Monetary Economics

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An analysis of the Mundell-Fleming Model

Course Code: ECON 3005
Course Title: Monetary Economics
Lecturer: Colin F Bullock
UWI ID#: 620030733

Title:

a) Carefully outline the analysis of the Mundell-Fleming model of the relative effectiveness of monetary and fiscal policy in floating and fixed exchange rate regimes.

b) Critically evaluate recommendations for the substitution of an exchange rate peg for a flexible exchange rate regime in Jamaica.

In Jamaica, the debate for the exchange rate to remain floating or be fixed has been protracted for some time now. This essay will look at the Mundell-Fleming Model and how it explains the relative effectiveness [impact] of monetary and fiscal policies in each regime. Mundell and Fleming assume that in a small open economy domestic interest rate is equivalent to the world interest rate. The IS-LM framework is employed in the model to show equilibrium levels of income and exchange rate. The downward sloping IS curve is derived from the Keynesian Cross and the net export schedule and indicates a negative relationship between income and exchange rate. Using the standard LM curve and constant interest rate the intersection of these curves determined the level of income irrespective of the exchange rate. The optimal rate of exchange and income in both markets will be determined by the intersection of the IS and LM curves. The Mundell-Fleming model in addition to the IS-LM framework incorporates the balance of payment equilibrium conditions (a BP curve). Again what does monetary and fiscal policy have to do with the regimes and are they both effective?

Perfect mobility allows for the monetary policy to be effective under a flexible exchange regime. Since the domestic interest rate for a small economy is the same as the world interest rate then the BP curve will be horizontal; indicating that domestic interest rate cannot deviate from the world and depreciation will not cause the BP to shift. In cases of monetary expansion the exchange rate will depreciate sharply due to large outflow of capital and cause a BP deficit. If a BP deficit sets in as a consequence of declining current and financial accounts then an excess supply of foreign currency will be generated. Unlike under the fixed regime, Central Banks will not intervene and leave market forces to determine the new exchange rate. Excess demand for foreign currency will increase its price and depreciate the local currency. Goods on the local market will be cheaper stimulating an increase in demand by foreigners and locals and causing the IS to shift outwards followed by the LM to maintain equilibrium. Figure 1 shows the movement in equilibrium from (a) to a higher level output (c). With perfect capital mobility under a fixed regime monetary expansion will shift the LM curve to the right causing a decline in interest rate. An infinite outflow of capital will be the result to which the Central Bank must respond. In effect monetary policy is ineffective in a fixed exchange rate regime. The BP curve is horizontal and small increases in money supply must be reversed immediately because the domestic interest rate cannot deviate from the world. The result is that any shift in the LM curve is improbable. If the interest rate should deviate an unpredicted amount of capital outflow will occur in order to maintain BP equilibrium (fig 3).

An expansionary fiscal policy under flexible regime will shift the IS curve to the right triggering an increase in money demand and interest rates. Because demand for money has now increased, demand for imports will increase and the current account will depreciate. However, under flexible exchange rate, interest rate will equate the world’s rate and the BP curve will be horizontal. Fiscal policy is ineffective under a flexible exchange regime with perfect capital mobility. This is because for a slight shift in the IS curve a wedge will occur between the domestic and world...
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