(8) Mundell Fleming Model

7/23/2019 (8) Mundell Fleming Model

http://slidepdf.com/reader/full/8-mundell-fleming-model 1/22

Mundell Fleming Model The dominant policy paradigm for studying open-

economy monetary and scal policy

Dr. R. Sinha Ray

MDI Gurgaon

1



apital Mo!ility

• Meaning- Free "o# of capital from oneeconomy to the other and $ice $ersa#ithout any restrictions

• This implies integration of capitalmar%ets in the #orld li%e !onds mar%etand stoc% mar%et

• This also implies that a resident of anycountry #ill loo% for the highest yield inthe #orld mar%et and tends to e&uatethe #orld rate of return on capital

'



Factors that a(ect capitalmo!ility

• Ta) di(erences among countries

• *)change Rates

•

+olitical ris%s in a country , nycountry can put some o!stacles oncapital "o#s



Macroeconomic Mechanism#ith capital mo!ility

• /ith capital mo!ility !et#een countries thee&uili!rium in the #orld mar%et #ill producesame le$el of interest rates 0rate of return oncapital

• If country 2s interest rate !ecomes less relati$eto the ountry 34 then there #ill !e a capitalout"o# from to 3. This in turn #ill #orsencountry 2s 35+ and impro$e country 32s 35+.

•

Therefore monetary and scal policies ofcountries #hich a(ect interest rates ofrespecti$e countries4 can a(ect 35+ conditionsof t#o countries through c&apital "o#s.

6



35+ and apital "o#s

• 3alance of +ayments surplus is dened !y3+7890:4 :f4 R ; F0r-rf 01

• #here 89 is the net e)ports4 F is the netcapital "o#s4 r and rf are domestic and foreignrates of interests.

• Increase in income #orsens the trade !alance• Increase in interests leads to net capital in"o#• So #ith rise in income if interest rate rises then

trade decit #ill !e nanced !y capital in"o#and o$erall 35+ #ill !e !alanced.

<



+olicy dilemma= Internal and*)ternal !alance

• +olicy dilemma e)ists if there is a con"ict!et#een internal and e)ternal goals

• Internal !alance dened !y full employment

• *)ternal !alance is dened !y 35+ !alance#here entral go$ernment neither depletesits reser$es nor accumulates more reser$es.

• n e)pansionary monetary policy may sol$eunemployment pro!lem !ut #orsen 35+decit if the economy #as already facing35+ decit

>



Internal and *)ternal!alance

Y*

Y

r

rf BP=0E

O

*635+?@

Anemployment

*35+?@

5$eremployment

*'35+B@

5$eremployment

*135+B@Anemployment

C



Internal and e)ternal !alanceunder )ed e)change rate

regime• +olicy dilemma in one 1 has !eenalready e)plained in pre$ious slides

• Dilemma may !e resol$ed through

mi) of scal and monetary policy• Anderta%ing one policy may #orsen

the situation.

• For e)ample *)pansionary scalpolicy #ith contractionery monetarypolicy may resol$e the issue.

E



Mundell Fleming model= +erfectapital mo!ility in Fi)ed

e)change rate regime• This model e)tends the standard IS-Mmodel to open economy macroeconomy

• ssumptions= +erfect capital mo!ility

under )ed e)change rate regime

• onclusions=

• Independent Fiscal policy is e(ecti$e

• Independent Monetary policy isine(ecti$e



*(ecti$eness of Fiscal +olicy underFi)ed *)change Rate #ith capital

Mo!ility• /ith e)pansionary scal policy output and income risethere!y raising consumption and import demand

• transaction demand for money rises there!y raisinginterest rate

• Interest rate rises there!y cro#ding out in$estment

and also more capital in"o#• In order to %eep the e)change rate )ed some surplus

dollar in"o# gets a!sor!ed in meeting trade decit4!ut remaining in"o# #ill result in R3I inter$ention

• R3I !uys dollar and supply more rupee increasingMoney supply

• Rate of interest comes do#n and in$estment againe)pands

• Fiscal policy is fully e(ecti$e as it does not cro#d outIn$

• ase of Greece #hy they had gone for scal policy1@



Fiscal +olicy in IS-M model

Y

r

rf BP=0

O

IS

IS1

LMLM

1

:1 :'

E E’

11



*(ecti$eness of Fiscal +olicy underFi)ed *)change Rate #ith capital

control• /ith e)pansionary scal policy output andincome rise there!y raising consumption andimport demand

• Transaction demand for money rises there!y

raising interest rate• Interest rate rises there!y cro#ding out

in$estment #ithout any capital in"o#• Import demand creates 35+ decits. In order

to %eep the e)change rate )ed R3I

inter$enes !y selling dollars and reducingMoney supply

• Rate of interest goes up further andin$estment gets more cro#ded out e)pands

•

Fiscal policy is fully ine(ecti$e here 1'



• /ith e)pansionary monetary policy there #ill!e fall in interest rate

• This fall in interest rate #ill lead to rise inIn$estment !ut leads to capital out"o#

• This leads to pressure on rupee todepreciate.

• R3I inter$enes to %eep the e)change rate)ed !y selling more dollars and reducing

money supply #hich #ill again increase theinterest rate• Thus independent monetary policy cannot !e

pursued as it is completely ine(ecti$e

*(ecti$eness of Monetary policyunder Fi)ed *)change Rate #ith

capital Mo!ility

1



Monetary +olicy in IS-Mmodel

Y

r

rf BP=0

O

IS LMLM

1

:1

E

E’

16



• /ith e)pansionary monetary policy there#ill !e fall in interest rate

• This fall in interest rate #ill lead to rise in

In$estment and income !ut no capitalout"o#

• There #ill some trade decit due to rise inincome and imports and in the process R3I#ill ha$e to supply some dollars and moneysupply #ill !e a(ected !y some e)tent

• *(ecti$eness is !etter here as it #ill !ringa!out some increase in income.

*(ecti$eness of Monetary policyunder Fi)ed *)change Rate #ith

capital control

1<



pplying M-F model in Fle)i!lee)change rate regime #ith perfect

capital mo!ility• Fully "e)i!le currency implies nointer$ention from R3I

• Thus any current account decit is

nanced !y pri$ate capital in"o# onlyma%ing 35+ !alance ero.

• *)change rate adHusts fully

• Ander such a system scal policy isine(ecti$e !ut monetary policy ise(ecti$e

1>



*(ecti$eness of Fiscal +olicy underFle)i!le *)change Rate #ith

capital Mo!ility• /ith e)pansionary scal policy output andincome rise there!y raising consumption andimport demand

• transaction demand for money rises there!yraising interest rate

• Interest rate rises there!y cro#ding outin$estment and also more capital in"o#

• Rupee appreciates against dollar and e)portsare cro#ded out and net e)ports fall

•

Fiscal policy is fully ine(ecti$e to !ring a!outchanges in output• Thus scal policy #as ne$er an e(ecti$e tool for

countries after they mo$ed to "e)i!le e)changearte regime. Fiscal consolidation is al#ays

ad$ocated in these countries 1C



Ine(ecti$e Fiscal +olicy in"e)i!le e)change rate regime

Y

r

rf BP=0

O

IS

IS1

LM

:1

E

1E



*(ecti$eness of Fiscal +olicy underFle)i!le *)change Rate #ith

capital control• /ith e)pansionary scal policy output andincome rise there!y raising consumption andimport demand

• Transaction demand for money rises there!yraising interest rate

• Interest rate rises there!y cro#ding outin$estment #ithout any capital in"o#

• Import demand creates 35+ decits that #illlead to rupee depreciation and net e)ports #illincrease to increase rise in income and outputfurther.

• ere though in$estment cro#ds out !ut e)portsgro#

• Fiscal policy is therefore e(ecti$e to !ring a!out

come increase in output 1

*( i f M li



• /ith e)pansionary monetary policy there #ill !efall in interest rate

• This fall in interest rate #ill lead to rise inIn$estment !ut leads to capital out"o#

• This leads to rupee depreciation.

• This leads to increase in e)ports and nete)ports and increases further output and income

• Thus independent monetary policy is completelye(ecti$e in !ringing a!out a change in output

• This is #hy any "e)i!le e)change rate regimede$eloped nations tool had !een Monetarypolicy

*(ecti$eness of Monetary policyunder Fle)i!le *)change Rate #ith

capital Mo!ility

'@



*(ecti$e Monetary +olicy in"e)i!le e)change rate

Y

r

rf BP=0

O

IS LMLM

1

:1

E

E’

E’’

:' '1

*( ti f M t li



• /ith e)pansionary monetary policy there#ill !e fall in interest rate

• This fall in interest rate #ill lead to rise in

In$estment and income !ut no capitalout"o#

• There #ill some trade decit due to rise inincome and imports. This #ill lead to rupee

depreciation and net e)ports #ill rise• Thus Monetary policy is also !etter in this

system to !ring a!out gro#th

*(ecti$eness of Monetary policyunder Fle)i!le *)change Rate #ith

capital control

''

Documents

(8) Mundell Fleming Model