Question

a. Consider a small open economy with perfect capital mobility under the Mundell- Fleming framework. Discuss the effectiveness of monetary and fiscal policy under different exchange rate regimes.

b. Briefly explain some of the shortcomings of the Mundell-Fleming model..

Please provide a full answer.

Answer 1

Mundell-Fleming Model

Mundell-Fleming Model examines the impact of an expansionary policy that is fiscal measures and monetary measures in the small open economy under fixed and floating exchange rates. Mundell-Fleming model is a revised version of the IS-LM model and becomes ISLM-BoP model.

Government infuse the expenditure will force the central bank to supply the money in the market so that exchanged rate will effected and that is the case of perfect mobility. Under perfect mobility BOP curve becomes horizontal on interest rate. Under the Mundell?Fleming framework of a small economy facing perfect capital mobility, the domestic interest rate is fixed and equilibrium in both markets can only be maintained by adjustments of the nominal exchange rate or the money supply

a) Effect of fiscal and monetary policy under flexible exchange rate-

Effect of monetary policy-

a) Increase in money supply due to the expansionary policy of central bank LM curve shift from LM1 to LM2 this will decrease the interest rate of the home country from r0 to r1.

b) Due to a decrease in the interest rate of return, people start investing more in foreign countries. Therefore the exchange rate rises.

c) The rise in the exchange rate makes goods more costly in the international market Effect of fiscal policy-

Effect of fiscal measure-

a) Increase in investment due to more spending of government money shift IS curve from IS1 to IS2. This will increase the interest rate from r0 to r1.

b) Due to the increase in the interest rate of return, people start investing more in the home country this tends to fall in the exchange rate.

c) Fall in exchange rate makes domestic goods more costly.

Effect of fiscal and monetary policy under fixed exchange rate-

Effect of fiscal policy-

a) The government infuses more investment. This will raise the investment curve from IS1 to IS2.

b) The central bank fixed the exchange rate lead to a shift in LM curve from LM1 TO LM2 because money supply increases and interest rate come to initial level that is to r0 but output increase to Q2.

Effect of monetary policy-

a) Expansionary effect of monetary policy leads to a rise in money supply shifts LM curve to the right

b) To control the exchange rate central bank fixed, the exchange rate leads to reduce the money supply. Therefore LM curve shifts from LM1 to LM0 but output has reduced.

​​​​​​B) Shortcomings of Mundell-Fleming model

Firstly, this theory underlying simple assumption: it must be the established equilibrium of domestic economy; BP’s is carried out under a floating exchange rate and the price level is fixed .Foreign Y*, i* are given.

Secondly, the methodology used in the Mundell-Fleming Model is one of comparative static; making assumption to create new equilibrium is analyzed without take into account the dynamics of adjustment. Because the Mundell-Fleming Model is to show how equilibrium is affected by policy instruments. It compares equilibrium, situations in which the economy has come to rest, in which variables do not change any more and become static. This kind of reasoning is called comparative static analysis. In addition, this model can be used to analysis relatively small country; it assumes the country will not be impact on the rest of world; Mundell himself extended his own model to the large-country case (Mundell 1964). Typically, the large-country case is treated in the context of a world assume to be composed of two large country only; independence and interaction are identified and analyzed.