The Mundell-Fleming model (1963)- exchange rate determination and how to deal with exchange

rate fluctuations

Mundell- 1963, Fleming-1962

It has been used to argue that an economy cannot maintain a fixed exchange rate, free capital
movement and independent monetary policy- the impossible trinity

Will explore NX in this model (Y=C+I+G+NX)

MFM-

1. Small economy, open in terms of goods and financial assets

2. Aka IS-LM-BoP model
3. Y= f(i, E)
4. Assumptions-
 Spot and forward rates are identical, existing exchange rates are expected to persist
indefinitely
 Price level is constant, inflation is 0, r=I because money wage rate is fixed, there are
unemployed resources and constant returns to scale (o/p is not severely affected by
factors of production)
 Tax and saving are a function of income, T= f(Y)
I= f(Y, i)= f(Y, r)
 X= f(Y*, E), Y*= foreign income, E= exchange rate
 M= f(Y, E)/E, Y= income; we divided by E to get value in domestic terms
 BoT= f(Y and e), BoT= balance of trade
 e= nominal exchange rate, E=real exchange rate, E=e*p/p*
 capital mobility is not perfect, securities are perfect substitutes, all investors are risk
neutral
 country is so small such that it cannot affect foreign incomes or world level of
interest rates

Questions addressed-

What affects exchange rate?

Policy for it?

How does it determine national output?

1. Goods market equilibrium-

Y= C(Y-T) +I(Y,r)+G-IM(Y,E)/E+X(Y*,E)
Term correlation
C+ Y-T +
I+ Y +, r –
IM+ Y + , E +
X+ Y* +, E –
 (X-M)=NX- if E+

Y= C(Y-T) +I(Y,i)+G-IM(Y,E)/E+X(Y*,E) as r=I because inflation is 0

(graphs from ppt IS curve)

e+, NX-, Y- (here e=E as r=r* and P=P*, * means world)

2. Financial market equilibrium-

Closed economy- people can either hold money either in the form of currency(money) or
bonds, both only domestic
MD = MS
Hence, M/P=YL(i)

Open economy- four options- money- foreign or domestic and bonds- foreign or domestic
M/P=YL(i)
Because demand for domestic money is there because no one will want to exchange foreign
currency in domestic market
Makes sense to hold foreign bonds, hence MD= Y(i)

(graphs from ppt LM curve)- New LM curve is vertical, exchange rate has no effect on
income(Y)

Choice between domestic vs foreign bonds

Decision depends on difference in interest rates, expectation of what will happen to the
nominal exchange rate in the future, ignoring transaction cost and risk

Interest parity condition (refer to slide)-

(1+it)=(1+it*) (Et/Eet+1)
i+, E+
i*+, E-

Impossible trinity happens here- if exchange rates of two countries is the same, that is there
is a fixed exchange rate system (today ex rate=future ex rate) then interest rates of both
countries are the same and hence no flow of capital.
If flow of capital then fixed ex rate system cannot exist and there will be a floating ex rate
system.
If fixed ex rate then monetary policy cannot be independent.

If domestic interest rate +, then domestic inv – and foreign investment + as exchange rate +
(that is currency depreciated)

3. Goods and Financial market equilibrium-

(refer to slides for eqn and graphs)

4. Effects of MP and FP on open economy

MP- i-, LM curve shifts left, more FDI/FII =, over time IS shifts right as overall out increases,
E+(currency depreciates)
5. Fixed exchange rate systems
Leads to impossible trinity