Mundell-Fleming model
Encyclopedia
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 economy under autarky
(or 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," the "Irreconcilable Trinity," the "inconsistent trinity" or the Mundell–Fleming "trilemma."
s e is exogenous and the balance of payments surplus is determined by the model.
Under both types of exchange rate regime, the nominal domestic money supply M is exogenous, but for different reasons. Under flexible exchange rates, the nominal money supply is completely under the control of the central bank. But under fixed exchange rates, the money supply in the short run (at a given point in time) is fixed based on past international money flows, while as the economy evolves over time these international flows cause future points in time to inherit higher or lower (but pre-determined) values of the money supply.
In this graph, under less than perfect capital mobility the positions of both the IS curve and the BoP curve depend on the exchange rate (as discussed below), since the IS-LM graph is actually a two-dimensional cross-section of a three- dimensional space involving all of the interest rate, income, and the exchange rate. However, under perfect capital mobility the BoP curve is simply horizontal at a level of the domestic interest rate equal to the level of the world interest rate.
A decrease in the money supply causes the exact opposite process.
A decrease in government expenditure reverses the process.
Under perfect capital mobility, the BoP curve is always horizontal at the level of the world interest rate. When the latter goes up, the BoP curve shifts upward by the same amount, and stays there. The exchange rate changes enough to shift the IS curve to the location where it crosses the new BoP curve at its intersection with the unchanged LM curve; now the domestic interest rate equals the new level of the global interest rate.
A decrease in the global interest rate causes the reverse to occur.
Under the fixed exchange rate system, the central bank operates in the foreign exchange market
to maintain a specific exchange rate. If there is pressure to depreciate the domestic currency's exchange rate because the supply of domestic currency exceeds its demand in foreign exchange markets, the local authority buys domestic currency with foreign currency to decrease the domestic currency's supply in the foreign exchange market. This keeps the domestic currency's exchange rate at its targeted level. If there is pressure to appreciate the domestic currency's exchange rate because the currency's demand exceeds its supply in the foreign exchange market, the local authority buys foreign currency with domestic currency to increase the domestic currency's supply in the foreign exchange market. Again,this keeps the exchange rate at its targeted level.
, it would absorb newly arrived money by decreasing its holdings of domestic bonds (or the opposite if money were flowing out of the country). But under perfect capital mobility, any such sterilization would be met by further offsetting international flows.
Increased government expenditure shifts the IS curve to the right. The shift results in an incipient rise in the interest rate, and hence upward pressure on the exchange rate (value of the domestic currency) as foreign funds start to flow in, attracted by the higher interest rate. However, the exchange rate is controlled by the local monetary authority in the framework of a fixed exchange rate system. To maintain the exchange rate and eliminate pressure on it, the monetary authority purchases foreign currencies with local currency until the pressure is gone. Such action, by increasing the domestic money supply, shifts the LM curve rightward in tandem with the IS shift. This action increases the local currency supply in the market and counters the upward pressure on the exchange rate. In the end, the exchange rate stays the same but the general income in the economy increases. In the IS-LM-BoP graph, the IS curve has been shifted exogenously by the fiscal authority, and the IS and BoP curves determine the final resting place of the system; the LM curve merely passively reacts.
The reverse process applies when government expenditure decreases.
If the global interest rate increases, shifting the BoP curve upward, capital flows out to take advantage of the opportunity. This puts pressure on the home currency to depreciate, so the central bank must buy the home currency — that is, sell some of its foreign currency reserves — to accommodate this outflow. The decrease in the money supply resulting from the outflow shifts the LM curve to the left until it intersect the IS and BoP curves at their intersection. Once again, the LM curve plays a passive role, and the outcomes are determined by the IS-BoP interaction.
Under perfect capital mobility, the new BoP curve will be horizontal at the new world interest rate, so the equilibrium domestic interest rate will equal the world interest rate.
If the global interest rate declines below the domestic rate, the opposite occurs. The BoP curve shifts down, foreign money flows in and the home currency is pressured to appreciate, so the central bank offsets the pressure by selling domestic currency (equivalently, buying foreign currency). The inflow of money causes the LM curve to shift to the right, and the domestic interest rate becomes lower (as low as the world interest rate if there is perfect capital mobility).
assumption. Results for a large open economy, on the other hand, can be consistent with those predicted by the IS-LM model. The reason is that a large open economy has the characteristics of both an autarky and a small open economy. In particular, it may not face perfect capital mobility, thus allowing internal policy measures to affect the domestic interest rate, and it may be able to sterilize balance-of-payments-induced changes in the money supply (as discussed above).
In the IS-LM model, the domestic interest rate is a key component in keeping both the money market and the goods market in equilibrium. Under the Mundell–Fleming framework of a small economy facing perfect capital mobility, the domestic interest rate is fixed and equilibrium in both markets can only be maintained by adjustments of the nominal exchange rate or the money supply (by international funds flows).
Consider an exogenous increase in government expenditure. Under the IS-LM model, the IS curve shifts upward, with the LM curve intact, causing the interest rate and output to rise. But for a small open economy with perfect capital mobility and a flexible exchange rate, the domestic interest rate is predetermined by the horizontal BoP curve, and so by the LM equation given previously there is exactly one level of output that can make the money market be in equilibrium at that interest rate. Any exogenous changes affecting the IS curve (such as government spending changes) will be exactly offset by resulting exchange rate changes, and the IS curve will end up in its original position, still intersecting the LM and BoP curves at their intersection point.
The Mundell–Fleming model under a fixed exchange rate regime also has completely different implications from those of the closed economy IS-LM model. In the closed economy model, if the central bank expands the money supply the LM curve shifts out, and as a result income goes up and the domestic interest rate goes down. But in the Mundell-Fleming open economy model with perfect capital mobility, monetary policy becomes ineffective. An expansionary monetary policy resulting in an incipient outward shift of the LM curve would make capital flow out of the economy. The central bank under a fixed exchange rate system would have to instantaneously intervene by selling foreign money in exchange for domestic money to maintain the exchange rate. The accommodated monetary outflows exactly offset the intended rise in the domestic money supply, completely offsetting the tendency of the LM curve to shift to the right, and the interest rate remains equal to the world rate of interest.
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...
model first set forth (independently) by Robert Mundell
Robert Mundell
Robert Mundell, CC is a Nobel Prize-winning Canadian economist. Currently, Mundell is a professor of economics at Columbia University and the Chinese University of Hong Kong....
and Marcus Fleming
Marcus Fleming
John Marcus Fleming was Deputy Director of the research department of the International Monetary Fund for many years; he was already a member of this department during the period of Mundell's affiliation. At approximately the same time as Mundell, Fleming presented similar research on...
. The model is an extension of the IS-LM model. Whereas the traditional IS-LM Model deals with economy under autarky
Autarky
Autarky is the quality of being self-sufficient. Usually the term is applied to political states or their economic policies. Autarky exists whenever an entity can survive or continue its activities without external assistance. Autarky is not necessarily economic. For example, a military autarky...
(or 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," the "Irreconcilable Trinity," the "inconsistent trinity" or the Mundell–Fleming "trilemma."
Basic set up
The Mundell-Fleming model is based on the following equations.
(the IS curve)
- where
is GDP, 
is consumptionConsumption (economics)Consumption is a common concept in economics, and gives rise to derived concepts such as consumer debt. Generally, consumption is defined in part by comparison to production. But the precise definition can vary because different schools of economists define production quite differently...
,
is physical investmentFixed investmentFixed investment in economics refers to investment in fixed capital, i.e., tangible capital goods , or to the replacement of depreciated capital goods which have been scrapped....
,
is government spendingGovernment spendingGovernment spending includes all government consumption, investment but excludes transfer payments made by a state. Government acquisition of goods and services for current use to directly satisfy individual or collective needs of the members of the community is classed as government final...
and
is net exports.
- where
(The LM Curve)
- where
is the nominal money supplyMoney supplyIn economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...
,
is the price levelPrice levelA price level is a hypothetical measure of overall prices for some set of goods and services, in a given region during a given interval, normalized relative to some base set...
,
is liquidity preference ( real money demandMoney demandThe demand for money is the desired holding of financial assets in the form of money: that is, cash or bank deposits. It can refer to the demand for money narrowly defined as M1 , or for money in the broader sense of M2 or M3....
), and
is the nominal interest rateInterest rateAn interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...
. A higher interest rate or a lower income (GDP) level leads to lower money demand.
- where
(The BoP Curve (Balance of Payments))
- where
is the balance of paymentsBalance of paymentsBalance of payments accounts are an accounting record of all monetary transactions between a country and the rest of the world.These transactions include payments for the country's exports and imports of goods, services, financial capital, and financial transfers...
surplus,
is the current accountCurrent accountIn economics, the current account is one of the two primary components of the balance of payments, the other being the capital account. The current account is the sum of the balance of trade , net factor income and net transfer payments .The current account balance is one of two major...
surplus, and
is the capital accountCapital accountThe current and capital accounts make up a country's balance of payment . Together these three accounts tell a story about the state of an economy, its economic outlook and its strategies for achieving its desired goals...
surplus.
- where
IS components
- where
is consumption, 
is GDP, 
is taxes, 
is the nominal interest rate, and 
is the expected rate of inflationInflationIn economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...
. Higher disposable income or a lower real interest rate (nominal interest rate minus expected inflation) leads to higher consumption spending.
- where
- where
is physical investment and 
is GDP in the previous period. Higher lagged income or a lower real interest rate leads to higher investment spending.
- where
, government spending, is an exogenous variable.
- where
is net exports, 
is the nominal exchange rateExchange rateIn finance, an exchange rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency...
(the price of domestic currency in terms of units of the foreign currency),
is GDP, and 
is the combined GDP of countries that are foreign trading partners. Higher domestic income (GDP) leads to more spending on imports and hence lower net exports; higher foreign income leads to higher spending by foreigners on the country's exports and thus higher net exports. A higher e (more expensive domestic currency in terms of foreign currency, and equivalently less expensive foreign currency in terms of domestic currency) leads to more purchasing of foreign goods due to the lesser cost of acquiring the foreign currency to pay for them, and also leads to less purchasing of the country's exports by foreigners since they find it more costly to acquire the country's currency with which to pay for them; for both reasons, higher e leads to lower net exports.
- where
Balance of payments (BoP) components
- where
is the current account and 
is net exports. That is, the current account is viewed as consisting solely of imports and exports.
- where
- where
is the foreign interest rate, 
is the exogenous component of financial capital flows, 
is the interest-sensitive component of capital flows, and the derivative of the function 
is the degree of capital mobility (the effect of differences between domestic and foreign interest rates upon capital flows KA). This derivative is positive if there is any capital mobility (since a higher relative domestic interest rate makes funds more prone to flow into the country), and it is infinitely positive if there is perfect capital mobility.
- where
Variables determined by the model
After the subsequent equations are substituted into the first three equations above, one has a system of three equations in three unknowns, two of which are GDP and the domestic interest rate. Under flexible exchange rates, the exchange rate is the third endogenous variable while BoP is set equal to zero. In contrast, under fixed exchange rateFixed exchange rate
A fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange rate regime wherein a currency's value is matched to the value of another single currency or to a basket of other currencies, or to another measure of value, such as gold.A fixed exchange rate is usually used to...
s e is exogenous and the balance of payments surplus is determined by the model.
Under both types of exchange rate regime, the nominal domestic money supply M is exogenous, but for different reasons. Under flexible exchange rates, the nominal money supply is completely under the control of the central bank. But under fixed exchange rates, the money supply in the short run (at a given point in time) is fixed based on past international money flows, while as the economy evolves over time these international flows cause future points in time to inherit higher or lower (but pre-determined) values of the money supply.
Mechanics of the model
The model's workings can be described in term of an IS-LM-BoP graph with the domestic interest rate plotted vertically and real GDP plotted horizontally. The IS curve is downward sloped and the LM curve is upward sloped, as in the closed economy IS-LM analysis; the BoP curve is upward sloped unless there is perfect capital mobility, in which case it is horizontal at the level of the world interest rate.In this graph, under less than perfect capital mobility the positions of both the IS curve and the BoP curve depend on the exchange rate (as discussed below), since the IS-LM graph is actually a two-dimensional cross-section of a three- dimensional space involving all of the interest rate, income, and the exchange rate. However, under perfect capital mobility the BoP curve is simply horizontal at a level of the domestic interest rate equal to the level of the world interest rate.
Under a flexible exchange rate regime
In a system of flexible exchange rates, central banks allow the exchange rate to be determined by market forces alone.Changes in the money supply
An increase in money supply shifts the LM curve to the right. This directly reduces the local interest rate relative to the global interest rate. This depreciates the exchange rate of local currency through capital outflow. (To the extent that funds are internationally mobile, they flow out to take advantage of the interest rate abroad, which has become relatively more attractive, and hence the currency depreciates.) The depreciation makes local goods cheaper compared to foreign goods, and this increases exports and decreases imports. Hence, net exports are increased. Increased net exports lead to the shifting of the IS curve (which is Y = C + I + G + NX) to the right, partially or entirely mitigating the initial decline in the domestic interest rate. At the same time, the BoP curve shifts rightward, since with a depreciated currency it takes a lower interest rate or higher income level to give a zero balance of payments surplus (which is what the curve describes). The combined effect of these three curves shifting is to increase the economy's income.A decrease in the money supply causes the exact opposite process.
Changes in government spending
An increase in government expenditure shifts the IS curve to the right. The shift causes both the local interest rate and income (GDP) to rise. The increase in the local interest rate causes increased capital inflows, and the inflows make the local currency stronger compared to foreign currencies. On the other hand, the higher GDP increases spending on imports, tending to make the currency weaker. Assuming the BoP curve is not as steep as the LM curve (i.e., assuming that capital mobility is relatively strong), the former effect will dominate and the currency will become stronger. The stronger exchange rate also makes foreign goods cheaper compared to local goods. This encourages greater imports and discourages exports, so net exports become lower. As a result of this exchange rate change, the IS curve shifts back toward its original location. The stronger currency also shifts the BoP curve upward, as higher levels of the interest rate would now be consistent with a zero payments surplus in the presence of the stronger currency exchange rate. The LM curve is not at all affected in the short run. The net effect of all this is that, if there is perfect capital mobility, the level of income of the local economy is unchanged from originally, while it has gone up if capital is less than perfectly mobile.A decrease in government expenditure reverses the process.
Changes in the global interest rate
An increase in the global interest rate shifts the BoP curve upward and causes capital flows out of the local economy. This depreciates the local currency and boosts net exports, shifting the IS curve to the right. Under less than perfect capital mobility, the depreciated exchange rate shifts the BoP curve somewhat back down. The net effect is an increase in income and the local interest rate.Under perfect capital mobility, the BoP curve is always horizontal at the level of the world interest rate. When the latter goes up, the BoP curve shifts upward by the same amount, and stays there. The exchange rate changes enough to shift the IS curve to the location where it crosses the new BoP curve at its intersection with the unchanged LM curve; now the domestic interest rate equals the new level of the global interest rate.
A decrease in the global interest rate causes the reverse to occur.
Under a fixed exchange rate regime
In a system of fixed exchange rates, central banks announce an exchange rate (the parity rate) at which they are prepared to buy or sell any amount of domestic currency. Thus net payments flows into or out of the country need not equal zero; the exchange rate e is exogenously given, while the variable BoP is endogenous.Under the fixed exchange rate system, the central bank operates in the foreign exchange market
Foreign exchange market
The foreign exchange market is a global, worldwide decentralized financial market for trading currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends...
to maintain a specific exchange rate. If there is pressure to depreciate the domestic currency's exchange rate because the supply of domestic currency exceeds its demand in foreign exchange markets, the local authority buys domestic currency with foreign currency to decrease the domestic currency's supply in the foreign exchange market. This keeps the domestic currency's exchange rate at its targeted level. If there is pressure to appreciate the domestic currency's exchange rate because the currency's demand exceeds its supply in the foreign exchange market, the local authority buys foreign currency with domestic currency to increase the domestic currency's supply in the foreign exchange market. Again,this keeps the exchange rate at its targeted level.
Changes in the money supply
In the very short run the money supply is normally predetermined by the past history of international payments flows. If the central bank is maintaining an exchange rate that is consistent with a balance of payments surplus, over time money will flow into the country and the money supply will rise (and vice versa for a payments deficit). If the central bank were to conduct open market operations in the domestic bond market in order to offset these balance-of-payments-induced changes in the money supply — a process called sterilizationSterilization (economics)
Sterilization in macroeconomics refers to the actions taken by a country's central bank to counter the effects on the money supply caused by a balance of payments surplus or deficit....
, it would absorb newly arrived money by decreasing its holdings of domestic bonds (or the opposite if money were flowing out of the country). But under perfect capital mobility, any such sterilization would be met by further offsetting international flows.
Changes in government expenditure
The reverse process applies when government expenditure decreases.
Changes in the global interest rate
To maintain the fixed exchange rate, the central bank must accommodate the capital flows (in or out) which are caused by a change of the global interest rate, in order to offset pressure on the exchange rate.If the global interest rate increases, shifting the BoP curve upward, capital flows out to take advantage of the opportunity. This puts pressure on the home currency to depreciate, so the central bank must buy the home currency — that is, sell some of its foreign currency reserves — to accommodate this outflow. The decrease in the money supply resulting from the outflow shifts the LM curve to the left until it intersect the IS and BoP curves at their intersection. Once again, the LM curve plays a passive role, and the outcomes are determined by the IS-BoP interaction.
Under perfect capital mobility, the new BoP curve will be horizontal at the new world interest rate, so the equilibrium domestic interest rate will equal the world interest rate.
If the global interest rate declines below the domestic rate, the opposite occurs. The BoP curve shifts down, foreign money flows in and the home currency is pressured to appreciate, so the central bank offsets the pressure by selling domestic currency (equivalently, buying foreign currency). The inflow of money causes the LM curve to shift to the right, and the domestic interest rate becomes lower (as low as the world interest rate if there is perfect capital mobility).
Differences from IS-LM
It is worth noting that some of the results from this model differ from those of the IS-LM model because of the open economyOpen economy
An open economy is an economy in which there are economic activities between domestic community and outside, e.g. people, including businesses, can trade in goods and services with other people and businesses in the international community, and flow of funds as investment across the border...
assumption. Results for a large open economy, on the other hand, can be consistent with those predicted by the IS-LM model. The reason is that a large open economy has the characteristics of both an autarky and a small open economy. In particular, it may not face perfect capital mobility, thus allowing internal policy measures to affect the domestic interest rate, and it may be able to sterilize balance-of-payments-induced changes in the money supply (as discussed above).
In the IS-LM model, the domestic interest rate is a key component in keeping both the money market and the goods market in equilibrium. Under the Mundell–Fleming framework of a small economy facing perfect capital mobility, the domestic interest rate is fixed and equilibrium in both markets can only be maintained by adjustments of the nominal exchange rate or the money supply (by international funds flows).
Example
The Mundell–Fleming model applied to a small open economy facing perfect capital mobility, in which the domestic interest rate is exogenously determined by the world interest rate, shows stark differences from the closed economy model.Consider an exogenous increase in government expenditure. Under the IS-LM model, the IS curve shifts upward, with the LM curve intact, causing the interest rate and output to rise. But for a small open economy with perfect capital mobility and a flexible exchange rate, the domestic interest rate is predetermined by the horizontal BoP curve, and so by the LM equation given previously there is exactly one level of output that can make the money market be in equilibrium at that interest rate. Any exogenous changes affecting the IS curve (such as government spending changes) will be exactly offset by resulting exchange rate changes, and the IS curve will end up in its original position, still intersecting the LM and BoP curves at their intersection point.
The Mundell–Fleming model under a fixed exchange rate regime also has completely different implications from those of the closed economy IS-LM model. In the closed economy model, if the central bank expands the money supply the LM curve shifts out, and as a result income goes up and the domestic interest rate goes down. But in the Mundell-Fleming open economy model with perfect capital mobility, monetary policy becomes ineffective. An expansionary monetary policy resulting in an incipient outward shift of the LM curve would make capital flow out of the economy. The central bank under a fixed exchange rate system would have to instantaneously intervene by selling foreign money in exchange for domestic money to maintain the exchange rate. The accommodated monetary outflows exactly offset the intended rise in the domestic money supply, completely offsetting the tendency of the LM curve to shift to the right, and the interest rate remains equal to the world rate of interest.