Mundell-Fleming Model Research Paper

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The Mundell-Fleming model integrates international trade and finance into macroeconomic theory. This approach was developed in the early 1960s by the Canadian economist Robert Mundell (winner of the 1999 Nobel Prize in economics) and the British economist J. Marcus Fleming (1911–1976). In this period, both authors were members of the International Monetary Fund’s Research Department, where they independently extended the traditional Keynesian model to an open economy setup in which the capital and goods markets are internationally integrated. The resulting research constitutes the original version of the Mundell-Fleming model (Mundell 1963; Fleming 1962).

The Mundell-Fleming model shows that, under a flexible exchange rate regime, fiscal policy does not have any power to affect output, while monetary policy is very effective. The opposite is true if the exchange rate is fixed. The assumption that international capital markets are completely integrated plays a crucial role in determining these results.

Flexible Exchange Rate Case

Since a monetary expansion tends to decrease the interest rate, this policy also encourages an outflow of financial capital as domestic investors seek higher returns by purchasing foreign bonds. Investors need to buy foreign currency to acquire foreign bonds. Accordingly, the supply of domestic currency increases to purchase the foreign currency needed to acquire foreign bonds. The domestic exchange rate depreciates; that is, more units of domestic currency must be exchanged for each unit of foreign currency. This makes domestic goods cheaper compared to foreign goods, thus improving the trade balance (purchases of imports decline and sales of exports increase) and stimulating domestic output and employment. The domestic money demand therefore increases, bringing the domestic interest rate back in line with the world interest rate. In the equilibrium that emerges after the monetary expansion, the interest rate is unaltered while output is increased proportionally to the increase in the money supply.

In the case of a fiscal expansion, the initial increase in domestic government spending creates an excess demand for goods and tends to raise output, employment, and income. This, in turn, raises the demand for money and the level of the interest rate. The fact that the domestic interest rate is now higher than the world interest rate causes an inflow of capital, which causes an appreciation of the domestic exchange rate (fewer units of domestic currency must be provided for each unit of foreign currency). In this case, therefore, domestic goods become more expensive compared to foreign goods, and the trade balance deteriorates (more imports are purchased and fewer exports are sold), depressing domestic output, employment, and income. A new equilibrium is reached in which the trade balance is worsened while output and the interest rate are restored to their original levels.

Free capital mobility and trade integration therefore determine the ability of monetary policy to stimulate the domestic economy but frustrate the effects of fiscal policy when the exchange rate is flexible.

Fixed Exchange Rate Case

The results illustrated above are reversed in a pegged exchange rate regime. With pegged interest rates, the central bank increases or decreases the money supply as necessary so as to maintain a fixed rate of exchange of domestic currency for foreign currency. In this case, the pressure for exchange rate depreciation that follows a monetary expansion is neutralized by central bank intervention in the foreign exchange market, with no final effect on domestic output. Similarly, the central bank intervenes to neutralize the domestic exchange rate appreciation that follows a fiscal expansion. This allows the fiscal policy shock to raise the level of domestic output. The central bank commitment to a given exchange-rate level therefore implies high effectiveness of fiscal policy.

Real World Relevance of the Model

Some of the underlying assumptions and policy options of the Mundell-Fleming model, such as international capital market integration and the possibility of permitting the fluctuation of the exchange rate, were not predominant features of the world economy in the early 1960s. Restrictions to trade assets and foreign exchange were widespread, and the majority of currencies were fixed within the Bretton Woods system. In this regard, the Mundell-Fleming model is, to a large extent, more appropriate for describing the global economy as it developed after the collapse of the Bretton Woods system, which is characterized by high financial integration and floating exchange rates, than the economic reality of the times in which the model was originally developed. This prophetic trait of the analysis, as well as the success of the theoretical predictions in matching empirical facts (such as the effects of U.S. macroeconomic policies in the 1980s), help explain the influence of the Mundell-Fleming model among both academics and policymakers. The model has nevertheless not been immune to criticisms, some of which have stimulated further research.

Criticisms and Extensions

One important criticism of the model is that the assumption of perfect capital mobility might be extreme. Mundell (1963) was well aware of this limitation and recognized that the assumption should not be taken literally.

Introducing imperfect capital mobility into the model implies that a fiscal expansion can play a role in affecting output under a flexible exchange rate and monetary policy can have a role under a fixed exchange rate, but the results on the relative effectiveness of the two policy instruments still hold.

Several other shortcomings of the Mundell-Fleming model have also been emphasized. In particular, the model is completely static and therefore not able to address issues related to the long run, as well as to the transitional dynamics of private wealth and government finance. In order to address this limitation, Rudiger Dornbusch (1976) introduced more sophisticated, “rational” (rather than static) private agents’ expectations into the model. This extension implies an “overshooting” result: following a monetary expansion, the exchange rate depreciates more in the short run than in the long run.

Furthermore, in the Mundell-Fleming model the relations between economic variables are not explicitly derived from a microfoundation of agents’ behavior. This prevents an analysis of the welfare impact of macroeconomic policies based on a utility measure. Because of this, any welfare consideration in the Mundell-Fleming model is necessarily limited to the effects of output movements, neglecting the welfare implications of such variables as consumption and leisure time. Several researchers are therefore attempting to move beyond the MundellFleming model (see Obstfeld 2001) by developing a new framework for the analysis of macroeconomic interdependence, which is explicitly based on microeconomic foundations and intertemporal optimizing behavior. This field of research aims at introducing a more rigorous analysis of the welfare impact of macroeconomic policies. Whether the new framework will ultimately succeed in supplanting the Mundell-Fleming model remains to be seen. The fact that the researchers active in this area still consider the Mundell-Fleming model as the relevant benchmark against which to compare their results is, in any case, a testimony to the model’s lasting influence.

Bibliography:

  1. Dornbusch, Rudiger. Expectations and Exchange Rate Dynamics. Journal of Political Economy 84: 1161–1176.
  2. Fleming, Marcus. 1962. Domestic Financial Policies under Fixed and under Floating Exchange Rates. International Monetary Fund Staff Papers 9: 369–379
  3. Mundell, Robert 1963. Capital Mobility and Stabilization Policy under Fixed and Flexible Exchange Rates. Canadian Journal of Economics and Political Science 29: 475–485
  4. Obstfeld, M 2001. International Macroeconomics: Beyond the Mundell-Fleming Model. International Monetary Fund Staff Papers 47: 1–39

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