Econdiscussion
  • Home
  • Articles
  • About Me

Articles

6. "The Mundell-Fleming Trilemma: Two out of three ain't bad" - The Economist

4/2/2017

0 Comments

 
Synopsis: The last in the series of seminal economics ideas discusses the Mundell-Fleming trilemma, its uses, and whether it actually stands the test of time.

Click here to read the original article.
Discussion:

What is international macroeconomics?

The Mundell-Fleming trilemma is rooted in international macroeconomics, which is the study of policymaking decisions that affect how global economies interact with one another. International macroeconomics deals with issues such as balance of payments, trade agreements, and capital controls.

What is the Mundell-Fleming trilemma?
​

The Mundell-Fleming trilemma is described as the essence of international macroeconomics, according to Michael Klein from Tufts University. It states that, given the choice between monetary autonomy (explained under ‘Context’), free capital mobility, and a fixed exchange rate, an economy can only choose two of them. The trilemma is represented below.
Picture
​Two of the three corners of the triangle can be achieved by any economy; the third must be forsaken. Below is a table showing three different economies and which of the choices they surrendered.
Picture
Forsaking free capital mobility

For example, let’s take an economy that decides to maintain both monetary autonomy and a fixed exchange rate.

Assume the U.K. has its interest rate set at 2% a year, and its exchange rate is at parity with the U.S. dollar, i.e. $1 will get you £1. The U.K. decides to fix its exchange rate such that it is always at parity with the U.S. dollar.
​
Given this scenario, U.S. investors convert $10,000 a day to £10,000 and invest it in the U.K. economy. Now, assume that the Bank of England wants to decrease interest rates in order to encourage British investment in the local economy: the interest rate falls to 1%.
U.S. investors now feel less inclined to invest as much money as their return has decreased by 1%. Thus, they want to convert fewer U.S. dollars into the British sterling, i.e. the exchange rate falls. This is illustrated below.
Picture
Originally, the Bank of England released an amount Ms of the British pound (GBP) in the international markets. The demand for the GBP, indicated by D1, resulted in an exchange rate of $1=£1. When the Bank of England reduced its interest rate to 1%, the demand for GBP fell from D1 to D2. Resultantly, the exchange rate fell to $0.8=£1. Because Britain has chosen to maintain both monetary autonomy (i.e. it will not increase its interest rate back to 2%) and a fixed exchange rate, it has to forsake free capital mobility by decreasing the money supply to Ms’. In other words, it cannot allow the amount of financial capital, including money flows, to be determined by external forces. Now, the exchange rate is back at $1=£1.

Forsaking a fixed exchange rate

If an economy decides it wants monetary autonomy and free capital mobility, it will have to give up control over its exchange rate. Assume that a certain event in the U.K., such as Brexit, has caused panic amongst international investors. They withdraw their financial capital (such as money) due to uncertainty over the future of the British economy, which depletes the U.K.’s reserves of foreign currency. Without the Bank of England’s increasing interest rates to encourage capital influx, foreign reserves stay low. Without these reserves, the U.K. cannot maintain a fixed exchange rate (explained under ‘Context’), and must allow its exchange rate to float.

Forsaking monetary autonomy

If an economy decides to maintain both a fixed exchange rate and free capital mobility, it must forsake monetary autonomy. To maintain a fixed exchange rate, the U.K. must have a certain level of foreign reserves, i.e. it has to ensure that foreign investors are incentivized to invest in the British economy, which would maintain the level of foreign reserves. If it wants to allow capital to move freely between borders, it must set an interest rate high enough to encourage a certain level of foreign investment. In other words, the U.K.’s interest rate must be determined by the amount of foreign reserves it requires to maintain a currency peg.

An example of a currency peg is the Hong Kong dollar, which, since 1983 has been pegged to the U.S. dollar at a rate of US$1 = HK$7.80. Between 1974 and 1983, the Hong Kong dollar was allowed to float. In 1974, the U.S. dollar depreciated, which encouraged capital influx to the U.S., and consequently, capital outflows from Hong Kong. As Hong Kong chose not to stem capital outflows, it had to choose between allowing its currency to float and forsaking monetary autonomy. Until 1983, it chose the former. To read more about the history of the Hong Kong dollar, click here.

The trilemma and the EU

The Euro was first launched in 1992, under the Maastricht Treaty. In order for an economy to participate in the Euro, it had to fulfill six conditions, one of which was to have an interest rate set close to the EU average. In the run-up to the establishment of the Euro, economies fixed their currencies to the Deutschmark (the currency used earlier in Germany) and allowed their capital to move freely across borders. The participating European economies then relinquished monetary autonomy and followed Germany’s interest rate closely. Wim Duisenberg, the head of the Dutch central bank, was dubbed “Mr. Fifteen Minutes” due to the alacrity with which he copied the interest rate decisions of the Bundesbank, the German central bank.

Today we can see the implications of a single interest rate in the EU. For economies that followed Germany’s business cycle back when the Euro was first established, such as the Netherlands, there was little impact of copying Germany’s interest rate. However, for economies that did not parrot Germany’s business cycle, such as Greece and Spain, interest rates were too low during booms, which caused major troubles when their economies faced busts.

After the Global Financial Crisis (GFC), the EU was hesitant to embark upon QE, a policy that necessitated lower interest rates across the common market. Even though it would have helped the suffering PIIGS (Portugal, Italy, Ireland, Greece, and Spain) economies by encouraging domestic investment, Germany voiced its hesitance, stating that it would leave Germany vulnerable to hyperinflation. Determining an interest rate that placates all members of a common market has proven to be nearly impossible.

The history of the trilemma

The first mention of some tension when it comes to international macroeconomic policymaking was by J.M. Keynes, who, in his 1930 essay “A Treatise on Money”, stated that “[preserving]… the stability of local currencies… and [preserving] an adequate local autonomy for each member over its domestic rate of interest and its volume [poses a dilemma]”.

This dilemma (Keynes assumed free capital mobility­) was the basis of Keynes’ criticism of the interwar gold standard: trade imbalances forced deficit countries to raise interest rates and lower wages to stop the hemorrhage of capital, which led to mass unemployment. If surplus economies increased their imports, this problem would be self-solving, but no surplus economy had any mandate to do so.

In the Bretton Woods conference, Keynes proposed a solution in which an international clearing bank (ICB) aids with deficits and dissuades surpluses. Unsurprisingly, this idea faced great opposition from America, which was an economy with a large trade surplus. The ICB was abandoned, but the idea of an international bank aiding deficit countries became the basis for the IMF.

Marcus Fleming was in touch with Keynes when he wrote his paper on the impotence of monetary policy in the face of a fixed exchange rate and freely-moving capital. Independently, Canadian economist Robert Mundell reached a similar conclusion, but was inspired by different circumstances.

Years after the Second World War, there were scarcely any countries that faced rapid and free capital mobility. Canada was an exception: it allowed capital to travel freely through its border with America. Because it valued monetary autonomy highly, it had no choice but to let its currency float from 1950 to 1962.

Maurice Obstfeld, the current Chief Economist of the IMF, was the first one to mention the term “policy trilemma” in a paper he published in 1997. Since then, the trilemma has become a centerpiece of macroeconomic textbooks, and a conversation piece for international policymakers.

Why the trilemma matters

International trade and globalized economic activity became increasingly commonplace after the Second World War. Economies that had to deal with sudden capital flight or influx, or struggled to maintain control over their currency, had to turn to a previously-ignored idea to not only understand why they did not have as much control over their markets as they did before the war, but also to understand how to deal with it and what the opportunity costs of choosing certain policies were.

The Mundell-Fleming trilemma paved the way for conversation about policymaking with reference to international economies. Today, we notice the impact of all policy decisions on global economic activity: divergence in terms of QE policies between the U.S. and Japan might lead to carry trade; China’s maintaining both monetary autonomy and a strongly-managed exchange rate means that it must employ capital controls; the Bank of England’s decision to continue with QE resulted in a depreciation of the GBP.

A criticism of the trilemma
A big critique of the Mundell-Fleming trilemma has been provided by Helene Rey, from the London Business School, who stated that an economy that allows both capital flows and a floating exchange rate will not necessarily have control over its monetary policy. To hear her lecture on why, click here.

Context

1. What is monetary autonomy?

Monetary autonomy denotes a central bank’s ability to choose its policies, especially interest rates, without taking into account the impact of its interest rate on international markets.
If a central bank has to take into account the reaction of international markets due to an interest rate decision, it would be because higher interest rates would encourage investors to purchase local government bonds, leading to capital influx. Alternatively, lower interest rates would lead to capital flight.

2. Why does a fixed exchange require lots of foreign reserves?

A central bank that wants to peg its exchange rate must meet decreased demand for its currency by lowering the stock of its currency in the forex market, and increased demand by increasing the stock of its currency in the forex market.

To increase the stock of its currency, a central bank must buy foreign currency using its own currency. Conversely, to decrease the stock, it must buy its own currency using foreign currency, which means  that it should have a stock of foreign currency to do so.

An economy must have enough foreign currency in its reserves to have the full flexibility to both buy and sell its own currency. Hong Kong, for example, has a large stock of foreign reserves to maintain its peg to the U.S. dollar. For this reason, speculators do not attack the Hong Kong dollar.
0 Comments

“Economics and democracy” – The Economist

16/3/2016

1 Comment

 
Synopsis: How economics has shaped the evolution of politics.

Click here to read the original article. 

Discussion:


This article discusses the history of prevalent economic thought and its effects on politics. Throughout history, politicians have adopted only those economic policies that allow them to stay in power. In this way, a country’s economic issues can be viewed through the “prism of the political structure.”

19th Century:

Political scenario: Wealthy creditors with no real interest in the government were concerned with “maintaining the real value of their money”, as can be seen by the use of the gold standard (explained in Key Terms) and their one allowance of government intervention, through the use of the central bank, to ensure the success of the financial system.

Economic climate: Classical theory dominated economics. Classical theory concerned itself with the self-correcting nature of an economy (explained in Context), and thus reasoned that the government had little place in the free market.

1914 – 1929:

Political scenario: World War I (1914-1918) resulted in the sudden need for ammunition and manpower. The brief respite during the Roaring Twenties was overshadowed by the Great Depression, which began in 1929.

Economic climate: Government intervention, high inflation and debt during World War I destroyed classical theory. Any attempts to rebuild classical theory during the twenties were outweighed by the Great Depression: there was great reluctance by mass democracies to put the strain of the gold standard on the already suffering working class.
​
1930s and 40s:

Political scenario: In the aftermath of the Great Depression, economies did not return to full employment. This was a great cause for concern among politicians, and the worry was carried into World War II.

Economic climate: Popular economist J.M. Keynes focused on government spending to boost demand, and thus, lower unemployment, through the use of fiscal policy (explained under Key Terms). This theory gained traction during World War II, where government intervention increased greatly and unemployment was wrestled down to a manageable level. Welfare states (explained in Key Terms) seemed like a small concession compared to the threat of communism (explained in Context).

1960s and 70s:

Political scenario: The rapid rise of inflation led politicians to believe that the government focus on unemployment was wrong. Middle-class voters, angry at high taxes, were quick to support an economic reform. Reagan and Thatcher adopted new policies quickly, with Europe following later, having been shaken by the scare of Eurosclerosis (explained under Key Terms).

Economic climate: The previously successful Phillips curve (explained under Context) was falling apart. Milton Friedman and his followers thus argued that governments should shift their focus away from controlling unemployment and towards managing inflation through controlling the money supply. Supply-side economics (explained in Key Terms) became popular quickly, as did monetary policy, which led to an active central bank.

1980s and 90s:

Political scenario: The fall of inflation resulted in a reputation boost for central bankers, despite the fact that inflation may have decreased due to China’s entry into the global economy (explained under Context). Reagan's and Thatcher’s reforms were well underway, which led to a rise in the debt-to-GDP ratio.

Economic climate: Reagan's and Thatcher’s reforms meant the recognition of the financial sector as a key player in any economy.

1987:

Political scenario: The riskiness of the system that ensued from the increasing debt-to-GDP ratio encourage central banks to cut interest rates during any period of uncertainty, as was seen on Black Monday.

Economic climate: Economic actors interpreted central banks’ nervous response to a wobbly economy as their “[underwriting of] asset prices”. Buying assets with borrowed money seemed to be the quick and easy way to make fortunes.

1990s:

Political scenario: The end of fixed exchange rates, and along with it, capital controls (explained in Context) made global finance very powerful, as money could easily enter and exit economies and sectors. At the same time, the wealth of the financial sector allowed its key players to fund and win favour of the political elite.

Economic climate: The loss of control over capital flows turned government focus towards dissuading capital flight, while the wealth of the financial sector meant that politics supported economic policy that favoured financial markets.

1980s to 2007:

Political scenario: The threat of communism fell along with the Soviet Union. Center-right politicians who had acquiesced to government regulation during the Great Depression gained political power, while center-left politicians supported more right-wing policies. At the same time, trade-union power fell, partially due to globalization, and partially due to the “relative decline in manufacturing”. Organizing protests became harder when many of its remaining members were dispersed across different jobs in different economies.

Economic climate: Right-wing economic policies such as the freedom for free markets to function with minimal intervention were established. The decline in trade-union power and blue-collar worker votes resulted in the larger economic actors having a greater say in shaping economic policy. It is no surprise that today we see the central banks and other large institutions as the most powerful actors in our economies.

During this time, mainstream economic theory became more micro-based as well as mathematical, despite the rise of behavioural economics.

2008 on:

The aftermath of the Great Financial Crisis has taught us that debt and the financial sector should be more central to macroeconomics and macroeconomic policy. Popular policy focus now is on attacking and trying to prevent the effects of globalization, such as the movement of jobs away from developed economies to countries that provide cheap labor. The problem is that globalization has already happened, and its effects are already underway. What will determine the success of globalization is how the Chinese economy will deal with its financial system and whether the Federal Reserve will withdraw its monetary stimulus effectively.

Just as politicians have always reacted to the economic climate, we may find that our future economic state may be a shift away from globalization and towards nationalism.

​Key terms:

1. Gold standard: A system in which the value of currency is fixed in terms of gold, and could be traded in for gold.

2. Fiscal policy: the process of government spending to stimulate demand (fiscal expansion) or government saving to decrease debt (austerity).

3. Welfare state: Where the state plays a pivotal role in protecting and promoting the economy and its citizens.

4. Eurosclerosis: A term coined in the 70s by Herbert Giersch to describe the state of stagnation in Europe that may have resulted from over-regulation by the government.

5. Supply-side economics: also known as “trickle-down economics” and “Reaganomics” – the latter due to Reagan’s active promotion of supply-side economics – argues that production is the most important determinant of economic growth. For this reason, investors and businessmen should face less barriers to production and investment through lower taxes.

Context:

​1. Classical theory: The self-correcting nature of markets was first alluded to by the father of Classical theory, Adam Smith. The idea is that prices adjust themselves and equilibrium is regained in the economy.
Picture
Suppose this is the market for a good X. Initially, the supply of X is denoted by S, and the demand denoted by D1. The resulting price P1 and quantity Q1 is shown by the intersection of D1 and S at equilibrium point A.

Now, demand for X increases to D2. At the original price P1, more of X is demanded, resulting in quantity demanded Q3. This is point B. Seeing the increase in demand, suppliers increase the price of X to increase their profits. Now, fewer people can afford the good, but enough people still want more of the good that suppliers feel like they can increase the price. Still fewer people can afford the good, but suppliers can still increase the price. This process, indicated by the red arrows, continues until the economy adjusts to a new equilibrium C, where all the demand is met by supply. Classical economists refer to this as the work of the invisible hand, guiding the economy from one equilibrium to another.

While the theory of the invisible hand is often attributed to Adam Smith, Smith used it as a term to
discuss international trade, and did not mean it to be the process described above. Still, Smith, along with other classical economists like David Ricardo and John Stuart Mill, believed the economy to be self-correcting.

2. Why would the presence of a welfare state result be a small price to pay in the face of the threat of communism? During the Great Depression, it is the democratic countries that suffered, while communist countries seemed to be fairing better. To ensure that communism does not dominate democratic countries, the government had to ameliorate the economic situation by being heavily involved in the economy.

3. To learn more about the Phillips curve and its failure in the U.S. economy, read my article here.

4. Why did China’s entry into the global economy decrease inflation? Not only were cheap goods and services provided by China, but so was cheap labor. For this reason, costs of goods, services and labor fell around the world, resulting in decreased inflation.

5. Why would the end of the fixed exchange rate system lead to the end of capital controls? Under a fixed exchange rate regime, high levels of reserves are needed to keep the exchange rate from fluctuating. For example, Hong Kong needs high levels of reserves for its currency to remain pegged to the U.S. dollar. If, for some reason, Hong Kong becomes less appealing to investors, the demand for the Hong Kong dollar will decrease, and the reserves will deplete. Capital controls are needed to make sure sudden capital influx or capital flight does not deplete the reserves, and thus, the exchange rate.
1 Comment

    Categories

    All
    Abenomics
    Adam Smith
    Adverse Selection
    Ageing
    Amazon
    Arrows
    Arthur Okun
    Asset
    Asymmetric Information
    Ben Bernanke
    Booms And Busts
    Braess' Paradox
    Brazil
    Bretton Woods
    Brexit
    Bubble
    Bull Market
    Business Cycle
    Capital Control
    Capital Flows
    Capital In The Twenty First Century
    Capital In The Twenty-First Century
    Carry Trade
    Causation
    Central Bank
    China
    Christopher Sims
    Classical Economics
    Consumption
    Counter-cyclical
    CPI
    Creative Destruction
    Crisis
    Daron Acemoglu
    David Cameron
    David Ricardo
    Debt
    Debt-to-GDP
    Deflation
    Deleverage Cycle
    Demography
    Devaluation
    Developing Economies
    Development
    Diffusion
    Diminishing Returns
    Dominant Strategy
    Dominated Strategy
    ECB
    Economic History
    Economic Theory
    Equality
    Equitity
    Equity
    Equity Investments
    EU
    Exchange Rate
    FDI
    Fed
    Federal Reserve
    Finance
    Financial Crisis
    Financial Instability Hypothesis
    Financial-instability Hypothesis
    Financial Times
    Fiscal Multiplier
    Fiscal Policy
    Fixed Exchange Rate
    Fleming
    Floating Exchange Rate
    Free Market
    Free Trade
    Freshwater
    Game Theory
    GDP
    George Akerlof
    Germany
    GFC
    Gini Coefficient
    Global Financial Crisis
    Globalization
    Government Intervention
    Government Spending
    Great Depression
    Growth
    Heckscher-Ohlin
    Helene Rey
    Hyman Minsky
    ICOR
    Illiquid
    Immigration
    Income
    Inequality
    Inflation
    Infrastructure
    Innovation
    Interest Rates
    Investment
    Italy
    James Robinson
    Janet Yellen
    Japan
    Jean Tirole
    J.M. Keynes
    John Nash
    Keynesian Economics
    Labor
    Lawrence Summers
    Leverage
    Lindau
    Liquid
    Malaysia
    Managed Exchange Rate
    Mario Draghi
    Matteo Renzi
    Michael Spense
    Minsky Moment
    Mixed Strategy
    Monetary Policy
    Monopoly
    Monopsony
    Moral Hazard
    Mundell
    Mundell-Fleming Trilemma
    Nash
    Nash Equilibrium
    Nigeria
    Nobel
    Nobel Laureates
    Nobel Prize
    Paul Krugman
    Paul Samuelson
    Perfect Information
    Phillips Curve
    Politics
    Poverty Traps
    Principal Agent Problem
    Prisoner's Dilemma
    Productivity
    Protectionism
    QE
    Qualitative Easing
    Quantitative Easing
    Redistribution
    Regulation
    Retrenching
    Rich
    Risk
    Robert Shiller
    Saltwater
    Saving
    Secular Stagnation
    Shiller
    Shinzo Abe
    Signaling
    Stakeholders
    Stolper-Samuelson Theorem
    Strategy
    Subsidies
    Tariff
    Taxation
    Taxes
    The Economist
    The Market For Lemons
    Theory Of Comparative Advantage
    Thomas Piketty
    Total Factor Productivity
    Trade
    Trilemma
    UK
    Unemployment
    U.S.
    USD
    Wage Benefits
    Wages
    Wealth
    Wealth Effect
    Wolfgang Stolper
    WTO
    Yuan

    Author

    JANANI DHILEEPAN
    A gap year student trying to explore real-world economics

    Archives

    May 2018
    February 2018
    January 2018
    December 2017
    November 2017
    April 2017
    February 2017
    December 2016
    October 2016
    September 2016
    August 2016
    July 2016
    May 2016
    March 2016
    January 2016
    November 2015
    September 2015
    August 2015
    July 2015
    June 2015
    April 2015
    March 2015
    February 2015
    January 2015
    December 2014
    November 2014
    October 2014
    September 2014

    RSS Feed

Proudly powered by Weebly