The Mundell Fleming Model
The Mundell Fleming Model adds valuable depth to the Keynesian model of macroeconomics by extending its analysis to include the foreign trade sector. As with all models it is not intended to explain all possible scenarios, and it includes some unrealistic real-world assumptions in order to make a more general point.
In particular, the Mundell Fleming model assumes a world with 'perfect capital mobility' in an open economy whereby any small differential in the domestic interest rate on an asset class (i.e. assets with a given level of associated risk) will cause inflows/outflows of money across the world in search of the highest returns, which would thereby equalize those returns through the forces of supply and demand.
There is, of course, no such perfect capital mobility. All economies are unique and highly complex, with very different mixes of resources and different comparative advantages. Some countries are land rich, others are resource rich, some are capital rich, all have different tax structures, and all are specialized to their particular mix of attributes. On top of this, our governments have different policy agendas and different approaches to management of their economies.
Consumers in different countries have different tastes, different preferences, and different cultures - all of which leads to an enormous amount of diversity that affects their economies relative to other economies in unpredictable ways, and make risk-return calculations extremely complex. Because of these realities, there is no equalization of interest rates, because there is no equalization of risk for any given asset class.
However, the scope for differences in interest rates is reduced by international capital flow opportunities, and that means that there are still some useful policy implications to be drawn from the Mundell Fleming model.
As with all Keynesian models, we continue to simplify the analysis with the standard assumption that the economy is operating on the horizontal section of the aggregate supply curve, and therefore that prices are unaffected by increases in economic output.
The Mundell Fleming Model with a Fixed Exchange Rate
As the graph illustrates, monetary policy under a fixed exchange rate regime is ineffective. The reason for that is because any attempt by the government to boost the economy via a monetary expansion will cause a fall in the domestic interest rate.
This is illustrated by the movement of the LM curve, (click the link for clarity).
With a lower interest rate, US financial assets offer lower returns than foreign financial assets, and this causes a capital outflow from the domestic economy, which in turn creates a deficit on the balance of payments (BoP).
The central bank can try to plug the gap on the BoP by running down its reserves of foreign currency, but with perfect capital mobility the outflow of foreign currency would be far larger than the total amount of the central bank's reserves, and so any attempt at plugging the gap is futile.
The horizontal BP curve shows that only an interest rate of R gives stability on the BoP, higher rates would give a surplus and a capital inflow, lower rates give a deficit and a capital outflow.
In this example, as foreign currency flows out, the inevitable deficit on the BoP forces the central bank to reduce the money supply back to its original level if it wishes to maintain the fixed exchange rate regime. If it does not do this, it will run out of foreign reserves of money and thereby lose control of the rate at which foreign currency is exchanged for domestic currency.
With the money supply reduced back to its original level, the interest rate also returns to its original level, meaning that domestic capital assets no longer have lower returns than foreign capital assets. This will restore equilibrium to the BoP and foreign exchange market, but the independent monetary policy has been completely nullified.
In economic jargon, we say that there is no monetary autonomy under this system.
Whilst monetary policy is ineffective under fixed exchange rates, fiscal policy is very powerful. If the government increases its spending in order to boost the consumption function, the result can be illustrated as a rightward shift of the IS curve (again, click the link for clarity).
Unlike monetary policy, the fiscal policy expansion causes the interest rate to increase, which attracts an inflow of foreign money because domestic capital assets now offer a higher yield. This causes a payments surplus on the BoP and puts pressure on the domestic currency to revalue to a higher exchange rate.
In order to maintain the fixed exchange rate, the central bank is forced to expand the money supply in order to bring the interest rate back down to its original level, so that domestic financial assets have the same yield as before. This causes a rightward shift of the LM curve, and domestic output increases from Y1 to Y2 as illustrated. The increase in income/output here is in accordance with the full effect of the Keynesian Multiplier.
In the next section we stick with the Mundell Fleming model, and its assumed perfect capital mobility, to consider the same policies under a floating, or flexible exchange rate system.