Mundell-Fleming Model Essay ⋆ Business Essay Examples ⋆ EssayEmpire

The Mundell-Fleming model is a theoretical model in international macroeconomics. The model demonstrates that the effectiveness of fiscal and monetary policies in the open economy depends on the exchange rate regime. The Mundell-Fleming model was developed in the early 1960s by Robert Mundell (b.1932, 1999 Nobel Laureate in Economics) and Marcus Fleming (1911–76) of the International Monetary Fund.

From 1946–71, the exchange rates of the industrialized nations were fixed to the U.S. dollar, while the dollar was pegged to gold at $35/oz. This was known as the “Bretton Woods system.” During 1950–62, Canada experimented with a flexible exchange rate. During the early 1960s, both the United States and Canada had intense internal debates concerning the appropriate mix of fiscal and monetary policies. Working independently, Mundell (a Canadian) and Fleming sought to answer the following question: how effective are monetary and fiscal policies under fixed and flexible exchange rates?

According to Warren Young and William Darity, Jr., Mundell-Fleming is a special case of a more general open economy model. The name Mundell-Fleming was coined by Rudiger Dornbusch, who synthesized the work of Mundell and Fleming during 1976–80. Versions of the Mundell-Fleming model can be found in many textbooks.

Two important cases are: (a) flexible exchange rates under perfect capital mobility and (b) fixed exchange rates under perfect capital mobility. The MundellFleming model is based on Keynesian assumptions: output is determined by aggregate demand, and prices are sticky (inflexible). Individuals hold domestic money, domestic bonds, and foreign bonds. The country under analysis is a small country, which means that it cannot influence the world interest rate. Under perfect capital mobility, there are no restrictions on movements of financial capital. If the domestic interest rate is above the world interest rate, a massive amount of financial capital flows into the country instantaneously, as foreign and domestic residents shift their financial holdings to domestic bonds. This causes a massive increase in the demand for domestic currency. Conversely, if the domestic interest rate is below the world interest rate, a massive amount of financial capital flows out of the country instantaneously, as foreign and domestic residents shift their financial holdings to foreign bonds. This causes a massive increase in the demand for foreign currency. For these examples, we assume that initially, the domestic and world interest rates are equal.

Exchange Rate Regimes

With a flexible exchange rate regime, the exchange rate is set by market forces. An exchange rate appreciation reduces exports and increases imports, and leads to a decrease in the interest rate. An exchange rate depreciation increases exports and reduces imports, and leads to an increase in the interest rate.

For fixed exchange rate regimes, the central bank keeps the exchange rate fixed. If there is excess demand for domestic currency (the domestic currency is undervalued), the central bank sells domestic currency and buys foreign currency. This action expands the money supply, since the public receives new domestic currency (money) in exchange for foreign currency (a nonmoney asset). If there is excess supply of domestic currency (the domestic currency is overvalued), the central bank buys domestic currency and sells foreign currency. The money supply contracts, since the public receives foreign currency (a nonmoney asset), and the central bank receives domestic currency (currency is defined as money only if held by the public). To successfully defend an overvalued currency, the central bank must have large foreign currency reserves; otherwise, it runs out of reserves and is forced to devalue or float the currency (adopt a flexible exchange rate).

Predictions

For case “a” above, under fixed exchange rates and perfect capital mobility, monetary policy is completely ineffective. An increase in the money supply lowers the interest rate below the world interest rate and induces a massive capital outflow. The central bank maintains the exchange rate by selling foreign currency, which leads to a contraction in the money supply. This reverses the original monetary expansion and increases the interest rate. The process continues until domestic and foreign interest rates return to equality, and output returns to its original level.

Under fixed exchange rates and perfect capital mobility, fiscal policy is very effective. Expansionary fiscal policy (lower taxes and/or higher government spending) leads to an increase in the interest rate above the world interest rate, and induces a massive capital inflow. The central bank maintains the exchange rate by buying foreign currency, which generates an expansion of the money supply and a decrease in the interest rate. The process continues until domestic and foreign interest rates return to equality. Thus, the original fiscal expansion leads to a subsequent monetary expansion, which reinforces the original positive effect on output.

For case “b” above, under flexible exchange rates and perfect capital mobility, monetary policy is very effective. An increase in the money supply lowers the interest rate below the world interest rate and induces an exchange rate depreciation. The depreciation leads to an increase in exports. The interest rate increases; this process continues until domestic and foreign interest rates return to equality. Output rises as a result of monetary expansion and the increase in exports.

Under flexible exchange rates and perfect capital mobility, fiscal policy is completely ineffective. Expansionary fiscal policy raises the interest rate above the world interest rate and induces an exchange rate appreciation. The appreciation leads to a reduction in exports, thus reversing the effects on output of the original fiscal expansion. The interest rate declines. This process continues until domestic and foreign interest rates return to equality, and output returns to its original level.

Bibliography:

James M. Boughton, “On the Origins of the Fleming-Mundell Model,” IMF Staff Papers (v.50/1, 2003);
Royal Swedish Academy of Sciences, “Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel,” Press Release, October 13, 1999, nobelprize.org (cited March 2009);
Lance Taylor, “Exchange Rate Indeterminacy in Portfolio Balance, Mundell-Fleming and Uncovered Interest Rate Parity Models,” Cambridge Journal of Economics (v.28/2, 2004);
Warren Young and William Darity, Jr., “ISLM-BP: An Inquest,” History of Political Economy (Annual Supplement, 2004).

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