Macroeconomics

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 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 mod-

els 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 fluc-

tuations 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

1

The quotation is from Maurice Obstfeld and Kenneth Rogoff, Foundations of International Macro-

economics (Cambridge, Mass.: MIT Press, 1996)—a leading graduate-level textbook in open-

economy macroeconomics. The Mundell–Fleming model was developed in the early 1960s.

Mundell’s contributions are collected in Robert A. Mundell, International Economics (New York:

Macmillan, 1968). For Fleming’s contribution, see J. Marcus Fleming, “Domestic Financial Poli-

cies Under Fixed and Under Floating Exchange Rates,’’ IMF Staff Papers 9 (November 1962):

369–379. Fleming died in 1976, so he was not eligible to share in the Nobel award.

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P A R T   I V

Business Cycle Theory: The Economy in the Short Run

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 includ-

ing the effects of international trade and finance discussed in Chapter 5.

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, in his original 1963 arti-

cle, explained why he made this assumption:

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 mobili-

ty 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 centers, of which Zurich, Amsterdam, and Brussels may

be taken as examples, where the authorities already recognize their lessening abili-

ty to dominate money market conditions and insulate them from foreign influ-

ences. 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 cap-

ital mobility will prove useful in developing a tractable and illuminating model.

2

One lesson from the Mundell–Fleming model is that the behavior of an econo-

my 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 pol-

icy. We begin by assuming that the economy operates with a floating exchange rate.

That is, we assume that the central bank allows the exchange rate to adjust to chang-

ing economic conditions. We then examine how the economy operates under a

fixed exchange rate. After developing the model, we will be in a position to address

an important policy question: what exchange-rate system should a nation adopt?