Mundell-Fleming Model

The Mundell-Fleming model is a theoretical model in international macroeconomics. The model demonstrates that the effectiveness of fiscal and monetary policies in the open economy depends on the exchange rate regime. The Mundell-Fleming model was developed in the early 1960s by Robert Mundell (b.1932, 1999 Nobel Laureate in Economics) and Marcus Fleming (1911–76) of the International Monetary Fund.

From 1946–71, the exchange rates of the industrialized nations were fixed to the U.S. dollar, while the dollar was pegged to gold at $35/oz. This was known as the “Bretton Woods system.” During 1950–62, Canada experimented with a flexible exchange rate. During the early 1960s, both the United States and Canada had intense internal debates concerning the appropriate mix of fiscal and monetary policies. Working independently, Mundell (a Canadian) and Fleming sought to answer the following question: how effective are monetary and fiscal policies under fixed and flexible exchange rates?

According to Warren Young and William Darity, Jr., Mundell-Fleming is a special case of a more general open economy model. The name Mundell-Fleming was coined by Rudiger Dornbusch, who synthesized the work of Mundell and Fleming during 1976–80. Versions of the Mundell-Fleming model can be found in many textbooks.

Two important cases are: (a) flexible exchange rates under perfect capital mobility and (b) fixed exchange rates under perfect capital mobility. The Mundell-Fleming model is based on Keynesian assumptions: output is determined by aggregate demand, and prices are sticky (inflexible). Individuals hold domestic money, domestic bonds, and foreign bonds. The country under analysis is a small country, which means that it cannot influence the world interest rate. Under perfect capital mobility, there are no restrictions on movements of financial capital. If the domestic interest rate is above the world interest rate, a massive amount of financial capital flows into the country instantaneously, as foreign and domestic residents shift their financial holdings to domestic bonds. This causes a massive increase in the demand for domestic currency. Conversely, if the domestic interest rate is below the world interest rate, a massive amount of financial capital flows out of the country instantaneously, as foreign and domestic residents shift their financial holdings to foreign bonds. This causes a massive increase in the demand for foreign currency. For these examples, we assume that initially, the domestic and world interest rates are equal.

Exchange Rate Regimes

With a flexible exchange rate regime, the exchange rate is set by market forces. An exchange rate appreciation reduces exports and increases imports, and leads to a decrease in the interest rate. An exchange rate depreciation increases exports and reduces imports, and leads to an increase in the interest rate.

For fixed exchange rate regimes, the central bank keeps the exchange rate fixed. If there is excess demand for domestic currency (the domestic currency is undervalued), the central bank sells domestic currency and buys foreign currency. This action expands the money supply, since the public receives new domestic currency (money) in exchange for foreign currency (a nonmoney asset). If there is excess supply of domestic currency (the domestic currency is overvalued), the central bank buys domestic currency and sells foreign currency. The money supply contracts, since the public receives foreign currency (a nonmoney asset), and the central bank receives domestic currency (currency is defined as money only if held by the public). To successfully defend an overvalued currency, the central bank must have large foreign currency reserves; otherwise, it runs out of reserves and is forced to devalue or float the currency (adopt a flexible exchange rate).

...