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International Economics and Mundell-Fleming Model: Case Study of Brunei and Bhutan - Essay Example

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The researcher of this paper explores the Mundell-Fleming model in providing a theoretical rationale for the existence at the current account imbalances experienced by Brunei and Bhutan, following their resolution to join the global financial market. …
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International Economics and Mundell-Fleming Model: Case Study of Brunei and Bhutan
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International Economics and Mundell-Fleming Model: Case Study of Brunei and Bhutan

Download file to see previous pages... It is evidently clear from the discussion that the Mundell-Fleming model revolves around the pillars of an open economy including nominal exchange rate and interest rate, and how such relationship determine the income or output of a given economy. With that in mind, economic scholars postulate that no economy can possibly preserve an independent monetary policy in the presence of a financial regime characterized by either fixed exchange rate or free capital movement. As a result, the Mundell-Fleming model ascertains that any attempts to maintain such conflicting financial systems would not survive the dynamic global financial forces. According to Foote, the strength of every economy depends largely on its Gross Domestic Product, nominal money supply and price levels. All these complementary elements are determinant factors in setting the monetary and fiscal policies including financial exchange rates and nominal interest rates. It is, therefore, possible that external forces, such as those presented by the global financial market, are bound to impact on the performance of a local economy, as argued by the proponents of Mundell-Fleming theory. Such include export prospects, foreign investment extrapolations, as well as the liquidity preference in real money demand. In line with modern economic theories, Mundell-Fleming model is based on the concept of IS-curve, where GDP equals the summation of consumption spending, investment, net exports and government spending. Moreover, the model takes into account the LM-curve where high interest rate or low GDP decreases the liquidity preference: M/P = L(i,Y) described by Waelti (2001, p.3). Considering that the supply and demand of money depends on the price levels, and that price levels are determined by GDP and exchange rates, it follows that an increase in exchange rate will lead to decrease in money supply. However, when the exchange rate is fixed, output remains relatively stable (Copeland 2008, p.63). Besides, high exchange rates are generally responsible for increased importation of foreign commodities at the expense of reduced net exports. This translates to higher consumptions spending and less physical investment spending. Thus, an economy with flexible exchange rate is bound to experience increased investment spending and higher income if it lowers its exchange rates in line with global money market demands (Foote 2011, p.17). The reverse is true if the country increases its exchange rate with changes in world economy. In that case, increase in exchange rate decreases net export which, in turn, shifts the planned expenditure downwards. The interaction results in decreased income among small economies that have imperfectly integrated. On the contrary, a fixed exchange rate would mean that a country has to find an alternative to cushion its investment prospects amidst fluctuating global financial activities. As such, reduction in real money demand for domestic currency results in higher expenditures of central bank in buying foreign currencies at the promised fixed rate. In addition, a country will have to trade at a fixed exchange ...Download file to see next pagesRead More
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