Mundell fleming model

A graphical approach for understanding Mundell Fleming Model in a simple way.

1. Mundell Fleming Model BY SAMYAK CHAUDHARY(13261) SAHIL KANOJIA(13251) BMS 2E

2. The M-F model is an extension of the IS/LM model It can also be called as the IS/LM model in the open economy Here, imports and exchange rates are additionally considered For exchange rates, they are in the form of domestic/foreign (for eg . US $/ euro when we consider US as home country) Another assumption is that inflation and its effects are ignored

3. Robert Mundell Marcus Fleming

4. Goods market equilibrium Y = C (Y-T) + I ( Y,r )+ G + X(Y*, e) – M( Y,e ) (+) (+,-) (+, + ) (+, -) Money market equilibrium M = L(Y, r) P

5. Shifts IS curve to right – increase in government expenditure Decrease in taxes Increase in foreign income Increase in exchange rate LM curve to right – Money supply(as price level assumed to be constant)

6. Perfect capital mobility Situation when foreign interest rate = domestic interest rate initially Also, it is assumed that foreign interest rate rf is constant

7. Flexible exchange rate (fiscal policy) Increase in government spending IS shifts right to IS1 Domestic interest rate increases, massive capital inflow(as people invest more inside US) To invest in US, people convert more to dollar (dollar demand increase, hence exchange rate fall(dollar appreciation) Fall in exchange rate, domestic goods expensive, exports reduce, output falls, to initial level r1 r0 Y LM e0 r Y IS IS1

8. Flexible exchange rate (monetary policy) Increase in monetary supply LM shifts right to LM1 Domestic interest rate decreases, massive capital outflow(as people invest more outside US) To invest outside US, people convert more to others (dollar demand decrease, hence exchange rate rise(dollar depreciates) rise in exchange rate, foreign goods expensive, exports rises, output rises back to initial level of interest rate Y1 r0 Y LM e0 r Y IS IS1 LM1 e1

9. Balance of payments Accounts which record transactions of a country with outside world for 1 financial year Consists of Current a/c – records transactions of trade of goods and services, transfer payments Capital a/c – records capital transaction Equation: X – Z + F(r – r’) = 0 F = (net capital inflow) BOP schedule: plots all interest rate-income combinations that result in BOP equilibrium at a given exchange rate It is upward sloping in case of imperfect mobility bcoz domestic and foreign assets are not perfect substitutes Perfect mobility, horizontal schedule.

10. Fixed exchange rate(fiscal) Govt. expenditure rise IS shifts right to IS1 Domestic rate >foreign interest rate Capital inflows Central bank to maintain fixed exchange rate, increases money supply LM right to LM1 Interest rate back to old level, exchange rate maintained, output further increases Y1 r0 Y LM e0 r Y IS IS1 LM1 e1 BP Y2 r1 = rf

11. Fixed exchange rate(monetary) Monetary supply increases LM shifts to right Domestic interest< foreign interest , capital outflow To maintain exchange rate fixed, central bank reduces money supply LM1 back to LM, at previous equilibrium point e0 r0 Y LM e0 r Y IS LM1 BP r1 = rf

12. Imperfect capital mobility fixed exchange rate( monetary) Increase in money supply, equilibrium shifts from e0 to e1 Interest rate falls, income rises New equilibrium below BP schedule, shows BOP deficit Inference: expanding monetary policy here increases output puts BOP in deficit, so not a good solution Y1 r0 Y LM e0 r Y IS LM1 e1 BP r1

13. Imperfect capital mobility fixed exchange rate( fiscal) Increasing govt. expenditure shifts IS curve to right If BOP schedule flatter, then equilibrium is above BP curve, hence BOP surplus(better way to increase output) If BOP schedule steeper, then equilibrium is below BP curve, hence BOP deficit(not so good way to increase output) Y1 r0 Y LM e0 r Y IS e1 BP r1 IS1

14. Imperfect capital mobility flexible exchange rate( monetary) Money supply increases, LM to LM1, equilibrium From e0 to e1 E1 below BP schedule, BOP deficit Due to flexible exchange rates, the rate rises and subsequently, exports rise due to which BP schedule shifts to right Increase in exports causes shift in IS curve also and by equal amount Final equilibrium at e2 Y1 r0 Y LM e0 r Y IS e1 BP r1 IS1 BP1 LM1 r2 Y2 e2

15. Imperfect capital mobility flexible exchange rate( fiscal) Increase in govt. spending, IS shifts to right to IS1, moving equilibrium point from e0 to e1 BP schedule flatter than LM and e1 above BP hence there is BOP surplus Due to this, we cut down exports as we already have surplus, exchange rate will fall, BP falls and shift to left Now, IS curve falls by equal amount, and new equilibrium set up at point e2. hence, overall output increases by utilising surplus Y1 r0 Y LM e0 r Y IS e1 BP1 r1 IS2 BP r2 Y2 e2 IS1

16. Conclusion The overall result of this model shows that fiscal stimulus is likely to have little effect on the value of the currency but reduce net exports, while monetary stimulus is likely to have little effect on net exports but reduce the value of the currency The model thus suggests that a combination of fiscal expansion and monetary contraction would boost the value of the currency and reduce net exports. Conversely, fiscal contraction and monetary expansion would boost net exports and reduce the value of the currency.

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