MUNDELL - FLEMING THEORY
...e refer to it as the Mundell-Fleming model. Mundell-Fleming Model The Mundell-Fleming model is a simple generalization of a closed-economy IS-LM model for a small open economy with perfect capital mobility. This model was developed in the 1930s by John Hicks (1937) in a purely domestic context. In 1963, a pioneering article (1963) addresses the short-run effects of monetary and fiscal policy in an open economy. The analysis is simple, but the conclusions are numerous, robust and clear. Mundell introduced foreign trade and capital movements into the so-called IS-LM model of closed economy. He showed that the effects of stabilisation policy hinge on the degree of international capital mobility. In particular, Mundell shows that under fixed exchange rates and perfect capital mobility, a country cannot pursue an independent monetary policy. Interest rates cannot move out of line with those prevailing in the world market. Any attempt at independent monetary policy leads to capital flows and a need to intervene until interest rates are back in line with those in the world market. (Dornbusch & Fischer & Startz, 2001, p.285) Whereas under floating exchange rate, monetary policy becomes powerful and fiscal policy become a completely impotent tool of macroeconomic management. Under Fix Exchange Rates Under a fixed exchange rate, monetary policy is the victim. Because of the expansion in international trade and globalization of international finance, many developing and transitional economies in the world are facing the problem of choosing an appropriate exchange rate regime. In light of the improvement in international capital mobility, many small countries are choosing a pegged (fixed) exchange rate system. As pointed out in Mundell(1963) and Fleming(1962), money stock is endogenous when a small country tries to maintain a fixed exchange rate in a word of perfect capital mobility.Attempts to pursue independent monetary policy carry the seeds of their own destruction, since the central banks committed to fixing the exchange rate. When a central bank attempt to combat a recession by increase domestic credit and the money supply would lower interest rates, under perfect capital mobility the slightest interest differential provokes infinite capital flows. As a result of huge capital outflow, the balance of payments shows huge deficit the international investors start taking their funds abroad to earn a higher return. This capital outflow puts downward pressure on the value of the currency. To keep the exchange rate fixed, the country has to use its foreign currency reserves to buy back some own currency and this leading to a loss in reserves. The resulting shrinkage of the money supply leads the economy back to its initial equilibrium. Why would many small developing and transitional economies choose a fixed exchange rate system in a world dominated by globally floating key currencies? There are many pros and cons, but one fundamental reason may be that the lack of financial institutions and securities markets makes the execution of the monetary policy ineffective. Under this situation, fiscal policy become the only remaining powerful policy instrument in a fixed exchange rate system. Any increase in government expenditures, or other fiscal policy measures, can raise national income and the level of domestic activity, thereby escaping the impediments of rising interest rates or a stronger exchange rate. Floating exchange rate By way of contrast, when the exchange rate is flexible, the central bank has perfect control over the money supply. Monetary policy works, but fiscal policy is ineffective in changing the level of economic activity. The expansionary fiscal policy expenditures give rise to a greater demand for money; this result in budget deficit and pushes interest rates upward. International investors quickly respond to any rise in interest rates by bringing in funds from abroad, bidding up the value of the domestic currency. The exchange appreciation means, of course, that import prices fall and domestic goods become relatively more expensive. Demand shifts away from domestic goods, and net exports decline. This in turn would lead to a deterioration of the trade balance, offsetting the initial fiscal stimulus. Thus there is pure crowding out real disturbances change only the composition of output, not its level. Floating exchange rates and high capital mobility accurately describe the present monetary regime in many countries. But in the early 1960s, an analysis of their consequences must have seemed like an academic curiosity. Almost all countries were linked together by fixed exchange rates within the so-called Bretton Woods System. International capital movements were highly curtailed, in particular by extensive capital and exchange rate controls. During the 1950s, however, Mundell's own country - Canada - had allowed its currency to float against the US dollar and had begun to ease restrictions. His far-sighted analysis became increasingly relevant over the next ten years, as international capital markets opened. The primary argument for a floating exchange rate is that is allows monetary policy to be used for other purpose. Under fixed rates, monetary policy is committed to the single goal of maintaining the exchange rate at its announced level. Yet the exchange rate is only one of many macroeconomic variables that monetary policy can influence. A system of floating exchange rates leaves monetary policymakers free to pursue other goals, such as stabilizing employment or prices. (Mankiw, 2000, p334) Limitations MundullĄ¯s original paper has a number of obvious shortcomings (which it shares with FlemingĄ¯s work). For instance, it makes highly simplified assumptions about expectations in financial markets and assumes price rigidity in the short run. Capital mobility is perfect, implying that assets denominated in different currencies are perfect substitute. It is a static model without forward-lookin...