Mundell-Fleming Model

Paul Kohlhaussen

Agenda• History• IS-LM• Balance of Payments• The Impossible Trinity• Applications• Further points of investigation

Assumptions

HistoryMundell’s & Fleming’s Expansion

• 1960s• Robert Mundell• Marcus Fleming } Independently expanded

on the Keynesian model of macroeconomic policy

• Small open economy, short run• Impact of macroeconomic policy under

• Floating exchange rates• Fixed exchange rates

IS-LMInvestment Savings Curve Liquidity Preference

Money Supply Curve• IV: Interest Rate • DV: Level of Y

• IV: Level of Y • DV: Interest Rate

Y = C + I + G + NX M/P = L(i,Y)

i I

= YMD = i

Y

Balance of PaymentsCurrent + Capital Accounts:

A country’s transactions with the rest of the world

BoP = CA + KA

Current Account Capital Account

• Imports & exports • Investment income • Foreign aid - transfers

• ± Foreign holdings of country’s assets

• ± Country’s holdings of foreign assets

Under a Flexible Exchange Rate

Global interest rates increase:

i

YIS

LM

BoPBoP1

IS1

• Capital flows out • Depreciates currency • Boosts exports • IS curve shifts to the right

(Marshall-Lerner condition)}

iW

iW1

Y1Y

Under a Fixed Exchange Rate

Expansionary Monetary Policy:

i

YIS

LM

BoP

• Gov. buys bonds: money supply • i decreases, Y increases = capital outflow • Y = Imports increase: NX<0: currency depreciates

iW

iW1 BoP1

LM1

Y1Y

Under a Fixed Exchange Rate

Expansionary Fiscal Policy:

• Government expenditure , IS shifts right • i increases, Y increases = capital inflow • Current account , BoP shifts up • Sell currency, money supply = new Y

i

YIS

LM

BoP

BoP1

IS1

iW

iW1

Y1Y

LM1

The Impossible Trinity

Free capital mobility

Fixed exchange

rates

Independent monetary policy

Applications

• Croatia: only monetary or only fiscal policy will have no effect on economy because of capital flows (LC!)

• German reunification: i increased with strong growth, caused France and Belgium to lose demand & output due to EMS ties

• Poland? (Too big?)• Other suggestions?

Aim: to investigate the effectiveness of different policies under the Mundell-Fleming model

Transition of socialist

planning to open capitalism }