The Mundell-Fleming Model

The Mundell-Fleming Model

• The MF model is an extension of the IS-LM model to
the open economy.

• The base-line MF model

– A small open economy (takes foreign income and
interest rate as given)
– Fixed price (horizontal AS curve with fixed P and
variable Y)
– Static exchange rate expectations
– The Marshall-Lerner condition holds.
– Perfect capital mobility
1. References
a. Robert A. Mundell (1963), “Capital mobility and stabilization
policy under fixed and flexible exchange rates,” Canadian J
of Economics and Political Science 29, 475-85.
b. Marcus J. Fleming (1962), “Domestic financial policies under
fixed and under floating exchange rates,” IMF Staff Papers
9 , 369-79.
2. A Keynesian model
– Nominal goods prices are rigid.
– Output is determined by aggregate demand.
– The supply side of the economy is irrelevant.
3. Ad hoc model
4. Static, not dynamic
5. Model of a “semi-small” open economy
– Too small to affect the world interest rate or the
world price level
– Large enough to have the price-setting power for
its own exports
6. Three markets
– The goods market: the IS curve
y   ( s  p *  p )  y   (i   e )  g , 0   1
y  s  y   i  g

– The money market: the LM curve

m  p  y   i
m  y   i
– The financial market: interest rate parity
se  s
i  i 
*

s
i  i*
 Covered Interest Parity (CIP)
Covered interest arbitrage leads to CIP:

1 + i$ = (F/S)(1+i£).

Using approximation,
i$ = i£ + (F-S)/S
or i$ - i£ = (F-S)/S

The RHS is the forward premium on £.

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 Uncovered Interest Parity

Uncovered interest parity holds if

i$ - i£ = (Se-S)/S.

• Se is the expected future exchange rate.

• i£ +(Se-S)/S is the expected return from uncovered

investment in foreign assets.

• The (Se-S)/S is called the expected rate of

depreciation of the domestic currency.

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7. Endogenous variables and exogenous
variables

a. Under a floating exchange rate

• Endogenous variables: , ,
∗ ∗
• Exogenous variables: , , ,

b. Under a fixed exchange rate

• Endogenous variables: _________
• Exogenous variables: _________
Figure Equilibrium in the goods market (IS), money market
(LM), and balance of payments (BP)
 The IS Curve
• Equilibrium in the Goods Market:
Y = C+I+G+(X-IM)

• The IS curve shows the combinations of (Y, i) that

provide equilibrium in the goods market.

• On the IS curve, Y and i are negatively related.

• There is an excess demand for goods to the left of

the IS curve and an excess supply of goods to the
right .
 Shifts in the IS curve
• If aggregate demand increases for reasons other
than an increase in income or a decrease in the
interest rate, the IS curve shifts to the right.

Examples: In each of the following cases, the IS curve

shifts to the right.
• Expansionary fiscal policy
– An increase in G
– A decrease in T
• C or I increases due to optimism about the future
• An increase in the current account due to
– Foreign boom
– Devaluation of the domestic currency*
 The Money Market
• Money supply (M)
– Money supply (M) = currency in circulation +
demand deposits
– Monetary base (MB) = currency in circulation +
bank reserves
– M = the money multiplier  MB
– Assume the money multiplier = 1

• Money demand (L)

– arises due to transactions, precautionary or assets
reasons.
– It depends positively on real income and
negatively on the interest rate.
 The LM Curve
• The LM curve shows the combinations of (Y, i) that
satisfy the money market equilibrium condition.

• On the LM curve, Y and i are positively related with a

given supply of money (M).

• There is an excess demand for money to the right of

the LM schedule and an excess supply of money to
the left.
• Shifts in the LM curve:
– An increase in money supply or a decrease in
money demand shifts the LM curve to the right.
 Short-run equilibrium
• The short-run equilibrium of the economy is obtained
at the intersection of the IS and LM curves or when
both the goods and the money markets are cleared.
• At other points, either the goods market or the money
market or both are in disequilibrium.
 Balance of Payments (BP)

• BP = the sum of the current account balance (CA)

and private capital flows (KA)
• BP = CA + KA
• CA = X – IM = X0 – (M0 + mY) = (X0 – M0) - mY
• KA = KA0 + k(i-i*); k>0

– X0, M0, and KA0 are autonomous components.

– (X0- M0) depends positively on the exchange rate
(The Marshall-Lerner condition is satisfied.)
– m is the marginal propensity to import
– Capital inflows increase if the domestic interest
rate rises relative to the foreign interest rate.
– k measures the degree of capital mobility. The
greater is capital mobility, the higher is k.
 The BP Curve
• The BP curve shows the combinations of (Y,i) that
satisfy the condition: BP  CA+KA=0.
– On the BP curve, Y and i are positively related.
– To the right (left) of the BP curve, BP is in _____.

• The higher is capital mobility, the greater is k and the

flatter is the BP curve.
– The slope of the BP = m/k
– With perfect capital mobility (and perfect asset
substitutability), k is infinitely large and the BP
curve becomes horizontal at i*.
• The SLOPE of the BP curve

– Horizontal: Perfect capital mobility

– Vertical: No capital mobility
– Positive and steeper than LM: Low capital mobility
– Positive and flatter than LM: High capital mobility

– We deal with the case of PCM in most cases.

However, other cases can be useful as well.
• The BP curve shifts to the right if
CA rises (for reasons other than changes in y or i)
– Foreign income increases and our exports to them rise.
– The domestic currency depreciates.

• Note: In both cases, the IS curve shifts to the right.

• In the case of PCM (the “flat” BP), the new BP will

be identical to the old one after a horizontal shift. (to
be discussed shortly)
 BP and Money Supply
• The Simplified Balance Sheet of the Central Bank

Assets | Liabilities
Gov't securities (GS) | Currency in circulation
Foreign reserves (FR) | Bank reserves

• Monetary base (MB) consists of currency in circulation and bank

reserves.
• GS is a main component of domestic reserves. It consists of
securities issued by the government. (May use “domestic credit”
for the same purpose.)

• (Assume that foreign central banks do not buy or sell domestic

assets. Then,)
• BP = FR = increase in domestic central bank’s holding of
foreign reserves (FR)
 Intervention

• If BP is in surplus, foreign reserves and MB increase.

(The central bank buys FX with dollars.)
• If BP is in deficit, foreign reserves and MB decrease.
(The central bank sells FX for dollars.)
– Foreign reserves may change for reasons other than
intervention.
 Sterilization
• The changes in monetary base due to FX market
intervention can be sterilized by open market operations.

• In the case of a BP deficit, foreign reserves and MB

decrease if there is no sterilization. The central bank can
purchase government bonds from banks or the public to
restore MB to the original level. In this case, a reduction in
FR is offset by an increase in GS.

• Similarly, a BP surplus can be sterilized by the central

bank's open market sale of government bonds.

• Note that sterilization, especially that of BP deficits, is

feasible only for a while until foreign reserves last.
 Perfect Capital Mobility (PCM)
• Perfect capital mobility is a polar case in which capital
movement in search for arbitrage profits is fast and
efficient so that there are no unexploited profits from
interest arbitrage.
• It means that covered interest parity holds continuously.
(to be discussed later)

• In this extreme case, k is infinitely large and the BP curve

becomes flat at i = i*. (Note: the slope of the BP = m/k.)
• A small deviation of i from i* will result in huge capital
inflow if i > i* or outflow if i < i*. Under a fixed exchange
rate, money supply changes accordingly. (Sterilization will
not be possible.)
 Summary
• The balance sheet of the central bank
GS + FR = MB
• Open market operation
MB = GS
• Intervention (non-sterilized)
_____________
• Sterilized intervention
_____________________
 Order of discussion
• Fiscal policy
– Float / PCM
– Fixed / PCM
– Float / NCM
– Fixed / NCM
– The cases of Low and High CM are left as
homework exercise.

• Monetary policy
– Do the same order
 Monetary Policy
under a Floating Exchange Rate
• An open market purchase of government bonds by the
central bank increases both GS and MB. (a rightward shift
in the LM)
• Income increases while the interest rate falls. Capital flows
out (KA deficit). No intervention under pure floating
o The domestic currency depreciates.
o (X-IM) increases. The IS shifts to the right.
• The change in the exchange rate works in the same
direction as the money supply change does. Thus, MP is
more effective in an open economy than in a closed
economy.
• What happens to CA and KA in the new equilibrium? *
Figure Monetary expansion with floating exchange rates
and perfect capital mobility
 Fiscal Policy
under a Floating Exchange Rate
• An increase in government spending (G) shifts the IS
schedule to the right.
• Both income and the interest rate increase.
• The current account declines while the capital account
increases.
• If the capital mobility is high or perfect, the change in the
capital account dominates.
o The domestic currency appreciates.
o CA declines and the IS shifts to the left, offsetting the
effect of the increase in G.
• Under perfect capital mobility, fiscal policy becomes
completely powerless in a small country.
• What happens to CA and KA in the new equilibrium?
Figure Fiscal expansion with floating exchange rates and
perfect capital mobility
 Monetary Policy
under a Fixed Exchange Rate
• An open market purchase of government bonds by the
central bank increases both GS and MB. (a rightward shift in
the LM)
• Income increases while the interest rate falls. Imports
increase and the current account declines.
• Capital flows out (KA deficit).
• The domestic currency tends to weaken.
• The central bank intervenes and buys domestic currency by
selling foreign reserves. (BP turns to deficit.)
• Money supply decreases due to losses in foreign reserves.
• This shifts the LM back towards the initial situation.
• In a small economy under fixed exchange rates,
monetary policy is relatively ineffective in influencing
economic activity.
• Greater capital mobility further reduces the scope for
independent management of monetary policy.
• Under perfect capital mobility, monetary policy
becomes completely ineffective in a small country
with a fixed exchange rate.
•This is an example of Monetary Policy Trilemma in a
small open economy.
Figure Monetary expansion with fixed exchange rates and
perfect capital mobility
 The case of no capital mobility
• The shape of the BP under no capital mobility:

• What happens when the economy is off the BP line?

• Redo the case of monetary expansion under a fixed

exchange rate.
 International Monetary Policy Trilemma
• The following three cannot coexist:
– A fixed exchange rate
– Perfect capital mobility
– Independent monetary policy

• A typical government wants to retain independent

monetary policy. The impossibility theorem implies
that it will have to give up either one of the first two
and choose
– a flexible exchange rate (i.e., sacrificing fixed
exchange rate) or
– controls on international capital movements (i.e.,
giving up perfect capital mobility)
 Fiscal Policy
under a Fixed Exchange Rate
• An increase in government spending (G) shifts the IS
schedule to the right.
• Both income and the interest rate increase.
• The current account declines while the capital
account increases.
• If the capital mobility is high or perfect, the change in
the capital account dominates and the domestic
currency tends to appreciate.
• The central bank intervenes and buys foreign
exchange. (BP turns to deficit.)
• Money supply increases due to the increase in
foreign reserves.
• This shifts the LM curve to the right.
• Thus, in a small economy under fixed exchange rates,
a fiscal expansion is accompanied by an increase in
money supply. It makes fiscal policy becomes more
effective in influencing economic activity.
• Under PCM, fiscal policy becomes a powerful tool of
macroeconomic policy in a small country.
Figure Fiscal expansion with fixed exchange rates and
perfect capital mobility
 International transmission
• Consider a foreign monetary contraction.

• It will raise i* and lower y*.

• Under a flexible exchange rate, the higher i* causes
an incipient capital outflow and a DC depreciation.
The IS shifts out and domestic output expands. (note)
• In this case, (foreign) monetary policy is
NEGATIVELY transmitted.

• Consider the case of a fixed exchange rate and show

that (foreign) monetary policy is POSITIVELY
transmitted.
 Solving the IS-LM-BP model under PCM
IS: Y = C(Y,i,T) + I(i) + G + CA(Y,e)  IS(Y, i, e: G,T)
LM: M/P = L(Y,i)  LM(Y, i: M)
BP: i = i*

• In this model, there are three endogenous variables: Y, i,

and e in 3 equations.
• Under a flexible ER, e is endogenously determined. The
three equations can solve 3 endogenous variables.
• The solution procedure:
– (i) Determine i from BP
– (ii) Use LM to determine Y;
– (iii) Use IS to find the equilibrium value of e.
• Graphically, this means that i is given by BP and Y is determined by
BP and LM. Exchange rate changes allow the IS curve to move to the
intersection point so that all three curves intersect at the same point.
• Under a fixed ER, e is held fixed by the government
and no longer an endogenous variable.

• However, M (the money supply) become and

endogenous variable under a fixed ER. When the
central bank intervenes in the FX market, changes in
the central bank holdings of foreign reserves affect
the money supply.

• The solution procedure

– (i) determine i from BP as above
– (ii) use IS to determine equilibrium Y
– (iii) use LM to find the equilibrium value of M.
• Graphically, this means that i is given by ____and Y is
determined by ____ with the given interest rate. Changes in M
allow the ____ curve to move to the intersection point so that all
three curves intersect at the same point.