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Prepared by Douglas Laxton and Steven Symansky.
The Mundell-Fleming model amends the familiar closed economy IS-LM model with a condition requiring a balance of payments equilibrium. See Dornbusch and Fischer (1978), pp. 627-629, or Mundell (1961) for a diagrammatical exposition of this simple model. While this model has insights for understanding the short-run effects of fiscal policy it does not provide a very adequate framework for understanding the: medium-term and long-term implications of fiscal policy. Indeed, as discussed below, a contractionary fiscal policy that permanently reduces government debt will result in a real exchange rate depreciation in the short ruin and a real exchange rate appreciation in the long run.
The version of MULTIMOD used in this chapter is based I on recent work by Faruqee, Laxton, and Symansky (1995). The revised model, relaxes the assumption that the real interest rate equals the real growth rate of GDP in the steady state. In addition, the revisions make private consumption more responsive to changes in current disposable income.
The same story would hold if government expenditures were reduced for 10 years although the quantitative effects would be somewhat different. In general because government expenditures usually have stronger effects on aggregate demand, monetary conditions have to adjust more in the short run.
In addition, the simulation experiment assumes that the new fiscal plan is fully credible and tax rates adjust immediately. If the public was skeptical that the debt reduction was going to be permanent, the short-run contractionary impulse would be larger and this would necessitate a larger depreciation in the short run. On the other hand, there are cases when policies are announced but expenditure and tax parameters do not change until sometime in the future. When these changes are credible the exchange rate will tend to lead movements in actual fiscal instruments. Indeed, one interpretation of the recent weakness in the U.S. dollar and the decline in U.S. long-term interest rates is that market participants are now expecting large cuts in the U.S fiscal deficit.
For examples of recent work in this area, see Aizerman (1989), Alesina and Tabellini (1989), Bhandari, Haque, and Turnovsky (1989), Alesina, Prati, and Tabellini (1990), Alesina, De Broeck, Prati, and Tabellini (1993), and Bayoumi, Goldstein, and Woglom (1994).
In the context of the Mundell-Fleming model, this would be equivalent to a large downward shift in the world interest rate.
For a discussion of these issues for Canada, see Bayoumi and Laxton (1994) and Chapter 14 in SM/95/81.
The shock is assumed to last for 20 years since in the long run the uncertainty regarding fiscal policy is assumed to be eliminated.
Equation 1 follows from the balance of payments condition that the current account balance (CA) has to be equal to the change in net foreign assets (CA = ΔNFA = NFAt-NFAt-1). If we define g to be the steady-state growth rate of all nominal variables then (NFAt/NFAt-1-1) = g or NFAt = NFAt/(1+g). Substituting this last expression into the CA equation and dividing by nominal GDP produces Equation 1.
Although it is true that the real interest rate sometimes falls below the real rate of growth, this is not likely to be sustainable in the steady state.
The same steady-state results could also be achieved with a temporary cut in government expenditures.
If the shock were induced by a change in government expenditures, instead of taxes, then the long-run appreciation in the real exchange rate would occur earlier. This will also be the case for tax shocks in models where consumption is tied more closely to changes in disposable income. See, for example, Laxton and Tetlow (1992).