11.1 Mundell-Fleming Model

The Mundell-Fleming model extends the IS-LM framework to open economies, considering international trade and capital flows. It explores how monetary and fiscal policies impact output, employment, and balance of payments under different exchange rate regimes and capital mobility scenarios.

Understanding this model is crucial for grasping monetary policy in open economies. It highlights the trade-offs policymakers face when managing internal and external balance, and how the effectiveness of different policy tools varies based on exchange rate regimes and capital mobility.

Mundell-Fleming Model Assumptions

Key Components and Assumptions

Top images from around the web for Key Components and Assumptions

• 

  IS-LM diagram | TikZ example View original

  Is this image relevant?

• 

  File:Mundell Fleming Model (fiscal policy under fixed exchange rates).png - Wikimedia Commons View original

  Is this image relevant?

• 

  Economic model - Wikiquote View original

  Is this image relevant?

• 

  IS-LM diagram | TikZ example View original

  Is this image relevant?

• 

  File:Mundell Fleming Model (fiscal policy under fixed exchange rates).png - Wikimedia Commons View original

  Is this image relevant?

1 of 3

Top images from around the web for Key Components and Assumptions

• 

  IS-LM diagram | TikZ example View original

  Is this image relevant?

• 

  File:Mundell Fleming Model (fiscal policy under fixed exchange rates).png - Wikimedia Commons View original

  Is this image relevant?

• 

  Economic model - Wikiquote View original

  Is this image relevant?

• 

  IS-LM diagram | TikZ example View original

  Is this image relevant?

• 

  File:Mundell Fleming Model (fiscal policy under fixed exchange rates).png - Wikimedia Commons View original

  Is this image relevant?

1 of 3

• The Mundell-Fleming model extends the IS-LM model incorporating the effects of international trade and capital flows in an open economy
• Assumes a small open economy with perfect capital mobility where domestic interest rates are determined by world interest rates
• Considers three markets:
  • Goods market (IS curve) representing the equilibrium showing the relationship between output and interest rates
  • Money market (LM curve) representing the equilibrium showing the relationship between money supply, interest rates, and output
  • Balance of payments (BP curve) representing the equilibrium showing the combinations of interest rates and output that result in a balanced current and capital account
• Assumes prices are fixed in the short run and the economy operates below full employment
• Considers two exchange rate regimes: fixed exchange rates and flexible exchange rates

Capital Mobility and Exchange Rate Regimes

• The degree of capital mobility has important implications for the effectiveness of monetary and fiscal policies in an open economy
• Under perfect capital mobility, domestic interest rates are determined by world interest rates, and the balance of payments is highly sensitive to changes in interest rates
  • Monetary policy cannot independently target both interest rates and the exchange rate, as changes in one will automatically affect the other
  • Fiscal policy can have a larger impact on output and employment, as it does not lead to changes in interest rates that would offset its effects
• Under limited capital mobility, domestic interest rates can deviate from world interest rates, and the balance of payments is less sensitive to changes in interest rates
  • Monetary policy has more scope to independently target interest rates and the exchange rate, as changes in one may not automatically affect the other
  • Fiscal policy may have a smaller impact on output and employment, as it can lead to changes in interest rates that partially offset its effects
• The degree of capital mobility can change over time, depending on factors such as financial market development, regulatory policies, and investor sentiment (capital controls, financial liberalization)
• Policymakers need to consider the prevailing degree of capital mobility when designing and implementing monetary and fiscal policies
• Changes in capital mobility can affect the sustainability of different exchange rate regimes, making it more difficult to maintain a fixed exchange rate or manage a flexible exchange rate (currency crises, speculative attacks)

Monetary and Fiscal Policies in Open Economies

Fixed Exchange Rate Regime

• Under a fixed exchange rate regime, monetary policy is ineffective in influencing output and employment, as the central bank must maintain the fixed exchange rate by intervening in the foreign exchange market
  • An expansionary monetary policy leads to a balance of payments deficit, forcing the central bank to sell foreign reserves and contract the money supply to maintain the fixed exchange rate
  • A contractionary monetary policy leads to a balance of payments surplus, forcing the central bank to buy foreign reserves and expand the money supply to maintain the fixed exchange rate
• Fiscal policy is effective in influencing output and employment under a fixed exchange rate regime, as it shifts the IS curve without affecting the LM curve
  • An expansionary fiscal policy (increased government spending, tax cuts) increases output and employment, leading to a balance of payments deficit that must be financed by the central bank's foreign reserves
  • A contractionary fiscal policy (reduced government spending, tax increases) decreases output and employment, leading to a balance of payments surplus that increases the central bank's foreign reserves

Flexible Exchange Rate Regime

• Under a flexible exchange rate regime, monetary policy is effective in influencing output and employment, as the exchange rate adjusts to maintain the balance of payments equilibrium
  • An expansionary monetary policy lowers interest rates, leading to capital outflows and a depreciation of the domestic currency (increased competitiveness), which stimulates net exports and increases output and employment
  • A contractionary monetary policy raises interest rates, leading to capital inflows and an appreciation of the domestic currency (reduced competitiveness), which reduces net exports and decreases output and employment
• Fiscal policy is less effective in influencing output and employment under a flexible exchange rate regime, as it leads to changes in the exchange rate that partially offset the initial impact of the policy
  • An expansionary fiscal policy increases output and employment but also leads to higher interest rates, capital inflows, and an appreciation of the domestic currency, which reduces net exports and partially offsets the initial increase in output
  • A contractionary fiscal policy decreases output and employment but also leads to lower interest rates, capital outflows, and a depreciation of the domestic currency, which increases net exports and partially offsets the initial decrease in output

Policy Effectiveness in Open Economies

Internal and External Balance

• Internal balance refers to the achievement of full employment and price stability, while external balance refers to the achievement of a sustainable balance of payments position
• The Mundell-Fleming model suggests that the effectiveness of monetary and fiscal policies in achieving internal and external balance depends on the exchange rate regime and the degree of capital mobility
• Under a fixed exchange rate regime with perfect capital mobility, fiscal policy is the most effective tool for achieving internal balance, as it can influence output and employment without affecting the balance of payments
  • However, the use of fiscal policy may be constrained by concerns about government debt and the sustainability of budget deficits (fiscal space, debt sustainability)
• Under a flexible exchange rate regime with perfect capital mobility, monetary policy is the most effective tool for achieving internal balance, as it can influence output and employment by adjusting the exchange rate
  • However, the use of monetary policy may be constrained by concerns about inflation and the stability of the financial system (inflation targeting, financial stability)

Achieving External Balance

• Achieving external balance requires a combination of policies that address the underlying causes of balance of payments imbalances, such as changes in competitiveness, trade policies, and international capital flows
• Exchange rate adjustments can help to correct balance of payments imbalances in the short run, but they may not be sufficient to address the underlying structural issues
  • Devaluation can improve competitiveness and boost exports, but it may also lead to higher inflation and reduced purchasing power
  • Revaluation can reduce inflationary pressures and increase purchasing power, but it may also lead to reduced competitiveness and lower exports
• Policies that promote productivity growth, innovation, and human capital development can help to improve competitiveness and support long-term external balance
  • Investments in education, research and development, and infrastructure can enhance productivity and create new comparative advantages
  • Structural reforms that improve the business environment, reduce barriers to competition, and promote efficient resource allocation can also support long-term competitiveness

Capital Mobility and Policy Outcomes

Perfect Capital Mobility

• Under perfect capital mobility, domestic interest rates are determined by world interest rates, and the balance of payments is highly sensitive to changes in interest rates
• Monetary policy cannot independently target both interest rates and the exchange rate, as changes in one will automatically affect the other
  • Attempting to lower interest rates will lead to capital outflows and a depreciation of the domestic currency, while attempting to raise interest rates will lead to capital inflows and an appreciation of the domestic currency
• Fiscal policy can have a larger impact on output and employment under perfect capital mobility, as it does not lead to changes in interest rates that would offset its effects
  • An expansionary fiscal policy will not lead to higher interest rates and capital inflows that would appreciate the currency and reduce net exports, as domestic interest rates are determined by world interest rates
  • A contractionary fiscal policy will not lead to lower interest rates and capital outflows that would depreciate the currency and increase net exports, as domestic interest rates are determined by world interest rates

Limited Capital Mobility

• Under limited capital mobility, domestic interest rates can deviate from world interest rates, and the balance of payments is less sensitive to changes in interest rates
• Monetary policy has more scope to independently target interest rates and the exchange rate, as changes in one may not automatically affect the other
  • The central bank can use monetary policy tools (open market operations, reserve requirements, policy rates) to influence domestic interest rates without necessarily affecting the exchange rate
  • The effectiveness of monetary policy in influencing output and employment will depend on the sensitivity of capital flows to interest rate differentials and the degree of exchange rate pass-through to domestic prices
• Fiscal policy may have a smaller impact on output and employment under limited capital mobility, as it can lead to changes in interest rates that partially offset its effects
  • An expansionary fiscal policy may lead to higher interest rates and capital inflows that would appreciate the currency and reduce net exports, partially offsetting the initial increase in output
  • A contractionary fiscal policy may lead to lower interest rates and capital outflows that would depreciate the currency and increase net exports, partially offsetting the initial decrease in output