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American Economist

Mundell-Fleming model revisited, The

Mundell-Fleming model revisited, The

Fan, Liang-Shing

Abstract

With the globalization of the world economy, improved international capital mobility, and the popularity of fixed (pegged) exchange rates among small developing and transition economies, the Mundell– Fleming model has reasserted its importance as an analytical tool. This paper surveys the Mundell-Fleming model in major macroeconomics and international economics textbooks.

In the graphical presentations, all textbooks use the traditional IS-LM curves in the (y, i) plane except Mankiw who presents a model in the (y, e) plane with a unique addition of the effect of import restriction policies.

It is generally known that fiscal expansions will worsen the trade balance. A synthesized model is presented in which a necessary condition for such effect is derived.

I. Introduction

As a result of awarding the 1999 Nobel Prize for Economics to Robert Mundell, one of his major contributions, the Mundell-Fleming model, has become a focus of attention. Because of the expansion in international trade and the globalization of international finance, many developing and transitional economies in the world are facing the problem of choosing an appropriate exchange rate regime. In light of the improvement in international capital mobility, many small countries are choosing a pegged (fixed) exchange rate system. As pointed out in Mundell (1963) and Fleming (1962), when a small country tries to maintain a fixed exchange rate in a world of perfect capital mobility, money stock becomes endogenous. This result renders the monetary policy completely ineffective as a stabilization policy instrument.

Why would many small developing and transitional economies choose a fixed exchange rate system in a world dominated by globally floating key currencies? There are many pros and cons, but one fundamental reason may be that the lack (or backwardness) of financial institutions and securities markets makes the execution of the monetary policy ineffective. This situation leaves fiscal policy as the only remaining powerful policy instrument in a fixed exchange rate system. Thus, the understanding of policy effectiveness in an open economy becomes a very important part of any macro and international economics teaching.

This paper first investigates the key role the Mundell-Fleming model plays in the analysis of open economy stabilization policies in most of the major upper-division macro and international economics textbooks. Different models presented in these textbooks are compared. Most models are of the standard IS-LM framework in the original Mundell-Fleming fashion in the (y, i) plane, with y and i being income and the interest rate, respectively. N. G. Mankiw (2000) presents an innovative approach in the (y, e) plane, where e represents the exchange rate, instead.

The major motivation for this synthesis of the Mundell-Fleming model is that, in spite of Mankiw’s innovative approach, his conclusion that fiscal expansion has no effect on the trade balance is counter to that of all other texts. Moreover, his unique contribution of adding a trade restriction policy needs further clarification. This is because trade restriction policies may not improve the trade balance under certain circumstances. This situation is clearly evidenced by the experiences of some rapidly expanding Asian countries before the 1997 Asian Crisis. These countries chose to peg their exchange rates to the U. S. dollar, adopted fairly restrictive import policies and experienced amazing GDP growth until 1997, but maintained huge sizes of current account deficits throughout the expansion period as shown in Table I below.

This paper first surveys most of the current major macro and international textbooks and presents three major approaches by Dorsbusch/Fisher/Startz, Blanchard, and Mankiw, respectively. Then, a synthesized Mundell-Fleming model is constructed. It is generally believed that trade restriction policies will improve the trade balance. With this model, a necessary condition for such desired effect is derived.

II. Survey of Macro and International Economics Textbooks

The Mundell-Fleming model uses the Hicksian IS and LM framework to analyze the effectiveness of fiscal and monetary policies for small countries under fixed and flexible exchange rates with the assumptions of perfect capital mobility. The analysis belongs to the domain of open macroeconomics as well as international economics. The first appearance of this model in a book was Mundell’s (1968) Chapter 18 on capital mobility and stabilization policy under fixed and flexible exchange rates, adapted from his original article (Mundell, 1963). Other major advanced books such as Obstfeld and Rogoff’s Foundations of International Macroeconomics (Obstfeld and Rogoff, 1996), present it as the Mundell-Fleming-Dornbusch Model. However, our emphasis in this paper is on the treatment of the Mundell-Fleming model in undergraduate macro and international economics. With this specific focus of the study, Dornbusch’s Open Economy Macroeconomics (1980) would be too difficult for undergraduate students, even though it provides the most advanced treatment of the Mundell-Fleming model. In this paper, fourteen major macro and international economics textbooks are examined. Surprisingly, six of them (Abel and Bernanke 1998, Barro 1997, Farmer 1999, Gordon 2000, Hall and Taylor 1997, and Krugman and Obstfeld 2000) did not even cite Mundell’s contributions, and none of them has analyzed the problem.

Auerbach and Kotlikoff (1998) argues that in a small open economy the IS curve is virtually horizontal which renders the fiscal policy completely ineffective. Thus they argue in favor of a flexible exchange rate regime under which monetary policy is effective.

Baily and Friedman (1995) use the basic IS-LM diagram to discuss the macroeconomic policy in an open economy strictly in terms of a floating exchange rate system. Dornbusch, Fischer, and Startz (1998, pp. 283-293) present the essence of the Mundell-Fleming model by arguing that even though later research has refined the Mundell-Fleming analysis, the initial formulation remains intact for the purpose of understanding the basic policy effects under a regime of high capital mobility. With perfect or near perfect capital mobility, the balance of payment (BP) will be at equilibrium at the world interest rate, i.e., BP = 0 at i = i^sub f^, where i and i^sub f^ represent the domestic and the foreign (world) interest rates, respectively. Then the standard model will neatly demonstrate that a deviation of domestic interest rate from the world rate due to the monetary expansion (contraction) will create a pressure on currency depreciation (appreciation) through capital outflow (inflow). In order to eliminate this pressure, a subsequent monetary contraction (expansion) policy will have to be taken. This makes the monetary policy completely ineffective. On the contrary, the fiscal policy is effective under the fixed exchange rate system. Analytically, the monetary policy would regain its independence and become an effective policy under the flexible exchange rate system. Using only the basic tools of the IS-LM analysis, the presentation of Dornbusch, Fischer, and Startz (1998) is actually very appropriate for the undergraduate students in terms of its simplicity.

Froyen (1999) devotes one whole chapter on monetary and fiscal policies in an open economy and states that the chapter is strictly fashioned after the Mundell-Fleming model. However, Froyen provides a neat addition for the case where capital mobility is imperfect so that the BP = 0 curve is upward sloping.1 He then analyzes the monetary and fiscal policies under such a condition. In the second half of the chapter, the standard Mundell– Fleming small country with perfect capital mobility situation is analyzed.

Blanchard (2000) presents a unique extension of the Mundell-Fleming model.2 He introduces simple, but very clear, financial investor arbitrage behavior that seeks the highest global expected rate of return so that, at the equilibrium, the interest parity condition’ must hold. Thus, his general open economy model consists of IS, LM, and the interest parity condition. His fixed exchange rate case will transform the interest parity condition to the condition requiring i = i^sub f^ and is equivalent to Mundell-Fleming’s small country with perfect capital mobility. In other words, the Mundell-Fleming fixed exchange rate case is a very special case in Blanchard’s general framework.

In his latest edition, Mankiw (2000) presents a Mundell-Fleming model in the (y, e) plane instead of the traditional IS-LM framework in the (y, i) plane. He calls his model the IS*-LM* model. Since the LM* function is independent of the exchange rate, and with the i = i^sub f^ condition of perfect capital mobility, a unique level of GDP is obtained from the LM* function M/P = L(i^sub f^, y). The advantage of the Mankiw approach is that the exchange rate, instead of the interest rate, appears explicitly on the vertical axis. This result makes it easier for students to understand the role of the exchange rate, e. He also presents in his framework the effect of trade restriction policies vastly ignored by all others.

In major international economics textbooks, the analysis of external balance, i.e., BP = 0, plays a major role. In general, BP (y, i) = 0 is an upwardsloping function (curve) because as y increases, the current account balance (especially the trade balance) worsens so that BP = 0 resumes only when a higher domestic interest rate, i, attracts capital inflow to offset the deficit. Moreover, the interest sensitivity of international capital flow (i.e., the interest elasticity of BP = 0) can be greater or less than that of the LM function (curve). Linden and Pugel (1996) and Salvatore (2001) present cases where the BP = 0 curve is steeper than the LM curve, flatter than the LM curve, or is horizontal. Under the fixed exchange rate, as the BP = 0 becomes flatter, the effectiveness of fiscal policy as a stabilization policy will increase. This situation is exactly the case in the Mundell-Fleming model. Appleyard and Field (2001) add another extreme case where BP = 0 is completely interest inelastic (i.e., the BP = 0 curve is vertical). In this case there is a complete capital immobility such that there is only one level of GDP which is commensurate with BP = 0. Thus, any fiscal expansion will create a balance of payments deficit, and the money supply will contract until the original y is restored again. In contrast to the Mundell-Fleming case, the fiscal policy is completely ineffective.

It is clear from this survey that the original contribution of Mundell and Fleming has become a very special case of a general model in most international economics textbooks. Of course, Froyen and Blanchard also generalized the model in their books. In this paper, attention will be focused on the original contribution, i.e., the horizontal BP, as most macroeconomics textbooks do.

III. The Formal Analysis of Various Models

VI. Summary

A synthesis of the Mundell-Fleming model, incorporating the income effect on the investment function and the trade balance function, has enabled us to present a simple but important necessary condition which states that in order for an expansionary fiscal policy and a trade restriction policy to have worsening effects on the trade balance, the marginal propensity to save has to be less than the marginal propensity to invest, i.e., (alpha

The importance of this synthesis can also be seen from the fact that Mankiw concluded that under a fixed exchange rate system, the expansionary fiscal policy does not have any effect on the trade balance because dNX(e) = 0. However, this conclusion contradicts his statement that as y increases, NX(e) = (S – I) > 0 (Mankiw p. 327). In a comparative static model, (S – I) > 0 always implies that net exports have to be positive. In our synthesis, as long as alpha

The analysis here is carried out for small open economies with perfect capital mobility under a fixed exchange rate regime. Today, many small emerging economies have indeed tried to peg their exchange rates to the U.S. dollar or to other key currencies in order to increase the capital mobility and attract foreign capital inflows to stimulate their economic growth.

Notes

1. A simple explanation for the BP curve’s being upward sloping is that as income, y, increases, the trade balance worsens such that for BP = 0, the domestic interest, i, has to be higher to attract capital inflows (or reduce capital outflows).

2. He states that his model keeps the spirit, but differs in its details from the original Mundell– Fleming model. (Blanchard p. 381)

3. The interest parity condition is: i = i^sub f^ + (e^sup e^ e)/e, or e = e^sup e^/(1 + i – i^sub f^). i is the domestic inter

est rate, if is the foreign interest rate, e is the exchange rate, and el is the given expected depreciation of the exchange rate. This formula omitted a third cross-product term whose order of magnitude is small. However, if the interest/inflation differentials are large, this omitted term may be significant. (See Krugman and Osbtfeld 2000, p. 361.)

4. e, the exchange rate is a unit of foreign currency in U.S. dollars, i.e., as e increases, the dollar depreciates. However, Mankiw’s e is the number of foreign currency units per dollar, i.e., as e increases, the dollar appreciates.

5. See Mankiw p. 328, Table 12-1.

References

Andrew B. Abel and Bernanke, B. S., Macroeconomics, 3rd edition, Addison-Wesley, 1998.

Dennis R. Appleyard and Field, A. J., International Economics, 4th edition, McGraw Hill, 2001.

Alan Auerbach and Kotlikoff, L. J., Macroeconomics: An Integrated Approach, 2nd edition, the MIT Press, 1998.

Martin Baily and Friedman, P. Macroeconomics, 2nd edition, Irwin, 1995.

Robert J. Barro, Macroeconomics, 5th edition, MIT Press, 1997.

Olivier Blanchard, Macroeconomics, 2nd edition, Prentice-Hall, 2000.

Rudiger Dornbusch, Open Economy Macroeconomics, Basic Books, 1980.

Rudiger Dornbusch, Fischer, S., and Startz, R., Macroeconomics, 7th edition, Irwin/McGrawHill, 1998.

Liang-Shing Fan and Fan, C. M., “A Fundamental Analysis of Asian Crisis,” Proceedings of Academy of Business & Administrative Sciences International Conference, 1999.

Marcus Fleming, “Domestic Financial Policies under Fixed and Under Floating Exchange Rates,” International MONETARY Fund Staff Papers 9, Nov. 1962, pp. 369-79.

Roger E. A. Farmer, Macroeconomics, South Westem College Publishing, 1999.

Richard T. Froyen, Macroeconomics, 6th edition, Prentice-Hall, 1999.

Robert Gordon, Macroeconomics, 8th edition, Addison-Wesley, 2000.

Robert E. Hall and Taylor, J. B., Macroeconomics, 5th edition, Norton, 1997.

Paul Krugman and Obstfeld, M., International Economics: Theory and Policy, 5th edition, Addison-Wesley, 2000.

Peter H. Linden and Pugel, T. A., International Economics, 10th edition, Irwin, 1996.

N. Gregory Mankiw, Macroeconomics, 4th edition, Worth, 2000.

Robert Mundell, “Capital Mobility and Stabilization Policy under Fixed and Flexible Exchange Rates,” Canadian Journal of Economic and Political Science, 29, Nov. 1963, pp. 475-85.

Robert Mundell, International Economics, MacMillan, 1968.

Maurice Obstfeld and Rogoff, K., Foundations of International Macroeconomics, MIT Press, 1996.

Dominick Salvatore, International Economics, 7th edition, John Wiley, 2001.

by Liang-Shing Fan* and Chuen-mei Fan*

* Professors of Economics, Colorado State University, Fort Collins, CO 80523. We appreciate the anonymous referee’s comments which have greatly improved our presentation.

Copyright Omicron Delta Epsilon Fraternity Spring 2002

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