Neven Vidakoviæ
1
UDK 330.5
330.834
APPLICATION OF THE
MUNDELL-FLEMING MODEL ON A SMALL
OPEN ECONOMY
November 2002.
ABSTRACT
The object of this paper is to investigate the applicability of a
Mundell-Fleming model. The model was developed in 1960s
with the main intention of opening the standard closed economy
Keynesian IS-LM model and adjusting the variables for the
capital flows and other shocks that might result from capital
flow. The paper develops the models into detail, contrasts the
closed economy and open economy IS-LM model. The paper
also extents the model for the application to the standard ratio-
nal expectations theory. After developing the model, I apply the
model to a small open economy. In this case, I chose Croatia.
Small open economy in the middle of Europe. The country was
chosen because it is currently undergoing the transition from
socialistic planed economy to open capitalistic economy and it
is very susceptible to the capital flows. The model fits the data
very good and proves on the data that monetary and fiscal pol-
392
1
Neven Vidakoviæ, B. Of Art in Economics and Mathematics, Smith Barney, City
Group USA
icy if used separately will have no effect on the economy be-
cause of the capital flows.
PART I = INTRODUCTION
The issue of how to model an open economy has always been one of
the key interests for the economic research. With the Keynesian revo-
lution that started with the publishing of Keynes’ monumental work
“General Theory of Money, Interest and Unemployment” the
grounds were set to investigate the nature of a closed economy, but
not until 1960s did the Keynesian economics had a substantial and
credible answer to the questions how to model a small open economy.
The answer came mostly through the research done by Robert
Mundell; Nobel Prize winner, in economics, in 1999 for his research
on the issues of the capital flow and behavior of the open economy.
The purpose of this paper is to apply the model proposed by Mundell,
expand it and give empirical analysis of the model. The model will be
analyzed through a small open economy, for the country I choose
Croatia. Country in the middle of Europe with area of 56 000 square
kilometers and population of 4.3 million people.
The model is called Mundell-Fleming model, it tires to adjust the
standard Keynesian IS-LM model to a small open economy
sucepptible to outside credit and real shocks. In order to do so
Mundell added another variable to the standard IS-LM model. He
called this variable the capital mobility line. By doing so and through
the comparative static method he was able to perform new analysis of
the existing problems and offer some interesting interpretations of the
problems that could not be solved through the standard IS-LM analy-
sis.
The specific part of the model that I will analyze will be the monetary
and fiscal aspect. The main reason why I choose Croatia is the fact
that Croatia is in the middle of transition from the socialistic planed
economy to capitalistic open economy. In such enviroment capital
mobility will be a crucial part of the development and the transition
from a socialistic to the capitalistic market and adjustment to the
world of free trade dominated by the ever-changing world of free
movements of goods and capital.
Since it is a fact that the model is out of date and that lot of things have
changed in a way we look at the macroeconomic variables from
393
NEVEN VIDAKOVIÆ: Application of the Mundell-Fleming on Small Open Economy
EKONOMIJA / ECONOMICS, 11 (3) str. 392 - 423 (2005)
www.rifin.com
1960s, I will try to update the model by adding some of the rational
expectations theory. I will adjust both the Keynesian model and the
standard Lucas based rational expectation model in order to get
model that is both functional and applicable to the data and the prob-
lems that the Croatian or any other small open economy might face.
The other part of the completely Keynesian model is the labor market.
In this paper, I will not go into depth analyzing the labor market. Al-
though the unemployment in Croatia is significant problem and it is
above 15% in the whole time period during which the data is ana-
lyzed. There is no point in trying to solve the problem of unemploy-
ment; since the unemployment is a derivative of the monetary and fis-
cal problems that the Croatian economy is experiencing.
The rest of the paper is separated in the following parts. The second
part is the derivation and the explanation of the model. The model
will be presented as a standard Keynesian model whose basic equa-
tion is Y=C+I+G+(EX-IM). GDP is presented as a function of five in-
dependent functions that all are dependent on several other variables.
The standard IS-LM relationship will be given as the basis for the
analysis of the data presented in part four.
In part three I will solve some practical problems that are encountered
in a real economy and which can be solved by using the model pre-
sented in part two. The problems will be focused on monetary and fis-
cal sides of the economy. In this part there will be some interesting re-
sults concerning the decision-making in a small open economy.
Part 4 is the application part, where I will take the actual data from the
Croatian economy and see is the economy behaving in a way the
model predicts. In part, five I will give a conclusion about the whole
analysis.
PART II = THE MODEL:
The model used is the basic Keynesian model used by Mundell.
When Mundell approached the standard Keynesian model of aggre-
gate demand presented through the IS-LM relationship, he realized
that the model is insufficient and cannot be applied for an open econ-
omy that is subjected to currency oscillations, changes in real ex-
change rate and free flow of capital. In order to go around the problem
Mundell introduced a capital mobility curve. This curve represented
the real interest rate imposed upon the country from the rest of the
394
NEVEN VIDAKOVIÆ: Application of the Mundell-Fleming on Small Open Economy
EKONOMIJA / ECONOMICS, 11 (3) str. 392 - 423 (2005)
www.rifin.com