Oct 14

Nobel Prize in Economics Science

The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, most commonly referred to as The Nobel Prize in Economic Sciences, is the most prestigious prize that can be awarded in Economics. Every year the Laureates in Economics are selected by the Royal Swedish Academy of Science, based in Stockholm, Sweden. It is based on a donation given by the Sveriges Riksbank (Sweden’s central bank) to the Nobel Foundation in 1968, on the occasion of the bank’s 300^th anniversary.

As for The Nobel Prize, that have been awarded since 1901, the criterion followed to select the winners is to “those who, during the preceding year, shall have conferred the greatest benefit on mankind”.

The first economists to be awarded this prize were the Dutch and Norwegian economists Jan Tinbergen and Ragnar Frisch in 1969 “for having developed and applied dynamic models for the analysis of economic processes”

1970: Paul A. Samuelson “for the scientific work through which he has developed static and dynamic economic theory and actively contributed to raising the level of analysis in economic science”

1971: Simon Kuznets “for his empirically founded interpretation of economic growth which has led to new and deepened insight into the economic and social structure and process of development”

1972: John R. Hicks and Kenneth J. Arrow “for their pioneering contributions to general economic equilibrium theory and welfare theory”

1973: Wassily Leontief “for the development of the input-output method and for its application to important economic problems”

1974: Gunnar Myrdal and Friedrich August von Hayek “for their pioneering work in the theory of money and economic fluctuations and for their penetrating analysis of the interdependence of economic, social and institutional phenomena”

1975: Leonid Vitaliyevich Kantorovich and Tjalling C. Koopmans “for their contributions to the theory of optimum allocation of resources”

1976: Milton Friedman “for his achievements in the fields of consumption analysis, monetary history and theory and for his demonstration of the complexity of stabilization policy”

1977: Bertil Ohlin and James E. Meade “for their path breaking contribution to the theory of international trade and international capital movements”

1978: Herbert A. Simon “for his pioneering research into the decision-making process within economic organizations”

1979: Theodore W. Schultz and Sir Arthur Lewis “for their pioneering research into economic development research with particular consideration of the problems of developing countries”

1980: Lawrence R. Klein “for the creation of econometric models and the application to the analysis of economic fluctuations and economic policies”

1981: James Tobin “for his analysis of financial markets and their relations to expenditure decisions, employment, production and prices”

1982: George J. Stigler “for his seminal studies of industrial structures, functioning of markets and causes and effects of public regulation”

1983: Gerard Debreu “for having incorporated new analytical methods into economic theory and for his rigorous reformulation of the theory of general equilibrium”

1984: Richard Stone “for having made fundamental contributions to the development of systems of national accounts and hence greatly improved the basis for empirical economic analysis”

1985: Franco Modigliani “for his pioneering analyses of saving and of financial markets”

1986: James M. Buchanan Jr. “for his development of the contractual and constitutional bases for the theory of economic and political decision-making”

1987: Robert M. Solow “for his contributions to the theory of economic growth”

1988: Maurice Allais “for his pioneering contributions to the theory of markets and efficient utilization of resources”

1989: Trygve Haavelmo “for his clarification of the probability theory foundations of econometrics and his analyses of simultaneous economic structures”

1990: Harry M. Markowitz, Merton H. Miller and William F. Sharpe “for their pioneering work in the theory of financial economics”

1991: Ronald H. Coase “for his discovery and clarification of the significance of transaction costs and property rights for the institutional structure and functioning of the economy”

1992: Gary S. Becker “for having extended the domain of microeconomic analysis to a wide range of human behaviour and interaction, including nonmarket behaviour”

1993: Robert W. Fogel and Douglass C. North “for having renewed research in economic history by applying economic theory and quantitative methods in order to explain economic and institutional change”

1994: John C. Harsanyi, John F. Nash Jr. and Reinhard Selten “for their pioneering analysis of equilibria in the theory of non-cooperative games”

1995: Robert E. Lucas Jr. “for having developed and applied the hypothesis of rational expectations, and thereby having transformed macroeconomic analysis and deepened our understanding of economic policy”

1996: James A. Mirrlees and William Vickrey “for their fundamental contributions to the economic theory of incentives under asymmetric information”

1997: Robert C. Merton and Myron S. Scholes “for a new method to determine the value of derivatives”

1998: Amartya Sen “for his contributions to welfare economics”

1999: Robert A. Mundell “for his analysis of monetary and fiscal policy under different exchange rate regimes and his analysis of optimum currency areas”

2000: James J. Heckman “for his development of theory and methods for analyzing selective samples”. And Daniel L. McFadden “for his development of theory and methods for analyzing discrete choice”

2001: George A. Akerlof, A. Michael Spence and Joseph E. Stiglitz “for their analyses of markets with asymmetric information”

2002: Daniel Kahneman “for having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty“. And Vernon L. Smith “for having established laboratory experiments as a tool in empirical economic analysis, especially in the study of alternative market mechanisms”

2003: Robert F. Engle III “for methods of analyzing economic time series with time-varying volatility (ARCH)”. And Clive W.J. Granger “for methods of analyzing economic time series with common trends (cointegration)”

2004: Finn E. Kydland and Edward C. Prescott “for their contributions to dynamic macroeconomics: the time consistency of economic policy and the driving forces behind business cycles”

2005: Robert J. Aumann and Thomas C. Schelling “for having enhanced our understanding of conflict and cooperation through game-theory analysis”

2006: Edmund S. Phelps “for his analysis of intertemporal trade-offs in macroeconomic policy”

2007: Leonid Hurwicz, Eric S. Maskin and Roger B. Myerson “for having laid the foundations of mechanism design theory”

2008: Paul Krugman “for his analysis of trade patterns and location of economic activity”

2009: Elinor Ostrom “for her analysis of economic governance, especially the commons”. And Oliver E. Williamson “for his analysis of economic governance, especially the boundaries of the firm”

2010: Peter A. Diamond, Dale T. Mortensen and Christopher A. Pissarides “for their analysis of markets with search frictions”

2011: Thomas J. Sargent and Christopher A. Sims “for their empirical research on cause and effect in the macroeconomy”

2012: Alvin E. Roth and Lloyd S. Shapley “for the theory of stable allocations and the practice of market design”

2013: Eugene F. Fama, Lars Peter Hansen and Robert J. Shiller “for their empirical analysis of asset prices”

2014: Jean Tirole “for his analysis of market power and regulation”

2015: Angus Deaton “for his analysis of consumption, poverty, and welfare”.

2016: Oliver Hart and Bengt Holmström “for their contributions to contract theory”.

Oct 10

Lope Gallego

Government intervention

Government intervention is any action carried out by the government or public entity that affects the market economy with the direct objective of having an impact in the economy, beyond the mere regulation of contracts and provision of public goods.

Government intervention advocates defend the use of different economic policies in order to compensate the flaws of the economic system that give way to large economic imbalances. They believe the Law of Demand and Supply is not sufficient in order to ensure economic equilibriums and government intervention should be used to assure a correct functioning of the economy. Examples of these economic doctrines include Keynesianism and its branches such as New Keynesian Economics, which relay heavily in fiscal and monetary policies, and Monetarism which have more confidence in monetary policies as they believe fiscal policies will have a negative effect in the long run. On the other hand, there are other economic schools that believe that governments should not have an active role in the economy, and therefore should limit its intervention, as they believe it will have a negative impact in the economy. They believe that the economy should be left to run in a laissez-faire way and it will find its optimal equilibrium. Advocates of none or limited intervention include liberalism, the Austrian school and New Classical Macroeconomics.

As in most imperfect competition markets and especially in monopolistic ones, a firm may practice an abusive behaviour, which will translate into a loss of welfare. In such cases, government intervention will be praised both by consumers and those firms that seek for lower prices and a profitable share of the market. Regulations such as price setting, taxation or subsidies may be used in order to restore and maximise the initial efficiency of natural monopolies.

Nevertheless, the government must be cautious when setting and applying regulations, as an incorrect comprehension of the market structure may bring a higher cost to social welfare instead of the expected benefits. In order to achieve an optimal regulation level, governments should analyse and determine if natural monopolies can be sustained whenever they ensure a lower total cost. If this is the case, the government will have to guarantee that the firm does not make excessive revenues, and that fair prices are maintained. If, on the contrary, the total costs of the industry would diminish if new firms entered the market, the government should regulate their entrance. Essentially, what governments should do is to correctly balance the conflict between the industry’s efficiency and its profitability.

Oct 7

Lope Gallego

Economic growth

Economic growth is defined as an increase in the real value of the goods and services that an economy produces. It is important to emphasize the word “real” in this definition, and to understand the difference when talking in nominal terms, as an increase in the money supply could increase the nominal value, without changing the real one.

In economics, economic growth is usually measured by the percentage change in the Gross Domestic Product (GDP) of a country. This variable gives us an idea on the growth of a determined economy, but not on its quality and its effects on welfare, which are closely examined by those who are concerned with the development of life quality. When dealing with development economics, the focus switches to GDP per capita and focuses on the processes involved in the development of low-income countries.

Economic growth can come as a result of three phenomena: demographic growth, increase in the quality and quantity of natural resources, and productivity growth. While with the two former ones economic growth comes as a result of an increase in one of the productive factors, labour and capital respectively, in the latter, with the same amount of factors there is an increase in production, which as a result implies an increase in efficiency.

Although there are many growth models, for a matter of simplification, we will only name the main ones, from which in any case the majority of the models derive from.

-Harrod-Domar model: this model was deeply inspired by Keynesianism and it was concerned with the persistence of situations that deviated from full employment. It postulated that there were measures to accelerate investment, along with growth which is why they advocated for government intervention policies;

-Solow-Swan model: this model follows a neoclassical production function of good behaviour but also considers technological progress. It’s probably the best-known growth model;

-Ramsey-Cass-Koopmans model: this dynamic model is developed from the neoclassical model, enriching it without differing from the basics. The model also analyses the optimal quantities of consumption and supply.

The biggest increase in productivity throughout humankind has come from specialization, technological progress and education. In fact the increase in productivity has had positive effects over demographic growth, increasing even more economic growth, as it occurred during the Industrial Revolution which allowed the population to escape the Malthusian trap.

Sep 30

Lope Gallego

International trade

International trade is the exchange of capital, goods and services between countries. Along with international finance it forms the larger branch of international economics. Although research on international trade has been carried out since the start of the study of the economic science, its importance over history has never been as great as over the last 50 or 70 years. The globalization phenomenon is both a consequence and a cause of international trade.

International trade studies which countries engage in trading amongst each other, why they do so, what goods they exchange, analyses the benefits and costs of it and reasons and effects of government policies that limit or promote international trade. The main economic theories or models that try to explain all determinants of international trade are:

–Adam Smith’s, developed in his book “An Inquiry into the Nature and Causes of the Wealth of Nations” 1776, also known as the absolute advantage explanation, which considers what countries can produce more efficiently;

-The classical, or Ricardian trade theory, (developed by Ricardo in his book “On the Principles of Political Economy and Taxation”, 1817) which considered relative costs across countries the determinant factor which explained trade patterns, using comparative advantage as the reason why countries trade with each other;

-The neoclassical theory, which even though simultaneously considers countries differences in technology and factor endowment, also emphasizes in the importance of tastes across countries: even if technology and factor endowment were equal across two countries, tastes differences would still explain trade between them;

-The Heckscher-Ohlin theory, developed by Eli Heckscher and Bertil Ohlin, according to which the factor endowments of different countries determines in what product does the country specialize its production and, subsequently, its trade patterns;

-The new trade theory, according to which economies of scale and network effects are the core explanation of international trade patterns, as Paul Krugman’s trade model suggests (developed in his article “Increasing Returns, Monopolistic Competition, and International Trade”, 1978).

Even though these theories and models use different reasoning to analyse and explain trade patterns, there is a common idea throughout international trade literature that exchange amongst countries is beneficial from a normative point of view. Indeed, international trade, and therefore globalization, is not a zero-sum game, but has positive effects on social welfare and consumers’ surplus. Even though globalization can cause some job outsourcing to foreign countries, or demand for goods and services shifting from one country to another, it is beneficial for the group of countries trading, as a whole. A good and easy way to see this is using the Ricardian trade model, or analysing the effect of tariffs on consumers and producers’ surpluses.

Jun 5

Lope Gallego

Loanable funds

Net capital outflows (NCOs, also called net foreign investment) make reference to the difference between the acquisition of foreign assets by domestic residents and the acquisition of domestic assets by non-residents. Therefore, it has to do with savings and investment (loanable funds) and foreign currency exchange.

The relationship between net capital outflows and foreign currency exchange can be easily seen using a model, which analyses the market for loanable funds and the market for foreign currency exchange, in the context of an open economy. The link between these two markets will be net capital outflows. Let’s start by defining each market.

The market for loanable funds

In a few words, this market is a simplified view of the financial system. All savers come to the market for loanable funds to deposit their savings. Also, everyone looking for a loan (either to spend it or to invest it) comes to this market. In order to see how the supply and demand of loanable funds work, we use the following identity:

S = I + NCO

where

S = savings
I = domestic investment
NCO = net capital outflows

Savings corresponds to everything an economy saves from its income, both from the private sector and government accounts. Therefore, it represents national savings. On the other side of the identity we have national investment and net capital outflows. In other words, on one side we have savings being supplied to the market, while on the other side we have money demanded for national investment and net foreign investment (net capital outflows). As seen in the adjacent figure, equilibrium is reached when the quantity of savings (which correspond to supply of loanable funds) equals investment and net capital outflows (demand for loanable funds).

The supply for loanable funds (S_LF) curve slopes upward because the higher the real interest rate, the higher the return someone gets from loaning his or her money. The demand for loanable funds (D_LF) curve slopes downward because the higher the real interest rate, the higher the price someone has to pay for a loan.

The market for foreign currency exchange

In order to understand this market, which is the market in which domestic currency (let’s say euros) is exchanged for foreign currencies, we must use another identity:

NX = NCO

where

NX = net exports
NCO = net capital outflows

Again, if the economy is running a trade deficit (NX<0), it must be financing the net purchase of goods and services by selling assets abroad, so foreign capital is entering the economy (NCO<0). In order to buy domestic assets, foreign economies must exchange their currencies into euros, which increases the demand for euros. If the economy is running a trade surplus (NX>0), the excess in foreign currency it receives is being used to buy assets from abroad, which means domestic capital is flowing out of the economy (NCO>0). In this case, residents must exchange their euros for foreign currency, which increases the supply of euros, as seen in the adjacent figure.

The equilibrium is determined by the real exchange rate, since it corresponds to the relative price of domestic and foreign goods, thus affecting net exports. The supply of euros (S_€, derived from net capital outflows) curve is vertical because it does not depend on the real exchange rate (as seen before, it depends on real interest rate, which is considered as given in this market). The demand for euros (D_€, derived from net exports) curve slopes downwards because the higher the real exchange rate, the more expensive European goods are for foreign economies, thus reducing the quantity of euros demanded to buy those goods (since less people wants to buy European goods).

Net capital outflow

Net capital outflow links both markets. It does so because it depends on real interest rates, and because it determines the supply of euros. As we can see in the figure below, the net capital outflow curve slopes downwards. This is because the higher domestic real interest rates, the more attractive our assets are. This will attract foreign investment, which will in turn reduce net capital outflow (since more capital is entering the economy).

The equilibrium

As seen in the figure below, the equilibrium is guaranteed by net capital outflows. The supply and demand for loanable funds determines a total quantity of loanable funds, but also a real interest rate, which in turn affects net capital outflows. Supply and demand of euros determine the real exchange rate, which also affects net capital outflows.

As we can see, these two markets and the net capital outflows linking them are tightly interconnected. In order to understand how this model can become a really useful tool, let’s review a few scenarios to see how the model responds.

Effects of budget deficits, trade policies and political instability

–Government budget deficit: when a government runs a budget deficit, it reduces the quantity of available loanable funds, thus shifting S_LF to the left. This happens because the government’s expenses surpass its revenues. Therefore, it has negative savings, which reduces total savings. Shifting the supply of loanable funds reduces the total quantity at equilibrium, but also increases the real interest rate (to i₁). This increase of the real interest rate reduces net capital outflow. The reduction of net capital outflow decreases the quantity of euros being supplied to be exchanged for foreign currency, which ultimately causes the real exchange rate to appreciate.

-Trade policy: let’s see how import quotas affect the market for loanable funds. Since an import quota reduces imports at any real exchange rate, net exports rise. Therefore, foreigners will need to buy more euros to buy EU net exports, which will shift the demand for euros (D_€) to the right. This will appreciate the real exchange rate, but will have no effect on the market for loanable funds, and therefore the real interest rate will remain the same. Since the real interest rate does not change, neither do net capital outflows. However, the appreciation of the euro will increase imports and decrease exports (domestic goods are more expensive relative to foreign goods). This will gradually return the demand for euros (D_€) to its initial state. Therefore, we can conclude that trade policies do not affect the trade balance.

-Political instability: this can easily turn into capital flights, such as the ones lived in Mexico in 1994, in some Asian countries in the late nineties, or the one that ultimately caused the Argentinian crisis of 2001. Capital flights basically mean that large quantities of assets or money are leaving an economy, which will shift the net capital outflow curve upwards, to show increasing net capital outflows. This will affect both the market for loanable funds and the market for foreign currency exchange. First, it will increase the demand for loanable funds (in order to increase the purchase of assets overseas), shifting the demand curve (D_LF) to the right, increasing the real interest rate. Secondly, since people wants to convert their euros into a more “secure” currency, supply of euros rapidly increases, shifting the supply curve to the right.

Jun 3

Lope Gallego

Net capital outflow

Net capital outflows (NCOs, also called net foreign investment) make reference to the difference between the acquisition of foreign assetsby domestic residents and the acquisition of domestic assets by non-residents. Net capital outflows takes two forms: foreign direct investment, and portfolio investment. Foreign direct investment implies actively managing the asset or the interest bought, while portfolio investment requires no role at all in management.

An open economy can therefore buy and sell assets in the financial markets, generating flows of capital.

NCO = Acquisition of foreign assets by residents – Acquisition of domestic assets by nonresidents

When the net capital outflow is positive, domestic residents are buying more foreign assets than foreigners are purchasing domestic assets. When it’s negative, foreigners are purchasing more domestic assets than residents are purchasing foreign assets.

Imbalances in the net capital outflow (NCO) are associated with imbalances in the trade balance (or net exports, NX), following the identity NCO = NX. Each exchange that affects the net capital outflow, also affects net exports in the same amount. For instance, if an economy is running a trade deficit, it must be financing the net purchase of goods and services by selling assets abroad. If it’s running a trade surplus, the excess in foreign currency it receives is being used to buy assets from abroad.

Since net capital outflows are related to net exports, they are therefore related to gross domestic production. From the equation showing the relationship between the current account, savings and investment, we have:

S = I + NX = I + NCO

where

S = savings
I = domestic investment
NX = net exports
NCO = net capital outflows

From these equations, we can derive an easy-to-use cheat sheet about international flows of goods, services and investment:

May 22

Lope Gallego

IS-LM-BP model

The IS-LM-BP model (also known as IS-LM-BoP or Mundell-Fleming model) is an extension of the IS-LM model, which was formulated by the economists Robert Mundell and Marcus Fleming, who made almost simultaneously an analysis of open economies in the 60s. Basically we could say that the Mundell-Fleming model is a version of the IS-LM model for an open economy. In addition to the balance in goods and financial markets, the model incorporates an analysis of the balance of payments.

Even though both economists researched about the same topic, at about the same time, both have different analyses. Mundell’s paper “Capital Mobility and Stabilization Policy under Fixed and Flexible Exchange Rates”, 1963, analyses the case of perfect mobility of capital, while Fleming´s model, depicted in his article “Domestic Financial Policies under Fixed and under Floating Exchange Rates”, 1962, was more realistic as it assumed imperfect capital mobility, and thus made this one a more rigorous and comprehensive model. However, nowadays, his model has lost cogency, as the actual world situation has more resemblance with total capital mobility, which corresponds better to Mundell’s view.

In order to understand how this model works, we’ll first see how the IS curve, which represents the equilibrium in the goods market, is defined. Secondly, the LM curve, which represents the equilibrium in the money market. Thirdly, the BP curve, which represents the equilibrium of the balance of payments. Finally, we’ll analyse how the equilibrium is reached.

IS curve: the market for goods and services

In an open economy, the equilibrium condition in the market for goods is that production (Y), is equal to the demand for goods, which is the sum of consumption, investment, public spending and net exports. This relationship is called IS. If we define consumption (C) as C = C(Y-T) where T corresponds to taxes, the equilibrium would be given by:

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

We consider that investment is not constant, and we see that it depends mainly on two factors: the level of sales and interest rates. If the sales of a firm increase, it will need to invest in new production plants to raise production; it is a positive relation. With regard to interest rates, the higher they are, the more expensive investments are, so that the relationship between interest rates and investment is negative. Now, in addition to what we have in the IS-LM model, since we have net exports, we have also to take into account the exchange rates, which directly affect net exports. Let’s say e is the domestic price of foreign currency or, in other words, how many units of our own currency have to be given up to receive 1 unit of the foreign currency. The new relationship is expressed as follows (where i is the interest rate):

Y = C (Y- T) + I (Y, i) + G + NX(e)

If we keep in mind the equivalence between production and demand, which determines the equilibrium in the market for goods, and observe the effect of interest rates, we obtain the IS curve. This curve represents the value of equilibrium for any interest rate.

An increasing interest rate will cause a reduction in production through its effect on investment. Therefore, the curve has a negative slope. The adjacent graph shows this relationship.

As stated before, we also need to analyse changes in exchange rates (here, e). If e decreases, then we’ll be able to buy more foreign currency with less of our own currency. On the other hand, foreigners we’ll need to pay more of their currency to buy our own. Therefore, when e decreases, also called an appreciation under flexible exchange rates or a revaluation under fixed exchange rates, domestic residents have more purchasing power, thus being able to buy the same amount of goods using less domestic currency. The opposite works in the same way: if e increases (also called a depreciation under flexible exchange rates or a devaluation under fixed exchange rates), domestic residents will pay more for the same goods. To sum up, an increase in e causes net exports to increase (IS curve shifts to the right) and a decrease in e causes net export to decrease (IS curve shifts to the left).

LM curve: the market for money

The LM curve represents the relationship between liquidity and money. In an open economy, the interest rate is determined by the equilibrium of supply and demand for money: M/P=L(i,Y) considering M the amount of money offered, Y real income and i real interest rate, being L the demand for money, which is function of i and Y. Also, the exchange rate must be analysed since it affects money demand (investors may decide buy or sell bonds in a country depending on the exchange rate).

The equilibrium of the money market implies that, given the amount of money, the interest rate is an increasing function of the output level. When output increases, the demand for money raises, but, as we have said, the money supply is given. Therefore, the interest rate should rise until the opposite effects acting on the demand for money are cancelled, people will demand more money because of higher income and less due to rising interest rates.

The slope of the curve is positive, contrary to what happened in the IS curve. This is because the slope reflects the positive relationship between output and interest rates.

BP curve: the balance of payments

The BP curve shows at which points the balance of payments is at equilibrium. In other words, it shows combinations of production and interest rates that guarantee that the balance of payments is viably financed, which means that the volume of net exports that affect total production must be consistent with the volume of net capital outflows. It will usually slope up since the higher the production, the higher the imports, which will disturb the equilibrium of the balance of payments, unless interest rates rise (which would cause capital inflows to maintain the equilibrium). However, depending in how great the mobility of capital is, it will have a greater or smaller slope: the higher the mobility, the flatter the curve.

Once the BP curve is derived, there is an important thing to know about how to use it. Any point above the BP curve will mean a balance of payments surplus. Any points below the BP curve will mean a balance of payments deficit. This is important since depending where we are, different things may affect the interest rates.

The IS-LM-BP model

In the model we distinguish between perfect and imperfect capital mobility, but also between fixed and flexible exchange rates. For each of these cases, we’ll see what happens when both an expansionary monetary and fiscal policy are applied to the economy. We’ll first review Mundell’s model, which deals with perfect mobility. Then, we’ll analyse Fleming’s imperfect mobility model.

1 Perfect capital mobility

1.1 Fixed exchange rate

An expansionary monetary policy will shift the LM curve to LM’, which makes the equilibrium go from point E₀ to E₁. However, since we are below the BP curve, we know the economy has a balance of payments deficit. Since exchange rates are fixed, government intervention is required: the government will purchase domestic currency and sell foreign currency, which will drop the money supply and therefore shift the LM’ curve to its original position (which makes the equilibrium go to E₂). Monetary policy has therefore no effect under these circumstances.

An expansionary fiscal policy will shift the IS curve to IS’, moving the equilibrium form point E₀ to point E₁. Since the economy has now a balance of payments surplus, and because the exchange rate is fixed, government will intervene in the exact opposite way: they’ll purchase foreign currency and sell domestic currency. This will increase the money supply, shifting the LM curve to the right. The final equilibrium is reached at point E₂ where, at the same interest rate, production has increased greatly: fiscal policy works perfectly under these circumstances.

1.2 Flexible exchange rate

An expansionary monetary policy will shift the LM curve to LM’, which makes the equilibrium go from point E₀ to E₁. However, since now exchange rates are flexible, we have a different situation: the balance of payments deficit will depreciate the domestic currency. This will increase net exports (since foreigners can now buy more of our products with the same amount of money), which will shift the IS curve to the right (to IS’). The final equilibrium is reached at point E₂ where, at the same interest rate, production has increased greatly: monetary policy works perfectly under these circumstances.

An expansionary fiscal policy will shift the IS curve to IS’, moving the equilibrium from point E₀ to point E₁. The economy will therefore have a balance of payments surplus, which in this case of flexible exchange rate will appreciate the domestic currency. This will decrease net exports, since we are able to import more goods and services with less money, while foreigners will import less of our products because of our appreciated domestic currency. This drop in net exports will shift the IS’ curve back to its original position. Since now the final equilibrium E₂ corresponds to the initial equilibrium, we know fiscal policy is no good in this case.

It is easy to see why Mundell devised what is known as the impossible trinity. In a few words, no economy can have the following three: perfect capital mobility, fixed exchange rates and an independent and efficient monetary policy. Under the perfect capital mobility assumption, and in order to have an efficient monetary policy, exchange rates must be flexible. Or have fixed exchange rates but assume that monetary policy won’t be efficient.

2 Imperfect capital mobility

2.1 Fixed exchange rate

Here we have the exact same situation as before: an expansionary monetary policy will shift the LM curve to LM’, which makes the equilibrium go from point E₀ to E₁. However, since we are below the BP curve, we know the economy has a balance of payments deficit. Since exchange rates are fixed, the government will purchase domestic currency and sell foreign currency, which will drop the money supply and therefore shift the LM’ curve to its original position (which makes the equilibrium go to E₂). Monetary policy has again no effect, no matter how great or small capital mobility is.

An expansionary fiscal policy will shift the IS curve to IS’, moving the equilibrium from point E₀ to point E₁. Now, depending on capital mobility, we’ll either have a balance of payments surplus (high capital mobility, BP+ curve) or a balance of payments deficit (small capital mobility, BP- curve). Since exchange rates are fixed, government will need to intervene: its acquisitions and disposals of both domestic and foreign currency will shift the LM curve to either LM’ or to LM* (you can review what happens above: a balance of payments surplus is the same scenario as in a fiscal policy with perfect capital mobility and fixed exchange rates, while the balance of payments deficit corresponds to the monetary policy scenario). Under these circumstances, fiscal policy is completely efficient. It’s actually the more efficient the higher capital mobility is.

2.2 Flexible exchange rate

An expansionary monetary policy will shift the LM curve to LM’, which makes the equilibrium go from point E₀ to E₁. However, since now exchange rates are flexible, the balance of payments deficit will depreciate the domestic currency. This will increase net exports, shifting the IS curve to IS’. Also, since domestic assets are less expensive, the BP curve will shift to the right (to either BP’+ or BP’-). Therefore, with high capital mobility, final equilibrium will be at point E₂. Monetary policy works well under these assumptions. It’s actually the more efficient the higher capital mobility is.

An expansionary fiscal policy will shift the IS curve to IS’, moving the equilibrium from point E₀ to point E₁. Now, depending on capital mobility, we’ll either have a balance of payments surplus (high capital mobility, BP+ curve) or a balance of payments deficit (small capital mobility, BP- curve). In the case of a balance of payments surplus, and considering flexible exchange rates, there will be an appreciation of the domestic currency. This will decrease net exports, which will shift the IS’ curve to the left. Also, since domestic assets are more expensive, the BP+ curve will shift to the left. The final equilibrium will therefore be at point E₂. If there is a balance of payments deficit (the case for the BP- curve), the result will be the same one as in the monetary policy case (being E₂* the final equilibrium). In this scenario, fiscal policy will be more efficient the smaller capital mobility is.

The Mundell-Fleming model is a very useful tool when dealing with the analysis of open economies. A great deal of textbooks and papers argue for or against each of these models. However, there’s no denying the world is moving towards liberalizing international trade and capital movements (mostly through WTO’s agreements), which would make us lean towards Mundell’s view. To sum up, under perfect capital mobility, monetary policy will only work with flexible exchange rates, while fiscal policy will only work with fixed exchange rates.

May 20

Lope Gallego

Financial account

The financial account is one of the components of the balance of payments. It shows the net acquisition and disposal of both financial assets and liabilities. As stated in the sixth edition of the Balance of Payments Manual (BPM), by the International Monetary Fund, “The financial account records transactions that involve financial assets and liabilities and that take place between residents and nonresidents”. The table below, taken from the BPM, shows an overview of the financial account.

The financial accounts may correspond to either entries to goods, services, income or capital account, or to entries of opposite sign to the financial account itself. For instance, when a country sells goods to another country, there will be an entry in the current account (an increase in the goods and services account, since the country is exporting), but also an entry in the financial account, such as currency, deposits or trade credit. Sometimes, entries in the financial account will be matched by other entries in the same account: bonds may be exchanged for deposits or currency.

Therefore, the balances of both the current account and the capital account will be conceptually equal to the net balance of the financial account, as seen in the following formula:

CAB + KAB = NFA

where:

CAB = current account balance
KAB = capital account balance
NFA = net financial account

This must be understood as follows: the sum of the balances on the current and capital accounts represent the surplus(net lending) or deficit(net borrowing) that an economy has with the rest of the world. This is equal to the financial account, since it measures how the net lending or borrowing from non-resident is financed.

May 15

Lope Gallego

Capital account

The capital account is one of the components of the balance of payments. It mainly reflects net foreign holdings of capital. When a country incurs on a deficit on current account, it needs to be financed by capital from abroad, it needs to have a capital account surplus. The opposite occurs in the case of current account surplus, there will be an outflow of capital to foreign countries. As stated in the sixth edition of the Balance of Payments Manual (BPM), by the International Monetary Fund, “the capital account in the international accounts shows (a) capital transfers receivable and payable between residents and nonresidents and (b) the acquisition and disposal of nonproduced, nonfinancial assets between residents and nonresidents”.

In other words, the capital account shows acquisitions and disposals of nonproduced nonfinancial assets, such as the sales of leases and licenses, as well as capital transfers (when one party provides capital resources without anything of economic value being supplied as a counterpart). The table below, taken from the BPM, shows an overview of the capital account.

May 13

Lope Gallego

Current account

The current account is one of the components of the balance of payments. It mainly shows the value of movements in exports and imports and income derived form transactions related to net purchases of goods and services. As stated in the sixth edition of the Balance of Payments Manual (BPM), by the International Monetary Fund, “the current account shows flows of goods, services, primary income, and secondary income between residents and nonresidents”. Let’s review all these components:

“The goods and services account shows transactions in items that are outcomes of production activities”. The first thing to mention is that, even though goods are physical, and services are a production that changes the consuming units, or facilitates some kind of exchange, both are considered as products, and are measured at the moment of exchange and at market value. The table below, taken from the BPM, shows an overview of the goods and services account.

“The primary income account shows primary income flows between resident and nonresident institutional units”. In other words, these are income flows concern to some extent governments and other institutions. For instance, taxes, subsidies or other income associated with the production process and with the ownership of financial assets and renting natural resources. It’s worth mentioning that cross-border primary income flows constitute a link between gross domestic product and gross national income. The table below, taken from the BPM, shows an overview of the primary income account.

Current account-Primary income account

“The secondary income account shows current transfers between residents and nonresidents”. These transfers, which might be in cash or in kind, do not include capital transfers, which are shown in the capital account. This is because, as opposed to secondary income, capital transfers do not affect disposable income. The table below, taken from the BPM, shows an overview of the secondary income account.

Current account-Secondary income account

The balance on these three account is known as the current account balance, which shows the difference between the sum of exports and income receivable, and the sum of imports and income payable. It’s also worth mentioning that the current account balance equals the savings-investment gap for the economy, as seen in the following formula:

S – I = CAB

where

S = savings

I = investment

CAB = current account balance