Let me (try) to explain the Mundell-Fleming model regarding perfect capital mobility under fixed and flexible exchange rates and see if any of you agree with their model.

Mundel-fleming extends the standard IS-LM model in their 1960’s model of how policy’s work with capital mobility.

Under perfect capital mobility the slightest interest rate differential provokes infinite capital flows which leads to the conclusion that under fixed exchange rates, a country can’t pursue an independent monetary policy. Interest rates can’t move out of line with those prevailing in the world market. Any attempt at independent monetary policy leads to capital flows and a need to intervene until interest rates are back in line with those in the world markets.

Any monetary expansion (contraction) of the money supply is met capital flows that are so fast and large that the central bank must reverse the expansion (contraction) as soon as it attempts it. Basically, Mundel-Fleming shows that monetary policy as a economic tool is very much moot with fixed exchange rates. So fiscal policy (government taxation and spending) is the key economic driver in this case.

The opposite is true for flexible exchange rates. With flexible exchange rates and perfect capital mobility, monetary policy can be independent and thus the central bank can act to effect capital inflows or outflows. The exchange rates adjust ensuring the sum of the capital account and current accounts (the balance of payments) equals zero. So monetary expansion under flexible exchange rates provides for output expansion (GDP growth and a better economy) and exchange rate depreciation whereas fiscal expansion results in no output change, reduced net exports and exchange appreciation.

Another factor that must be considered is the mix of both fiscal and monetary policy and the need for both of them to be moving in the same direction. But I’ll save that for another day.

Did I lose anyone? I bet I did… 😦

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