Mundell-Fleming model: Diagrammatic Representation
The Mundell- Fleming model is portrayed in figure 1. On the axes are two variables central to macroeconomic performance: on the horizontal axis, Y measures domestic output (GDP) produced in the small, open economy; on the vertical axis, r is the level of domestic interest rates. Two of the loci are familiar from Hicks’s (1937) classic article: XX, representing equilibrium in the domestic goods market; and LL, representing equilibrium in the domestic assets market.
The XX locus is negatively sloped because some expenditures are sensitive to interest rates. With a higher interest rate, such expenditures are reduced, and other things being equal, this causes output to decrease. One of the variables held constant in drawing this curve is the value of the exchange rate. Defining the exchange rate as the domestic-currency price of one unit of foreign currency, we note that a rise in the exchange rate’s value tends to raise the price of foreign goods relative to domestic goods. The resulting lower relative price for domestic goods increases demand for them and, according to the Keynesian view of supply, output responds to this rise in demand at constant prices. With such a change, the XX locus would shift to the right. We proceed with the assumptions that the quantity of money in this small economy does not have a direct impact on the goods market equilibrium condition, and that the domestic-currency price level has a value which is given.
The LL locus is positively sloped, being drawn for a given quantity of money and given values of domestic- currency prices. Everywhere along this locus the quantity of money demanded is constant, consistent with its given supply, so that for these points there is equilibrium in the domestic financial assets market.The reason is that an increase in interest rates causes the quantity ofmoney demanded to be lower, since now bonds, an alternative form in which to hold funds, provide a higher yield. If this ismatched by an increase in output, then the resulting higher volume of transactions necessitates an increase in the quantity of money held. In the right proportions, these two influences onmoney demand exactly offset each other and demand is back at its original (equilibrium) value. An increase in themoney supply will cause a rightward shift in the LL curve.
The argument concerning the LL locus, for the simple case in which domestic-currency prices are taken to be constant, can be represented algebraically as follows:
M¼l (r) Y (1)
This specification is consistent with the one in Fleming, in that it assumes a unitary income elasticity of demand for money, where l is the inverse of velocity. If l depends negatively on the interest rate, then a rise in rmust bematched by a rise in Y in order to keep the product of the two factors on the righthand side of this equation constant. This is necessary in order tomaintain equality to the given value of the money supply, M, in this equation. This specification employs the assumption of the standard model that demand for money is independent of the exchange rate.
As noted, these two curves are identical to those in Hicks (1937). Hicks’s model is the basis for the simplified presentations of conventional macroeconomic theorizing, so little further discussion is needed here, except to note that the XX locus is relevant for equilibrium in the domestic goods market alone. No separate analysis needs to be carried out for themarket for imports, since this small economy is able to obtain all the foreign-produced goods it demands.
The final curve, FF, was added by Mundell to represent equilibrium in the foreign exchange market. In the perfect capital mobility case shown, this locus is horizontal: if domestic bonds are perfect substitutes for foreign bonds, then their rates of return must be equated. No matter what the level of domestic output, the yield on domestic bonds must equal the yield available from holding foreign financial instruments, denoted by rw.
The economy is assumed to start in equilibrium at point Q0, where there is clearing (so that supply and demand are equated) of all themarkets analyzed here.