illustrates the effects of a fall in r* when there is high, but imperfect capital mobility. For simplicity, we assume that the economy begins at point A, where both internal and external equilibrium are satisfied (BP = 0, IS=LM), and that CA = KA = 0.
Following the fall in r*, we obtain a downward shift in the BP line to BP’, as increased capital inflows result in a balance of payments surplus. There is an influx of funds into Brunei, as the expected rate of return on investments increase. At point B, there is substantial balance of payments disequilibrium; returns on domestic investments increase and an emerging demand for the Brunei dollar (BND) ensues.
The BND now faces pressure to appreciate, as the rest of the world bids up the exchange rate by converting foreign currency into BND. Due to the fixed exchange rate regime in operation, the value of the BND must be preserved by accumulating foreign reserves. This results in a gradual increase in the foreign exchange or gold reserves component (FX) of the monetary base, and the LM curve shifts to LM’ due to an increase in money supply. We achieve a new equilibrium at B, on BP’ where internal and external equilibrium are restored, r is lower and Y is higher.
BP
BP’
Two effects can explain the resulting current account deficit- the effect of the change in exchange rate e and the change in Y. The first effect is zero due to the central bank’s intervention to keep e constant. Given that the non-reserve financial account, K, is positive due to the positive differential in real interest rates (r’-r*), the only way for C to be an external equilibrium point would mean that the current account has to be in deficit, i.e. the effect of lowered income is the sole contributing factor.
B

Figure 1: Fixed Exchange Rate Regime

In reality, the fixity of the exchange rate becomes less sustainable and credible if there is continued pressure of appreciation and threats of current account deficits. This situation is reminiscent of the Mexican Peso crisis in 1990s, whereby pressure on the exchange rate to depreciate resulted in high domestic interest rates and an accelerating CA deficit.

Bhutan (Flexible Exchange Rate Regime) The impacts of the fall in r* on the BP line, capital account and demand for the Ngultrum are identical to the previous example.
Despite being pegged to the Rupee and having limited scope for fluctuations, the ensuing minimal appreciation of the Ngultrum has implications for both the IS and BP curve. As Bhutanese exports become relatively more expensive for foreigners, demand for domestic commodity exports (particularly manufacturing and mineral-based products) decreases. Coupled with increased government imports for hydropower projects, the current account deteriorates, causing leftward shifts from IS to IS’ and BP’ to BP’’. We observe the new short run equilibrium at Point C, where both r’’ and Y’’ are lower than their initial levels, despite a partial increase in interest rates from point B. If the M-L condition holds, the Ngultrum appreciation swings the CA into a deficit. At the same time, the decrease in Y improves the CA as import demand falls. As per the previous argument, the non-reserve financial account, K, is positive due to (r’’-r*), and the only way for C to be an external equilibrium point would mean that the CA has to be in deficit. The difference between both models is, now, the effect of currency appreciation dominates the effect of lowered income. In reality, the external indicators of Bhutan as observed over FY2009/10 and FY2010/11 are in support of these findings (see Appendix B), and the CA deficit is expected to widen. The above example shows that, in reality, countries operating on relatively fixed exchange rate regimes such as currency boards or a single currency (i.e. the EMU) should ideally have coordinated fiscal and monetary policies. For example, huge government budget deficits in one member state could lead to high interest rates and decreased income in the other countries. Under a fixed exchange rate regime, the issue of conflicting policy externalities and considerations is one that is still of significance today. A flexible regime instead helps to act as an “insulator” from overseas shocks, whereby associated currency revaluations can work to reduce the impact on K.

Figure 2: Flexible Exchange Rate Regime While the M-F model sheds useful implications on exchange rate policies, it has not been largely successful empirically. The main reason for this is that the model is completely static and cannot be employed to the long run, particularly where price changes, M-L condition, long-run budget constraints, stock-flow interactions and wealth effects are neglected. Secondly, in reality, there are no completely free-floating or fixed exchange rates; most countries adopt a combination of flexibility and stability and actively control the extent to which the curves shift. Thus, the M-F model can only provide direction, but not clearly evaluate the implications on the CA.

Appendix A
The Marshall-Lerner Condition
The value of the current account in domestic currency is given by

where P represents domestic price of exported goods in domestic currency, P* is the foreign price of imports in foreign currency, e is the nominal exchange rate while X and M are the volumes of exports and imports. Expressed in terms of the real exchange rate q, we obtain
, where ---(a) we initially assume that the current account is balanced, i.e. .
Dividing (a) by volume of exports, X, we get

With simplification and substituting the condition for a balanced current account initially, we get

where the change in the current account is affected by both a price effect () and the volume effect .
Given the price effect, a real depreciation implies that is negative, and a real depreciation deteriorates the current account. The net effect on the current account, however, depends on the relative size of both effects.
The current account improves if the volume effect dominates the first, i.e.

or, divided by :

From a situation of balanced current account, a real depreciation improves the current account is the sum of both elasticities is greater than one. For the purpose of this essay, we assume that the volume effect dominates the price effect, so all currency depreciations necessarily improve the current account balance.
Appendix B
External Indicators of Bhutan

External Balances of Bhutan

Bibliography
Copeland, S. (2000) Exchange Rates and International Finance, 3rd Edition, Prentice Hall, pp175-94.
Faini, R. (2005), Fiscal Policy and Interest rates in Europe, Preliminary Paper prepared for 41st Panel of Economic Meeting in Luxembourg.
Hubbard, R. (2005) A Paradox of Interest, The Wall Street Journal, 23. Trichet, J.C. (2005), Speech on Monetary Policy in the EU – views and challenges, European Central Bank.
Roubini, N. & Backus, D., Lectures in Macroeconomics, Chapter 8.
Sachs, J.D., Kawai, M., Lee, J., Wing, T. (2010), The Future Global Reserve System – An Asian Perspective, Asian Development Bank.
The World Bank (September 2011), Bhutan Economic Update, Poverty Reduction and Economic Management, South Asia Region
Trichet, J.C. (2005), Speech on Monetary Policy in the EU – views and challenges, European Central Bank.

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[ 1 ]. The M-L condition states that, for a currency depreciation to impact its trade balance positively, the sum of price elasticity of exports and imports in absolute value must be greater than 1. (See Appendix A for derivation)
[ 2 ]. Several regional initiatives targeted at financial cooperation in East Asia include the ASEAN Surveillance Process and Asian Bond Markets Initiative. For Bhutan, there have been multiple reforms to strengthen the financial management framework. The Credit Information Bureau, for example, makes Bhutan’s financial system more reliable by making credit-risk assessment more efficient.
[ 3 ]. The rupee is accepted as legal tender in Bhutan and equally preferred in circulation.
[ 4 ]. Note: In reality, Brunei runs a current account surplus of over 30% of GDP, contributed by exports of chemicals, tourist arrivals and income from foreign assets. However, this model could be applied in the long run to Brunei as the “current account surplus is currently narrowing”, “growth in imports is projected to more than offset higher exports, reflecting increases in machinery and equipment...” and “growth in construction materials for government infrastructure projects”. (Source: Southeast Asia Department, ADB, Manila, and http://www.imf.org/external/np/sec/pn/2011/pn1176.htm)
[ 5 ]. The sharp interest rate differentials experienced by Mexico encouraged unsustainable and temporary foreign borrowing. However, once investor confidence fell, expected returns plummeted. Given a sterilized foreign exchange intervention, If the foreign exchange intervention is sterilized, or neutralised by means of changing domestic credit to offset changes in foreign exchange reserves, the speculative pressure on the exchange rate to depreciate remained and the central bank continued to haemorrhage its foreign reserves, resulting in an accelerating current account deficit and currency collapse.
[ 6 ]. The real effective rate between the Indian Rupee and Bhutanese Ngultrum has been broadly stable, and close to its ten year average. (Source: The World Bank, 2011)
[ 7 ]. In particular, the current account deficit is a result of the resumption of interest payments for the Tala power project during the global economic crisis.
[ 8 ]. Foreign capital inflows in Bhutan have grown at about 13% annually since FY2002/3, standing at 13.6 months of import cover at present. (Source: The World Bank, 2011)
[ 9 ]. http://www.imf.org/external/np/sec/pn/2011/pn1167.htm
[ 10 ]. The work of Gale and Orszag (2002) show that, for the US, a 1% increase in budget deficit is associated with interest rate hikes of about 50-70 basis points. In the case of the EMU, countries such as Greece (with 142.8% debt to GDP ratio) have seen a spike in interest rates up to almost 40%.
[ 11 ]. The M-F model produces diametrically opposed results for interest rates and outputs for fiscal and monetary policies.
[ 12 ]. Variations of exchange rate systems include crawling, adjustable peg, managed float, currency baskets etc.