### 21.1 Basic principles and assumptions

At the core of the Mundell-Fleming model is the balance of payments (BoP) equilibrium, i.e. the ex post equilibrium according to which every international transaction of goods is paid for. If goods or services are exported or imported, it is recorded in the current account. Payments are recorded in the capital account. The sum of the two is called the balance of payments and must be even (apart from balancing items, see below), as each transaction is recorded on both sides "delivery" and "payment" (this can also be a debt or credit).

With flexible exchange rates, the balance of trade is kind of automatically balanced. On the foreign exchange market, if there is a trade balance surplus, the supply of foreign currency is greater than the demand. The domestic currency appreciates. As the external value of the domestic currency increases, domestic goods become more expensive abroad. Exports fall and domestic growth is impaired. At the same time, however, imports become cheaper. Falling import prices have a moderating effect on the domestic rate of price increase and thus support economic development.

Since the early 1990s, the USA has had a substantial current account deficit. Despite flexible exchange rates, the compensation that takes places via the foreign exchange market is apparently not sufficient. Contrary to the textbooks, the dollar has not depreciated in the long run. Obviously, other factors influencing the exchange rate have been more significant, but they did not bring about the compensation of the current account deficit.

In the Mundell-Fleming model, the relationship between exchange rate and BoP equilibrium is controlled by the reactions of the international capital market and the real competitive position of a country. The responsiveness (interest rate elasticity) of international investors is finite, i.e. interest rate differences lead to limited capital transfers. The exchange rate adjusts so that the value of foreign currency inflows multiplied by the exchange rate equals the value of outflows. Export surpluses thus represent an increased demand for the domestic currency and thus lead to appreciation pressure.

##### Current account, capital account, balance of payments

The balance of payments consists of four sub-balance-sheets: the current account (LB), the capital account (KB), the capital transfers account (BV) 1 and the statistical residual item (sR). Within the framework of the MF-model, we will restrict ourselves to the current and capital account. Because on the one hand, the other two items are generally relatively small and, on the other hand, we assume that they are exogenous with regard to the dynamics of the MF-model, i.e. they can be treated as constants. Since the statistical residual item (also the balance of unrecorded transactions) is defined as an adjustment item, ex post the following identity is always valid:

 $\mathit{LB}+\mathit{KB}+\mathit{BV}+\mathit{sR}=0$

The current account2 consists of the trade and services balance, which contains all exports and imports of goods and services including additional and transport costs, the acquisition and capital account (primary income)3 and the current transfers balance (secondary income)4.

 $\text{LB=}\underset{\text{Handelsbilanz}}{\underbrace{\text{Warenhandel}}}+\underset{\text{Dienstleistungsbilanz}}{\underbrace{\text{Dienstleistungen}}}\text{+Primäreinkommen+Sekundäreinkommen}$

The capital account records the inflows and outflows of payments from exports, imports and capital transfers (usually for investment purposes at home or abroad) and changes in foreign exchange holdings in the foreign exchange balance.

 $\text{KB=Direktinvestitionen+Wertpapieranlagen+Finanzderivate+ÜbrigerKapitalverkehr+Währungsreserven}$

For the Mundell-Fleming model, we will concentrate on the illustration of the trade and services balance within the current account and will not differentiate the capital account in most cases, but only use the overall effect.

 $\mathit{LB}+\mathit{KB}=0$

A positive value of the current account indicates an export surplus. A positive value of the capital account indicates a net capital import. The above identity – which is generally always valid, independently of any model – shows a particularly important and often ignored fact:

Being the export world champion therefore also means being the world champion in exporting capital. This can be easily illustrated with an example:

1. A car is sold to the USA (=export of goods)
2. Payment is made in US$to an account or cash. This corresponds to a claim on the USA, which means it is capital that belongs to D but is located in the USA. (= export of capital) 3. In order to bring back the capital to D, either something must be bought from the USA with the$ (= import of goods) or the \$ must be exchanged for , i.e. set off against a claim on D which originates from a previous import (US goods against ).

Hence, politicians who first (sometimes even in one and the same speech) celebrate German exports and then demonize capital exports show that they either have no idea what they are talking about or that they want to deceive the citizens.

##### Current account imbalances since the 1990s

At the beginning of the 1990s, individual countries developed large and persistent current account imbalances and this trend has worsened since the end of the 1990s. While some countries have persistent current account surpluses, others have almost permanent current account deficits. These structural and permanent trade imbalances are seen as one of the causes of the global economic and financial crisis as well as the European crisis. Although the EU as a whole shows a nearly balanced external trade, there are strong imbalances within the EU. In the last three years, for example, Germany annually exported 250 billion  more in goods than it imported. In order to limit these imbalances, the EU has introduced the MIP (macroeconomic imbalance procedure), under which macroeconomic imbalances are monitored and assessed. If required, the states must work to reduce these imbalances. Outside the eurozone, in particular the USA, with current account deficits of up to 6% of GDP, and China and Japan, with permanent high surpluses, stood out.

Current account imbalances are not bad per se. If they arise in free markets without being induced by political or exogenous shocks, they are the result of different savings, investment and consumption preferences of countries. However, they do become a problem,

1. if the market processes are massively distorted by policy measures, for example in the case of exchange rate manipulation or unilateral export promotion, e.g. through the tax and customs system, subsidies or trade barriers.
2. if the deficits are permanent, so that there is a risk of over-indebtedness.
3. if competitive differences within a monetary union are no longer balanced.

This is where the failure of politics within the EU is particularly evident. Even after the start of the monetary union, many countries acted as if they still had their own currencies as a compensatory instrument. While in Germany - mainly due to the Hartz-laws - unit labor costs fell by 6%, in Greece they rose by almost 10%. Thus, the relative competitive advantage for Germany increased by 15%, resulting in an increase in both the current account surplus of Germany and the current account deficit of Greece. Since no real depreciation can take place within the monetary union, the only remaining option to solve this structural problem are rising wages in Germany or falling wages in Greece.

1The capital transfers account includes mainly gifts such as debt relief and payments on intangible non-produced goods like royalties.

2see German Central Bank: https://www.bundesbank.de/Redaktion/DE/Dossier/Statistik/zahlungsbilanz.html?notFirst=true&docId=172974

3These include, in particular, cross-border income from employment and interest- and dividend-payments.

4This includes, primarily, payments by the state to international organizations and development aid, as well as remittances by foreign workers to their home country which are not matched by any direct output.

(c) by Christian Bauer
Prof. Dr. Christian Bauer
Chair of monetary economics
Trier University
D-54296 Trier
Tel.: +49 (0)651/201-2743
E-mail: Bauer@uni-trier.de
URL: https://www.cbauer.de