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The Open Economy Revisited: The Mundell–Fleming Model and the Exchange-Rate Regime

The world is still a closed economy, but its regions and countries are becoming increasingly open. . . . The international economic climate has changed in the direction of financial integration, and this has important implications for economic policy.

— Robert Mundell, 1963

When conducting monetary and fiscal policy, policymakers often look beyond their own country’s borders. Even if domestic prosperity is their sole objective, it is necessary for them to consider the rest of the world. The international flow of goods and services (measured by net exports) and the international flow of capital (measured by net foreign investment) can affect an economy in profound ways. Policymakers ignore these effects at their peril.

In this chapter we extend our analysis of aggregate demand to include international trade and finance. The model developed in this chapter is called the Mundell–Fleming model. This model has been described as “the dominant policy paradigm for studying open-economy monetary and fiscal policy.” In 1999, Robert Mundell, a Canadian, was awarded the Nobel Prize for his work in open-economy macroeconomics, including this model.¹

The Mundell–Fleming model is a close relative of the IS–LM model. Both models stress the interaction between the goods market and the money market. Both models assume that the price level is fixed and then show what causes short-run fluctuations in aggregate income (or, equivalently, shifts in the aggregate demand curve). The key difference is that the IS–LM model assumes a closed economy, whereas the Mundell–Fleming model assumes an open economy. The Mundell–Fleming model extends the short-run model of national income from Chapters 10 and 11 by including the effects of international trade and finance discussed in Chapter 5.

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The Mundell–Fleming model makes one important and extreme assumption: it assumes that the economy being studied is a small open economy with perfect capital mobility. That is, the economy can borrow or lend as much as it wants in world financial markets and, as a result, the economy’s interest rate is determined by the world interest rate. Here is how Mundell himself motivated this assumption in his original 1963 article:

In order to present my conclusions in the simplest possible way and to bring the implications for policy into sharpest relief, I assume the extreme degree of mobility that prevails when a country cannot maintain an interest rate different from the general level prevailing abroad. This assumption will overstate the case but it has the merit of posing a stereotype towards which international financial relations seem to be heading. At the same time it might be argued that the assumption is not far from the truth in those financial centres, of which Zurich, Amsterdam, and Brussels may be taken as examples, where the authorities already recognize their lessening ability to dominate money market conditions and insulate them from foreign influences. It should also have a high degree of relevance to a country like Canada whose financial markets are dominated to a great degree by the vast New York market.

As we will see, Mundell’s assumption of a small open economy with perfect capital mobility will prove useful in developing a tractable and illuminating model. With the interest rate determined, we can concentrate our attention on the role of the exchange rate.

One lesson from the Mundell–Fleming model is that the behaviour of an economy depends on the exchange-rate system it has adopted. Indeed, the model was first developed in large part to understand how alternative exchange-rate regimes work and how the choice of exchange-rate regime impinges on monetary and fiscal policy. We begin by assuming that the economy operates with a flexible, or floating, exchange rate. That is, we assume that the central bank allows the exchange rate to adjust to changing economic conditions. We then examine how the economy operates under a fixed exchange rate, and we discuss whether a floating or fixed exchange rate is better. This question has been extraordinarily important in recent years, as many nations around the world have debated what exchange-rate system to adopt.