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.