Question

In our baseline Mundell-Fleming model, we assumed that there is a positive relationship between the real exchange rate and the current account (i.e. when the real exchange rate of a country depreciates, its current account balance improves). Explain the necessary relationships in terms of the “value effect” and “volume effect” for this assumption to hold using your own words. In your answer make sure you explain the meaning of “value effects” and “volume effects”.

Answer 1

The Mundell-Fleming model, also termed as the IS-LM-BoP model is an economic model which is an extension of the IS-LM model to deal with a small open economic system. It is used to describe the working of a small economy which is open to international trade in goods and financial assets and also focus on the various effects and analysis of fiscal and monetary policies in such an economy. Before the analysis, let us understand the basic terms given in the question

A Real exchange rate is defined as the product of nominal exchange rate and the ratio of the prices between the two countries. Thus, it represents a weighted average of the currency of a country in relation to a basket of other currencies and is used to determine the individual currency value in relation to other currencies.

The Current Account of a nation is one of the components of the Balance of Payment of the nation and includes the balance of trade, net primary income and net unilateral transfers over a period of time.

The ‘Value effect’ refers to the effect on the value of a currency with respect to variation in the economic and trading patterns of the country and the ‘Volume effect’ refers to the variation and effects on the trade volume of a nation with respect to variations in the international economic market.

                                    The Mundell-Fleming model states that a positive relation exists between the real exchange rate and the current account. Thus, a fall in the real exchange rate would mean that the current account balance would improve. Considering the ‘value’ and volume effects, it can be explained as follows

· A fall in the real exchange rate means that the ‘value’ of the money in the international market is reduced.

· With a fall in the ‘value’ of money, the export of a nation would be boosted and the imports would be made costlier which would mean that the trade ‘volume’ of exports would be more that the trade ‘volume’ of imports.

· With an increase in the export trade volume, the total export revenue of the nation would be improved and hence the Current Account balance of the nation would be improved as it follows the difference between exports and imports.

                                     Thus, from the above explanation it would become clear that how a decline in the real exchange rate would bring improvements in the current account balance of a nation in accordance with the Mundell-Fleming model and considering the ‘value’ and ‘volume’ effects in the economy.