Let us make in-depth study of the role of Mundell Fleming model in open economy of a country.
Introduction:
One of the important fact about the world economy today is the high degree of integration or linkage among financial or capital markets.
Households, banks or corporations of different countries search around the world for the highest return (of course, adjusted for risk).
As a result, returns or yields in capital markets in different countries get linked together. For example, if rates of interest or return on equity capital in India rise relative to those in the USA, the US investors would try to lend or invest their capital in India to take advantage of higher returns. On the other hand, the borrowers would turn to the USA to borrow funds from the US financial markets to take advantage of lower rates of return.
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The tendency for the rates of return on capital to become equal in financial markets of different countries as a result of perfect mobility of capital was formalized in a model in the 1960s by Robert Mundell, now a professor at Columbia University and the Late Marcus Fleming, an economist at the IMF.
They assume:
(1) A small open economy
(2) Tax rates are the same everywhere,
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(3) Foreign investors do not face political risk (i.e. the fear of nationalism of foreign assets, restrictions of transfer of assets, risk of default by foreign governments).
Under these conditions and with perfect mobility of capital investors or foreign asset holders would try to invest in the asset in any country that yields the highest return. This would force rates of return on assets to become equal everywhere in the international capital markets because no one would invest at a lower return.
It may however be noted that perfect equalization of returns in different countries is crucially dependent on the twin assumptions of perfect mobility of capital and fixed foreign or world interest rate for an economy. In fact, Mundell-Fleming model assumes a small open economy which is incapable of influencing world interest rate.
Besides, it assumes perfect capital mobility.. “Capital is perfectly mobile internationally when investors can purchase assets in any country they choose, quickly with low transaction costs, and in unlimited amounts. When capital is perfectly mobile, asset holders are willing and able to move large amounts of funds across borders in search of the highest return or lowest borrowing costs.”
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The assumption of a small open economy with perfect capital mobility plays an important role in Mundell-Fleming model. The assumption of a small open economy implies that the economy can borrow or lend as much as it likes in world financial markets without affecting rate of interest. Thus, for a small open economy, rate of interest is determined by the world interest rate.
Mathematically, we can state this assumption as:
r = rf
where r stands for domestic interest rate in the economy and rf is the world rate of interest. It is the perfect mobility of capital that makes domestic interest rate (r) equal to the world interest rate. If due to some event or economic policy domestic interest rate happens to be lower than the world interest rate, the capital outflows would drive the domestic interest rate back to the world interest rate.
On the other hand, if some event or policy causes domestic interest to exceed world interest rate, then the capital inflows would bring down the domestic interest rate to the level of world interest rate. Hence the equation r = rf represents that international flow of capital quickly brings the domestic interest rate equal to the world interest rate.
The Mundell-Fleming model, with domestic interest rate determined by the world interest rate, focuses on the role of exchange rate in the determination of national income in the short run. Another important aspect of Mundell-Fleming model is that behaviour of the economy depends on whether it adopts the fixed exchange rate system or flexible exchange rate system.
In what follows we first explain below Mundell-Fleming model when the economy operate under the fixed exchange rate system and then analyse the model when the economy has adopted the flexible exchange rate system.
The Mundell-Fleming model of a small open economy with perfect capital mobility can be described by the following equations for IS and IM curves
IS equation:
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Y = C (Y- T) + I(rf) + G + NX(R)
LM equation:
M/P = L(rf, Y)
The IS equation describes the goods marks equilibrium and the second LM equation describes money market equilibrium. G and Tare the variables determined by fiscal policy, M is the monetary policy variable and they are important exogenous variables. The price P and world interest rate (r4) are the other exogenously given variables.
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The interest rate being given, the intersection of IS and LM curves determine the level of national income at which both the goods market and money market are in equilibrium. Besides, in case of the variable exchange rate system, the equilibrium of the two markets also determine the exchange rate.
However, Mundell – Fleming Model is based on same conditions which do not prevail in the real world. First, there are tax differences among countries which hinder the mobility of capital in response to interest-rate differentials among countries.
Secondly, exchange rates between different currencies can change, sometimes considerably, which affect return in dollars on foreign investment. Finally, countries adopt measures to restrict capital outflows or simply default in making payments. These are some of the reasons due to which interest rates in different countries are not equal.
Mundell-Fleming Model of the Small Open Economy with a Fixed Exchange Rate Regime: Impact of Monetary Policy:
An important result of the Mundell-Fleming linkage model under fixed exchange rate regime is that a central bank of a country cannot pursue an independent monetary policy. Under perfect mobility, a very small difference in interest rates in different countries would cause infinite capital flows that would bring about changes in balance of payments.
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These changes in balance of payments will affect exchange rate between different national currencies which would eliminate interest rate differential. Take an example. Suppose Central Bank of a country tightens its monetary policy so as to raise interest rate in the economy. When with the adoption of this policy interest rate rises in the economy, foreigners will shift their investible funds to this country so as to take advantage of the higher interest rate.
With a huge inflow of capital, foreign exchange rate of the domestic currency will rise, that is, the currency of the country that adopts a higher interest rate monetary policy will appreciate. This appreciation of the currency will discourage exports and encourage imports which would have an adverse effect on balance of payments.
This will force the Central Bank of the country which is committed to maintain the exchange rate at the fixed level to intervene to prevent the appreciation of exchange rate of the national currency.
To prevent the currency from appreciation, the Central Bank will buy the foreign currency, say US dollar. This will lead to the increase in foreign exchange reserves with the Central Bank which will issue more national currency against the increase in foreign exchange reserves.
As a result, money supply in the economy will expand causing the rate of interest to fall. Thus, with the perfect mobility of capital and given a fixed exchange rate, domestic interest rate has been pushed back to the initial level.
To quote Dornbusch and Fischer again, “Under fixed exchange rates and perfect capital mobility, a country cannot move out of line with those prevailing in the world market. Any attempt at independent monetary policy leads to capital flows and need to intervene until interest rates are back in line with those in the world market”.
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It follows from above that, given a higher degree of capital mobility across countries; interest rates cannot be very much different. The differences in interest rates beyond a point will bring about capital flows across countries that will tend to provide world level yield in all of them.
Expansionary Monetary Policy under Fixed Exchange Rate and Perfect Capital Mobility:
Let us now analyse the effect of monetary expansion under the fixed exchange rate regime using IS-LM model. Consider Figure 25.2 where in panel (a) we have drawn the IS and LM curves as well as the horizontal straight line BP. The horizontal line BL= 0 at domestic interest rate i equal to foreign interest rate if (i = if) shoes that the country has neither deficit or surplus in its balance of payments, that is, its balance of payments is in equilibrium.
At any other interest rate massive capital flows will occur which will cause disequilibrium in the balance of payments and will force the Central Bank to intervene to maintain the exchange rate. To illustrate this we consider that Government adopts a policy of monetary expansion. Let the economy in panel (a) of Fig. 25.2 is initially at point E where the given IS-LM curves intersect at E which determines domestic rate of interest i which is equal to foreign rate of interest if.
With monetary expansion, LM curve shifts to the right and as a result the economy moves to the new equilibrium position E’ where domestic rate of interest has fallen to i1. At the new position E’ economy will have a large deficit in balance of payments which will exert a pressure on the exchange rate of domestic currency to depreciate.
Determination of foreign exchange rate is shown in panel (b) of Fig. 25.2 where initially demand curve DD and supply curve SS of US dollars determine exchange rate equal to OR (i.e. number of rupees per US dollar). When as a result of expansion in money supply, LM1 curve shifts to the right to the new position LM and consequently domestic rate of interest falls to i1 (panel (a) of Figure 25.2), there will be large capital outflows.
These capital outflows will reduce the supply of US dollars in foreign exchange market and as a result supply curve of US dollars shifts to the left to S’S’ (panel (b) of Figure 25.2) resulting in the new exchange rate R’ (that is, more rupees per US dollar). This means Indian rupee will depreciate. To maintain the exchange rate, the Central Bank of the country will intervene; it will sell foreign currency reserves in the foreign exchange market.
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The supply of domestic money supply in the economy will therefore decrease. As a result of this reduction in domestic money supply, LM curve will shift back to the left [see panel (a) of Fig. 25.2], This process of contraction in money supply and consequent shifting back of LM curve to the left will continue until the initial equilibrium at E is reached again.
As a matter of fact, with perfect capital mobility, the economy is not likely to reach at the new equilibrium joint E’. This is because the response of capital flows is so large and quick that the Central Bank will be forced to reverse quickly the initial expansion in money supply before the new equilibrium at E’ is reached.
Contraction in Money Supply under Fixed Exchange Rate System:
Conversely, if the Central Bank adopts the policy of contraction in money supply, LM curve will shift to the left of the initial equilibrium point E. Given the IS curve the new equilibrium will be reached at a higher domestic rate of interest as compared to foreign interest rate. This will induce massive capital inflows which will increase the demand for domestic currency and as a result domestic currency will appreciate.
To maintain the exchange rate, the Central Bank will buy the foreign currency and give the domestic currency in exchange. As a result, central bank will be forced to expand the money supply and this monetary expansion will cause shift in LM curve to the right so that ultimately the domestic economy returns to the initial equilibrium situation.
Conclusion:
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From the foregoing analysis of Mundell-Fleming model under the fixed exchange rate regime, it follows that when capital mobility is perfect, interest rates in the home country cannot deviate from those prevailing abroad. It is quite evident from above that with perfect mobility of capital, under fixed exchange rate regime, monetary policy in a small open economy is quite ineffective to influence the levels of national income (output) and employment.
Any attempt by the central bank of the country to reduce interest rate by expansion in money supply would lead to massive outflows of capital tending to cause depreciation of the home currency. The Central Bank, which is under obligation to maintain the exchange rate at a fixed level, would buy the domestic currency in exchange for foreign currency.
This will result in reduction in money supply to its original level with the home economy again attaining equilibrium at the initial level. This shows under fixed exchange rate regime, the Central bank of a country cannot undertake an independent monetary policy.
Mundell-Fleming Model: Role of Expansionary Fiscal Policy under Fixed Exchange Rate System:
While expansionary monetary policy under fixed rate regime is quite ineffective to affect national income and output, fiscal policy is highly effective, given the perfect mobility of capital. To show this through open economy IS-LM model, consider Figure 25.3.
Suppose adopting expansionary fiscal policy Government increases its expenditure with money supply remaining unchanged. It will be seen from panel (a) that increase in government expenditure causes shift in the IS curve to the right to the new position IS’. As will be seen from panel (a) this raises both the interest rate and level of national income (output). The higher domestic rate of interest as compared to the world interest rate (if) will cause capital inflows into the economy.
These capital inflows will bring about appreciation in exchange rate of national currency. The determination of foreign exchange rate is illustrated in panel (b) of Figure 25.3. It will be observed from panel (b) that as a result of capital inflows, supply curve of foreign exchange (i.e. US dollars) shifts to the right from SS to S’S’.
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The new supply curve S’S’ of foreign exchange rate intersects the demand curve for foreign exchange at point Q’ and determines the lower new foreign exchange rate R’ (rupees per US dollar). This implies that there is appreciation of rupee. To maintain the exchange rate at R the Central Bank will have to expand money supply which will cause a shift in LM curve to the right and increase national income further.
It will be seen from panel (a) of Figure 25.3 that money supply is increased so much that LM curve shifts to the new position LM’ and domestic rate of interest falls back to the original level so that it is again equal to the world interest rate (I = if). Thus, in this case, with endogenous expansion in money supply to maintain the exchange rate, interest rate effectively remains fixed at a given level. Fiscal expansion leads to increase in national income by Y1 Y3, equal to the Keynesian multiplier effect.
Conclusion:
The upshot of the above analysis is that the commitment to maintain a fixed exchange rate makes the changes in money supply endogenous. This is because the Central Bank through its intervention has to sell or buy the foreign exchange as the case may be to maintain the exchange rate system at the fixed level.
The Central Bank under the fixed exchange rate system with perfect capital mobility cannot conduct an independent monetary policy to achieve domestic economic stability. However, government can use expansionary fiscal policy to raise the level of national income and employment.
Mundell-Fleming Model for a Small Open Economy under Flexible Exchange Rates:
We now use Mundell-Fleming Model to explain how monetary and fiscal policies in a small open economy work when there is completely flexible exchange rate regime and perfect capital mobility. It is assumed that domestic prices remain fixed while exchange rate is fully flexible.
It is important to note that under flexible exchange rate regime, the Central Bank does not intervene in the market for foreign exchange. The exchange rate adjusts itself to bring the demand for and supply of foreign exchange in equilibrium. Therefore, under flexible exchange rate system and without the intervention of the Central Bank, balance of payments must always be in equilibrium, that is, there is neither any deficit nor any surplus.
This implies that any current account deficit must be financed by private capital inflows. On the contrary, any current account surplus must be balanced by capital outflows. It is worth noting again that it is adjustments in foreign exchange rate under flexible exchange rate system that guarantees that sum of current and capital accounts of balance of payments is zero.
A second important consequence of fully flexible exchange rate regime is that under it the Central Bank can pursue its independent monetary policy, that is, it can expand or contract the money supply at will according to its assessment of the needs of the domestic economy. Since under flexible exchange rates, there is no obligation for the Central Bank to intervene there is no any link between the balance of payments and the money supply in the economy.
In Mundell-Fleming model the assumption of perfect capital mobility ensures that at only one interest rate which is equal to world interest rate (i = if) the balance of payments is zero, that is, in equilibrium (BP = 0). At any rate of interest other than this causes a change in the real exchange rate through its effect on capital flows for the domestic economy.
Assuming that domestic and foreign prices of goods (p and pf) remain constant, decline in the domestic interest rate below the world interest rate (i.e. if) will cause unlimited capital outflows and bring about depreciation in the ex-change rate. Exchange rate is a determinant of net exports (NX) which in the open economy affects aggregate demand and therefore determines level of open-economy IS curve (IS curve : Y = (Y, i) + NX(Y,Yf R) where R stands for real exchange rate and NX for net exports).
Now, depreciation in the exchange rate following capital outflows when i < if will raises exports and reduce imports and will cause increase in net exports (NX). The increase in net exports will shift the ‘S curve to the right and thereby affect national income and output.
On the contrary, if i >if, there will be unlimited capital inflows causing appreciation in the exchange rate which will reduce exports and increase imports and will thus lead to the reduction in net exports (NX). The reduction in net exports (NX) as a result of appreciation in the exchange rate causes a shift in the IS curve to the left and will therefore affect national income and output.
In the small open economy with international linkages in terms of trade of goods and capital flows, our open economy model under flexible exchange rate regime consists of the following three equations.
IS curve: Y = A (Y, i) + NX (Y, Yf, R) . . .(i)
BP = NX (Y, Yf R) + CF (I – if) . . .(ii)
i = if . . .(iii)
where CF stands for capital flows.
With this Mundell-Fleming linkage model of a small open economy under flexible exchange rate regime we explain below the effect on national income (output), interest rate and exchange rate of the following factors and policies.
1. Exogenous increase in exports
2. Fiscal policy
3. Monetary policy
Exogenous Increase in Exports under Flexible Exchange Rate:
The effect of exogenous increase in exports, say due to the increase in world demand for our goods, is shown in Figure 25.4 Initially, the economy is in equilibrium at point E with national output equal to Y0 and interest rate i which is equal to world interest rate if (i=if). When there is exogenous increase in our exports, IS curve shifts to the right to IS’.
Now, new IS’ curve interests LM curve at point E’ where both goods and money markets clear. It may be noted that at this new equilibrium point, E’, national income increases. The increase in national income also induces the rise in equilibrium interest rate above the world interest rate if.
This higher domestic interest rate will lead to the capital inflows which will exert pressure on the exchange rate. These capitals inflows, as seen above, will cause the domestic currency to appreciate. The appreciation in exchange rate will make our exports relatively expensive and imports cheaper than before. As a result, demand shifts away from domestic goods and as a result net exports (NX) to decline.
In Figure 25.4, the appreciation of exchange rate and consequently decline in net exports will cause a shift in the IS curve back to the left. The capital inflows will continue and net exports will go on declining as a result of appreciation of domestic currency until is curve shifts back to the original level IS and equilibrium level of national income and output is restored at OY0 level which is consistent with monetary equilibrium at the world rate of interest.
Conclusion:
It follows from above that under conditions of perfect capital mobility, increase in exports of a small open economy has no lasting effect on the equilibrium level of national income and output. Increase in net exports (NX) causes interest rate to rise through increase in level of national income.
This induces capital inflows which result in appreciation of the exchange rate and reduces net exports. This cancels out the effect on national income of the initial exogenous increase in exports of a country.
Effect of Expansionary Fiscal Policy in a Small Open Economy under Flexible Exchange Rate:
We can use the Mundell-Fleming linkage model to analyse the effect of expansionary fiscal policy in a small open economy under flexible exchange rate system. Expansionary fiscal policy has the same effect as that of exogenous increase in exports. Under expansionary fiscal policy either government expenditure is increased or taxes are reduced.
This fiscal expansion leads to the increase in aggregate demand and causes a shift in the IS curve to the right. This, given the LM curve, induces the interest rate to rise and invites capital inflows into the economy. These capital inflows result in appreciation of the exchange rate.
This appreciation of the exchange rate induced by higher interest rate leads to reduction in exports and increase in imports. As a result, there is the reduction in net exports which completely offsets the impact of fiscal expansion on national income and output.
We arrive at an important conclusion from our above analysis. Real disturbances such as exogenous increase in exports or expansion in government expenditure or a tax cut does not affect equilibrium level of income in a small open economy under flexible exchange rate system with perfect capital mobility.
Under the fixed exchange rate regime, expansionary fiscal policy in a small open economy is highly effective in increasing the level of national income. However, under flexible exchange rate system with conditions of perfect capital mobility, equilibrium level of aggregate income or output remains unaffected as a result of expansionary fiscal policy.
Under flexible exchange rate fiscal expansion causes appreciation of exchange rate which causes exports to decrease and imports to increase and thus leads to a shift in the composition of domestic demand towards foreign goods and away from domestic goods.
Mundell-Fleming Model: Expansionary Monetary Policy in a Small Open Economy under Flexible Exchange Rates:
In sharp contrast to the expansionary fiscal policy, in Mundell-Fleming model expansionary monetary policy under flexible exchange rate regime is highly effective in raising the level of national income or output. This favourable affect of expansion in money supply on the level of national output comes through its causing depreciation in exchange rate of domestic currency.
Consider Figure 25.5 where to begin with IS and LM curves interest at point E and determine level of national income Y0 and rate of interest i, (i = if). Now, suppose there is increase in the nominal quantity of money supply M. Since we are assuming that prices of goods remain constant, increase in money will bring about increase in real money balances, M/P .
With this at the equilibrium point E, there will be excess supply of real money balances. To restore equilibrium, rate of interest will have to fall or aggregate income will have to rise. As a result LM curve shifts to the right to the new position LM’. The new LM’ curve intersects the original IS curve at new point E’.
At the new point E’, whereas goods and money markets are in equilibrium (at the initial exchange rate), rate of interest has fallen below the world interest rate if. This will cause capital outflows from the country.
These capital outflows will reduce the supply of foreign exchange (say US dollars) and lead to the depreciation of the domestic currency. The depreciation of domestic currency will make exports of the country relatively cheaper and its imports relatively expensive than before. This will lead to increase in exports and reduction in imports of the country resulting in larger net exports (NX).
Increase in net exports (NX), which is a component of aggregate demand, will cause IS curve to shift to the right. The point E’ is really not a final equilibrium point as adjustment process is not complete at point E. IS curve will continue shifting to the right until the joint equilibrium of goods market and money market is established at the rate of interest which is equal to the world interest rate.
In Figure 25.5. such equilibrium is reached at point E” at which new LM and IS curves intersect and determine rate of interest i = if. It will be seen from Figure 25.5 that at the new final equilibrium point E”, level of national income (or aggregate output) Y1 is greater than the initial income Y0.
Comparison:
It is interesting to compare in case of a small open economy the impact of expansion in money supply under flexible rate system with that under fixed exchange rate regime. Under the fixed exchange rate regime the expansionary monetary policy is quite ineffective in raising national income or aggregate output.
Any attempt to increase money supply lowers rate of interest below the world interest rate which causes unlimited capital outflows. These capital outflows lead to the reversal of increase in money supply so that finally the equilibrium of the economy is restored at the initial level of income or output.
On the other hand, under flexible exchange rate system where Central Bank does not intervene, increase in money supply, as seen above, is not reversed in the foreign exchange market. Capital outflows that take place in the foreign exchange market following the fall in the rate of interest below the world rate of interest leads to depreciation of domestic currency.
This depreciation causes exports to increase and imports to decline resulting in increase in net exports (NX). Consequently, expansion in income or output actually occurs assuming fixed prices. Thus, ability of the Central Bank to control money supply under flexible exchange rate is an important effect of the flexible exchange rate system.
Beggar Thy Neighbour Policy and Competitive Depreciation:
We have seen above expansionary monetary policy causes depreciation of domestic currency and thereby leads to increase is net exports and therefore an increase in income and employment in the economy. Depreciation of domestic currency causes a shift in demand from foreign goods towards domestic goods.
As a result, income (or output) and employment abroad decline. That is, one country gains at the expense of the other country. Therefore, expansion in net exports and therefore in income and employment as a result of depreciation has been called beggar thy-neighbour policy. That is, increase in output and employment in one country takes place by creating unemployment and loss of output in other countries.
It follows from above that depreciation in exchange rate is mainly a way of shifting demand from foreign goods towards domestic goods rather than increasing the level of world demand. Exchange rate adjustment can play an important role in promoting economic stability at full employment level when different countries find themselves in different phases of business cycles.
That is, some are in boom phases and experiencing over full employment while others are in recession phase of business cycles. In this case, if the countries experiencing recession depreciate their domestic currencies, they will shift foreign demand to their domestic products. In this way this will remove divergence from full employment in each country.
However, it has been witnessed that business cycles are highly synchronized such as worldwide depression in the early 1930s and consequence of oil shack of 1973 and also recently in 2001- 03, exchange rate adjustment will not contribute much towards achieving world-wide full employment conditions.
For example, if level of total world demand is deficient, then depreciation in exchange rate by various countries will affect only the distribution of given world demand among countries and will not help in increasing the level of world demand for goods and services. In other words, exchange rate adjustments by various countries experience recessionary conditions are merely policies of beggar thy-neighbour variety.
Of course, from the angle of an individual country depreciation of domestic currency shifts foreign demand to itself and is able to increase its output and employment. But, if one country can raise its output and employment by depreciating its currency, others can also do so. This leads to competitive depreciation by different countries for attracting world demand for their goods at the expense of others.