The Mundell-Fleming Model: Underlying Principles

 

Basic Features of Keynesian Theory That Play a Role in Mundell-Fleming

(these points are from the Basic Economics course, and are in the reading assigned as background in 5149)

 

• Investment spending is sensitive to the interest rate.  Firms will invest more at a low interest rate than at a high interest rate.  Therefore, a low interest rate will promote strong demand in the economy and a high pace of output and income, ceteris paribus.
• The interest rate is determined by the “demand and supply for money”.  The conventional analysis of the “money market” holds that people will hold large cash balances if the interest rate is low, and smaller balances (they will be “fully invested in bonds”, for example) if the interest rate is high.
• The money supply is taken to be a given, set by Fed policy.
• The interaction of money demand and money supply determine the interest rate.
• Starting with some equilibrium output/income (GDP), fiscal policy or monetary policy actions could be used to bring about a higher/lower equilibrium output.
• During recessionary periods, expansionary policies would possibly include tax cuts, government expenditure increases, and/or increases in the money supply (which would cause a reduction of prevailing interest rates).
• During demand-pull (too much demand) inflationary periods, contractionary policies would possibly include tax increases, government spending decreases, and/or decreases in the money supply (which would cause an increase in prevailing interest rates).

 

International Economics Principles That Play a Role in the Mundell-Fleming Model

 

The exchange rate for a country tends to fall when:

• There is a growing current account deficit (trade deficit) that is not offset by a capital account surplus
• There is a capital outflow from the country due to low interest rates compared to elsewhere

The exchange rate for a country tends to rise when:

• There is an increasing current account surplus (trade surplus) not offset by a capital account deficit
• There is a capital inflow to the country due to high interest rates compared to elsewhere

If the Fed wants to raise our exchange rate (appreciation of the dollar), they must

• Buy dollars with foreign currency reserves, and/or
• Raise interest rates

 

If the Fed wants to push down our exchange rate (depreciation of the dollar) they must

• Sell dollars for other currencies, and/or
• Lower interest rastes