4. RESULT AND DISCUSSION 1. Product Mapping
2.1. The Mundell-Fleming Model
Where the traditional IS-LM model deals with close economy, The Mundell-Fleming deals with open economy. The Mundell-Fleming model describes the relationship between the nominal exchange rate and economy output (Young and Darity Jr, 2004). This paper uses this model to render an argument that an economy cannot simultaneously maintain a fixed exchange rate, an independent monetary policy and free capital movement. In the open economy, the equation for the LM and the IS schedules are as follow.
The LM Equation
( ) (1)
The IS Equation
(2)
where (X-Z), net exports, is the foreign sector‘s contribution to aggregate demand. For the IS equation, import is on the left-hand side. It indicates the variable upon which each element in the equation depends. Therefore, the IS equation for open economy can be written as:
( ) ( π) ( ) ( ) (3) Based on equation 3, imports depend positively on income and also depend negatively on the exchange rate ( ) It signifies that a rise in the exchange rate will increase the price of foreign goods and it causes import to fall. According to Froyen (2009), balance of payment equilibrium means that the official reserve transaction balance is zero. The equation for the BP schedule can be written as:
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( ) ( ) ( ) (4) The first two terms in the equation 4 constitute the net export or the trade balance. The third item, which is denoted by F, is the net capital inflow. Net capital inflow depends positively on the spread between domestic interest rate and the foreign interest rate (r - rᶠ). It implicates that a rise in the domestic interest rate relative to the foreign interest rate leads to an increased demand for domestic financial assets at the expense of foreign assets.
Hence, the net capital inflows increase (Froyen, 2009).
2.1.1 The BP Curve in the IS-LM Framework
The BP curve illustrates different combinations of income and interest rate that assure the balance of payment equilibrium (Froyen, 2009). Figure 3 exhibits that the point above the BP curve refers to the balance of payment surplus and the point below the BP curve means balance of payment deficit.
Source: Mankiw, 2013 Figure 3. BP Curve in the IS-LM
Curve
Source: Mankiw, 2013 Figure 4. The Shift of BP Curve
Once there is a change in income (Y*), interest rate (r*), the BP curve will shift in the ISLM framework. Figure 4 shows that a fall of Y* together with an increase of r* will shift the BP to the left (BP‘‘). For a given r, the point at BP shows a deficit.
However, an increase of Y* together with a fall of r* will shift the BP to the right (BP‘). Hence, the BP shows a surplus.
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Source: Mankiw, 2013
Figure 5. The Slope of BP Curve
The slope of BP curve depends on the international mobility level of capital. There are three situations that the slope of BP curve can be. When there is perfect capital mobility, the slope of BP curve is horizontal. When there is no capital mobility, the BP curve is vertical. Moreover, BP curve has positive slope if there is imperfect capital mobility (see Figure 5).
Source: Mankiw, 2013
Figure 6. The Equilibrium in thr Mundell-Flemming Model
Figure 6 shows the equilibrium in the model with perfect capital mobility. This figure shows that the equilibrium in the model is intersection by all three curves that are IS, LM and BP curves. Based on Figure 6, it can be said that when the point is below the BP curve, the balance of payments is deficit. However, when the point is above the BP curve, the balance of payments is surplus.
2.1.2 Exchange Rate Regime: Fixed Exchange Rates versus Flexible Exchange Rates
According to Froyen (2009), the Mundell-Fleming model implies that the effectiveness of national macroeconomic policy depends on the exchange rate system. This is because in an open economy,
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variable that influencing the net export and income is real exchange rate. In practice, it is very rare to see a country uses a fully flexible exchange rate regime. Mostly often, countries choose exchange rate regimes in which exchange rate is somehow controlled by monetary authorities.
In the case of Thailand, the monetary policy is under fixed exchange rates with perfect capital mobility. The policy that had been used by Thailand is no monetary policy autonomy.
Consequently, Thailand sacrificed its autonomy in monetary policy in order to have fixed exchange rate and capital mobility.
Figure 7. The Case of Thailand Figure 8. The Case of Malaysia
Figure 7 reveals that expansionary monetary policy will shift the LM0 to the right (LM1) that leads to an increase of income (Y) and a fall of interest rate (r). As a result, a fall in interest rate will cause a decrease in capital inflow and a balance of payments becomes deficit. In order to keep the exchange rate fixed, central bank sells foreign currencies and cuts money supply. By selling foreign money and receiving back the domestic money, it would reduce real balances in the economy. As a result, the LM curve shifts back to LM0. Accordingly, income falls and interest rate increases to the previous level. In conclusion, the income and interest rate will be constant and monetary policy is ineffective.
In the case of Malaysia, the monetary policy is under fixed exchange rates with imperfect capital mobility. The policy had been used by Malaysia is capital control. Therefore, Malaysia has sacrificed the goal of capital mobility in order to attain its fixed exchange rate and monetary policy autonomy. Figure 8 depicts that expansionary monetary policy will shift the LM0 to the right (LM1) which leads to an increase of income and a fall of interest
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capital inflow and a balance of payments deficit. The equilibrium point shifts from E0 to E1. The rate of interest falls and the level of income rise. The new equilibrium point is below the BP schedule, indicating a deficit in the balance of payment.