Mundell – Fleming Model

Robert Mundell developed an analysis of perfect capital mobility under fixed exchange rates in 1960s which is named as Mundell – Fleming model. The analysis is very helpful in deciding which policy should be used – fiscal policy or monetary policy? Before we begin, we need to understand the meaning of perfect capital mobility. Under perfect capital mobility there are no barriers against the movement of capital from one country to another country. Investment in capital has no restrictions by the government and monetary authorities.

According to this model independent monetary policy is not beneficial under the fixed exchange rates system. The reason is the perfect capital mobility. To put it in perspective, let’s assume an economy who wants to increase its interest rate. In order to increase the interest rate and attract foreign investment, the central bank would adopt a monetary policy aimed at money contraction. Now the interest rate in the domestic country is higher. Because of this, the domestic country would be an attractive place for investors worldwide to earn better returns. Also, there is perfect capital mobility. This will result in huge capital inflow in the form of foreigners buying domestic assets.

There would balance of payments surplus. A balance of payments surplus implies an appreciation of the domestic currency. But we had begun with the fixed exchange rate system. Thus, now the central bank would intervene to make sure the exchange rate is constant. The central bank buys foreign currency in exchange of the domestic currency. Domestic currency’s supply will increase and thus its price will decrease till it is back to the constant rate fixed by the country. Because of this process the money stock in domestic currency increases. As a result the monetary contraction with which we began is reversed and we are back to the same situation. The output is same as with what we begin.

Therefore by this analysis Mundell concluded that economies with fixed exchange rates and perfect capital mobility cannot use a monetary policy to stimulate the output. Interest rates cannot be different from those prevailing in the world market.

Then what should be done?

Under fixed exchange system and perfect capital mobility fiscal policies are highly effective. An expansionary fiscal policy increases both the interest rate and output. Because of an increase in interest rate again the same process will follow and it will end with an expansionary monetary policy and interest will be back to original. But in contrast to the previous result, this time the output has increased.

Therefore a fiscal policy is able to increase the output or the income, while the monetary policy is ineffective under these conditions. It is a very famous model which has been used in developing various other modern theories. The contribution goes to the both the economists who have contributed to this – Mundell and Fleming.

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