The Model Dynamics and Mundell-Fleming Model - Essay Example

r IS0 IS1 LM0 LM1 r=r* E0 E* r1 E`1 0 Y0 Y1 Yf Y Mundell-Fleming Model: The famous Mundell-Fleming Model is basically a macroeconomic model of open economy regarding the policy prescriptions to solve the problem of a Balance of Payment deficit coupled with the problem of severe unemployment. There has been a long celebrated debate regarding the appropriate policy prescription and the role of the government in the period of internal and external disequilibrium. The Model dynamics: Let us start our analysis on the basis of a small open economy characterized by the existence of a flexible exchange rate regime. The exchange rate is determined by the interaction of demand and supply in the foreign exchange market. The capital market is perfectly elastic to the global capital market and capital is perfectly mobile. That implies the domestic rate of interest should be equal to the global interest rate. If there is any dispersion from the condition, that would cause a huge transfer of capital. For example if the domestic rate of interest exceeds global rate the global investors would find that investing in that country would secure higher return and hence that would be followed by a huge capital inflow and vice versa. On the other hand the capital market of the domestic country is so small that it would not influence the global capital market. In a floating exchange rate regime we cannot start our analysis from the simultaneous existence of internal and external disequilibrium as Balance of Payment is always balanced under a floating exchange rate regime. If there is any Balance of Payments disequilibrium (say deficit), the foreign exchange market and the product market play the role of automatic stabilizer. We consider a deficit; that implies an excess demand situation in the foreign exchange market. That is followed by the depreciation of domestic currency. While the domestic currency depreciates the domestic goods become cheaper in the global market and the foreign goods become dearer in the domestic market. That would result in an expenditure switching in favour of domestic product. (Marshall Lerner Condition is satisfied). Gradually the balance of trade would improve and finally the external balance would be achieved. According to the Mundell Fleming Model the government should adopt an expansionary monetary policy in that time to solve the problems simultaneously. What would happen with that expansion of money supply? It is quite natural that expansionary monetary policy would cause a rise in money in the hand of the people more than they require (excess supply situation in money market). People would start to spend that money on consumable goods (rise in consumption demand) and purchasing bonds. That would be followed by an excess demand situation in bond market. Consequently the bond price would rise. There is an inverse relationship between bond price and interest rate. Hence the rise in bond price would pull down the rate of interest. The decline in the rate of interest has two effects: 1. A decline in rate of interest always attracts the private investors to invest more as the future liability of present investment declines. So, the investment would be boosted up. That would cause a rise in aggregate demand and hence the employment level. 2. As the domestic rate of interest falls below the global interest rate the economy faces a huge outflow of capital. This would worsen the Balance of Payments situation of the economy. That implies an excess demand situation in the foreign exchange market. Consequently, there would be a depreciation of the domestic currency. The trade balance would improve gradually and the aggregate demand (and hence employment) shows a trend to increase. This process would be continued unless the internal and external balances are attained. The above logical explanation can be represented diagrammatically with the help of the above figure. In the above diagram r=r* line shows the capital market equilibrium condition. Any point above the line implies a Balance of Payments surplus through mammoth inflow of foreign capital and vice versa. The horizontal and the vertical axes measure aggregate output and rate of interest respectively. Yf represents the long run supply curve of the country any point on the supply curve represents full employment equilibrium in the economy (internal equilibrium) and any point at the left of the curve represents unemployment. Point E* is the desirable situation as it implies both internal and external disequilibrium. But the actual position of the economy is determined by the interaction of product and money markets i.e. the intersection of IS (product market) and LM (money market) curves. In the figure we start from point E0 (Intersection of IS0 and LM0). As this point is at the left of long run supply curve that implies the economy is facing an unemployment situation. Now the government adopts expansionary monetary policy. That is represented by a rightward shift in the LM curve to LM1. The equilibrium point is E1. This is below the capital market equilibrium line i.e. the economy starts to face acute balance of payments crisis. On the other hand the aggregate demand rises from Y0 to Y1 due to rise in aggregate demand through rise in the rate of interest. The balance of payments crisis is followed by the adjustment mechanism through the foreign exchange market and the product market. The rise in exchange rate causes a rise in the exchange rate. Consequently, import substitution and export promotion start. The impact is shown by the shift of IS curve from IS0 to IS1. The equilibrium is reached on the point E*. Hence we can say that the problem of internal disequilibrium can be solved by an expansionary monetary policy. The movement of Y from Y1 to Yf is the impact of the exchange rate and the product market that play the role of stabilizer. To be more precise later on the Mundell Fleming Model changed the mode of policy prescription. It was argued that the government could adopt hands off policy from the economy and it could let the economic forces work on their own. Under a flexible exchange rate regime there may be no disequilibrium in the Balance of Payments. Now if we consider the unemployment situation we can say that a neoclassical type of adjustment would take place. The excess supply situation in the labour market would pull down the real wage. The unemployed workers and the labour unions would make new contract with lower wage rates. That would certainly cause a decline in the cost of production which would be reflected by enhanced competitiveness of the domestic product in the global market. That would cause a rise in the export of domestic product and hence a rise in the aggregate demands. This automatic mechanism would ensure full employment equilibrium. In this context the famous Mundell Fleming model prescribes that to speed up the aforesaid monetary price adjustment mechanism the government can adopt the structural adjustment policy. That can be done by introducing tight monetary policy to worsen the unemployment situation immediately so that the adjustment process gets more speed. (Batiz and Batiz 1985) The IMF/World Bank also prescribes for structural adjustment policies for the solution of the problem of both internal and external disequilibrium. The matter of fact is that such policies are not much healthy for the developing economies having the problems of huge population and unemployment. It is theoretically true that the adjustment mechanism would secure full employment but nobody can say how long it would take to recover and within this period how the problem of unemployment and hunger can be solved. On the other hand the policies have some fallacies of composition. The policies are country specific in the sense that if a country, to recover itself, adopts such policies that would have some adverse effects on the other countries who sell the same types of products in the global market. Moreover, the policies are not country specific in the sense that same policies are prescribed for each economy without considering the internal market conditions. Moreover, there are many countries which sell the products with least price and income elasticity. (Sarkar 1991) Hence, for such a product, a fall in rice remains barren in solving the problem of shortage of aggregate demand. In a report published by the World Bank, it was found that the economies which adopted structural adjustment polices are more affected. References 1. Rivera-Batiz, F. L and Rivera-Batiz, L (1985), International Finance and Open Economy Macroeconomics, Macmillan Publishing Company 2. Sarkar. P, 1991, Debt Crisis of the Less Developed Countries and the Transfer Debate Once Again, Journal of Development Studies; Volume 27, 4, July Read More