Generally, Mundell-Fleming model states the impossibility an economy to sustain a fixed exchange rate system, liberalized trade and self-sufficient monetary regime altogether (cited in Cardona, unknown). Also known as impossible trinity, this implication of the model assumes that domestic and international interest rates are equal. Aside from the model, it should be noted that there are political and economic influences such as maintaining a strong currency ideology that motivates an economy to adapt a certain exchange rate system.
Bolivia is a small and open economy that is recovering from a debt crisis in 1980s (cited in Cardona, unknown). Under the crawling peg exchange rate system that the country adopts at that time, the model explains the inability of money supply to be moved because it has to follow dollars. The role of Central Bank is limited to auctioning of dollars in a daily basis to devaluate the boliviano. To prevent unemployment and slowdown in economic growth, the boliviano must follow the semi-fixed exchange rate system.
On the revise side, Mexico experienced crisis under fixed exchange rate system (cited in Cardona, unknown). The model predicts the inability of the currency to survive in the long-run under such system. The Mexican currency aimed at appreciation but ended in overvaluation. In this reason, Mexico should adopt flexible exchange rate system as increase in money supply (e.g. the cause of revaluation) can lead to lower domestic interest rate than global interest rate. As a result, devaluation and normalization of the currency can happen.
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The implication of the model which is the impossible trinity of fixed exchange rate system, liberalized trade and self-sufficient monetary is relevant between US and China currencies (Stockman, 2000). Both economies are large which enables them to capture the characteristics of IS-LM model (e.g. autarky) and Mundell-Fleming model (e.g. small open economy). This makes them independent and very flexible on what exchange rate system would be employed. For example, with pressures of revaluation of RMB from US authorities, the Chinese Government refused to do so in the grounds that it can cause lack of confidence and impression of conceding to the US from Chinese citizens.
The RMB, especially in the pre-floating system, has captured a fixed rate system, exponential global trade intervention and autocratic monetary authorities at the same time. This shows how the impossibility of trinity is relevant to the discussion of RMB especially when China assumes a conservative position regarding external trade to its economy. On the other hand, the US Dollars would not dare to assume a fixed rate stance simply because virtually all currencies are pegged to it.
Government ideology can serve as ultimate answer of Chinese authorities in their action to introduce fixed exchange rate system from 1995-2005 (Stockman, 2000). However, economic ends also motivated Chinese authorities to use fixed system. It is meant to allow increasing trade (e.g. export and import) that the country houses from 1998-2003 and the aim to stabilize the current account balance throughout those years. China is aware that beyond 1995 expels promising economic improvements particularly in trade liberalization efforts.
In a study about the period1995-2005, it is proved that the fixed exchange rate system aided in the increase of Chinese income and price export elasticity (Garcia-Herrero & Koivu, 2007). This means that any change in income of Chinese workers as well as prices of export commodities can lead to substitution effect from importing countries.
The significance of these findings is that through the fixed exchange rate system Chinese economy resisted the influx of foreign direct investments that are made to modify the country’s balance of payments in risky terms. To avoid dissolution of Chinese power in the minds of the population, the Government opt to fixed its exchange rate to prevent bowing to other currencies in the event of excessive trade and volatile net economic results.
U.S. Mortgage Crisis
Virtually all economic actors in the US mortgage industry contributed to its collapse in 2006 (Dupuis, 2007). The increasing value of homes lured non-owners to borrow excessively beyond their capabilities while existing owners borrowed by using their properties as collaterals. On the other end, lenders saw this scenario as opportunity to profit making them insensitive to creditworthiness of debtors. Wall Street is also blamed for its contribution in carrying trade with outsiders (e.g. Japan) through ripping-off loans in foreign markets to finance the needs of mortgage companies, banks and lender.
Lastly, and obviously the obvious conduit of mortgage crisis, is the lack of government intervention in housing sector. As a result of these actions, sub-prime mortgage financial crisis inflamed that led to home foreclosures as interest rate rise and impacting reduction of supposedly rising house values. The buyers of home did not have sufficient liquidity to solve their credit to lenders. In effect, the lenders run to investment funds which in turn run to foreign markets and back to the US financial sector to address the credit problem.
There are ways to mitigate the crisis. First, the Central Bank can conduct open market operations to increase the chance of banks to access liquidity particularly short-term borrowing. Second, homeowners and lenders can settle win-win terms in which the original contract can be modified based on the preference of one another. Third, as prevention scheme, credit rating agencies can aid in creating an environment of transparency in the mortgage industry to prevent the same crisis in the future. Lastly, authorities can contribute favorable legislations in lending methods, bankruptcy security and tax rate plans.
The White House can intervene by improving the legal environment of which the mortgage industry can reduce substantial risk. It can legitimize and support the media role in making the industry reports and practices more transparent. This will not only create a less risky mortgage environment but also make it more competitive in the global business.
The argument of President Bush is somewhat disciplinary as the profit-orientation of lenders is a clear manifestation of lack of public responsibility. In effect, the Government may have the option to disregard the plea of the lenders as they are faced with bankruptcy and non-performing loans. However, such argument does not mean to disregard the role of the Government in the mortgage industry and the White House should do its best to help lenders.
The Fed, as mentioned earlier can execute open market operations to increase liquidity in the banking sector which in turn will provide liquidity to lenders to ease the credit difficulty in the mortgage industry (Andrews, 2007). They can also affect money supply to affect interest rates and redeem the confidence of existing and potential homeowners about their abilities to pay their debts. However, this should be done gradually in order to make economic entities responsible for the crises remember the tragic cause of their risky actions.
The statement of the Fed Chairman is also coinciding with that of President Bush. He too is a disciplinary authority that lenders and investors in the mortgage industry may not appreciate in these difficult times. However, the penetrating open market operations may not seem a direct intervention to ease the needs but the effects will trickle down to small entities in the long-run.
The mortgage crisis must be applied with active policy in the short-run particularly in addressing the liquidity needs of bigger banks that ensures the solvency of smaller banks that serve as lenders to homeowners. The crisis is made by lack of experience of the sector in doing excessive speculation and craves for high priced assets.
This excuse should be considered by authorities if it wish to minimize economic problems that the mortgage sector can further apply. This act should be conducted through discretion and not by rule because the rule sometimes misinterprets the real world. Discretion from monetary authorities (e.g. by involving in open market operations) and fiscal authorities (e.g. by legislating pro-crisis preventive laws) should be initiate to save not only the sector but the whole economy as well.
Andrews, E. (2007). US Congress split on solution to sub-prime crisis. New York Times.
Cited in Cardona, R. (unknown). Aggregate demand in the short-run: The Mundell-Fleming Model.
Dupuis, F. (2007). Impacts of the US Mortgage Crisis. Available in www.desjardins.com/economics
Garcia-Herrero, Alicia and Tuuli Koivu, 2007, “Can the Chinese Trade Surplus Be Reduced through Exchange Rate Policy?” BOFIT Discussion Papers No. 2007-6 (Helsinki: Bank of Finland, March).
Stockman, A. (2000). Exchange rate systems in perspective. Cato Journal, vol. 20, no. 1.
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