Mexico in the World Economy Robert Mundell Columbia University

1. Mexico in the World Economy Robert Mundell Columbia University Universidad Autónoma de Baja California Tijuana, México September 27, 2007

2. I. Global Megatrends

3. Global Megatrends • Globalization • IT Revolution • The Euro • Rise of China • US and Global Governance

4. Currency Areas, 2007 ¥ Russia Canada U.K. Sweden Korea $ Taiwan RMB Hong Kong Gulf Countries A India Mexico Singapore Brazil CFA Latin American & Caribbean Nigeria A$

5. $ Plaza Accord

6. ¥-$ Rate and the Asian Crisis Asian Crisis

7. Should the RMB float? • Wrong Question! An Oxymoron! • Flexible Exchange Rate not a monetary rule. It is the removal of a monetary rule. Flexible rates are consistent with hyperinflation. • Correct Question: Should China’s fixed exchange rate monetary rule be replaced by an alternative monetary rule?

8. Choice of Monetary Rules • Exchange Rate Target? • Inflation target? • Money supply target? Which is better for China?

9. Observations • Since 1997, China has achieved better price stability by targeting the dollar than any other major country by “inflation targeting”. • The major countries include the United States, the Euro area, Chile, Mexico, Brazil, U.K., or Russia.

10. China should not float China’s policy of targeting the dollar has given the Yuan an anchor, and policy-makers a rudder for determining the best policy mix. An adequate case has not been made for changing that system. As long as the dollar is stable in terms of the US price level, China should maintain its current policy.

11. Asian Currency • Asia is considering the formation of an Asian Monetary Area. • Would help insulate the area against G-3 Instability. • Would eliminate competitive devaluation within the area. • Would enhance Asia’s power in the world.

12. Asia Wakes Up,2020? ₤ India $ Russia Asian Currency Area 15 RINGITT Baht YEN WON P-Peso EURO Africa RMB Rupiah ₤ HK$ Australia-NZ Arab Bloc

13. What about Latin America?

14. Would a Latin-American Dollar be Useful to the Region?

15. Conditions for a Latin American Monetary Union • Criterion for Monetary Stability • Common Measure of Inflation • Lock Exchange Rates • Common Monetary Authority • Division of Seigniorage • Fiscal Stability

16. Larger union is Preferable to a Smaller Union • Should include: • Brazil, Mexico, Argentina, Columbia, Venezuela, Peru, Chile, Ecuador, Uruguay, Paraguay, Bolivia, the Central American Countries and the Caribbean.

17. First Steps • 1. Latin American Monetary Fund • 2. Choice of Anchor • 3. Narrowing of Exchange Rates • 4. Pooling of Reserves • 5. Common Monetary Policy

18. World Currency Map: 2020? ₤ India $ Russia Euro Area Africa RMB Latin $ ₤ Dinar Area Indonesia

19. Or Maybe…

20. 2020? ₤ India $ Russia Asian Currency Area 15 RINGITT Baht YEN WON P-Peso EURO Africa RMB Rupiah ₤ HK$ Latin $ Australia-NZ Arab Bloc

21. II. Macroeconomic Policy

22. Some of My Contributions to Economic Theory • The Mundell-Fleming Model. • Mundell-Tobin Effect • The Mundell-Dornbusch Model • The Theory of Optimum Currency Areas • Supply-Side Economics

23. Nobel Prize in 1999 • It was for the first and fourth of these contributions that I received the Nobel Prize in 1999. • The Academy of Science in Stockholm stated that it was awarding me the Prize • “for (my) analysis of monetary and fiscal policy under different exchange rate regimes and his analysis of optimum currency areas.”

24. Phelps the 2006 Winner • My colleague and friend at Columbia University, Edmund (“Ned”) Phelps won last year. • It is perhaps interesting that I was the last solo winner of the 20th century, Phelps was the first solo winner in the 21st century. • The following are before and after pictures of Phelps. They show the prize makes a difference!

25. This one is before.

26. And this one is after!

27. Phelps Prize • Phelps won his prize for his analysis of ‘intertemporal tradeoffs in macroeconomic policy.’ • .

28. The Phillips Curve • In the early 1950s, monetary policy was strongly influenced by the idea of the ‘Philips Curve,’ named after a New Zealander Professor at the London School of Economics. • The Philips curve was a trade-off between unemployment and inflation. • The implication was that an increase in the rate of monetary expansion would raise the inflation rate and lower the rate of unemployment.

29. Inflation Expectations • Around 1968, Phelps and Milton Friedman independently made a critique of the Phillips Curve, taking into account inflation expectations. • They argued that the Philips curve assumed that labor unions would be indifferent to the inflation rate and not change their wage demands to compensate for inflation. • Their incorporation of inflation expectations into the model reduced the effectiveness of inflation as a stabilization policy. • If wage rates rise with inflation expectations, real wage rates would not fall and employment would not increase.

30. When inflation increases the Phillips Curve theory implies that equilibrium moves from A to B. But taking account of inflation expectations, the Phillips Curve shifts to the right and unemployment stays at the level indicated by C. . л C B A Phillips Curve u л= rate of inflation; u = rate of unemployment

31. The Natural Rate of Unemployment • Contrary to the Keynes model, the new theory implies that there is an equilibrium rate of unemployment independent of monetary policy. • This has been called the ‘natural rate of unemployment.’ • Classical Economics was right after all!

32. ‘TheNatural’ Rate of Unemployment л The dotted red line gives the equilibrium rate of Unemployment independently of the inflation rate. C B A Phillips Curve u

33. Blow to Keynesianism • The Friedman-Phelps critique combined with the application of rational expectations to the problem by Lucas sunk the idea that economic performance could be improved by ‘surprise inflation.’

34. Not just “not better,” but worse • The end result is that there would have been no permanent reduction in unemployment, whereas there would have been a ‘permanent’ increase in inflation. • The bottom line is that any short run gain would be more than wiped out by the long run loss.

35. III. Mexico in the World Economy

36. The International Monetary System • No discussion of any country “in the world economy” could be relevant without considering the international monetary system. • The IMS shows how prices expressed in different national currencies are connected together to enable trade in goods and services, capital and money to take place.

37. The World Economy Since WWII • The post-war international monetary system—sometimes called the Bretton Woods system--that was set up after World War II, evolved out of the international gold standard.

38. The International Monetary System in 1969 Soviet Union Canada Sweden Korea $ RMB France DM India Mexico CFA Italy Latin American & Caribbean

39. 8¢ Peso • The Mexican peso was fixed to the dollar at the exchange rate of $M12.5 = $US1.00. • The Mexican peso was worth 8 US cents from 1954 until 1976. • Throughout this period (or at least until 1971) Mexico had both a stable exchange rate and a pretty stable price level. • How does the Friedman-Phelps Critique of the Phillips Curve work in that period.

40. New Critique of the Model • I want, however, to make a new critique of both the Phillips Curve and the Friedman-Phelps Critique based on the fact that it was based on a closed economy. • In the 1960s the United States was not only an open economy but an open economy that was part of a fixed-exchange rate international monetary system.

41. Monetary Policy and Fixed Exchange Rates • Under fixed exchange rates, monetary policy is not free to choose its own inflation rate. • With an international monetary system such as existed under bimetallism, or the gold standard, or in the dollar-based gold exchange standard era from 1934 to 1971, there is a common inflation rate shared by all countries.

42. The World Economy • If the Phillips Curve was applicable at all, it was to the entire world economy, not to the individual nations making it up. • The same applies for the Friedman-Phelps Critique.

43. Mexico’s Fixed Exchange Rate • Let us accept the correctness of the Phillips Curve critique of Friedman and Phelps and see how it can be made relevant to an economy like Mexico’s. • From 1954 to 1976 Mexico had a fixed exchange rate. • The peso was 8 cents. • The exchange rate was 12.5 pesos = $1.00.

44. The Law of One Price • In fluid markets, prices in one country have to equal prices in other countries after converting into the same currency. • Thus p = ep* gives the equilibrium price ‘p’ of a good in (say) Mexican pesos where p* is (say) the US price in dollars, and e is the exchange rate, the price of the dollar in terms of pesos.

45. Dynamics • Differentiation of the equation p = ep* gives: • π = π* + ε • where πis the rate of inflation in Mexico, = π* is the US rate of inflation, and ε is the rate of depreciation of the peso against the dollar. • If the exchange rate is fixed, equilibrium of the Mexican price level requires the same rate of inflation in Mexico as in the U.S.

46. л The dotted red line gives the equilibrium rate of Unemployment independently of the inflation rate. Л = Л* +ε u

47. Variations around the Mean • There are of course reasons why inflation rates would differ even under fixed exchange rates. • The price levels might not be in equilibrium. • Differential changes in prices of domestic and international goods . • Blocks in information. • Changes in trade impediments. • Capital movements.

48. Mexico in the World Economy • We have now brought the discussion into the macroeconomic situation in Mexico. Let’s now discuss Mexico in the world economy.

49. II. Mexico and the World Economy

50. Flexible Exchange Rates • In 1971, the U.S. took the dollar off gold, and the European countries took their currency off the dollar. • This gave rise to floating exchange rates, but nobody liked it so they went back to the dollar after a few months. • But this didn’t work out and generalized flexible exchange rates came into being in 1973.