Analysing The Mundell-Fleming Model

The global financial crisis has a negative effect on global economies. It was lead to a significant reduction in growth on economic. So I would conduct expansionary monetary and fiscal policies to stimulate macroeconomic, in order to evaluation the effects of policies I will analysis and discuss underlying economic model which is the Mundell-Fleming model under conditions of high but imperfect capital mobility and flexible exchange rates. In addition the current crisis also exposure the limitations of M-F Model to use macroeconomic policy, in the final part, I will make a conclusion discussing of the limitation of the theory.

The Macroeconomic theory behind macroeconomic policy:

The IS-LM-BP model, sometimes referred as the “The Mundell-Fleming model” is an important parts of modern macroeconomic theory and useful vehicle for integrating the external and domestic sector in a full open-economy analysis. At this part I will introduce the Mundell-Fleming model under conditions of high-but-imperfect capital mobility and flexible exchange rates. This theory will help me to analysis and discuss effect of macroeconomic policy I have conducted.

When high-but-imperfect capital mobility under flexible exchange rate, the BP curve is not perfectly horizontal, but BP curve is flatter than the LM curve (note that 0<KBP <KLM). As we can know the intersection of the IS-LM curves establishes internal equilibrium and the BP curve establishes external equilibrium. So we can use this model to analysis effectiveness of monetary and fiscal policy.

(1)Monetary Policy 🙁 Expansionary monetary policy)

Briefly summarized this would be:­

• LM curve shifts right, Y increases and R (real interest rate) decreases.

• Lower Real interest (i < iW) lead to reduces foreign capital inflows and increase capital outflow.

• Creates BP deficit and downward pressure on currency.

• Currency depreciation stimulates net exports (NX).

• Higher exports, lower imports.

• Both IS curve and BP curve shift right.

• Result is higher Y and lower R interest rate. (Efficiency policy)

1(Diagram 1)

A monetary expansion, shown on Diagram 1, expansion on money supply, the LM curve shifts to the right; the economy move from point A to point B. Y increases and R (real interest rate) decreases at the B, then the domestic interest will be lower than foreign interest (i < iW); a falling interest rate leads to more capital outflow and thus a fall in capital account (KA) and lead to deficit in the Balance of Payments (BP<0). BP<0 will lead to exchange rate is depreciating and increase in exports and a decrease in imports ,as a result of current account (CA) increased. A rising Aggregate Expenditure and Current Account bring about the IS and BP curves moving to the right side, these shifts are marked as (a) and (b). The new equilibrium (the point of C) is on the BP1 curve, where the economy has increased in Y1. Thus, this policy is efficiency and powerful policy that increases in the domestic money supply is to increase domestic output and decrease real interest rate which makes more competitively than foreign market.

(2)Fiscal Policy: (Expansionary fiscal policy)

Briefly summarized this would be:

• IS curve shifts to right, Both Y and R increased

• Higher Real interest (i > iW) increases foreign capital inflows.

• Creates BP surplus and currency appreciates.

• Stronger domestic currency reduces net exports.

• Lower exports, higher imports.

• IS curve and BP curve shift to left side

• Result is higher Y and higher R.

2(Diagram 2)

A government spending expansion, shown on Diagram 2, increasing Government spending cause IS curve move to the right and the new equilibrium moves from point A to point B. At the point B, a rising interest rate (i >iW) leads to more capital inflows and raise in capital account (KA), which create surplus in the Balance of Payments; it means the domestic currency is appreciating and increase in imports and a decrease in exports; then Net Exports will be decreased(Current Account worsens). As a result of the IS curve and BP curve back off to left side. These shifts are marked as (a) and (b), respectively, the new equilibrium creates at point C, where the economy has increased in Y1. Under flexible exchange rates, the effectiveness of fiscal policy is generally low, although it does gain some power depending on the degree of capital mobility. In addition, higher domestic interest means higher cost of borrowing for domestic company, which will bear high risk of collapse; at the same time,

The result of computer simulation for three policies:

As we can see (Diagram 3) that the initial equilibrium position is (Y* at 700 and R* at 5.8%), the slope of the BP curve is important in the IS-LM-BP Model, one key influence on the BP curve is K the international mobility of capital, the higher is K (high but imperfect), the flatter will be the curve under flexible exchange rate.

(Diagram 3)

Fiscal policy with high capital mobility

(Diagram 4)

Here is the Scroll Log [3] showing the results in fiscal expansion, the increase in G from 150 to 185 caused a rightward shift of the IS curve (only the IS curve depends directly on government spending).With the money stock (Ms) fixed at 600.2, the rise in Aggregate Expenditure pushed R* up from 5.8% to 6.2%. Raising the interest differential R-RF by 1.7% therefore encouraging inward investment; the government spending also gave a boost to national income from 700 to 723.In addition; the capital inflow boosted demand for the domestic currency and put upward pressure on exchange rate and E*has risen from 2.0 to 2.15.we should note that the IS-LM intersection, creating the new point of

Internal equilibrium (between IS1 curve and LM curve), and lies above the BP1 curve, hence there is a BoP surplus. In this case, with a floating exchange rate and “non-accommodating’ monetary policy, using fiscal policy was not fully successful in influencing output. Because the fiscal policy was not only rising Real interest rate with fixed Money stock, but also raising Exchange rate that interest differential R-RF caused.

Monetary policy with high capital mobility

(Diagram 5)

The policy decision to boost activity in weak economy and to increase in Ms (money stock) from 600.2 to 808.6 caused a rightward shift of the LM curve, with an unchanged exchange rate, was to fall R* from 5.8% to 4.7% as the LM curve shifted rightward. The fall in the cost of finance encouraging investment and this increased Y* from 700 to 844.The fall in R* (i < iW) reduced foreign demand for our economy’s assets, the overall BoP moved into a deficit and downward pressure on currency and E*has fallen from 2.00 to 0.54. A rising Aggregate Expenditure and CA bring about the IS and BP curves moving to the right side, then the new equilibrium position is (Y* at 844 and R* at 4.7%).It is evident that, under a floating exchange rate, monetary policy can be relatively effective in influencing output, exchange rate depreciation induced by lower R* internal effect on Y* .

(3) Policy combination (Combination fiscal and monetary policy)

(Diagram 6)

When the state of the economy overheating and facing on inflation risks, the Government will use a tight fiscal policy, raising taxes and reducing government spending, as well as tight monetary policy at the same time ,in order to limits the amount of the money supply. When the government adopted tight fiscal policy, the performance of IS-LM curve is to make IS curve moves to the left side, because of the tax increase to reduce the consumption and investment spending reduced. LM curve unchanged at this time, the exchanges need to reduce the amount of money, the money supply is greater than the demand for money, and the corresponding decline in interest rates, IS-LM curve re-formation of the equilibrium interest rate will become smaller, the income also will be less, thus the policy have good effect on overheating of the economy and inflation (despite the decline in interest rates would have a corresponding increase in private investment, but in generally, GDP is due to government tightening fiscal policy declined.) .When the government adopted tight monetary policy, so that LM curve moves to the left because of the money supply decreased, people feel that the amount of money in the hands is too few, so they will sell their securities to satisfy the demand for money, then the stock price will fall , rising interest rates. However IS curve will not be unchanged, rising interest rates lead to reduced private investment, new equilibrium make incrassating interest rate, reduced balance of revenue and aggregate expenditure; it has effect on inflation and overheating of economic.

Limitations of the theory

Firstly, this theory underlying simple assumption: it must be the established equilibrium of domestic economy; BP’s is carried out under a floating exchange rate and the price level is fixed .Foreign Y*, i* are given.

Secondly, the methodology used in the Mundell-Fleming Model is one of comparative static; making assumption to create new equilibrium is analyzed without take into account the dynamics of adjustment. Because the Mundell-Fleming Model is to show how equilibrium is affected by policy instruments. It compares equilibrium, situations in which the economy has come to rest, in which variables do not change any more and become static. This kind of reasoning is called comparative static analysis. In addition, this model can be used to analysis relatively small country; it assumes the country will not be impact on the rest of world; Mundell himself extended his own model to the large-country case (Mundell 1964). Typically, the large-country case is treated in the context of a world assume to be composed of two large country only; independence and interaction are identified and analyzed.

In summary, monetary policy is a powerful tool for short-term, interest rates will be higher for some time caused higher exchange-rate appreciation. With the price adjustment, the nominal exchange rate appreciation leads to fall in the competitiveness. The reduction of demand for net export increased other effects of high interest rate in reducing aggregate demand.

Under floating exchange rate fiscal policy is a weak tool. Expansionary fiscal policy leads to boom and higher interest rates. The latter led to an exchange rate appreciation those crowds out some net exports reinforcing domestic crowding out of consumption and investment.