Policy Effectiveness in the Mundell-Fleming Model

The Building Blocks of the Mundell-Fleming Model

The Mundell-Fleming model retains the IS and LM curves but modifies them to account for international interactions. It adds a third key relationship, the Uncovered Interest Parity (UIP) condition, which governs the flow of capital. Let's build the model step-by-step.

For a thorough introduction to the model's components, the following lecture from MIT OpenCourseWare is an excellent resource. It provides the rigorous foundation that you prefer.

Let's recap the essential components from the video:

1. The IS Curve (Goods Market): The equilibrium condition is still $Y=C+I+G+NX$. The new term is Net Exports (NX), which depends negatively on domestic income $Y$ (as higher income leads to more imports) and negatively on the real exchange rate $e$ (an appreciation makes domestic goods more expensive, reducing exports and increasing imports).
2. The LM Curve (Money Market): This remains the same as in the closed economy, representing equilibrium in the money market where $M/P=L(Y,i)$.
3. Uncovered Interest Parity (UIP): This is the cornerstone of the model's open-economy features. It states that the domestic interest rate ($i$) must equal the foreign interest rate ($i^{\ast }$) plus the expected rate of depreciation of the domestic currency. $$i\approx i^{\ast }+\frac{E^e-E}{E}$$ For our analysis, we will make a simplifying assumption common in the basic Mundell-Fleming model: perfect capital mobility and static exchange rate expectations ($E^e$ is fixed). Under these conditions, capital is so sensitive to interest rate differences that any deviation of $i$ from $i^{\ast }$ would cause massive capital flows, forcing the domestic interest rate to converge back to the world rate. Therefore, the condition for equilibrium in the international asset market simplifies to: $$i=i^{\ast }$$ This means our analysis will center on a horizontal Balance of Payments (BP) curve at the level of the world interest rate, $i^{\ast }$.

Policy Effectiveness under a Floating Exchange Rate

In a floating (or flexible) exchange rate regime, the central bank allows the exchange rate to be determined by market forces. The bank sets a target for the money supply ($M$) but does not intervene in the foreign exchange market.

The following textbook chapter provides excellent graphical and textual explanations of how policies work in this regime.

Let's summarize the mechanisms for each policy type.

Monetary Policy (Floating Rate)

1. Expansion: The central bank increases the money supply ($\Delta M>0$), shifting the LM curve to the right.
2. Interest Rate Pressure: This puts downward pressure on the domestic interest rate, so $i<i^{\ast }$.
3. Capital Outflow: Investors sell the domestic currency to buy higher-yielding foreign assets.
4. Depreciation: The selling of domestic currency causes it to depreciate (the exchange rate $e$ rises).
5. Net Exports Effect: The weaker currency makes domestic goods cheaper, boosting net exports ($\Delta NX>0$). This shifts the IS curve to the right.
6. Outcome: The economy moves to a new equilibrium with a higher level of output ($Y$). The interest rate returns to $i^{\ast }$.

Conclusion: Under a floating exchange rate, monetary policy is highly effective. It stimulates the economy both by encouraging investment (initially) and by boosting net exports through currency depreciation.

Fiscal Policy (Floating Rate)

1. Expansion: The government increases spending ($\Delta G>0$), shifting the IS curve to the right.
2. Interest Rate Pressure: This puts upward pressure on the domestic interest rate, so $i>i^{\ast }$.
3. Capital Inflow: Investors buy the domestic currency to invest in higher-yielding domestic assets.
4. Appreciation: The demand for domestic currency causes it to appreciate (the exchange rate $e$ falls).
5. Net Exports Effect: The stronger currency makes domestic goods more expensive, causing net exports to fall ($\Delta NX<0$). This shifts the IS curve back to the left.
6. Outcome: The IS curve shifts back to its original position. The fiscal expansion is perfectly offset by a decline in net exports. Output ($Y$) does not change.

Conclusion: Under a floating exchange rate with perfect capital mobility, fiscal policy is completely ineffective. The initial stimulus is fully "crowded out" by the exchange rate effect on net exports.

Policy Effectiveness under a Fixed Exchange Rate

In a fixed exchange rate regime, the central bank commits to maintaining the exchange rate at a specific target level. To do this, it must be willing to buy or sell foreign currency as needed. This means the central bank loses control of the money supply; $M$ becomes an endogenous variable that adjusts to maintain the peg.

The core constraint is that the central bank must keep $i=i^{\ast }$. If any policy pushes $i$ away from $i^{\ast }$, the bank is forced to intervene, which alters the money supply. Let's analyze the consequences.

We'll turn to a video that clearly illustrates these dynamics.

Fiscal Policy (Fixed Rate)

1. Expansion: The government increases spending ($\Delta G>0$), shifting the IS curve to the right.
2. Interest Rate Pressure: This puts upward pressure on the domestic interest rate ($i>i^{\ast }$).
3. Forced Intervention: To prevent the currency from appreciating due to capital inflows, the central bank must intervene. It sells domestic currency and buys foreign currency, increasing the money supply.
4. Monetary Accommodation: The increase in the money supply shifts the LM curve to the right.
5. Outcome: The LM curve shifts rightward until the interest rate is pushed back down to $i^{\ast }$. The economy settles at a much higher level of output $Y$.

Conclusion: Under a fixed exchange rate, fiscal policy is highly effective. The central bank is forced to expand the money supply to prevent appreciation, reinforcing the initial fiscal stimulus.

Monetary Policy (Fixed Rate)

1. Expansion Attempt: The central bank tries to increase the money supply (e.g., through an open market purchase), shifting the LM curve to the right.
2. Interest Rate Pressure: This puts downward pressure on the domestic interest rate ($i<i^{\ast }$).
3. Forced Intervention: To prevent the currency from depreciating due to capital outflows, the central bank must intervene. It buys domestic currency and sells foreign currency, decreasing the money supply.
4. Sterilization: The money supply returns to its original level, shifting the LM curve back to its original position.
5. Outcome: The economy returns to the initial equilibrium. Nothing changes.

Conclusion: Under a fixed exchange rate, monetary policy is completely ineffective. Any attempt to change the money supply is immediately undone by the obligation to defend the exchange rate peg.

Summary and The Policy Trilemma

The results from our analysis are striking and symmetric. The effectiveness of monetary and fiscal policy is completely reversed when moving from a floating to a fixed exchange rate regime. The following table summarizes these crucial findings.

These results are a direct consequence of what economists call the Impossible Trinity or Policy Trilemma. This principle states that a country cannot simultaneously achieve all three of the following policy goals:

1. Exchange Rate Stability (a fixed exchange rate).
2. Monetary Independence (the ability to set your own interest rates/money supply).
3. Financial Integration (free movement of capital).

You can only ever choose two out of the three.

• Floating Rate (e.g., USA, UK): Chooses Monetary Independence and Financial Integration, but gives up Exchange Rate Stability.
• Fixed Rate (e.g., Denmark pegging to the Euro): Chooses Exchange Rate Stability and Financial Integration, but gives up Monetary Independence.
• Capital Controls (e.g., China in the past): Chooses Exchange Rate Stability and Monetary Independence, but gives up Financial Integration.

The Chinn/Irwin PDF provides an excellent discussion of the Trilemma.

Conclusion

In this lesson, we have used the Mundell-Fleming model to move from a closed to an open economy, uncovering a fundamental principle of international macroeconomics: the choice of exchange rate regime determines the power of domestic policy tools.

Key Takeaways:

• The Mundell-Fleming model integrates the IS-LM framework with international capital flows, governed by the Uncovered Interest Parity condition ($i=i^{\ast }$).
• Under a floating exchange rate, monetary policy is highly effective at influencing output through the exchange rate channel, while fiscal policy is rendered ineffective by the crowding out of net exports.
• Under a fixed exchange rate, the roles are reversed. Fiscal policy becomes highly effective as it forces monetary accommodation, while monetary policy becomes completely ineffective as the central bank loses its autonomy to defend the currency peg.
• These results are explained by the Impossible Trinity, which dictates that a country must sacrifice one of three goals: a fixed exchange rate, monetary autonomy, or free capital flows.

In our next lesson, we will shift our focus from demand-side policies to supply-side policy. We will explore how governments attempt to influence the economy's long-run productive capacity rather than just managing short-run aggregate demand.