Mundell Fleming Model

The dominant policy paradigm for studying openeconomy monetary and fiscal policy

Dr. R. Sinha Ray

MDI Gurgaon

Capital Mobility
Meaning- Free flow of capital from one
economy to the other and vice versa
without any restrictions
This implies integration of capital
markets in the world like bonds market
and stock market
This also implies that a resident of any
country will look for the highest yield in
the world market and tends to equate
the world rate of return on capital
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Factors that affect capital

mobility
Tax differences among countries
Exchange Rates
Political risks in a country Any
country can put some obstacles on
capital flows

Macroeconomic Mechanism
with capital mobility
With capital mobility between countries the
equilibrium in the world market will produce
same level of interest rates (rate of return on
capital)
If country As interest rate becomes less relative
to the Country B, then there will be a capital
outflow from A to B. This in turn will worsen
country As BOP and improve country Bs BOP.
Therefore monetary and fiscal policies of
countries which affect interest rates of
respective countries, can affect BOP conditions
of two countries through cqapital flows.
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BOP and Capital flows

Balance of Payments surplus is defined by
BP=NX(Y, Yf, R) + CF(r-rf)
(1)
where NX is the net exports, CF is the net
capital flows, r and rf are domestic and foreign
rates of interests.
Increase in income worsens the trade balance
Increase in interests leads to net capital inflow
So with rise in income if interest rate rises then
trade deficit will be financed by capital inflow
and overall BOP will be balanced.

Policy dilemma: Internal and

External balance
Policy dilemma exists if there is a conflict
between internal and external goals
Internal balance defined by full employment
External balance is defined by BOP balance
where Central government neither depletes
its reserves nor accumulates more reserves.
An expansionary monetary policy may solve
unemployment problem but worsen BOP
deficit if the economy was already facing
BOP deficit
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Internal and External

balance
r

E4
E3
BOP>0
BOP>0
Unemployment Overemployment
rf

BP=0

E2
E1
BOP<0
BOP<0
Unemployment Overemployment
O

Y*

Internal and external balance

under fixed exchange rate
regime

Policy dilemma in zone 1 has been

already explained in previous slides
Dilemma may be resolved through
mix of fiscal and monetary policy
Undertaking one policy may worsen
the situation.
For example Expansionary fiscal
policy with contractionery monetary
policy may resolve the issue.

Mundell Fleming model: Perfect

Capital mobility in Fixed
exchange rate regime

This model extends the standard IS-LM

model to open economy macroeconomy
Assumptions: Perfect capital mobility
under fixed exchange rate regime
Conclusions:
Independent Fiscal policy is effective
Independent Monetary policy is
ineffective

Effectiveness of Fiscal Policy under

Fixed Exchange Rate with capital
Mobility
With expansionary fiscal policy output and income rise

thereby raising consumption and import demand

transaction demand for money rises thereby raising
interest rate
Interest rate rises thereby crowding out investment
and also more capital inflow
In order to keep the exchange rate fixed some surplus
dollar inflow gets absorbed in meeting trade deficit,
but remaining inflow will result in RBI intervention
RBI buys dollar and supply more rupee increasing
Money supply
Rate of interest comes down and investment again
expands
Fiscal policy is fully effective as it does not crowd out
Inv
Case of Greece why they had gone for fiscal policy

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Fiscal Policy in IS-LM model

r
IS

IS1

rf

Y1

LM

Y2

LM
1

BP=0

Y
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Effectiveness of Fiscal Policy under

Fixed Exchange Rate with capital
control
With expansionary fiscal policy output and

income rise thereby raising consumption and

import demand
Transaction demand for money rises thereby
raising interest rate
Interest rate rises thereby crowding out
investment without any capital inflow
Import demand creates BOP deficits. In order
to keep the exchange rate fixed RBI
intervenes by selling dollars and reducing
Money supply
Rate of interest goes up further and
investment gets more crowded out expands
Fiscal policy is fully ineffective here

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Effectiveness of Monetary policy

under Fixed Exchange Rate with
capital Mobility

With expansionary monetary policy there will

be fall in interest rate
This fall in interest rate will lead to rise in
Investment but leads to capital outflow
This leads to pressure on rupee to
depreciate.
RBI intervenes to keep the exchange rate
fixed by selling more dollars and reducing
money supply which will again increase the
interest rate
Thus independent monetary policy cannot be
pursued as it is completely ineffective
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Monetary Policy in IS-LM

model
r
IS

rf

LM

LM
1

BP=0

E
E

Y1

Y
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Effectiveness of Monetary policy

under Fixed Exchange Rate with
capital control

With expansionary monetary policy there

will be fall in interest rate
This fall in interest rate will lead to rise in
Investment and income but no capital
outflow
There will some trade deficit due to rise in
income and imports and in the process RBI
will have to supply some dollars and money
supply will be affected by some extent
Effectiveness is better here as it will bring
about some increase in income.
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Applying M-F model in Flexible

exchange rate regime with perfect
capital mobility

Fully flexible currency implies no

intervention from RBI
Thus any current account deficit is
financed by private capital inflow only
making BOP balance zero.
Exchange rate adjusts fully
Under such a system fiscal policy is
ineffective but monetary policy is
effective

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Effectiveness of Fiscal Policy under

Flexible Exchange Rate with
capital
Mobility
With expansionary fiscal policy output and

income rise thereby raising consumption and

import demand
transaction demand for money rises thereby
raising interest rate
Interest rate rises thereby crowding out
investment and also more capital inflow
Rupee appreciates against dollar and exports
are crowded out and net exports fall
Fiscal policy is fully ineffective to bring about
changes in output
Thus fiscal policy was never an effective tool for
countries after they moved to flexible exchange
arte regime. Fiscal consolidation is always
advocated in these countries

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Ineffective Fiscal Policy in

flexible exchange rate regime
r
IS

IS1

rf

Y1

LM

BP=0

Y
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Effectiveness of Fiscal Policy under

Flexible Exchange Rate with
capital
control
With expansionary fiscal policy output and

income rise thereby raising consumption and

import demand
Transaction demand for money rises thereby
raising interest rate
Interest rate rises thereby crowding out
investment without any capital inflow
Import demand creates BOP deficits that will
lead to rupee depreciation and net exports will
increase to increase rise in income and output
further.
Here though investment crowds out but exports
grow
Fiscal policy is therefore effective to bring about
come increase in output

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Effectiveness of Monetary policy

under Flexible Exchange Rate with
capital Mobility

With expansionary monetary policy there will be

fall in interest rate
This fall in interest rate will lead to rise in
Investment but leads to capital outflow
This leads to rupee depreciation.
This leads to increase in exports and net
exports and increases further output and income
Thus independent monetary policy is completely
effective in bringing about a change in output
This is why any flexible exchange rate regime
developed nations tool had been Monetary
policy
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Effective Monetary Policy in

flexible exchange rate
r
IS

rf

LM

LM
1

BP=0

Y1

Y2

Y
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Effectiveness of Monetary policy

under Flexible Exchange Rate with
capital control

With expansionary monetary policy there

will be fall in interest rate
This fall in interest rate will lead to rise in
Investment and income but no capital
outflow
There will some trade deficit due to rise in
income and imports. This will lead to rupee
depreciation and net exports will rise
Thus Monetary policy is also better in this
system to bring about growth

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