In the is-lm-fe (Mundell-Fleming) open-economy macroeconomic model with imperfect capital mobility, what does the term 'imperfect capital mobility' actually mean?

IS-LM-FE Model 5

1. 
   In the IS-LM-FE (Mundell-Fleming) open-economy macroeconomic model with imperfect capital mobility, what does the term 'imperfect capital mobility' actually mean? (Clue: why is the FE curve not drawn horizontal?)
   

The Mundell Fleming model, also known as the IS-LM-FE Economic model by Robert Mundell and Marcus Fleming. This model is extension of IS-LM model. Whereas traditional IS-LM model deals with closed economy while Mundell-Fleming model describes a small open economy.

The Mundell–Fleming model portrays the short-run relationship between an economy's nominal exchange rate, interest rate, and output (in contrast to the closed-economy IS-LM model, which focuses only on the relationship between the interest rate and output).

Abstract

Mundell-Fleming model is a standard open macroeconomic theory that tries to describe the effects of fiscal and monetary policies. It is believed that, under assumptions of small country and perfect capital mobility, fiscal policy is strong under fixed exchange rate while monetary policy is strong under floating exchange rate. This article extends assumptions of this theory, discusses effects of fiscal policy in a big, open economy under different capital mobility situations.

In this article, we extends assumption of Mundell-Fleming model from a small country under perfect capital mobility to a big country under different capital mobility, reveals the effects of fiscal policy under different capital mobility situations which is very different from Mundell-Fleming Model.

It is an open macro application of the standard IS-LM analysis which considers three aspects of macro economy: (1) domestic product market equilibrium (IS curve); (2) money market equilibrium (LM curve); (3) foreign exchange market equilibrium (FE curve).

The IS curve shows all possible combinations of the interest and real GDP Y that are consistent with equilibrium in the goods and services sector of the national economy, given the state of other fundamental influences.

i FE

LM

IS

Y

Figure 1: The equilibrium situation of three markets together

In the foreign exchange market, official settlement balance B equals the current account balance CA plus the capital account balance KA.

B = CA(Y) + KA(i)

FE curve in above figure 1 shows the sets of all interest-and-production combinations in a country that result in a zero value for its official settlements balance. If any of other fundamental influences changes, the entire FE curve shift. They include: (1) an exogenous increase or decrease in exports or imports. (2) Exogenous changes that result in an increase or decrease in capital flows

Mundell-Fleming model believes that, under assumptions of small country and fully capital mobility, fiscal policy is strong under fixed exchange rate while monetary policy is strong under floating exchange rate.

If a country is in fully capital mobility, FE curve must be a flat one (figure 2), then

I

LM

FE

IS

Y

Figure 2: Fully capital mobility

Here Mundell Fleming model suppose that it is small country and country’s capital is fully mobile.

BUT IN PRACTICE, it is not often that country’s capital is fully mobile. Mostly it is IMPERFECT MOBILITY. Imperfect capital mobility is a most likely case.

Here, we extend hypotheses of Mundell-Fleming model to a big country and discuss effects of fiscal policy under different capital mobilities. Then, we will have three kinds of capital mobility: (1) perfect mobility (figure 1) (2) imperfect capital mobility (3) immobility.

i LM

FE

IS

Y

Figure 3: Imperfect Capital Mobility

2. 
   In the IS-LM-FE (Mundell-Fleming) open-economy macroeconomic model with imperfect capital mobility, explain what happens to the FE curve when the domestic currency appreciates on the foreign exchange market. (Do not merely state what happens. Explain clearly why it happens.)
   

If a country is imperfect capital mobility, FE curve is upward, an expansionary fiscal policy will move IS curve to right. The new intersection of IS’-LM curve is to the left of FE curve which is a balance of payment surplus. Balance of payment surplus will cause domestic currency appreciate.

Under a fixed exchange rate, government will intervene in foreign exchange market by buying foreign currency and sell domestic currency in order to prevent currency appreciation. The intervention will cause LM curve move to right. At last, the new intersection of IS-LM-FE is E’, which is a higher domestic production compare with initial E (figure 4-1). So, under fixed exchange rate and imperfect capital mobility, fiscal policy is strong.

If it is a floating exchange rate, currency appreciation will not cause government intervention because floating exchange rate allows currency fluctuation. The appreciation will increase import and decrease export which will cause IS and FE curve move to left. The new intersection of IS-LM-FE is E’ which is a higher production compare with initial E (figure 4-2). But the effect of fiscal policy under floating exchange rate is less strong than it is under fixed exchange rate.

i i

LM LM’ LM

E’ FE E’ FE

E FE’ E

IS’ IS’

IS IS

Y0 Y1 Y Y0 Y1 Y

Figure 4.1 Fixed Exchange Rate Figure 4.2 Floating Exchange Rate

Conclusion:

Imperfect Capital Mobility:

Fixed Exchange Rate	Floating Exchange Rate
STRONG	STRONG

C. Using diagrams, explain the consequences of a fiscal expansion funded by bond sales, within an economy operating under the assumptions of the IS-LM-FE (Mundell-Fleming) open-economy macroeconomic model with imperfect capital mobility and floating exchange rates,

(i) when the FE curve is more interest elastic than the LM curve.

(ii) when the LM curve is more interest elastic than the FE curve.

In each case, compare the predictions of each version of the model with those of the closed economy IS-LM model.
An expansionary fiscal policy will shift the IS curve to IS’, moving the equilibrium from point E0to point E1. Now, depending on capital mobility, we’ll either have a balance of payments surplus (high capital mobility, FE+ curve) or a balance of payments deficit (small capital mobility, FE- curve). In the case of a balance of payments surplus, and considering flexible exchange rates, there will be an appreciation of the domestic currency. This will decrease net exports, which will shift the IS’ curve to the left. Also, since domestic assets are more expensive, the FE+ curve will shift to the left. The final equilibrium will therefore be at point E2. If there is a balance of payments deficit (the case for the FE- curve), the result will be the same one as in the monetary policy case (being E2* the final equilibrium). In this scenario, fiscal policy will be more efficient the smaller capital mobility is.

FE- FE*-

i

LM

E1 FE’+

E2 FE+

E0 IS*

IS’

IS IS”

Y

1. 
   When FE curve is more interest elastic than LM curve it has interest rate lower in domestic country than in foreign exchange market. Interest rate of the domestic country influences more in foreign exchange markets. Hence, minor change in interest rate in domestic country will have major impact in foreign exchange market. And in this case to adjust the FE curve interest rate of domestic country, government plays an important role by selling bonds and buying foreign currency. This will settle the FE curve.
   
2. 
   When LM curve is more interest elastic than FE curve means foreign exchange market has more influence in domestic country. Minor change in interest rate of foreign market will influence huge in domestic country. Hence government here buys domestic currency to depreciate the currency in foreign exchange market.
   

500. 
     Which of the versions of the model discussed in part c) is more applicable to an economy with a central bank managing liquidity to maintain a constant policy interest rate? Explain your selection.
     

The Mundell-Fleming model is a very useful tool when dealing with the analysis of open economies. A great deal of textbooks and papers argue for or against each of these models. However, there’s no denying the world is moving towards liberalizing international market and capital movements, which would make us lean towards Mundell’s view. To sum up, we can see that effect of fiscal policy depends on capital mobility. Under perfect capital mobility, monetary policy will only work with flexible exchange rates, while fiscal policy will only work with fixed exchange rates. Under Imperfect capital mobility fiscal policy is strong under both fixed and floating exchange rate.

BY CA KHYATI SAVJANI