Week 12

Report
The Mundell-Fleming
model
From IS-LM to Mundell-Fleming
Policy in an open economy
The Mundell-Fleming model

Last week we introduced the basic
elements required to analyse an open
economy
The current account: imports and exports
 The capital account: saving/investment
flows
 The balance of payments equilibrium as a
combination of the two
 The role of exchange rates

The Mundell-Fleming model

This week we integrate these elements into
the Mundell-Fleming model, which is an ISLM model extended to account for imports
and exports


Although this will not be covered, in theory this
can be used in turn to modify the AS-AD model
to account for international trade with inflation
As we saw last week, the price level can be
included through the analysis of real exchange
rates
The Mundell-Fleming model
From IS-LM to the Mundell-Fleming
model
Effectiveness of policy
From IS-LM to Mundell-Fleming

Model developed by Robert Mundell and Marcus
Fleming

It extends the IS-LM model to an open economy
   
Y  C Y  T   I  i   G  X Y * , e  M Y , e



 
Aggregate demand now contains the current
account : i.e. the difference between exports
and imports.
 X(Y*,e) : Exports are a function of the income of

the rest of the world (exogenous) and the
exchange rate
M(Y,e) : Importations are a function of national
income and the exchange rate
From IS-LM to Mundell-Fleming

    
CA Y * , Y , e  X Y * , e  M Y , e

 


 
Determinants of the current account:
 If e falls (depreciation): exportations are more competitive



and imports more expensive. The net balance of the current
account increases.
If Y increases: imports increase and the net balance of the
current account falls.
Y* is exogenous, and Y is already determined in IS-LM.
There is an extra variable to account for: the exchange
rate e.
We need to add another equation (market) in order to be
able to solve the system: we use the equilibrium condition
on the balance of payments
From IS-LM to Mundell-Fleming

Reminder: the balance of payments is the sum of the
current account and the capital account:




BP Y * , Y , i, e  CA Y * , Y , e  KAi, e

The equilibrium exchange rate is achieved when BP is
equal to zero, in other words when the deficits and
surpluses of the two accounts compensate exactly.

KAi, e  CA Y * , Y , e



One can see that this equilibrium condition can be
expressed in the (Y,i) space of IS-LM.
We still need to relate the exchange rate e to these
variables
From IS-LM to Mundell-Fleming

The capital account (KA)




Is in surplus if the inflows of
capital are larger than the
outflows.
Is in deficit in the other case.
What determines these capital
flows ?
Intuitive answer: the earnings on savings

If savings earn a higher return in Europe compared to
the USA, one would expect American capital to flow
towards Europe.
From IS-LM to Mundell-Fleming

Investors choose between assets that pay
different interest rates in different currencies.

What is the expected return for each of the
possible investment?



Their decision needs to account for the interest
rate differentials…
…But also for the evolution of the exchange
rates between currencies.
This arbitrage mechanism produces what is
called the uncovered interest rate parity (UIRP)

This gives us a relation between interest rate
differentials and changes in the exchange rate
From IS-LM to Mundell-Fleming

You are a European investor with capital K
(in €) looking for a 1-year investment.

You can invest in €-denominated bonds, and
after a year you earn:
K  1  i€ 

Or you can buy $-denominated US bonds:
 Step 1: you first convert your capital into dollars:
K  e$ / €
 Step 2: after a year, you’ve earned (in dollars):
K  e$ / €  1  i$ 
From IS-LM to Mundell-Fleming

But you need to bring you investment back
home !



In other words you need to convert your
capital in $ back into €.
In the mean time the $/€ exchange rate may
have changed
Step 3: you convert your investment into €
K  e$/ €  1  i$ 
e$/E €

You are indifferent if the 2 returns are equal
From IS-LM to Mundell-Fleming

You’re indifferent between $ and € assets if:
K  1  i€  

K  e$/ €  1  i$ 
e$/E €
Rearranging gives:
e$/ €
1  i€  E 1  i$ 
e$/ €

1  i€ e$ / €
 E
1  i$ e$ / €
If the exchange rate is not too volatile, this
can be expressed as:
e$/ €  e$/E €
i€  i$ 
e$/ €
From IS-LM to Mundell-Fleming

Let’s summarise: Capital flows ensure an equalisation
of interest rates expressed in the same currency
e$/ €  e$/E €
Expected exchange rate
i€  i$ 
Home interest rate
depreciation
e$/ €
World interest rate

If the home interest rate is higher than world interest
rate, zero net capital flows between countries requires
investors to be expecting a depreciation of the home
currency.


If this is not the case, then capital will flow into the home
country, appreciating e until depreciation expectations occur
Only if the home rate equals the foreign rate will
depreciation/appreciation expectations be zero (equilibrium)
From IS-LM to Mundell-Fleming

i
BoP surplus
Appreciation of e

BP
On BP the balance of
payments is in
equilibrium
BP is upward-sloping


KA surplus
CA deficit

BoP deficit
Depreciation of e
Y
An increase in Y leads to a
BoP deficit (CA deficit)
Returning to equilibrium
requires a KA surplus, and
hence a higher i
The slope depends on
the international
mobility of capital

The lower capital mobility,
the larger the slope of BP.
From IS-LM to Mundell-Fleming
i
Perfect capital
mobility

i=i*
BoP Surplus
Appreciation of e
i*

BP

BoP Deficit
The MF model was
developed in the 60’s, when
capital mobility was low
(Bretton Woods)
As a simplification,
nowadays we assume
perfect capital mobility
However, this remains a
simplification!

Depreciation of e
Y
For certain cases (like the
case of trade with China),
The concept of imperfect
capital mobility remains
relevant.
From IS-LM to Mundell-Fleming

We now have 3 curves, IS-LM-BP :
i
LM
i*
BP
IS
Y
The Mundell-Fleming model
From IS-LM to the Mundell-Fleming
model
Effectiveness of policy
The effectiveness of policy

We now move to assessing the effectiveness of
policy under the possible exchange rate
settings:
Fixed
exchange
rate
Flexible
exchange
rate
Fiscal
Policy
??
??
Monetary
Policy
??
??
The effectiveness of policy

Monetary policy with fixed exchange rate:
i

LM

BP
i*
LM shifts to the right

IS
Y

The increase in the money
supply lowers the rate of
interest, leading to
depreciation pressures on e
In order to guarantee the
fixed exchange rate the CB
must immediately increase i
to i=i* by reducing money
supply
Such a policy cannot be
carried out in practice
The effectiveness of policy

Fiscal policy with fixed exchange rate:
i

LM

BP
i*
IS shifts to the right:

IS
Y

The crowding out effect
increases the rate of interest,
creating appreciation
pressures on e
In order to guarantee the
fixed exchange rate the CB
must immediately reduce i
to i=i* by increasing money
supply
Policy is effective in
increasing Y
The effectiveness of policy

Monetary policy with flexible exchange rate:
i

LM


BP
i*
LM shifts to the right
The depreciation of the
exchange rate stimulates
exports and penalises
imports

IS
Y

The interest rate falls, which
leads to a depreciation of the
exchange rate e
As a resut IS shifts to the
right
Policy is effective
The effectiveness of policy

Fiscal policy with flexible exchange rate:
i

LM

BP
i*
IS shifts to the right

The appreciation of the
exchange rate penalises
exports and stimulates
imports

IS
Y

The Central Bank doesn’t
have to react: The interest
rate increases and the
exchange rate appreciates
IS shifts left
Policy is ineffective
The effectiveness of policy


Summarising all this:
Fixed
exchange
rate
Flexible
exchange
rate
Fiscal
Policy
Effective
Ineffective
Monetary
Policy
Impossible
Effective
Even with this simple example (assumption of perfect
capital mobility), one can see that the effectiveness of
policy depends on international conditions!
The effectiveness of policy
Monetary
Union
Incompatibility
Triangle
(Mundell)
Financial
Autarky
Autonomous monetary policy
Flexible
Exchange rate

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