Monetary Policy In Switzerland: Applying The Mundell Fleming Model

1289 words - 6 pages

The continuous internationalization of capital markets has risen the concern about its implications on conducting macroeconomic policies (Pilbeam, 2013, p.74). A possible predicament is the impossible trinity, or the tenet that a country can only pursue two of the following three options: perfect capital mobility, fixed exchange rates, or autonomous monetary policy (Shambaugh, 2004, p. 302). Nevertheless, as of September 2011, Switzerland has attempted to pursue all three options, by continuing an expansionary monetary policy after adopting an exchange rate floor of 1.20 CHF per euro (IMF, 2013, p. 5). In theory, this policy should be rendered ineffective given Switzerland’s perfect capital ...view middle of the document...

475). The second assumption states that the price level is fixed (Mundell, 1963, p. 476). In the analysis, Mundell included three different schedules: the IS schedule, showing the combinations of interest rate and income that equilibrate the goods market; the LM curve, relating rates of interest and output that balance the money market; and the BP schedule, which represents the Balance of Payments and is in this case horizontal because of perfect capital mobility. The model is in equilibrium when the three schedules intersect (1963, p. 483). Then, according to the Mundell-Fleming model, a monetary expansion (here defined as an increase in M1) under a fixed exchange rate regime will put downward pressure on the domestic interest rate which will result in capital outflows, shifting the LM curve to the right (Pilbeam, 2013, p. 90). Then, to prevent depreciation, the central bank will have to buy domestic currency until the accumulated foreign deficit equals the initial expansion, so that the LM curve will return to its original position (Mundell, 1963, p. 479). Thus, a monetary expansion only affects the composition of the central bank’s assets, so that there is no substantial effect on output (Mundell, 1963, p. 479).
First of all, one should assess whether the Mundell-Fleming model can be used in the case of Switzerland. Indeed, according to Bäurle and Kaufmann, Switzerland is not only a small open economy, but also has had low inflation rates, thus fulfilling the two assumptions in the model (2013, p. 12).
In the case of Switzerland, however, there was a substantial effect on output: real GDP increased by 1% from 2011 to 2012 (OECD). Superficially, this does not only contradict the Mundell-Fleming model but also multiple studies (e.g. Shambaugh, 2004; Ramírez, 2001). The crux to this paradox is that the monetary expansion was not as autonomous as the policy declaration implied. First of all, the SNB initiated and continued an expansionary monetary policy because the Swiss franc had appreciated sharply against the euro since 2007 (Humpage, 2013, p. 2). This posed a threat to the Swiss economy: the appreciation would result decreasing demand for Swiss goods and thus downward pressure on the price level, so that there was a significant risk of deflation (SNB, 2011). In order to forego this threat, the Swiss national bank engaged in non-sterilized interventions, which allow the money supply to almost double in size (OECD, 2014). Then, in early 2010, the sovereign debt crisis worsened considerably and Switzerland was subject to ‘safe haven’ capital inflows which caused the franc to appreciate even more (Humpage, 2013, p. 3). This appreciation continued despite several sterilized interventions by the SNB, which do not affect the money supply but only affect its composition of foreign and domestic assets (Pilbeam, 2005, p. 378). Renewed efforts to spur the depreciation of the Swiss franc using non-sterilized interventions also proved to not have a...

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