Question

What are the underlying assumptions of the Monetarist model and the Mundell-Fleming model? Using graphical analysis, contrast the differences in policy implications for these models.

Answer 1

Ans.

Investors would try to lend or invest their capital in India to take advantage of higher returns. On the other hand, the borrowers would turn to borrow funds from the US financial markets to take advantage of lower rates of return.

The tendency for the rates of return on capital to become equal in financial markets of differ­ent countries as a result of perfect mobility of capital was formalized in a model in the 1960s by Robert Mundell, now a professor at Columbia University and the Late Marcus Fleming, an econo­mist at the IMF.

Assumptions

1. A small open economy
2. Tax rates are the same everywhere,
3. Foreign investors do not face political risk (i.e. the fear of nationalism of foreign assets, restric­tions of transfer of assets, risk of default by foreign governments).
4. Under these conditions and with perfect mobility of capital investors or foreign asset holders would try to invest in the asset in any country that yields the highest return. This would force rates of return on assets to become equal everywhere in the international capital markets because no one would invest at a lower return.
5. It may however be noted that perfect equalization of returns in different countries is crucially dependent on the twin assumptions of perfect mobility of capital and fixed foreign or world interest rate for an economy. In fact, Mundell-Fleming model assumes a small open economy which is incapable of influencing world interest rate.
6. Besides, it assumes perfect capital mobility.. “Capital is perfectly mobile internationally when investors can purchase assets in any country they choose, quickly with low transaction costs, and in unlimited amounts. When capital is perfectly mobile, asset holders are willing and able to move large amounts of funds across borders in search of the highest return or lowest borrowing costs.”
7. The assumption of a small open economy with perfect capital mobility plays an important role in Mundell-Fleming model. The assumption of a small open economy implies that the economy can borrow or lend as much as it likes in world financial markets without affecting rate of interest. Thus, for a small open economy, rate of interest is determined by the world interest rate.
8. Mathematically, we can state this assumption as:

r = r_f

1. where r stands for domestic interest rate in the economy and r_f is the world rate of interest. It is the perfect mobility of capital that makes domestic interest rate (r) equal to the world interest rate. If due to some event or economic policy domestic interest rate happens to be lower than the world interest rate, the capital outflows would drive the domestic interest rate back to the world interest rate.

On the other hand, if some event or policy causes domestic interest to exceed world interest rate, then the capital inflows would bring down the domestic interest rate to the level of world interest rate. Hence the equation r = r_f represents that international flow of capital quickly brings the domestic interest rate equal to the world interest rate.

The Mundell-Fleming model, with domestic interest rate determined by the world interest rate, focuses on the role of exchange rate in the determination of national income in the short run. Another important aspect of Mundell-Fleming model is that behaviour of the economy depends on whether it adopts the fixed exchange rate system or flexible exchange rate system.

The Mundell-Fleming model is a model relating to appropriate use of monetary and fiscal policy in an open economy under fixed exchange rates with capital mobility. Under floating exchange rate there is limited scope for government intervention to achieve internal and exter­nal balance. The model differentiates the effect of monetary and fiscal policy on the open economy.

The separation of monetary and fiscal policy was first accomplished by Swan’s model to include capital flows as well. ‘External balance’ or ‘balance of payments equilibrium’ was thus redefined by Mundell to mean a zero balance in the official financing accounts. In the Mundell world, the attainment of the external balance target is influenced by both monetary policy and fiscal policy.

For example, an expansionary monetary policy (in the term of an decrease in the money supply) which reduces interest rates will lead to a reduction in the short- term capital inflows or an increase in short-term capital outflows and to a BOP deficit.

An expansionary fiscal policy—in the term of an increase in income and an increase in imports and also a BOP deficit. Since either expansionary monetary policy or expansionary fiscal policy is assumed to have an adverse effect on the BOP, maintaining BOP equilibrium for a given ex­change rate requires an opposite use of monetary and fiscal policy in this model, i.e., expan­sionary fiscal policy must be supported by centractionary monetary policy, and vice versa.

There is an exactly similar type of policy relationship with respect to the internal balance target. An increase in the money supply leads to lower interest rates and tends to stimulate real investment. This is likely to be expansionary and/or inflationary. So an increase in investment has to be offset by a decrease in government spending or by an increase in taxes that will reduce consumption.

In what follows we first explain below Mundell-Fleming model when the economy operate under the fixed exchange rate system and then analyse the model when the economy has adopted the flexible exchange rate system.

The Mundell-Fleming model of a small open economy with perfect capital mobility can be described by the following equations for IS and IM curves

IS equation:

Y = C (Y- T) + I(r_f) + G + NX(R)

LM equation:

M/P = L(r_f, Y)

The IS equation describes the goods marks equilibrium and the second LM equation describes money market equilibrium. G and Tare the variables determined by fiscal policy, M is the monetary policy variable and they are important exogenous variables. The price P and world interest rate (r₄) are the other exogenously given variables.

The interest rate being given, the intersection of IS and LM curves determine the level of national income at which both the goods market and money market are in equilibrium. Besides, in case of the variable exchange rate system, the equilibrium of the two markets also determine the exchange rate.

However, Mundell – Fleming Model is based on same conditions which do not prevail in the real world. First, there are tax differences among countries which hinder the mobility of capital in response to interest-rate differentials among countries.

Secondly, exchange rates between different currencies can change, sometimes considerably, which affect return in dollars on foreign invest­ment. Finally, countries adopt measures to restrict capital outflows or simply default in making payments. These are some of the reasons due to which interest rates in different countries are not equal.

Mundell-Fleming Model of the Small Open Economy with a Fixed Exchange Rate Regime: Impact of Monetary Policy:

An important result of the Mundell-Fleming linkage model under fixed exchange rate regime is that a central bank of a country cannot pursue an independent monetary policy. Under perfect mobility, a very small difference in interest rates in different countries would cause infinite capital flows that would bring about changes in balance of payments.

These changes in balance of pay­ments will affect exchange rate between different national currencies which would eliminate interest rate differential. Take an example. Suppose Central Bank of a country tightens its monetary policy so as to raise interest rate in the economy. When with the adoption of this policy interest rate rises in the economy, foreigners will shift their investible funds to this country so as to take advantage of the higher interest rate.

With a huge inflow of capital, foreign exchange rate of the domestic currency will rise, that is, the currency of the country that adopts a higher interest rate monetary policy will appreciate. This appreciation of the currency will discourage exports and encourage imports which would have an adverse effect on balance of payments.

This will force the Central Bank of the country which is committed to maintain the exchange rate at the fixed level to intervene to prevent the appreciation of exchange rate of the national currency.

To prevent the currency from appreciation, the Central Bank will buy the foreign currency, say US dollar. This will lead to the increase in foreign exchange reserves with the Central Bank which will issue more national currency against the increase in foreign exchange reserves.

As a result, money supply in the economy will expand causing the rate of interest to fall. Thus, with the perfect mobility of capital and given a fixed exchange rate, domestic interest rate has been pushed back to the initial level.

Any attempt at independent monetary policy leads to capital flows and need to intervene until interest rates are back in line with those in the world market”.

It follows from that, given a higher degree of capital mobility across countries; interest rates cannot be very much different. The differences in interest rates beyond a point will bring about capital flows across countries that will tend to provide world level yield in all of them.

Expansionary Monetary Policy under Fixed Exchange Rate and Perfect Capital Mobility:

Let us now analyse the effect of monetary expansion under the fixed exchange rate regime using IS-LM model. Consider Figure where in panel (a) we have drawn the IS and LM curves as well as the horizontal straight line BP. The horizontal line BL= 0 at domestic interest rate i equal to foreign interest rate i_f (i = i_f) shoes that the country has neither deficit or surplus in its balance of payments, that is, its balance of payments is in equilibrium.

At any other interest rate massive capital flows will occur which will cause disequilibrium in the balance of payments and will force the Central Bank to intervene to maintain the exchange rate. To illustrate this we consider that Government adopts a policy of monetary expansion. Let the economy in panel (a) is initially at point E where the given IS-LM curves intersect at E which determines domestic rate of interest i which is equal to foreign rate of interest i_f.

With mon­etary expansion, LM curve shifts to the right and as a result the economy moves to the new equilib­rium position E’ where domestic rate of interest has fallen to i₁. At the new position E’ economy will have a large deficit in balance of payments which will exert a pressure on the exchange rate of domestic currency to depreciate.

Determination of foreign exchange rate is shown in panel (b) where initially demand curve DD and supply curve SS of US dollars determine exchange rate equal to OR (i.e. number of rupees per US dollar). When as a result of expansion in money supply, LM₁ curve shifts to the right to the new position LM and consequently domestic rate of interest falls to i₁ (panel (a), there will be large capital outflows.

These capital outflows will reduce the supply of US dollars in foreign exchange market and as a result supply curve of US dollars shifts to the left to S’S’ resulting in the new exchange rate R’ (that is, more rupees per US dollar). This means Indian rupee will depreciate. To maintain the exchange rate, the Central Bank of the country will intervene; it will sell foreign currency re­serves in the foreign exchange market.

The supply of domestic money supply in the economy will therefore decrease. As a result of this reduction in domestic money supply, LM curve will shift back to the left This process of contraction in money supply and consequent shifting back of LM curve to the left will continue until the initial equilibrium at E is reached again.

As a matter of fact, with perfect capital mobility, the economy is not likely to reach at the new equilibrium joint E’. This is because the response of capital flows is so large and quick that the Central Bank will be forced to reverse quickly the initial expansion in money supply before the new equilibrium at E’ is reached.

Conclusion:

From the foregoing analysis of Mundell-Fleming model under the fixed ex­change rate regime, it follows that when capital mobility is perfect, interest rates in the home coun­try cannot deviate from those prevailing abroad. It is quite evident from above that with perfect mobility of capital, under fixed exchange rate regime, monetary policy in a small open economy is quite ineffective to influence the levels of national income (output) and employment.

Any attempt by the central bank of the country to reduce interest rate by expansion in money supply would lead to massive outflows of capital tending to cause depreciation of the home currency. The Central Bank, which is under obligation to maintain the exchange rate at a fixed level, would buy the domes­tic currency in exchange for foreign currency.