Mundell-Fleming model

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The Mundell-Fleming model is an economic model first set forth by Robert Mundell and Marcus Fleming. The model is an extension of the IS-LM model. Whereas IS-LM deals with economy under autarky, the Mundell-Fleming model tries to describe a small open economy.

Typically, the Mundell-Fleming model portrays the relationship between the nominal exchange rate and the economy output (unlike the relationship between interest rate and the output in the IS-LM model) in the short run. The Mundell-Fleming model is frequently referred to as "the Unholy Trinity," the "Irreconcilable Trinity," the "Inconsistent trinity" or the Mundell-Fleming "trilemma."

Contents

1 Basic Set Up

1.1 IS Components
1.2 BoP Components

2 Differences from IS-LM
3 Example
4 History
5 Further reading

Basic Set Up

The traditional model is based around the following equations.

Y=C+I+G+NX (The IS Curve)
*Where Y is GDP, C is consumption, I is investment, G is government spending and NX is net exports.

M/P=L(i, Y) (The LM Curve)
*Where M is money supply, P is average price, L is liquidity, i is the interest rate and Y is GDP.

BoP=CA+KA (The BoP Curve)
*Where CA is the current account and KA is the capital account.

IS Components

C=C (Y-T, i-E(pi))
*Where C is consumption, Y is GDP, T is taxes, i is the interest rate, E(pi) is the expected rate of inflation.

I=I(i-E(pi), Y_-1)
*Where I is investment, i is the interest rate, E(pi) is the expected rate of inflation, Y_-1 is GDP in the previous period.

G=G
*Where G is government spending, an exogenous variable.

NX=NX (e, Y, Y*)
*Where NX is net exports, e is the real exchange rate, Y is GPD, Y* is the GDP of a foreign country.

BoP Components

CA=NX
*Where CA is the current account and NX is net exports.

KA=z(i-i*)+k
*Where z is the level of capital mobility, i is the interest rate, i* is the foreign interest rate, k is capital investments not related to i, an exogenous variable

Differences from IS-LM

It is worth noting that some of the result from this model differs from the IS-LM because of the open economy assumption. Result for large open economy on the other hand falls within the result predicted by the IS-LM and the Mundell-Fleming models. The reason for such result is because a large open economy has both the characteristics of an autarky and a small open economy.

In the IS-LM, interest rate will be the key component in making both the money market and the good market in equilibrium. Under the Mundell-Fleming framework of small economy, interest rate is fixed and equilibrium in both market can only be achieved by a change of nominal exchange rate.

Example

A much simplified version of the Mundell-Fleming model can be illustrated by a small open economy, in which the domestic interest rate is exogeneouly predetermined by the world interest rate (r=r*).

Consider an exogeneous increase in government expenditure, the IS curve will shift upward, with LM curve intacts, causing the interest rate and the output to rise (partial crowding out effect) under the ISLM model.

Nevertheless, as interest rate is predetermined in a small open economy, the LM* curve (of exchange rate and output) is vertical, which means there is exactly one output that can make the money market in the equilibrium under that interest rate. Even though the IS* curve still shift up, it will result in a higher exchange rate and same level of output (complete crowding out effect, which is different in the IS-LM model).

The example above makes an implicit assumption of flexible exchange rate. The Mundell-Fleming model can have completely different implications under different exchange rate regimes. For instance, under a fixed exchange rate system, with perfect capital mobility, monetary policy becomes ineffective. An expansionary monetary policy resulting in an outward shift of the LM curve would in turn make capital flow out of the economy. The central bank under a fixed exchange rate system would have to intervene by selling foreign money to depreciate the exchange rate. Selling foreign money and receiving domestic money would reduce real balances in the economy, until the LM curve shifts back to the left, and the interest rates come back to the world rate of interest i*.

History

The model was first set forth by Robert Mundell and Marcus Fleming. The two worked separately however, with each of them publishing a series of independent papers in the 1960s.