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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