International Economics and Mundell-Fleming Model: Case Study of Brunei and Bhutan - Essay Example

? International Economics and Mundell-Fleming Model: Case Study of Brunei and Bhutan Introduction Brunei and Bhutan had difference exchange rate policies as they resolved to join the global financial market. While Brunei anchored its financial regime on the principles of fixed exchange rate, Bhutan had a regulated flexible system of exchange rate. Nevertheless, both countries have since recorded current account deficits due to the excess savings in India which in turn triggered global liquidity abundance in the world economy. This paper, therefore, explores the Mundell-Fleming model in providing a theoretical rationale for the existence at the current account imbalances experienced by Brunei and Bhutan, following their resolution to join the global financial market. Mundell-Fleming model and open economy Primarily, it must be comprehended that the Mundell-Fleming model revolves around the pillars of an open economy including nominal exchange rate and interest rate, and how such relationship determine the income or output of a given economy. With that in mind, economic scholars postulate that no economy can possibly preserve an independent monetary policy in the presence of a financial regime characterized by either fixed exchange rate or free capital movement (Krugman, Obstfeld & Melitz 2011, p.136). As a result, the Mundell-Fleming model ascertains that any attempts to maintain such conflicting financial systems would not survive the dynamic global financial forces. According to Foote (2011, p.51), the strength of every economy depends largely on its Gross Domestic Product, nominal money supply and price levels. All these complementary elements are determinant factors in setting the monetary and fiscal policies including financial exchange rates and nominal interest rates. It is, therefore, possible that external forces, such as those presented by the global financial market, are bound to impact on the performance of a local economy, as argued by the proponents of Mundell-Fleming theory (Copeland 2008, p.15). Such include export prospects, foreign investment extrapolations, as well as the liquidity preference in real money demand. Mundell-Fleming model in the case of Brunei and Bhutan In line with modern economic theories, Mundell-Fleming model is based on the concept of IS-curve, where GDP equals the summation of consumption spending, investment, net exports and government spending. Moreover, the model takes into account the LM-curve where high interest rate or low GDP decreases the liquidity preference: M/P = L(i,Y) described by Waelti (2001, p.3). Considering that the supply and demand of money depends on the price levels, and that price levels are determined by GDP and exchange rates, it follows that an increase in exchange rate will lead to decrease in money supply. However, when the exchange rate is fixed, output remains relatively stable (Copeland 2008, p.63). Besides, high exchange rates are generally responsible for increased importation of foreign commodities at the expense of reduced net exports. This translates to higher consumptions spending and less physical investment spending. Thus, an economy with flexible exchange rate is bound to experience increased investment spending and higher income if it lowers its exchange rates in line with global money market demands (Foote 2011, p.17). The reverse is true if the country increases its exchange rate with changes in world economy. In that case, increase in exchange rate decreases net export which, in turn, shifts the planned expenditure downwards. The interaction results in decreased income among small economies that have imperfectly integrated. On the contrary, a fixed exchange rate would mean that a country has to find an alternative to cushion its investment prospects amidst fluctuating global financial activities. As such, reduction in real money demand for domestic currency results in higher expenditures of central bank in buying foreign currencies at the promised fixed rate. In addition, a country will have to trade at a fixed exchange rate even if the global market is increasing its demand for the local currency (Copeland 2008, p.75). This creates an economy with increased consumer spending but stunted output, leading to current account imbalances. In trying to cope with pressure on the local currency to depreciate beyond the set level, the local authority of Brunei was forced to increase its foreign reserves so as to sustain the fixed exchange rate, as reiterated by Krugman, Obstfeld and Melitz (2011, p.142). On the other hand, Mundell-Fleming concept suggests that an imperfect capital flow, as in the case of Brunei, will result in an upwardly aligned balance of payment since nominal money supply M cannot be exogenous in a fixed exchange rate regime. Therefore, fluctuations in the global exchange rate created upheavals for either capital inflow or outflow until the restoration of the desired equilibrium. With that in mind, Foote (2011, p.18) contends that the central bank of Brunei could not manage to fix the nominal money supply in an open global economy as illustrated in Figure 1. Since the central bank of Brunei has promised to trade at a fixed exchange rate, the arbitrageurs return all excess local currencies to the central bank to the looming M pressure on the pre-determined exchange rate. Thus, nominal money supply is kept at par. Eventually, the output of Brunei returns to its original level in the long run as in Figure 1(b). In addition, reduced foreign interest rates implied that the domestic currency of Brunei remained stronger (Copeland 2008, p.81). Meaning, the domestic import trade increases due to reduced global interest rates yet the Brunei economy cannot withstand increasing pursuits of foreign investors into the country. The result is that Brunei winds up the local currency, thus, increasing inflation. At that point the trend makes local commodities quite expensive and less competitive in the foreign market. The events ultimately impair performance of Brunei exports, which in turn increases its foreign debts and government expenditure (Waelti 2001, p.6). In the long-run, Brunei’s BoP becomes negative leading to the observed current account deficit. Figure 1: Monetary expansion under fixed exchange rate regime On a different note, the exchange rate system adopted by Bhutan was subject to the law of supply and demand in the currency market. In that light, the financial economy of Bhutan aligned itself to the prevailing foreign exchange rate where the balance of payment curve would ordinarily be horizontal at equilibrium price level (Copeland 2008, p.82). However, the economy of Bhutan was still imperfectly integrated into the global financial market as to effect any notable impact on the overall world economy. As a result, the financial performance of Bhutan remained a subject of the neighbouring economies. Notably, excess savings in Asia impacted the international economy with an overall reduction in foreign exchange rates. At the same time, the effect triggered the liquidity preference with perfect capital mobility across the world economy. It follows, therefore, that the floating interest rate of Bhutan also decline with a similar shift, provoking local investors to pursue foreign investment. Considering that an increase in foreign investment increases the expenditure of local currency, which in turn results in reduced availability of the local currency. Conversely, foreign investment increases capital outflow which enhances the need to appreciate the local currency so as to accommodate the high money demand. In addition, central bank must cooperate with other foreign governments to protect its physical investment and local industries. Combining these events, the money market becomes favourable for imports. Thus, foreign commodities become cheaper thereby increasing foreign capital inflow in Bhutan economy in line with the argument presented by Krugman, Obstfeld and Melitz (2011, p.159). Taking into account that the financial dynamics in Asia had caused a reduction in global interest rates, Bhutan took advantage of the cheap imports to support the home economy. This is because the reduced global interest rates generally prompted an increase in consumption expenditure and reduced export trade (Foote 2011, p.27). Locals tended to accumulate more foreign currencies to purchase imports. As a result, the country imported more that its exports owing to the fact that the local goods were renders more expensive at a time when the world economy shifted in favour of foreign trade. Translating the observed changes into the Mundell-Fleming model, a decrease in global interest rates decreased the foreign exchange rate as well. Thus, the Bhutan IS curve intercepted the LM curve at a lower point which, in turn, necessitates an increase in nominal exchange rate. The effect increases output in the short-run. Furthermore, continued foreign capital inflow increases pressure on the demand for local currency of Bhutan. As a result, liquidity preference thereof bids up the domestic exchange rate e (Copeland 2008, p.30). Recall, high nominal exchange reduces net exports NX, as well as output Y. If this condition persisted over an extended period of time, the domestic interest rate r is pushed back to the prevailing foreign interest rate r*. Since Bhutan has imperfect capital mobility within the Asian economy, the ultimate result continues to reduce net exports back to the original BoP equilibrium interception. In that way, income Y remains constant with reduced net export and increased import (Waelti 2001, p.5). The concept explains an imbalance in BoP. Where the capital account KA is greater than BoP; current account CA becomes negative, hence, the current account deficit experienced in Bhutan. References Copeland S., 2008. Exchange Rates and International Finance. (5th Edn), Pearson Education. Upper Saddle River, NJ. Foote C., 2011. Open Economy Revisited: Mundell-Fleming Concept in Floating and Fixed Exchange Regimes. Harvard University Press, Cambridge, MA. Krugman R., Obstfeld M., & Melitz M., 2011. International Economics: Theory and Policy. (9th Edn), Addison-Wesley Publishing Group, Boston, MA. Waelti M., 2001. The 2-country Economy: Mundell-Fleming Model. MIT Press, Cambridge, MA. Read More