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Published: декабря 16, 2012

# Mundell-Fleming model: Policy Shocks

Mundell-Fleming model

Mundell-Fleming model: The Hallmarks of the Mundell-Fleming Model

Mundell-Fleming model: Diagrammatic Representation

Mundell-Fleming model: Coining of the Expression

This diagramcan be used to derive the effects of monetary policy (changes in the quantity ofmoney, causing the LL locus in figure 1 to shift) and fiscal policy (changes in the level of expenditures by government, which shift the goodsmarket clearing condition, XX in figure 1, independent of displacements caused by exchange rate changes) under fixed and flexible exchange rates. These are the central applications of the Mundell- Fleming model. The difference between these two exchange rate regimes is that under fixed exchange rates the value of the exchange rate is given, and the central bank, in pegging the exchange rate at a particular value, uses changes in the quantity of money to maintain this value. That is, for this regime the money supply becomes a variable that responds to shocks, while the value of the exchange rate does not change. In contrast, for flexible exchange rates the quantity of domesticmoney outstanding is treated as a given, and the value of the exchange rate moves reactively in order to reequilibrate the system.

The effects of expansionary monetary and fiscal policy actions can be stated easily when the exchange rate is flexible: in that case fiscal policy has no impact on output, whereasmonetary policy has the effect to which we are accustomed. These conclusions derive directly from equation (1).

If the money supply is held constant in the face of an increase in government expenditures, then the level of output does not change. With such a shock, M is fixed, and the value of l, as well, is constant, because the perfect capital mobility assumption views the interest rate as unchanging. If bothMand l are given, then Y cannot change, as equation (1) shows. This is the famous ‘‘crowding out’’ or ‘‘ineffectiveness’’ result Fleming derived, which Mundell repeats.

In contrast, changes in the money supply, due to monetary policy initiatives, cause output to change in proportion to those changes. This conclusion is an unusual but straightforward implication of the Fleming specification ofmoney demand.Once again the derivation depends on the assumption of perfect capital mobility, which causes the value of l to be given because it is a function of only the interest rate, whose value is set by world market conditions.

These results are portrayed in figure 2.Anincrease in government expenditure shifts the XX locus to the right by amultiple of theamount of increase.With its original position shown as XX, this shift generates a new position for this locus shown byX0X0, drawn as a dotted line toemphasize that this is the newdisplaced position of that curve.

If the exchange rate is fixed by the central bank, then it must provide the larger quantity of money that is required at an unchanged interest rate. As this happens, the LL locus shifts to the right; this process continues until the locus attains the position shown as L0L0. The new equilibrium is at point Q1 where output and the money supply have increased (with output now having a value shown by Y1 whereas its previous value was Y0), and the values of both the interest rate and the exchange rate are unchanged.

In contrast, the same increase in government expenditures will have no effect on output and employment if the central bank is pursuing a flexible exchange rate regime. For this case, the money supply is held constant, and the value of the exchange rate must change in order to clear the various markets. Since money demand does not depend on the value of the exchange rate, its changing value does not alter the position of LL, which continues to run through point Q0. Instead, it is the XX locus that shifts back to its original position, as the value of the exchange rate falls, in order to reequilibrate all of thesemarkets. Since the equilibrium under this exchange rate regime does not move, it is clear that any increased government expenditurescomeat the expense of exports andimports. There is complete crowding out of such expenditures, so the composition of expenditures on domestic output changes, but its total quantity does not.

This idea that with high capital mobility, fiscal policy has a more limited impact on output under flexible exchange rates than its does under fixed is usuallyassociatedwithRhomberg(1964),whodidthe original empiricalwork on the Canadian experiment with flexible exchange rates in the 1950s. He appears to have inspired Fleming’s interest in this topic, as the Canadian experience seemed to suggest that flexible exchange rates vitiated fiscal policy.Mundell, aswell, credits Rhomberg’s work in this area.

The argument is reversed for monetary policy. In this case the increase in themoney supply is the given impulse that moves the money market equilibrium locus to position L0L0. Does this locusmaintain this position, setting up an equilibrium level of output equal to Y1, or does its revert to its original position, so that output remains at Y0? The answer depends again on the exchange rate regime.

For fixed exchange rates, the quantity ofmoney in the domestic economy is used to peg the value of the exchange rate. If that value is not changed, then there is no reason why the equilibrium quantity of money should change either. Thismeans that the quantity of money quickly reverts to its former value (or perhaps does not move at all).The end result is that output is not affected by monetary policy in the fixed exchange rate case.

The quantity of money is a responding variable under a fixed exchange rate regime. So there is the logical problem that the quantity of money cannot legitimately be changed in an arbitrary fashion. As McCallum (1996) noted, one should describe this Hume impotency conclusion as demonstrating not the ineffectiveness of monetary policy, but rather its unavailability.

For flexible exchange rates, there is no commitment to keeping the value of the exchange rate at a particular peg.As a result, the decision to increase the quantity of money causes themoneymarket locus to move to the dotted position shown, L0L0. In that case the value of the exchange rate must rise to clear the various markets. As domestic currency depreciates against foreign denominations, the goods market locus shifts over to the dotted position, X0X0.Output in this case increases to Y1 showing that monetary policy is effective in influencing the level of domestic economy activity in the small country case.