Mundell Model

Topics: Foreign exchange market, Bretton Woods system, Macroeconomics Pages: 11 (3294 words) Published: October 6, 2012
Mundell -Fleming Model

The Mundell–Fleming model, also known as the IS-LM-BP model, is an economic model first set forth (independently) by Robert Mundell and Marcus Fleming The model is an extension of the IS-LM model. Whereas the traditional IS-LM Model deals with a closed economy, the Mundell–Fleming model describes an open economy.

The Mundell-Fleming model portrays the short-run relationship between an economy's nominal exchange rate, interest rate, and output (in contrast to the closed-economy IS-LM model, which focuses only on the relationship between the interest rate and output). The Mundell–Fleming model has been used to argue that an economy cannot simultaneously maintain a fixed exchange rate, free capital movement, and an independent monetary policy. This principle is frequently called "the Unholy Trinity”.

Mundell-Fleming Model
(In short)

Robert Mundell and Marcus Fleming set up the Mundell-Fleming Model. This model is different from the IS-LM model in the sense that the former deals with a small open economy while the latter deals with autarky.

The Mundell- Fleming Model can be explained with the help of the following equations:

The IS component is expressed as

• Y = C + I + G + NX Where Y: GDP

• C = C(Y - T, i - E(p))
Where C: Consumption
T: Taxes
I: Interest Rate
E(p): Expected inflation rate

• I = I(i - E(p), Y - 1) Where Y - 1 : previous period GDP I is investment

• G = G where G: Government spending exogeneously given

• NX = NX(e,Y,Y * ) Where NX : Net exports
e : Real exchange rate
Y * : GDP of the foreign country

LM component

• M/P=L(i,Y)
Where M: money supply
P: average price
L: liquidity
BOP Component

• CA = NX Where CA: Current Account

• KA = z(i - i * ) + k
Where z: capital mobility
i *: foreign interest rate
k: capital investment exogeneously fixed

The Mundell-Flemming Model assumes that the domestic and the international interest rates are the same. The exchange rate is also assumed to be flexible where market forces lone determine it and government intervention is nil.

Before Mundell-Fleming
_ classical paradigm (until WWI) depicted a self-regulating global economy based on the gold standard
_ classical world as a stable dynamic system in which near-frictionless adjustment of national price levels and free ow of specie restore both full employment and equilibrium in national balances of payments (Hume). _ sovereign economic interventions limited by rules of the game.

Problems with the classical paradigm
Symmetric system, in theory. But countries running BOP deficits have stronger incentives to apply the rules of the game than countries running surpluses (sterilization of gold inflows prevents inflation) As a result, a recessionary bias in the system: deficit-countries adopt contractionary policies that harm employment without gaining reserves

The contribution by Mundell
Mundell reintroduced the idea of a self-regulating adjustment mechanism that had been central to the classical framework.
In line with the evolution of world financial markets Mundell put private international capital flows at center stage in his dynamic analysis. Keynesian frictions in wage/price adjustment

“Through a rare combination of analytical power and Schumpeterian ‘vision’ Mundell distilled from his mathematical formulations important lessons that permanently changed the way we think about the open economy" -Obstfeld IMFSP 2002

Basic set up

The Mundell-Fleming model is based on the following equations. • [pic](the IS curve)
o where [pic]is GDP, C is consumption, I is physical investment, G is government spending and NX is net exports. • [pic](The LM Curve)
o where M is the nominal money supply, P is the price level, L is liquidity preference ( real money demand), and i is the nominal interest rate. A higher interest rate or a lower income (GDP) level leads to lower money demand. • [pic](The BoP...
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