Chapter fixed prices: the mundell – fleming model

CHAPTER 6. FIXED PRICES: THE MUNDELL – FLEMING MODEL

The Mundell – Fleming (M – F) model adheres to the Keynesian tradition that it is AS which takes the passive role of fixing the price level, while AD variations determine the level of economic activity. It was developed by Bretton Woods system and was highly influential in the 1960s, particularly in policymakers circles, not least because it focuses mainly on normative questions relating to the optimal combination of monetary and fiscal measures for demand management in an open economy.

6.1 The Setting
The M – F model is set in the context of a macroeconomic model which is simply the special case referred to as Keynesian in chapter 3.

6.1.1 The Domestic Economy

A1. AS Curve is flat
Since output adjusts passively, the concentration will be made on AD side of the economy and the IS- LM framework will be considered within AD.

6.1.2 The Balance Of Payments (BOP)
The distinctive feature of the M – F model is in the specification of the external sector of the economy. Current Account (CA) is determined independently of capital account, so that the achievement of the overall balance requires the adjustment in the domestic economy.
The Current Account
A2. PPP does not hold even in the long run. CA positively depends on (real) exchange rates and negatively on (real) income. The CA surplus, B is given by:
B = B (y, q) = B (y, S) B_y < 0 and B_S > 0
The higher is income, the greater is the demand for imports and hence the smaller the surplus or greater the deficit.
The Capital Account
The role of interest rates is absolutely central to the M – F model.
A3. Exchange rate expectations are static.
A4. Capital mobility is less than perfect.
In Chapter 3, perfect capital mobility was assumed as a result of interest rate changes. In M – F model it is regarded as a special case. In general, interest rate differentials are assumed to provoke finite flows into or out of a country.
K = K (r – r^*) = K (r)
This simply says that domestic net capital inflow, K, is an increasing function of the extent to which the domestic interest rate is greater than the one in foreign country, inclusive of any depreciation expected in the value of domestic currency.

The BOP Focus

BOP equilibrium obtains when the flow of capital across the exchanges is just sufficient to finance the CA deficit or absorb the surplus. By definition, under a pure floating system, the overall BOP must be in equilibrium at all times. This means that the sum of the surplus on capital and CA must be zero; a surplus on one account must be balanced by a deficit on the other.
A pure float requires the following condition to apply at all times:
B(y, S) + K (y) = 0 where
F (y, S, r) = 0 F_y < 0 F_S > 0 F_r > 0
This relationship is plotted in figure 6.1.

BP lines plot the combinations of y and r consistent with BOP equilibrium for different values of S. The lines follow that higher income must be associated with higher interest rates for BOP equilibrium. As y increases at any given S, CA deteriorates as import demand grows. To preserve equilibrium, the capital account must improve, so r increases.

As S increases, there will be improvement in CA requiring more modest net capital flow and lower r which shifts BP line downward to the right.
The TT line plots CA balance of B = B (y, q) = B (y, S). The higher CA balance is, the greater must be the exchange rate. Any CA deficit (surplus), especially in floating rates, should be offset by a CA surplus (deficit) in capital account of the same size.
FF line plots F (y, S, r) = 0. BOP equilibrium associates higher r with lower price of foreign currency. FF line slopes downward at a given y. As y increases, FF shifts to the right, since equilibrium requires depreciation to compensate for the additional import demand.
FF line is flat if capital is perfectly mobile and hence there is no horizontal shift when y increases.

6.2 Equilibrium
Points A, a, and E gives initial equilibrium levels under floating exchange rates.

6.3 Monetary Expansion With a Floating Exchange Rate
A monetary expansion in floating rate system shifts LM curve to the rightwards, so that r has to fall to r₂ at point C. But at this point domestic currency should depreciate, because at lower r, the net capital inflow will be smaller and at higher y, CA balance must have deteriorated.
When S increases, the competitiveness of domestic production will improve and demand for domestic goods and services increases shifting IS curve to the right. The equilibrium will be settled at point B.
Conclusion of a monetary expansion in Floating rates of M – F model:

1. 
   Domestic currency depreciates
   
2. 
   Income increases
   
3. 
   Interest rates fall, provided capital is not completely mobile
   
4. 
   CA and BOP improve
   

6.4 Fiscal Expansion With a Floating Exchange Rate
Let’s assume a pure fiscal expansion (G increases) under floating rates with an unchanged money supply.
A fiscal expansion moves IS curve to the right, the Government can only finance its extra spending by borrowing more. Significant additional borrowing is only possible at higher r. The initial equilibrium will come to point C after fiscal expansion, but it is inconsistent with the equilibrium in the external sector. There will be influx of funds into domestic market and excess demand for domestic currency. The domestic currency should appreciate so to shift IS curve back to point B. The equilibrium will be restored at point B. At point F, there will be CA deficit.
Conclusion of a fiscal expansion in Floating rates of M – F model:

1. 
   Domestic currency appreciates
   
2. 
   Income rises, provided capital is not completely mobile
   
3. 
   Interest rates rise, provided capital is not completely mobile
   
4. 
   CA and BOP deteriorates
   

6.5 Monetary Expansion With a Fixed Exchange Rate
After a monetary expansion, LM curve shifts downward to the right. New equilibrium will be point B. A fall in r will worsen capital account balance and a rise in y with unchanged S causes deterioration in the CA at point F. A deficit in BOP will create excess supply of domestic currency, which causes FX to fall. Instead of increasing S in the fixed system, r, y and BOP moves back to the starting equilibrium point at A.

Conclusion of a monetary expansion in fixed rates of M – F model:

1. 
   In the short term, r falls, y rises, BOP on CA and capital account deteriorates, provided capital is not completely mobile
   
2. 
   In the long term, FX falls, no change in y, r and BOP
   

6.6 Fiscal Expansion With a Fixed Exchange Rate (G rises)
As a result of fiscal expansion, the IS curve shifts rightwards from A. r and y rise. Point C is not a LR equilibrium level. At higher r, capital account improves by more than the deterioration in CA, which causes a simultaneous increase in y. After FF shifts, r will be still too high for LR equilibrium.
So money supply will be expanded so to shift LM curve to the right at point B.
Conclusion of a fiscal expansion in Fixed rates of M – F model:

1. 
   In the SR, r and y rise, surplus in BOP
   
2. 
   In the LR, a further increase in y, r falls somewhat, BOP balance shrinks to zero, leaving substantial CA deficit.