Tuesday, March 8, 2016

The Mundell-Fleming Model and Republican Economics

As Paul Krugman has some fun with Republican brands of macroeconomics, I wish he would spend just a little time using the old fashion Mundell-Fleming model to succinctly analyze what their various ideas would entail. Let’s start with Ted Cruz monetary policy:
True, Ted Cruz is alone among the top contenders in calling explicitly for a return to the gold standard — you could say that he wants to Cruzify mankind upon a cross of gold.
Cruz wants to raise interest rates right now which of course could lead to a recession. If we do not also adopt fixed exchange rates, this could lead to a further appreciation of the dollar which would further reduce net exports. I say further as the dollar of late has appreciated quite a bit with the predictable fall in net exports. The latest, however, is the call of protectionism via Donald Trump:
establishment Republicans may talk free trade, but they are if anything more protectionist than Democrats in practice (although neither party is seriously protectionist these days.) Remember, it was Bush, not a Democrat, who imposed a WTO-illegal steel tariff, then had to back down in the face of European pressure. And going back, remember that Reagan, not Carter, imposed import quotas on Japanese cars.
Krugman writes about how a trade war might leave net exports unaffected on net. Even if we did not have a trade war, the Mundell-Fleming model predicts a similar result. Yes we restricted imports of Japanese automobiles in the early 1980’s but that likely further appreciated the currency even on top of Volcker’s tight monetary policy. What happens if we adopt the fiscal stimulus advocated by both Democrats running for the White House?
The exchange rate appreciates and the trade balance worsens until the initial increase in G is completely offset. The IS curve is pushed back to the original position, and Y cannot increase at all.
OK – this is the textbook answer that assumes both floating exchange rates and an upward sloping LM curve. If the Federal Reserve sensibly ignores Ted Cruz and keeps interest rates low, then maybe we can avoid a massive appreciation of the dollar. We would still get a fall in net exports as the economy improves but this translates into stronger net export demand abroad. Of course we could go with the Republican idea of balancing the budget which would lower our trade deficit by creating a recession and at the same time reduce net export demand abroad.


kevin quinn said...

Interesting. Of course, in the MF model, fiscal expansion can be effective in a Cruzian fixed-exchange rate regime - since the Fed is forced to increase the money supply to maintain its peg in the face of upward pressure on the exchange rate. Ted just wants a a more efficacious fiscal policy, don't you know.

Jack said...

I only want to point out that the issue of Japanese auto imports in the 1980s was very different from the issue of trade today, as exemplified by trade with China. The Japanese auto industry was not based on exploited labor. They used better manufacturing techniques to lower the cost of their cars. They produced cars that were far more fuel efficient and, therefore, more desirable. And when their auto industry matured, so to speak, they moved their production into the US, not out. The Chinese import phenomenon is based on labor exploitation and was initiated by American corporations looking for a cheaper source of labor.