The Keynesian Approach

One line of thinking leading to the research field of international macroeconomics has been brought forward or at least initiated by John Maynard Keynes’s theoretical work on war finance, on how the Bretton Woods/General Agreement on Tariffs and Trade (GATT) system might work, and on Britain’s post-war loans (Vines 2003).

In his work, Keynes laid the fundaments to and in many ways preceded the work of Mundell (1963) and Fleming (1962) and that of later studies on financial crises. He thereby used his earlier work published in the Treatise on Money (Keynes 1930) which he combined with the demand management from the General Theory (Keynes 1936). In his studies on war finance, Keynes has worked with an IS-LM-BP model in mind in a small open economy version and a two-country version. Yet, the open economy Keynesian model that we have been using had to wait until the 1960s to become popular and widely used (Vines 2003).

Open economy macroeconomics had been worked on and popularized particularly by the International Monetary Fund (IMF) where Mundell and Fleming worked in the Research Department which was headed by Polack at the beginning of the 1960s. Fleming’s Keynesian tradition met Mundells view which had also been shaped by other influences: Meade’s mathematical approach (Meade 1951), the discussion with Metzler on conditions of general equilibrium in an open economy (see Mundell 1961) and Samuelson’s stability analysis (Samuelson 1947) have been important in developing Mundell’s approach to the analysis of Open Economy Macroeconomics (Young and Darity 2004). Mundell looked for a way to analyse the difference between an economy with a fixed exchange rate and flexible prices and an economy with flexible exchange rates and fixed prices in a model with full-employment.

Given the low level of economic integration in the years of and immediately after the Great Depression, it is not surprising that Keynes’s General Theory was presented and discussed in a closed economy framework.

It has taken some time for the model for the open economy to be worked out, although there have been attempts from different directions. At the beginning of the 1960s, Mundell (1963) and Fleming (1962) succeeded in summarizing different attempts to achieve an open economy macroeconomics framework. Resulting from their work at the IMF, stabilization policy has been the focus of Mundell and Fleming’s analyses. Since then, their framework has become the dominant paradigm for studying open-economy monetary and fiscal policy issues, which have gained in importance relative to closed-economy models because of the continuing integration of regions and countries to unprecedented levels.

International economic integration affects the ability to conduct domestic financial policies mainly through the capital flows that these policies induce. To stress this point, Mundell (1963) assumes an extreme degree of capital mobility that yields an identical interest rate in all countries in equilibrium. In combination with static exchange rate expectations, this assumption implies that all securities (which are restricted to government bonds) are perfect substitutes. These are certainly extreme assumptions, yet they bring out the policy implications as sharply as possible. In the presence of interest rate differences, perfect substitutability of the securities induces capital flows until the differences are eliminated. That does away with all financial policies conducted to stabilize the economy that work through a change in the interest rate. A stabilization policy that intends to lower the interest rate would induce capital outflows, which prevent the interest rate from falling.

The effectiveness of monetary and fiscal policies depends thereby on the choice of the exchange rate regime. Mundell (1963) and Fleming (1962) discuss the polar cases of flexible and fixed exchange rates showing that the two regimes generate strongly different effects of stabilization policies on an open economy’s output.

While flexible exchange rate regimes allow a priori for an active monetary policy, in fixed exchange rate regimes the money supply has to secure the exchange rate. Money supply becomes an endogenous variable, which cannot freely be used as a policy measure to affect the economic outcome. In flexible exchange rate regimes, in contrast, an autonomous monetary policy is in principle possible. Yet, it is strongly affected by the perfect substitutability of the securities. An expansionary monetary policy puts a downward pressure on the interest rate, which induces capital outflows. These outflows cause a depreciation of the exchange rate, which increases (under the assumption that the Marshall-Lerner-Robinson condition holds) the trade balance and thereby output and employment. The new equilibrium features a higher money stock, higher employment and output levels, and an improved trade balance and net foreign investment position, but the interest rate remains constant at the world interest rate level.

Fiscal policy, that is, an increase in government spending financed by government borrowing, is also affected by capital mobility. Government spending tends to raise incomes. Yet, this increases the money demand, which increases the interest rate and induces capital inflows. Capital inflows in turn appreciate the exchange rate, which depresses (a normal reaction assumed) the trade balance. The lower trade balance reduces incomes. This negative effect exactly equalizes the positive effect of government spending. Hence, with fixed interest rates, income is also fixed. “Fiscal policy thus completely loses its force as a domestic stabilizer when the exchange rate is allowed to fluctuate” (Mundell 1963: 478).

Under fixed exchange rates the results reverse: monetary policy cannot be used to affect incomes while fiscal policy can be an effective stabilizer. Increased government spending requires the central bank to increase money supply to defend the fixed exchange rate.

Thus, income rises along with money stock. The government’s budget deficit equals the trade deficit, which is balanced by an inflow of capital. The new equilibrium features an increase in foreign reserves which is the actual reason for the increase in money supply needed to defend the exchange rate. Income increases, unemployment falls, money supply expands and the government deficit increases as result of an expansionary fiscal policy under fixed exchange rates. The interest rate is unaffected.

The assumption that the securities of two countries are perfect substitutes, that is, that there are no information and transaction costs and no risk, is certainly too strong. Fleming (1962) includes imperfect substitutability of securities from different countries. While weakening Mundell’s results, their tendency is supported by Fleming’s findings. Monetary policy is effective under flexible exchange rates while fiscal policy is not. Under fixed exchange rates, fiscal policy is possible while monetary policy is not (always).

In the world of the Bretton Woods system the assumption of static exchange rate expectations might be acceptable. In the flexible exchange rate episode afterwards, it is certainly an odd assumption. Investors would make systematic mistakes, which contradicts rational expectations, an assumption that has become very prominent in macroeconomics. Dornbusch (1976) presented a version of the Mundell-Fleming framework augmented by rational exchange rate expectations, which are introduced through the uncovered interest parity. The long-run equilibrium supports the Mundell-Fleming results that (unanticipated) monetary policy is an effective tool of stabilization policy under flexible exchange rates. In the short run, Dornbusch found a depreciation of the exchange rate that exceeds its long-run level: the famous over-shooting result.

The over-shooting of the exchange rate results from sluggish price adjustments in the goods markets. Exchange rate expectations react faster and force the exchange rate to change in reaction to investors’ shifts in the asset allocation.

The goods market is not cleared until the price adjustment is completed. Output is determined by demand in the meantime. The trade balance may worsen or improve in the short run depending on the change in interest rates and their effect on absorption. In the long run, the trade balance improves and the Mundell-Fleming result applies.

The Mundell-Fleming-Dornbusch framework offers realistic predictions of long-run movements in the exchange rate, interest rate and output following drastic changes in monetary policy. Countries choosing drastic tightening almost always experience real appreciations. As a tool to predict systematic interest rates and exchange rate movements, however, the model does not perform as well (Meese and Rogoff 1983, 1988). Above all, however, the Mundell-Fleming-Dornbusch framework predicts sharp contrasts in the effectiveness of economic policy under different exchange rate regimes. Monetary policy shocks spill over to the real economy only in the flexible exchange rate regime, which led many economists to argue for fixed exchange rates to reduce volatility in real variables. While theoretically appealing, the effect of the chosen exchange rate regime on real variables in an economy is empirically rather limited (Baxter and Stockman 1989).

The strength of the Mundell-Fleming-Dornbusch framework lies in its close connection to policy debates. It is quite flexible and can be applied to various situations to advise necessary policy actions. Yet, as Obstfeld and Rogoff (1996) argue, the approach has several methodical drawbacks: (1) the lack of a micro-foundation particularly of aggregate demand, (2) the lack of private and government inter-temporal budget constraints which make it hard to analyse the dynamics of the current account, and (3) the lack of a natural welfare metric which would allow to compare alternative macroeconomic policies. Obstfeld and Rogoff (1995) have therefore presented a new theoretical framework that preserves the strengths of the Mundell-Fleming-Dornbusch approach but overcomes its limitations.

<< | >>

↑

Source: Faccarello G., Kurz H.-D.. Handbook on the history of economic analysis. Volume III, Developments in major fields of economics. Edward Elgar,2016. — 659 p. 2016

The Keynesian Approach

More on the topic The Keynesian Approach: