11The Fleming-Mundell ModelAgenda• The Fleming-Mundell Model¾ Fiscal and Monetary Policy with Perfect Capital Mobility2Capital Mobility• The slope of the BP line indicates the degree of capital mobility in a country¾ Horizontal: perfect capital mobility• Domestic R = World R¾ Vertical: complete capital immobility• Domestic R completely independent of world R¾ Upward sloping: partial capital mobility• Domestic R differs from the world R3Policy Analysis with Perfect Capital Mobility• The Mundell-Fleming Model assumes a:¾ Small open economy with ¾ Perfect capital mobility• The BP line is horizontal4Perfect Capital MobilityYRBP5Policy Analysis with Capital Mobility• Policy Analysis with the BP Curve¾ The intersection of the IS-LM curves establishes internal equilibrium.¾ The BP curve establishes external equilibrium.¾ If joint internal and external equilibrium does not exist, then either:• The currency must appreciate or depreciate, or• The central bank must intervene to stabilize the currency6Perfect Capital MobilityYRBPIS0LM027Policy Analysis with Perfect Capital Mobility• Expansionary fiscal policy, fixed exchange rates¾ IS curve shifts right, Y and R increase.¾ Higher R increases foreign capital inflow.• Creates BP surplus and upward pressure on currency.¾ Central bank intervenes in the foreign exchange market.• Buys excess foreign currency.¾ Increases foreign exchange reserves.• Sells domestic currency.¾ Increases the domestic money supply. • That is, non-sterilized intervention.¾ LM curve shifts right, Y increases, R decreases to its original level.¾ Result is much higher Y and constant R.8Expansionary Fiscal Policy,Fixed Exchange RatesYRBPIS0LM0Y0R09Expansionary Fiscal Policy,Fixed Exchange RatesYRBPIS0LM0Y0R0IS1Y1R110Expansionary Fiscal Policy,Fixed Exchange RatesYRBPIS0LM0Y0R0 = R2IS1Y2R1LM2Y111Policy Analysis with Perfect Capital Mobility• Expansionary fiscal policy with fixed exchange rates is very powerful because it forces monetary policy to be fully accommodating.12Policy Analysis with Perfect Capital Mobility• Expansionary monetary policy, fixed exchange rates¾ LM shifts right, Y increases and R decreases.¾ Lower R decreases foreign capital outflows. • Creates BP deficit and downward pressure on currency.¾ Central bank intervenes in the foreign exchange market.• Sells foreign exchange reserves.• Buys excess domestic currency.¾ Decreases the domestic money supply.• That is, non-sterilized intervention.¾ LM curve shifts left, Y decreases and R increases to its original level.¾ Result is same Y and R.313Expansionary Monetary Policy,Fixed Exchange RatesYRBPIS0LM0Y0R014Expansionary Monetary Policy,Fixed Exchange RatesYRBPIS0LM0Y0R0R1LM1Y115Expansionary Monetary Policy,Fixed Exchange RatesYRBPIS0LM0 = LM2Y0 = Y2R0 = R2R1LM1Y116Policy Analysis with Perfect Capital Mobility• Expansionary monetary policy with fixed exchange rates is completely ineffective.17Policy Analysis with Perfect Capital Mobility• Expansionary fiscal policy, flexible exchange rates¾ IS curve shifts right, Y and R increase¾ Higher R increases foreign capital inflows.• Creates BP surplus and currency appreciates.• Stronger currency reduces net exports.¾ Lower exports, higher imports.• IS curve shifts left to its original position.¾ Result is same Y and R.18Expansionary Fiscal Policy,Flexible Exchange RatesYRBPIS0LM0Y0R0419Expansionary Fiscal Policy,Flexible Exchange RatesYRBPIS0LM0Y0R0IS1Y1R120Expansionary Fiscal Policy,Flexible Exchange RatesYRBPIS0 = IS2LM0Y0 = Y2R0 = R2IS1Y1R121Policy Analysis with Perfect Capital Mobility• Expansionary fiscal policy with flexible exchange rates is completely ineffective.¾ Exchange rate affects completely offset fiscal policy changes.22Policy Analysis with Perfect Capital Mobility• Expansionary monetary policy, flexible exchange rates• LM curve shifts right, Y increases and R decreases.• Lower R reduces foreign capital inflows.• Creates BP deficit and downward pressure on currency.• Currency depreciation stimulates net exports.• Higher exports, lower imports.• IS curve shifts right until R returns to its original level.• Result is much higher Y and constant R.23Expansionary Monetary Policy,Flexible Exchange RatesYRBPIS0LM0Y0R024Expansionary Monetary Policy,Fixed Exchange RatesYRBPIS0LM0Y0R0R1LM1Y1525Expansionary Monetary Policy,Flexible Exchange RatesYRBPIS0LM0Y0R0 = R2IS2Y2R1LM1Y126Policy Analysis with Perfect Capital Mobility• Expansionary monetary policy with flexible exchange rates is very powerful because it forces net exports to be fully accommodating.¾ Exchange rate affect compliments monetary policy adjustment.27Policy Analysis with Perfect Capital Mobility• Summary of Policy EffectivenessFixed FlexibleExchange ExchangeRates RatesMonetary Policy Completely Ineffective Extremely EffectiveFiscal Policy Extremely Effective Completely
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