The Mundell-Fleming Model

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The Mundell-Fleming Model
Chapter · January 2005

DOI: 10.1007/3-540-28524-5_6
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6 The Mundell-Fleming Model
The Mundell-Fleming model works with the assumption that prices are fixed. This
means that the aggregate supply curve is flat (horizontal in the extreme) and in-
come is determined by the aggregate demand only. Therefore, analysis in this
chapter is in the IS-LM framework, extended to incorporate the external sector –
the balance of payments, to become IS–LM–BP analysis, as studied in Section 5.2
of the previous chapter. The model has been originated in a series of papers and
collections by Mundell (1960, 1961, 1962, 1963 and 1964) and Fleming (1962 and
1971). The background, history and development of the Mundell-Fleming model
can be found in Mundell (2001) and Obstfeld (2001), which the interested reader
may refer to.
This chapter examines the effects of monetary policy and fiscal policy under
various assumptions on exchange rate regimes and capital mobility in the IS-LM-
BP framework. Specifically, we analyse and discuss the effects and effectiveness
of monetary policy and fiscal policy under the following scenarios: perfect capital
mobility or small open economy (SOE) with flexible exchange rates and fixed ex-
change rates respectively; and imperfect capital mobility or non-SOE with flexible
exchange rates and fixed exchange rates respectively. Under each of the scenarios
the effects of monetary policy changes and fiscal policy changes are considered
respectively, so there are eight sets of individual cases. Finally we compare the
outcomes and comment on the use of one policy against the other under certain
circumstances.
6.1 Effects and Effectiveness of Monetary Policy and

Fiscal Policy - Perfect Capital Mobility
Under perfect capital mobility (PCM), the domestic interest rate, after enduring a
shock such as a monetary/fiscal expansion/contraction, returns to its original level
eventually. In the SOE case, the original level of the interest rate is the world rate
of interest. We know from the standard closed economy IS-LM analysis that a
change in monetary policy shifts the LM curve while a change in fiscal policy
shifts the IS curve. In an open economy, one policy change may shift both LM and
IS curves. For example and under a flexible exchange rate regime, a monetary ex-
104 6 The Mundell-Fleming Model
pansion has direct effect on the LM curve and shifts the LM curve towards the
right initially; then the resulted increase in the exchange rate (depreciation) has the
consequence of moving the IS curve to the right as well, a phenomenon similar to
the effect of a fiscal expansion. Likewise and under a fixed exchange rate regime,
a fiscal expansion has direct effect on the IS curve and shifts the curve towards the
right initially. However, since the exchange rate is fixed, the deterioration in the
current account may not be exactly offset by the amount of capital inflows, lead-
ing to an adjustment or change in official reserves and money supply. This conse-
quently changes the LM curve position. From such preliminary reasoning, we be-
come aware that, in an open economy, the economy may benefit from the
implementation of a policy in more areas and to a larger extent than in a closed
economy. The opposite is also true and the economy can be put in a state of com-
plete mess.
6.1.1 Monetary Expansion - Perfect Capital Mobility, Flexible

Exchange Rates
The first case we analyse is the effects and effectiveness of an expansionary

monetary policy. Suppose the goods market, the money market and the balance of
payments were in equilibrium at point A before the monetary expansion. As Fig-
ure 6.1 indicates, a monetary expansion shifts the LM curve to the right but has no
immediate effect on the IS curve, so the latter maintains its original position, lead-
ing to a temporary equilibrium at point B. As the domestic interest rate is lower
than the interest rate in the rest of the world, capital flows out of the country, net
deficit in the capital account accumulating (net surplus decreasing). This takes ef-
fect on the current account of the balance of payments, resulting in an increase in
net current account surplus (decrease in net deficit) and shifting the CA curve to a
more favourable position CA’, accompanied by the depreciation of the domestic
currency. The wealth effect can be seen as the IS curve shifts to the right due to a
net increase in trade balance. A new equilibrium attains at point C. The IX curve
shifts to IXT temporarily when the domestic interest rate is lower than that in the
rest of the world and returns to its original position after the two interest rates be-
come equal again. The process can be more precisely described by changes in the
values of the variables in relevant equations as follows:
(1). Monetary expansion: the LM curve in the i-Y plane shifts from
M to M 'M .
JY Mi JY M i
P P
(2). Capital outflow: 'K k , k ! 0 (N=f, 'i = -0.).

The LX curve in the S-Y plane1 shifts to LXT.
1
Slightly different from the analysis in Chapter 5, we use the nominal exchange rate S in
this chapter in place of the real exchange rate Q, so the Q-Y plane become the S-Y plane.
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