What are the major criticism of the PPP theory?

The Purchasing Power Parity 

The purchasing power parity theory was propounded by Professor Gustav Cassel of Sweden. According to this theory, rate of exchange between two countries depends upon the relative purchas­ing power of their respective currencies. Such will be the rate which equates the two purchasing powers. 
Suppose in the USA one $ purchases a given collection of commodities. In India, same collection of goods cost 65 rupees. Then rate of exchange will tend to be $ 1 = 65 rupees. Now, suppose the price levels in the two countries remain the same but somehow exchange rate moves to $1=66 rupees.

Thus, while the value of the unit of one currency in terms of another currency is determined at any particular time by the market conditions of demand and supply, in the long run the exchange rate is determined by the relative values of the two currencies as indicated by their respective purchasing powers over goods and services.

The basis for PPP is the "law of one price". In the absence of transportation and other transaction costs, competitive markets will equalize the price of an identical good in two countries when the prices are expressed in the same currency. For example, a particular smart phone sells for  Rs.25750 in india and cost 300 US Dollars [USD] in new York when the exchange rate between Rs. and the US is 65 INR/USD. If the price of the Smart Phone in India was only 13,000 CAD, consumers in new York would prefer buying the Smart phone set in India. If this process (called "arbitrage") is carried out at a large scale, the US consumers buying Indian goods will bid up the value of the Indian Rupees, thus making Indian goods more costly to them. This process continues until the goods have again the same price.

There are three caveats with this law of one price.

(1) As mentioned above, transportation costs, barriers to trade, and other transaction costs, can be significant.

 (2) There must be competitive markets for the goods and services in both countries.

(3) The law of one price only applies to tradeable goods; immobile goods such as houses, and many services that are local, are of course not traded between countries.

Criticism of Purchasing Power Parity (PPP) Theory

The Purchasing Power Parity Theory ignores these influences altogether. Further, the theory, as propounded by Cassel, says that changes in price level bring about changes in exchange rates but changes in ex­change rates do not cause any change in prices. This latter part is not true, for exchange movements do exercise some influence on internal prices.

Limitations of the Price Index: As seen above in the relative version the PPP theory uses the price index in order to measure the changes in the equilibrium rate of exchange. However, price indices suffer from various limitations and thus theory too.

Neglect of the demand / supply approach: The theory fails to explain the demand for as well as the supply of foreign exchange. The PPP theory proves to be unsatisfactory due to this negligence. Because in actual practice the exchange rate is determined according to the market forces such as the demand for and supply of foreign currency.

Unrealistic Approach: Since the PPP theory uses price indices which itself proves to be unrealistic. The reason for this is that the quality of goods and services included in the indices differs from nation to nation. Thus, any comparison without due significance for the quality proves to be unrealistic.

Unrealistic Assumptions: It is yet another valid criticism that the PPP theory is based on the unrealistic assumptions such as absence of transport cost. Also, it wrongly assumes that there is an absence of any barriers to the international trade.

Neglects Impact of International Capital Flow: The PPP theory neglects the impact of the international capital movements on the foreign exchange market. International capital flows may cause fluctuations in the existing exchange rate.

Rare Occurrence: According to critics, the PPP theory is in contrast to the Practical approach. Because, the rate of exchange between any two currencies based on the domestic price ratios is a very rare occurrence.

Keynes’ Critique:

According to Keynes, there are two basic defects in the purchasing power parity theory, namely:

(i) It does not take into consideration the elasticities of reciprocal demand, and

(ii) It ignores the influences of capital movements.

Thus, the PPP theory is criticized on the above grounds.

Despite these criticisms the theory focuses on the following major points.

It tries to establish relationship between domestic price level and the exchange rates.

The theory explains the nature of trade as well as considers the BOP (Balance of Payments) of a nation.

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Link of PPP with Real Exchange Rate (RER):

Purchasing Power Parity and Real Exchange Rate

It is possible to suggest an interpretation of PPP in terms of RER. The instantaneous response of the profit-seeking international arbitrageurs implies that net exports are extremely sensitive to small movements in the RER.

A slight drop in the prices of domestic goods relative to foreign goods — or, what comes to the same thing, a marginal fall in RER — induces arbitrageurs to buy goods in the home country (where prices are low) and sell them in foreign countries (where prices are high). The converse is also true.

A slight increase in the relative price of domestic goods induces arbitrageurs to import the same goods. This means that the net export schedule NX(e_r) is almost horizontal (completely elastic) at the RER that equalises purchasing power among the nations.

A slight drop in the RER leads to a substantial increase in net exports. This very fact ensures that the equilibrium RER is very close to the level ensuring purchasing power parity. This relation always holds.

Theory and Evidence of PPP:

The PPP is not very realistic the following two points may be noted in this context:

(i) Non-traded goods:

There are various non-traded goods and services such as haircuts. There is no scope of arbitrage even if prices differ across national borders. A barber from London cannot go to New York every now and then to earn more even if a haircut in New York is more expensive than in London.

(ii) Substitutability:

Furthermore, traded goods are relative prices of Rolls Royce and Ford cars can vary to some extent due to differences in tastes. This means that there is hardly any opportunity for making profits through arbitrage operations.

For these reasons, real exchange rates may and often do vary over time. However, the PPP doctrine provides a very important insight the fluctuations in the RER are very small and do not last for long. The reason is easy to find out the farther the RER deviates from the level predicted by purchasing power parity, the stronger is the incentive for individuals to engage in international arbitrage.

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Discuss the Law of One Price as the basis of PPP. What are the two main types of the PPP theory?

The purchasing power parity theory was propounded by Professor Gustav Cassel of Sweden. According to this theory, rate of exchange between two countries depends upon the relative purchas­ing power of their respective currencies. Such will be the rate which equates the two purchasing powers. For example, if a certain assortment of goods can be had for £1 in Britain and a similar assortment with Rs. 80 in India, then it is clear that the purchasing power of £ 1 in Britain is equal to the purchasing power of Rs. 80 in India. Thus, the rate of exchange, according to purchasing power parity theory, will be £1 = Rs. 80.

The Law of One Price (LOOP)

The basis for PPP is the "law of one price". In the absence of transportation and other transaction costs, competitive markets will equalize the price of an identical good in two countries when the prices are expressed in the same currency. For example, a particular smart phone sells for  Rs.25750 in india and cost 300 US Dollars [USD] in new York when the exchange rate between Rs. and the US is 65 INR/USD. If the price of the Smart Phone in India was only 13,000 CAD, consumers in new York would prefer buying the Smart phone set in India. If this process (called "arbitrage") is carried out at a large scale, the US consumers buying Indian goods will bid up the value of the Indian Rupees, thus making Indian goods more costly to them. This process continues until the goods have again the same price.

There are three caveats with this law of one price.

(1) As mentioned above, transportation costs, barriers to trade, and other transaction costs, can be significant.

 (2) There must be competitive markets for the goods and services in both countries.

(3) The law of one price only applies to tradeable goods; immobile goods such as houses, and many services that are local, are of course not traded between countries.

Types

The two version of Purchasing Power Parity are:

(i) Absolute PPP and

(ii) Relative PPP.

(i) Absolute Purchasing Power Parity:    The absolute version of this theory maintains the that the absolute purchasing power of respective currencies does play a vital role in determining the equilibrium exchange rate.

The following conditions must be met for this relationship to be true:
1. The goods of each country must be freely tradable on the international market.
2. The price index for each of the two countries must be comprised of the same basket of goods.
3. All of the prices need to be indexed to the same year.

Relative Purchasing Power Parity

 Relative PPP describes the inflation rate, or the appreciation rate of a currency by calculating the difference between two countries’ exchange rates. Relative PPP is the more dynamic version of absolute PPP theory. Relative purchasing power parity relates the change in two countries' expected inflation rates to the change in their exchange rates. Inflation reduces the real purchasing power of a nation's currency.

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Critically examine the Purchasing Power Parity (PPP) Theory of Exchange Rate Determination

QUESTION-

Critically examine the Purchasing Power Parity (PPP) Theory? Do you agree that PPP is not very realistic?   On what grounds Keynes criticized the theory.

The purchasing power parity theory was propounded by Professor Gustav Cassel of Sweden. According to this theory, rate of exchange between two countries depends upon the relative purchas­ing power of their respective currencies. Such will be the rate which equates the two purchasing powers. For example, if a certain assortment of goods can be had for £1 in Britain and a similar assortment with Rs. 80 in India, then it is clear that the purchasing power of £ 1 in Britain is equal to the purchasing power of Rs. 80 in India. Thus, the rate of exchange, according to purchasing power parity theory, will be £1 = Rs. 80.

Let us take another example. Suppose in the USA one $ purchases a given collection of commodities. In India, same collection of goods cost 65 rupees. Then rate of exchange will tend to be $ 1 = 65 rupees. Now, suppose the price levels in the two countries remain the same but somehow exchange rate moves to $1=66 rupees.

Thus, while the value of the unit of one currency in terms of another currency is determined at any particular time by the market conditions of demand and supply, in the long run the exchange rate is determined by the relative values of the two currencies as indicated by their respective purchasing powers over goods and services.

The basis for PPP is the "law of one price". In the absence of transportation and other transaction costs, competitive markets will equalize the price of an identical good in two countries when the prices are expressed in the same currency. For example, a particular smart phone sells for  Rs.25750 in india and cost 300 US Dollars [USD] in new York when the exchange rate between Rs. and the US is 65 INR/USD. If the price of the Smart Phone in India was only 13,000 CAD, consumers in new York would prefer buying the Smart phone set in India. If this process (called "arbitrage") is carried out at a large scale, the US consumers buying Indian goods will bid up the value of the Indian Rupees, thus making Indian goods more costly to them. This process continues until the goods have again the same price.

There are three caveats with this law of one price.

(1) As mentioned above, transportation costs, barriers to trade, and other transaction costs, can be significant.

 (2) There must be competitive markets for the goods and services in both countries.

(3) The law of one price only applies to tradeable goods; immobile goods such as houses, and many services that are local, are of course not traded between countries.

Types

The two version of Purchasing Power Parity are:

(i) Absolute PPP and

(ii) Relative PPP.

(i) Absolute Purchasing Power Parity:    The absolute version of this theory maintains the that the absolute purchasing power of respective currencies does play a vital role in determining the equilibrium exchange rate.

 In this equation 'P' denotes prices related to the respective bundle of goods with same weights assigned in both the countries. Thus, the above equation explains that the equilibrium exchange rate(R) is determined by the ratio of the internal purchasing power of foreign currency and domestic currency in their own countries. This concept is derived from a basic idea known as the law of one price (LOOP), which states that the real price of a good must be the same across all countries.

R = P / P* where R is the spot exchange rate. P is the price index for domestic country and P* is the price index for foreign country.

The following conditions must be met for this relationship to be true:
1. The goods of each country must be freely tradable on the international market.
2. The price index for each of the two countries must be comprised of the same basket of goods.
3. All of the prices need to be indexed to the same year.
Relative Purchasing Power Parity

 Relative PPP describes the inflation rate, or the appreciation rate of a currency by calculating the difference between two countries’ exchange rates. Relative PPP is the more dynamic version of absolute PPP theory. Relative purchasing power parity relates the change in two countries' expected inflation rates to the change in their exchange rates. Inflation reduces the real purchasing power of a nation's currency.
 The relative version was put forward by Cassel in order to find the strength of the changes in the equilibrium exchange rate. Any departure from the equilibrium will lead to the disequilibrium. It can take place due to changes in the internal purchasing power of a particular currency. The changes in the purchasing power are measured with the help of domestic price indices if the respective nation. We need to assume any past rate of exchange as a base exchange rate in order to know the percentage change in the exchange rate. If we compare the price indices in the past i.e. base period with that of the present period, the new equilibrium exchange rate could be found out.

It can be simplified with the following equation. Thus, according to the equation when the price level in concerned nation changes, automatically the internal purchasing power of the currency of that nation goes on changing. This change leads to the change in the equilibrium exchange rate. Thus, under this theory Gustav Cassel has tried to link the purchasing power of two currencies in determining the equilibrium exchange rate.

Criticism of Purchasing Power Parity (PPP) Theory

The Purchasing Power Parity Theory ignores these influences altogether. Further, the theory, as propounded by Cassel, says that changes in price level bring about changes in exchange rates but changes in ex­change rates do not cause any change in prices. This latter part is not true, for exchange movements do exercise some influence on internal prices.

Limitations of the Price Index: As seen above in the relative version the PPP theory uses the price index in order to measure the changes in the equilibrium rate of exchange. However, price indices suffer from various limitations and thus theory too.

Neglect of the demand / supply approach: The theory fails to explain the demand for as well as the supply of foreign exchange. The PPP theory proves to be unsatisfactory due to this negligence. Because in actual practice the exchange rate is determined according to the market forces such as the demand for and supply of foreign currency.

Unrealistic Approach: Since the PPP theory uses price indices which itself proves to be unrealistic. The reason for this is that the quality of goods and services included in the indices differs from nation to nation. Thus, any comparison without due significance for the quality proves to be unrealistic.

Unrealistic Assumptions: It is yet another valid criticism that the PPP theory is based on the unrealistic assumptions such as absence of transport cost. Also, it wrongly assumes that there is an absence of any barriers to the international trade.

Neglects Impact of International Capital Flow: The PPP theory neglects the impact of the international capital movements on the foreign exchange market. International capital flows may cause fluctuations in the existing exchange rate.

Rare Occurrence: According to critics, the PPP theory is in contrast to the Practical approach. Because, the rate of exchange between any two currencies based on the domestic price ratios is a very rare occurrence.

Keynes’ Critique:

According to Keynes, there are two basic defects in the purchasing power parity theory, namely:

(i) It does not take into consideration the elasticities of reciprocal demand, and

(ii) It ignores the influences of capital movements.

Thus, the PPP theory is criticized on the above grounds.

Despite these criticisms the theory focuses on the following major points.

It tries to establish relationship between domestic price level and the exchange rates.

The theory explains the nature of trade as well as considers the BOP (Balance of Payments) of a nation.

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What is meant by Purchasing Power Parity? Does PPP determine exchange rates in the short term?

 Meaning of PPP:

The purchasing power parity theory was propounded by Professor Gustav Cassel of Sweden. According to this theory, rate of exchange between two countries depends upon the relative purchas­ing power of their respective currencies. Such will be the rate which equates the two purchasing powers. For example, if a certain assortment of goods can be had for £1 in Britain and a similar assortment with Rs. 80 in India, then it is clear that the purchasing power of £ 1 in Britain is equal to the purchasing power of Rs. 80 in India. Thus, the rate of exchange, according to purchasing power parity theory, will be £1 = Rs. 80.

Let us take another example. Suppose in the USA one $ purchases a given collection of commodities. In India, same collection of goods cost 65 rupees. Then rate of exchange will tend to be $ 1 = 65 rupees. Now, suppose the price levels in the two countries remain the same but somehow exchange rate moves to $1=66 rupees.

Thus, while the value of the unit of one currency in terms of another currency is determined at any particular time by the market conditions of demand and supply, in the long run the exchange rate is determined by the relative values of the two currencies as indicated by their respective purchasing powers over goods and services.

How is PPP calculated?

The simplest way to calculate purchasing power parity between two countries is to compare the price of a "standard" good that is in fact identical across countries. Every year The Economist magazine publishes a light-hearted version of PPP: its "Hamburger Index" that compares the price of a McDonald's hamburger around the world. More sophisticated versions of PPP look at a large number of goods and services. One of the key problems is that people in different countries consumer very different sets of goods and services, making it difficult to compare the purchasing power between countries.( The Economic Times).

Does PPP determine exchange rates in the short term?

No. Exchange rate movements in the short term are news-driven. Announcements about interest rate changes, changes in perception of the growth path of economies and the like are all factors that drive exchange rates in the short run. PPP, by comparison, describes the long run behaviour of exchange rates. The economic forces behind PPP will eventually equalize the purchasing power of currencies. This can take many years, however. A time horizon of 4-10 years would be typical.

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What are the major Assumptions of the Mundell Fleming Model

The major assumptions of the Mundell-Fleming Model are as follows:

Assumptions of the Mundell Flaming Model:

1.      Small size of the economy: It may be recalled that “smallness” of a country has no relation to its size. A small country is one which cannot alter the world rate of interest through its own borrowing and lending activities. In contrast, a large economy is one which has market (bargaining) power so that it can exert influence over the world rate of interest.

2.      Perfect Factor Mobility: The basic assumption of this model is that the domestic rate of interest (r) is equal to the world rate of interest (r*) in a small open economy with perfect capital mobility. No doubt any change within the domestic economy may alter the domestic rate of interest, but the rate of interest cannot stay out of line with the world rate of interest for long. The difference between the two, if any, is removed quickly through inflows and outflows of financial capital. Investment will flow to countries where the return is maximised.

3.      Interest Rate Parity: Forward and domestic exchange rates are identical and existing exchange rate are expected to persist indefinitely. In such a situation, if the domestic interest rate goes above the world rate, foreigners will start lending to the home country. This capital inflow will create excess supply of funds and the domestic rate of interest r again will fall to r*. The converse is also true. If, for some reason, the domestic rate of interest (r) falls below r*, there will be capital outflow from the home country and the resulting shortage of funds will push up r to the level of r*. Thus, in a world of perfect capital mobility, r will quickly get adjusted to r*.

4.      Fixed Money Wage: Unemployed Resources and Constant Returns to scale are assumed.

5.      Spot and forward exchange rates are identical, and existing exchange rates are expected to persist indefinitely. The main prediction from the Mundell-Fleming model is that the behaviour of an economy depends crucially on the exchange rate system it adopts, i.e., whether it operates a floating exchange rate system or a fixed exchange rate system. We start with adjustment under a floating exchange rate system, in which case there is no central bank intervention in the foreign exchange market.

6.      Domestic price level is kept constant and supply of domestic output is elastic.

7.      Taxes and savings increase with income

8.      Balance of trade depends only on income and exchange rate. Demand for money depends on income and interest rate.

9.      Capital Mobility is less than perfect and all securities are perfect substitutes. Only risk neutral investors are in the system. The demand for money therefore depends only on income and the interest rate, and investment depends on the interest rate.

Mundell-Fleming Model in a small open economy

Examine the Mundell-Fleming model in a small open economy with perfect capital mobility. Summarise the effects of Fiscal, Monetary and Trade policies in the Mundell-Fleming model.

The basic Mundell-Fleming (M-F henceforth) model — like the IS-LM model — is based on the assumption of fixed price level and shows the interaction between the goods market and the money market. The model is also known as IS-LM- BoP Model. The model is an extension of IS-LM Model. The traditional IS-LM model deals with economy under autarky (or closed economy) the  M-F model describe a small open economy. The model studies relationship between nominal exchange rate, interest rate and output whereas the IS_LM model studies the relationship between interest rate and output in a closed economy.

The model explains the causes of short-run fluctuations in aggregate income (or, what comes to the same thing, shifts in the AD curve) in an open economy.

The classical model of exchange rate determination is very simple as it assumes that domestic interest rates are unaffected by foreign interest rates. The M-F model is a model for an open economy. It considers a small open economy with perfect capital mobility. The MF model argues that a economy cannot simultaneously maintain a fixed exchange rate, free capital movement, and an independent monetary policy. The principal is called as “M-F trilemma”

This means that the economy can borrow or lend freely from the international capital markets at the prevailing rate of interest since its domestic rate of interest is determined by the world rate of interest. So, the rate of interest is not a policy variable in the small economy being studied.

This means that macroeconomic adjustment occurs only through exchange rate changes. In other words, the brunt of adjustment is borne by exchange rate movements in foreign exchange markets to maintain the officially determined exchange rate. The central bank permits the exchange rate to move up or down in response to changing economic conditions.

Assumptions of the Mundell Flaming Model:

1.      Small size of the economy: It may be recalled that “smallness” of a country has no relation to its size. A small country is one which cannot alter the world rate of interest through its own borrowing and lending activities. In contrast, a large economy is one which has market (bargaining) power so that it can exert influence over the world rate of interest.

2.      Perfect Factor Mobility: The basic assumption of this model is that the domestic rate of interest (r) is equal to the world rate of interest (r*) in a small open economy with perfect capital mobility. No doubt any change within the domestic economy may alter the domestic rate of interest, but the rate of interest cannot stay out of line with the world rate of interest for long. The difference between the two, if any, is removed quickly through inflows and outflows of financial capital. Investment will flow to countries where the return is maximised.

3.      Interest Rate Parity: Forward and domestic exchange rates are identical and existing exchange rate are expected to persist indefinitely. In such a situation, if the domestic interest rate goes above the world rate, foreigners will start lending to the home country. This capital inflow will create excess supply of funds and the domestic rate of interest r again will fall to r*. The converse is also true. If, for some reason, the domestic rate of interest (r) falls below r*, there will be capital outflow from the home country and the resulting shortage of funds will push up r to the level of r*. Thus, in a world of perfect capital mobility, r will quickly get adjusted to r*.

4.      Fixed Money Wage: Unemployed Resources and Constant Returns to scale are assumed.

5.      Spot and forward exchange rates are identical, and existing exchange rates are expected to persist indefinitely. The main prediction from the Mundell-Fleming model is that the behaviour of an economy depends crucially on the exchange rate system it adopts, i.e., whether it operates a floating exchange rate system or a fixed exchange rate system. We start with adjustment under a floating exchange rate system, in which case there is no central bank intervention in the foreign exchange market.

6.      Domestic price level is kept constant and supply of domestic output is elastic.

7.      Taxes and savings increase with income

8.      Balance of trade depends only on income and exchange rate. Demand for money depends on income and interest rate.

9.      Capital Mobility is less than perfect and all securities are perfect substitutes. Only risk neutral investors are in the system. The demand for money therefore depends only on income and the interest rate, and investment depends on the interest rate.

For such a country, either international capital mobility is far from perfect, or the country is so large that it can exert influence on world capital markets. One of the main assumptions in the MF model is the assumption of interest rate parity. We begin explaining this assumption.

M-F model is based on the following equations

The IS Curve:

Y=C+I+G+NX

Where;  C= consumption; I = physical investment; G= government spending and NX is net exports.

The LM Curve:

A higher interest rate or a lower income (GDP) level leads to lower money demand.

The BoP (Balance of Payments) curve:

BoP= CA+KA

Where Bop is a Balance of Payments surplus, CA is current account surplus and KA is capital account surplus.

Interest Rate Parity in the same currency area:

Countries using same currency are categorised as same currency area for example all countries using Euro is an example of same currency area. Within a currency area, at a certain point of time there may prevail the interest rate parity. There can be no significant differences in the interest rate geographically. If there are differences in the interest rate there would be the possibilities of simultaneously buying and selling currency and earn profit out of the differences in the prices known as arbitrage.  Capital will flow from low interest rate to high interest rate area.

This is not so simple in different currency areas. Even if you can borrow on low interest rate and lend it on high interest rate you cannot be sure that you will earn profit because the exchange rate may depreciate and what you gain from the interest rate differentials you lose from changes in exchange rate.

The main prediction from the Mundell-Fleming model is that the behaviour of an economy depends crucially on the exchange rate system it adopts, i.e., whether it operates a floating exchange rate system or a fixed exchange rate system. We start with adjustment under a floating exchange rate system, in which case there is no central bank intervention in the foreign exchange market.

In such a situation, if the domestic interest rate goes above the world rate, foreigners will start lending to the home country. This capital inflow will create excess supply of funds and the domestic rate of interest r again will fall to r*.

The converse is also true. If, for some reason, the domestic rate of interest (r) falls below r*, there will be capital outflow from the home country and the resulting shortage of funds will push up r to the level of r*. Thus, in a world of perfect capital mobility, r will quickly get adjusted to r*.

The Derivation of Open Economy IS Curve in the M-F Model:

In the Mundell-Fleming model, the market for goods and services is expressed by the following equation:

Y = C(Y – T) + I(r*) + G + NX(e) … (1)

All the terms have their usual meanings. Here investment depends on the world rate of interest R* since R = R* and NX depends on the exchange rate e which is the price of a foreign currency in terms of domestic currency.

In the Mundell-Fleming model, it is assumed that the price levels at home and abroad remain fixed. So, there is no difference between real exchange rate and nominal exchange rate. We now illustrate the equation of the goods market equilibrium in Figure-1

In part (a), an increase in the rate from e₀ to e₁, lowers net exports from NX(e₀) to NX(e₁). As a result, the planned expenditure line E₁ shifts downward to E₀. Consequently, income falls from Y₁ to Y₀. In part (c), we show the new IS curve, which is the locus of points, indicating alternative combinations of e and Y which ensure equilibrium in the goods market.

The new IS curve is derived by following this sequence:

e rises → NX falls → Y falls

The Derivation of Open Economy LM Curve in M-F Model:

The equilibrium condition of the money market in the Mundell-Fleming model is:

M = L(R*, Y) … (2)

since R = R*.

Here the supply of money equals its demand and demand for money varies inversely with R* and the posi­tively with Y. In this model, M remains exogenously fixed by the central bank.

In the Fig. 3, we show the general equilibrium of goods market and the money market. The equilib­rium income (Y₀) and exchange rate (e₀) are determined simultaneously at point A where the IS and LM curves intersect.

 The new LM curve, as shown in Fig. 12.2(b), is vertical — since the equation (2) has no relation to the exchange rate. This equation deter­mines only Y, whether e is high or low. In Fig. 12.2(a), we draw the closed economy LM curve as also a horizon­tal line showing parity between R and R*.

The intersection of the two curves at the point A determines the equilib­rium level of income Y₀, which has no relation to e, shown on the vertical axis of Fig.2(b). This is why the new (open economy) LM curve is vertical. The LM_N curve of Fig. 2(b) is derived from R* and the closed economy LM curve, shown in Fig. 2(a).

General Equilibriumin M-F model:

In the Fig. 2, we show the general equilibrium of goods market and the money market. The equilib­rium income (Y₀) and exchange rate (e₀) are determined simultaneously at point A where the IS and LM curves intersect.Main Message of Mundell-Flemming Model:

The main message of the Mundell-Fleming model is that the effect of any economic policy (fiscal, monetary or trade) depends on the exchange rate system of the country under consideration, i.e., whether the country is following a fixed or a floating exchange rate system. 

Table 1 summarises the effects of three different policies in the Mundell-Fleming model.

Table:1 The Effects of Three Types of Policies in the Mundell-Fleming Model

The Mundell-Fleming model shows how to make appropriate use of monetary, fiscal and trade policies to achieve any desired macroeconomic objective. The influence of these policies depends on the exchange rate system. Under floating exchange rate system, only monetary policy can alter national income.

The effect of expansionary fiscal policy is totally neutralised by currency appreciation. Under fixed exchange rate system, only fiscal policy can alter Y. The central bank loses control over money supply since it has to be adjusted upward or downward for maintaining the exchange rate at a predetermined level.

The IS LM model under fixed exchange rates:

Under fixed exchange rate system e (Exchange Rate) is given. We can illustrate this by drawing a new curve with IS LM diagram called the FE Curve (FE for foreign Exchange). We have drawn the diagram such that the IS curve intersect the LM curve at exactly the current interest rate R= R^* This is no coincidence- we will describe why the IS Curve must intersect the LM curve at exactly this interest rate.

Let us begin by analysing what will happen when Ms increases when initially we are at equilibrium.

·         LM curve shifts outwards from LM₁ to LM₂ we move from A to B

·         R falls now  R < R^F and the demand for foreign currency increases.

·         Our currency will depreciate and the central bank must intervene. They will sell foreign currency and buy domestic currency which will reduce foreign exchange reserves.

·         When they buy foreign currency money supply M_S will fall LM₂ shifts back to LM₁ and we are back at point A.

Monetary policy has no effect when the exchange rate is fixed according to the MF Model. Fiscal policy will however work. Fiscal policy works better in open economy then in closed economy. Monetary policy is less effective with fixed exchange rate- not that completely ineffective.

The IS LM model under flexible exchange rates:

With flexible exchange rates we must also consider depreciation, R=R^F + e  since e is assumed to be exogeneous the FE curve is still horizontal.

In this case, we analyse what will happen when G   increases from initial equilibrium position.

•  IS curve shifts outwards from IS₁ to IS₂ we move from A to B
• Y increases and R increases.now R > R^F+ eand the supply of foreign currency increases. (Foreigners will want to buy our currency and invest in our country.
• Since we have flexible exchange rates central bank will not intervene and the domestic currency will appreciare.
• When domestic currency appreciates exports will fall and imports will increase. This will shift IS curve back to its original position IS₁ The exchange rate continue to appreciate as long as R > R^F+ e and trade balance continue to deteriorate until R is again equal to  R^F+ e and IS₂ is back to IS₁.
• Fiscal policy has no effect under flexible exchange rates according to the MF model. However monetary policy works better.

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